Let me emphasize that it is too early to determine the degree that consumers will be restrained by credit availability in the current situation. But such trends will be easier to detect sooner and more accurately if the central bank has supervisory engagement with financial institutions.   

In sum, understanding banks is critical to understanding how financial shocks can be transmitted to the real economy. Unfortunately, understanding how banks are likely to respond to problems requires far more than published financial statements. While U.S. banks report detailed information on their balance sheets and their income statements, these reports do not provide sufficient information to allow central banks to really discern how banks are responding to problems.

When times are good, as they have been for many years and banks appear well-capitalized, it is very difficult for bank supervisors to convince bankers to heed warnings that they need to behave differently. Indeed, in many situations, there may be no legal basis for requiring a change in business or lending practices. Thus I don't think we can expect expanded supervision to prevent the types of financial excesses we have seen in recent years.

In the area of supervision, I would offer two thoughts. First, the current financial crisis reinforces the importance for a central bank to have accurate and timely information on the conditions of all institutions that might make use of its liquidity facilities. Personally, I believe this is most likely to happen when the central bank has ongoing supervisory responsibilities for all institutions eligible to use its liquidity facilities. Thus, I am not a supporter of the removal of supervisory responsibilities from central banks as has happened in a number of countries. If this separation is in effect, or segmented as it is in the United States, I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.

There probably will be some bank failures. There are, for example, some small, or, in many cases, de novo banks that are heavily invested in real estate in locales where prices have fallen and therefore they would be under some pressure.  So I expect there will be some failures.  Among the largest banks,  the capital ratios remain good. And I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.

From the Q&A session

As the mortgage industry has diversified, increasing coordination among regulators has been helpful. In particular, our need to cooperate with state bank regulators has increased in importance, and we have responded to that need.

Markets do tend to self-correct.  In response to the serious financial losses incurred by investors, the market for subprime mortgages has adjusted sharply.  Investors are demanding that originators employ tighter underwriting standards, and some large lenders are pulling back from the use of brokers.  The reassessment and resulting increase in the attention to loan quality should help prevent a recurrence of the recent subprime problems. 

Clearly, banking supervision on its own can create some distortions or burden, so it is also very important to let market forces work as much as possible, with reliance on market participants--in their role as depositors, counterparties, creditors, and shareholders--to exercise discipline on banks.  Policymakers have to find the right balance between the more visible hand of government supervision and the invisible hand of market forces. 

Most recently, supervisory guidance has emphasized the added dimension of risk when higher-risk loans are combined with other features--such as the use of simultaneous second lien loans in lieu of a down payment or the use of underwriting that involves little or no documentation of income or assets. Guidance has also underscored the safety and soundness and consumer protection concerns prompted by other underwriting practices often seen in subprime and nontraditional mortgage lending, such as excluding taxes and insurance in the underwriting process and allowing deferred repayment of principal by offering interest-only loans. Finally, this supervisory tool has been used to urge creditors to work with homeowners who are unable to make mortgage payments.

Again, from the Federal Reserve's perspective, our principal concern is the safety and soundness of the banking system. What we have done recently is worked with other regulators, such as the SEC and the OCC, and in some cases, also with foreign regulators -- the FSA in the U.K., for example, and German and Swiss regulators -- to do what we call horizontal reviews, which is that, collectively, we look at the practices of a large set of institutions -- both commercial banks and investment banks -- to see how they're managing certain types of activities, for example, the financing of leverage buyouts, equity -- bridge equity -- and the like, and trying to make an evaluation of what are best practices, trying to give back information back to the companies and trying to use that -- those reviews to inform our own supervision.

And so we are very aware of these issues from the perspective of the risk-taking by large financial institutions, and we are studying them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance.

The Board believes that the "Principles and Guidelines Regarding Private Pools of Capital" issued by the President's Working Group on Financial Markets (PWG) in February provides a sound framework for addressing these challenges associated with hedge funds, including the potential for systemic risk.¹ The Board shares the considered judgment of the PWG: the most effective mechanism for limiting systemic risks from hedge funds is market discipline; and, the most important providers of market discipline are the large, global commercial and investment banks that are their principal creditors and counterparties.

Another area of possible financial risk that we are watching is leveraged lending.  Business borrowing for mergers and acquisitions and for corporate refinancing has been quite robust over the past few years as firms have taken advantage of relatively low interest rates to reduce their cost of capital.  As underwriters have brought these deals to the market, the good earnings of corporate borrowers and several years of very low defaults have encouraged lenders and investors to fund hundreds of billions of dollars in leveraged loans.  However, with this growth we are seeing some trends in the leveraged loan market that warrant closer monitoring:  Deals continue to be structured with thin pricing, more leverage, and looser covenants than is typical for non-investment-grade borrowers.  Further, originating banks are capitalizing on the strong investor demand for these loans by underwriting to distribute them, including through securitization, while holding only nominal exposures themselves. 

Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit. We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers. At the same time, we must be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers.

What about borrowers already in distress?  The Board and other federal supervisory agencies have taken actions to encourage the banks and thrift institutions we supervise to work with borrowers who may be having trouble meeting their mortgage obligations.  Often, loan workouts are in the interest of both parties.  With effective loan restructuring, borrowers facing temporary economic setbacks may be able to work through their problems while staying in their homes, and lenders may be able to avoid the costs of foreclosure and the losses usually associated with selling a repossessed home.

In terms of the financial cushions, the challenge is to sustain a level of capital and liquidity that is large enough to withstand a more adverse financial and economic environment than we have experience recently. Here the job of the risk management discipline is to try to compensate for failure of imagination, to counteract the gravitational effect on measured exposure produced by recent history, and to try to anticipate the adverse effects on market liquidity that may come with a shock. This requires a healthy skepticism about models, discipline and care in the face of competitive pressures, and humility about what we can know about the future.