Mark Olson

As in the past, without strong risk management and credit discipline, the prolonged period of favorable conditions could breed behavior by lenders that will contribute to a more severe credit cycle the next time around.

The two perspectives on cycles in the financial services business--the performance of financial services firms in this phase of the business cycle, and what asset quality indicators tell us about the state of the economy--together suggest that growth in economic activity will continue to support favorable conditions for financial institutions for at least the near term.

We believe that by outlining what supervisors would expect, the proposed guidance gives banks a far better understanding of how to upgrade their systems, modify their procedures, and strengthen their controls in anticipation of eventual adoption of Basel II. Our hope is that, by clearly communicating expectations, we are giving both bankers and our own examiners sufficient time to prepare for the new framework.

Results from [the fourth Quantitative Impact Study] were more widely dispersed and showed a larger overall drop in capital than the agencies had expected. This was the impetus for deciding to delay the notice of proposed rulemaking for Basel II. We now have to determine whether these results arose from actual differences in risk among respondents, differences in stages of preparation (including data limitations) among respondents, limits of the QIS4 exercise, or a possible need for adjustments to the Basel framework itself.

Basel II is indeed a seminal step in the development of regulatory capital requirements. It is not necessarily the endpoint, but it does represent a substantial step forward--one that we believe will remain in place for many years to come.

In looking back, I believe Basel I, with its common definitions, common agreement on capital minimums, and the initial risk-weighting categories, has served the banking and financial community well. Indeed, there is no reason to replace Basel I for the vast majority of banks here in the United States. But our largest and most complex global banking organizations have, in a sense, outgrown Basel I.

From the Federal Reserve's perspective, delving into the results of QIS4 is an appropriate response by the agencies. But we should also acknowledge that this follow-up work has its limits. We can go only so far with the data given to us. We must recognize that banks--understandably--might not yet have their data systems ready to develop Basel II risk parameters and that it might take more time before we see Basel II parameters based on truly credible systems. But, in our view, that is not a reason to stop working.

I expect that the need for further clarification of regulations by the Federal Reserve will only grow as more innovation occurs within the payments system.

While the Federal Reserve has an interest in the smooth and secure functioning of the overall payments system, our regulatory authorities are specific to only certain operational aspects of the system, such as the interbank collection of checks, and specific consumer rights and protections, such as consumer liability for unauthorized electronic funds transfers.

The U.S. banking industry is healthy, strong, profitable, and well positioned to support economic growth and prosperity...The outlook for performance in the coming year is good. 

Bankers continue to rely significantly on the interest rate protection provided by their stable and reliable core deposit base. If recent deposit growth has been fueled by low interest rates and weakness in the equity markets, unexpected liquidity and interest rate pressures may develop if deposit customers shift funds to other investment vehicles.

As economic conditions and business loan demand have improved, we have expected and seen some degree of easing in commercial lending standards.

Supervisors have been attentive to indications that home equity lending standards and risk-management practices may not have kept up with the very rapid growth in this form of lending. Last month, the federal banking agencies issued guidance to the industry that was aimed at reinforcing sound practices for lending and credit risk management. I encourage bankers to review that guidance and consider its recommendations carefully.

Although bank consolidation largely reflects the search for efficiency and scope, it does not signal a threat to the banking charter or the community banking franchise. Consolidation and the growth of large banking organizations do not alter the fundamental competitive advantages that banks enjoy.

Bank capital ratios remain very strong.

Despite frequent reports from bankers that their compliance costs have increased significantly and that they have incurred some significant nonrecurring charges, expense control in the industry has been good.

Banks were not able to fully enjoy the benefits of growth in loans and securities, however, because banks' net interest margins narrowed further to 3.61 percent. Rising short-term interest rates, a flattening yield curve, competitive pressure on spreads, and rapid growth in assets funded with purchased money each played a role in the margin compression...This narrowing trend in margins bears watching, including the extent to which competitive pressures are playing a significant role. 

The dual banking system is critical to the remarkable diversity and flexibility of our financial system.

[Commercial real estate lending] accounted essentially for all of the asset growth at these institutions in 2003 and 2004...There is no indication at this time that the overall credit quality of CRE exposures at community banks has deteriorated, although there are signs that some underwriting standards have been under assault from competitive pressures.

