I'd like to spend a few minutes discussing the outlook for both residential and commercial real estate in the context of the current regulatory focus on the banking industry's lending to these sectors of the economy.

In fact, the San Francisco Fed has a long-standing supervisory interest in real estate conditions. We helped shape the current draft interagency guidance on commercial real estate concentrations, and our institutional memory of the devastating California real estate downturn in the early 1990s remains vivid. Frankly, it would be hard to forget that period, when California had 49 commercial bank failures between 1991 and 1996, accounting for about 11 percent of the state's banks. The vast majority—as well as many banks that survived in troubled condition—had very high construction loan concentrations for either commercial or residential properties, or both.
Of course, circumstances have changed a lot since then. For example, there is now ready access to information on real estate market conditions and active secondary markets for real estate loans; and certainly, bank underwriting practices have improved significantly. While these changes have helped to mitigate risk, we can't afford to become complacent; as history has taught us, concentrations still can prove dangerous when market conditions turn.

As you know, the performance of commercial real estate and construction loans on banks' balance sheets has been excellent, largely because of low interest rates and substantial appreciation of property values. These conditions may have encouraged banks to focus new lending towards these sectors—especially construction and land development. Although California banks no longer lead the nation in construction loan concentrations—as they did in the previous real estate cycle—more than 40 percent of the state's banks exceed the benchmark ratio contained in the draft interagency guidance, which, as you know, is 100 percent of total capital.
Construction lending causes some concern at this point in the cycle because our examiners have found that much of the recent loan growth in community and regional banks is in the softening residential market. The riskiest loans are those for land acquisition and speculative development; historically, these are the first to register the effects of a slowdown in terms of weakening demand for new loans and declining quality of existing loans. If housing markets continue to slow, such banks should watch closely for signs of trouble, such as project delays, houses not selling, price discounts, condos converting to rentals, and increasing loan renewals, extensions, and refinancings. Any of these developments could have a significant impact on revenue and growth projections as well as loan losses at some banks.

As the draft interagency guidance states, we expect banks to actively manage risk concentrations in commercial real estate and construction lending. Tomorrow, Jose will discuss some of the ways that banks are enhancing their approach to credit risk concentration management. Based on what we've seen in recent examinations, I'm pleased to say that it appears that a number of banks have already implemented most of the risk management practices outlined in the proposed guidance.

We are in a period of perceived strength in economic fundamentals in the United States and many countries around the world. This strength has helped to induce significant reductions in a range of market-based perceptions of risk. Much of this confidence may prove warranted and durable, but the extent to which it endures will depend in part on the degree to which those running the major financial institutions in the United States use the opportunity presented by this period of relatively high profitability to strengthen their capacity to withstand a less favorable overall macroeconomic and financial environment.

Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries. These changes have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system and efficiency of the process of financial intermediation have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes experienced over the past two decades.

Overall, the banking industry is healthy. However, some issues warrant the attention of bankers and their supervisors. One credit risk management issue that has been in the news quite a bit lately is home mortgage lending, particularly the surge in originations of nontraditional mortgages...Banks' risk management procedures must take into account the unique characteristics and credit risk profile of these novel types of loans, especially because our experience with them is quite limited.

The evolution of financial markets and institutions has greatly affected the process of risk management. The means of managing risk have broadened dramatically, but the resulting systems could well be challenged by developments over coming years.

Among the major non-bank financial institutions, the most important part of the financial system today where we need a stronger capital regime relates to the CSEs [Consolidated Supervised Entities]. Even with the improvements in risk management at these institutions over the last few years, we are some distance from the point where their regulatory capital requirements appropriately reflect their risk.

It is important that the world’s major private financial institutions run themselves with a sufficiently strong financial cushion, a cushion calibrated not just against the risks they confront in this uncertain world, but to the much more central role they play in many markets. Particularly for those institutions whose size and scope make them systemically important, capital, liquidity, and the overall risk management and control architecture need to be exceptionally strong.