The Board’s proposed amendment would authorize the Federal Reserve to pay explicit interest on contractual clearing balances and excess reserve balances, as well as required reserve balances. This authority would enhance the Federal Reserve’s ability to efficiently conduct monetary policy, and would complement another of the Board’s proposed amendments, which would give the Board greater flexibility in setting reserve requirements for depository institutions.  In order for the Federal Open Market Committee (FOMC) to conduct monetary policy effectively, it is important that a sufficient and predictable demand for balances at the Reserve Banks exist so that the System knows the volume of reserves to supply (or remove) through open market operations to achieve the FOMC’s target federal funds rate.

I will highlight the Board’s three highest priority proposals. These three proposals would allow the Federal Reserve to pay interest on balances held by depository institutions at Reserve Banks, provide the Board greater flexibility in setting reserve requirements, and permit depository institutions to pay interest on demand deposits. These amendments would improve efficiency in the financial sector, assist small banks and small businesses, and enhance the Federal Reserve’s toolkit for efficiently conducting monetary policy.

The Board [of Governors] is aware of the current and growing regulatory burden that is imposed on this nation’s banking organizations. Often this burden falls particularly hard on small institutions...The Board strongly supports the efforts of Congress to review periodically the federal banking laws to determine whether they can be streamlined without compromising the safety and soundness of banking organizations, consumer protections, or other important objectives that Congress has established for the financial system.

The payment of interest on required reserve balances, or reductions in reserve requirements, would lower the revenues received by the Treasury from the Federal Reserve. The extent of the potential revenue loss, however, has fallen over the last decade as banks have increasingly implemented reserve-avoidance techniques.

Over the past several years, there has been an explosion of new and novel mortgage products...Many of these products can be useful financial tools for homebuyers...But to the extent that these new mortgage products promote homebuying decisions that are premised on unrealistic rates of home appreciation, they raise concerns. Some borrowers may not be able to sustain such a loan over a long time horizon if the pace of home price growth moderates. In particular, when the payments on these novel mortgages adjust upward, the homebuyer may not be able to refinance such mortgages unless the home has increased in value. Homebuyers need to understand these risks and thus financial education, as well as a down payment, is a key ingredient for creating solid footing on the path to homeownership.

Effective community development involves a comprehensive approach focused not only on providing housing, but also on creating programs that increase residents' capacities to make economic contributions to the community...I believe the progress that has been made by policymakers in the field of community development over the last thirty years has been remarkable. 

Predatory lending is a serious problem that needs to be addressed in a way that preserves incentives for responsible subprime lenders so that worthy borrowers with imperfect credit can become homeowners. Constricting the market by pinpointing what might be considered predatory lending and returning to a situation where some borrowers have very limited access to credit is not an ideal solution. We want to encourage, not limit, mortgage lending by responsible lenders in low- and moderate-income markets.

The understanding that sustainable communities are as dependent on the creation of good jobs as they are on the availability of decent, affordable housing is, I believe, a relatively new construct in our political discourse.

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.

Corporate governance is more than effective risk management.

We have been in contact with many depository institutions in the affected [Gulf] areas and are carefully monitoring the situation. At this time, we have not seen evidence of significant funding difficulties or problems in balance-sheet management.

Community banks differentiate themselves by focusing on the specific needs of their local markets and by providing a high level of service and attention to the customers in those markets. [These] banks with assets of $1 billion or less continue to be quite successful.

At this point, the banking industry on the whole has shown resilience and flexibility in its response to [Hurricane Katrina]. While the challenges have by no means passed, banks appear to be taking the appropriate actions to provide their customers with access to much-needed cash and banking services.

Despite the dramatic changes in the markets for financial services products and in their regulatory framework, the banking system continues to operate well--indeed, it is thriving...Robust growth in loans and deposits has contributed to banks' strong profits, as has strong fee income, including mortgage origination and servicing revenues.

If left unchecked, persistent and widening federal government deficits will have an increasingly corrosive effect on the U.S. economy because, all else being equal, federal government borrowing takes up some of the funds that would otherwise go to finance capital accumulation or to purchase capital assets from abroad.

It is imperative that the nation come to grips with the fiscal implications of the retirement of the baby-boom generation. Creating a budget strategy and implementing policy changes to balance the federal government's budget over the long term will require hard choices, which will become more difficult the longer they are delayed.

As our September FOMC meeting followed Hurricane Katrina by approximately three weeks and was held concurrently with the formation of Hurricane Rita, I felt that there was insufficient information as well as great uncertainty about how these forces would play out in the near term. As a result, I voted to pause in the removal of policy accommodation until more was known.

Although the PAYGO budget rule, for example, appeared to help keep legislation from increasing federal deficits for a number of years, PAYGO did not provide a mechanism to deal with the long-term budget imbalances already in place. Thus, it is worth considering whether future budget rules should go beyond the scope of PAYGO and require more fundamental adjustments to spending and taxes. Clearly, there are numerous ways in which budget policy could be adjusted to bring the budget back into balance in the short run and to maintain it over the long run.

I want to emphasize that the national payments system of the United States has evolved through both private- and public-sector contributions. Both sectors have been involved in technological innovation and the development of payments infrastructure. In addition, the public sector has responded by addressing legal and other barriers that adversely affect the banking system. Together, private and public sectors have contributed to a more-efficient national payments system that facilitates greater commerce and innovation. Looking forward, market needs will ultimately shape the U.S. payments system and its direction. If the past is a guide, geography will continue to decline as an important factor in the national payments system just as it has in other areas of economic activity.

With regard to the Federal Reserve's role in promoting the growth of rural communities, the Fed is charged with maintaining credit conditions that are conducive to our nation's progress. To be sure, our main tool, monetary policy, is a blunt instrument that cannot be targeted at individual industries or regions. However, the Federal Reserve can play a critical role in creating a credit climate that fosters rural progress in general, a climate in which the inherent advantages of individual communities can be realized.  We can best promote a progressive credit climate by maintaining an environment of low inflation.

Gramm-Leach-Bliley reaffirmed as a matter of public policy that banks continue to be regarded as special. But the act offers a clear acknowledgment that the separation of banking and commerce is not a bright line but is instead a negotiated compromise--one that will continue to move as markets change and products are refined. The guiding consideration in this compromise will be the protection of the federal deposit insurance fund.

[T]hat is a key role for banks in a crisis: to obtain funds--through the discount window or from open market operations, if necessary--and to channel them to those needing funds, based on an assessment of their creditworthiness. Banks' access to the discount window and the payments system, as well as their ongoing relationships with customers and their credit-evaluation skills, allow them to play this role. During a crisis, those banks that play critical roles in the payments system are especially important. As a result, these banks are expected to be very resilient. Though banks now have a smaller role in transmitting monetary policy, they still help to transmit policy actions by arbitraging between the federal funds market and other money markets.

My observation is that the significant deficiencies in mutual fund practices resulted from a combination of factors and a breakdown in controls. First, mutual fund activities were not being effectively overseen by their mutual fund boards. Second, there were strong financial incentives at certain firms to increase the profitability of mutual fund activities, but the legal and reputational risks of these incentives were not appropriately addressed. Third, a lack of adequate employee training resulted in employees deviating from standard procedures, in order to accommodate certain large customers.

It is always a good idea to shine some light on areas historically labeled "low risk" to validate that assessment. The low occurrence of loss from an activity should not be the only factor considered when assessing risk.

The general contour of economic activity that most forecasters are expecting, in which they see little change in resource utilization over the year, should be consistent with relatively stable core inflation. As I noted earlier, the unemployment rate is now at a five-year low of 4-3/4 percent. More important, it and other indicators of resource utilization--such as the industrial capacity utilization rate--are now at levels at which, in the past, little or no economic slack remained. At this point, we have seen few signs of upward pressure on labor compensation or core inflation. Although we have experienced run-ups in prices of commodities, such as building supplies, that are more sensitive to changes in supply and demand conditions and in prices of energy-intensive commodities and services, the pass-through to core inflation appears to have been limited.

Because compliance failures have touched many businesses, including banking, securities, and insurance firms, it has become clear that companies operating in more than one type of business must have a compliance strategy that is both globally consistent and locally effective. Increasingly, large, complex organizations are taking an enterprise-wide compliance-risk management approach to augment and better coordinate what had been fragmented and duplicative compliance activities.

A successful compliance-risk management program starts at the top of the organization. It is essential that the board of directors take the lead by requiring a top-to-bottom compliance culture that is well-communicated and incorporated into the organization's day-to-day operations by senior management, in order to ensure that all staff members understand their compliance responsibilities and their roles in implementing the enterprise-wide program.

To be sure, most forecasters are expecting the overall pace of economic activity to moderate to a more sustainable pace in coming quarters as housing markets gradually cool and the delayed effects of higher interest rates and energy prices temper domestic demand. However, with economic activity abroad expanding at a solid pace, export sales should provide some support for domestic production.

The outlook for business investment should remain quite favorable even as the pace of overall activity moderates. Against a backdrop of sustained growth in sales, businesses should be well positioned to undertake potentially profitable projects.

The Federal Reserve’s most recent survey of bank lending practices, which was conducted in April, indicates that domestic banks are noticing increases in requests for business loans. They also indicated an increased willingness to supply business loans in an environment of brisk competition from other lenders, a liquid secondary market for business loans, and an increased tolerance for risk.

While all banking organizations should have a program in place to effectively manage compliance risk, these programs can vary considerably, depending on the size, complexity, and geographic reach of the banking organization and the inherent risks of its activities...Therefore, our supervisory expectations regarding an organization's risk-management program, and more specifically the scope of an examination, will vary according to the organization's size and complexity.

Federal Reserve examinations for compliance-risk management are not designed to be gotcha games in which examiners look for one-time breaches of specific regulations or laws. Rather, these examinations are designed to assess the adequacy of the structure and processes the institution uses for managing compliance risk. Examiners are expected to look for the bigger picture and to look at the effectiveness of the program (including policies and processes) for managing the organization's compliance risk.

Today, the focus of the discussion has shifted from which consumers get home loans to the terms on which consumers get home loans--but the essential concern about the possible role of illegal discrimination is the same.

The enhanced ability of lenders to assess credit risk gave rise to a segment of the mortgage market often referred to as subprime lending.  In the subprime market, higher-risk borrowers pay higher prices.  Subprime lending has grown rapidly, from less than 5 percent of all mortgage lending in 1994 to an estimated 20 percent in 2005, or over $600 billion.  The wider range of loan pricing available in the subprime market helped to expand consumers’ homeownership opportunities and to increase their access to home equity.  But this same price variability has raised concerns about unequal treatment of borrowers.  It also has raised concerns about whether certain loan terms and lending practices are appropriate, whether consumers have the ability and knowledge to shop for the most beneficial loan terms, and whether the subprime market is sufficiently competitive.

The Board responded to these concerns by amending Regulation C, the regulation that implements HMDA, to expand the available data on higher-priced lending.  The data released by the FFIEC in September 2005, which covered lending activity in 2004, contained the first loan-level information on loan pricing ever available to the general public.  The data contain price information for loans whose prices exceeded thresholds set by the Board.  The thresholds were selected to target segments of the home loan market that have raised the most concern, taking into consideration the cost and burden of reporting.  The thresholds generally correspond to an unofficial line separating the prime and subprime markets.  But that line of separation is not always clear, and its correspondence with the reporting thresholds is in any event imprecise.  Therefore, we call loans whose prices exceed the reporting threshold "higher-priced loans" rather than "subprime loans."

[I]t is the abusive end of the spectrum that has drawn so much attention and generated the discussion about discrimination in pricing and terms.

Although the line between legitimate and predatory subprime loans is often fuzzy, it is clear that some lenders make subprime loans with the intent of separating borrowers from the equity in their homes. Borrowers with good credit ratings have a dizzying array of mortgage loan products to choose from. For those with poor credit ratings or those who may be unfamiliar with financial-service providers and products, the choices are even more baffling. And because of the many different ways in which lenders might disclose information about this array of products, even knowledgeable borrowers who are familiar with the process and who have shopped diligently may not feel certain that they have gotten the loan that is best for them.