Senate Hearing, 111TH Congress - Examining The State of The Banking Industry

S. HRG.
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EXAMINING THE STATE OF THE

BANKING INDUSTRY
HEARING
BEFORE THE
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS
OF THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
THE CURRENT CONDITIONS OF KEY FINANCIAL INSTITUTIONS AND
EXAMINING THE CONTINUING CHALLENGES THESE INSTITUTIONS
FACE
OCTOBER 14, 2009
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota
RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island
ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky
EVAN BAYH, Indiana
MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii
BOB CORKER, Tennessee
SHERROD BROWN, Ohio
JIM DEMINT, South Carolina
DAVID VITTER, Louisiana
JON TESTER, Montana
MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin
KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
EDWARD SILVERMAN, Staff Director
WILLIAM D. DUHNKE, Republican Staff Director and Counsel
DEAN SHAHINIAN, Senior Counsel
JULIE CHON, Senior Policy Adviser
MARK OESTERLE, Republican Chief Counsel
HESTER PEIRCE, Republican Senior Counsel
DAWN RATLIFF, Chief Clerk
DEVIN HARTLEY, Hearing Clerk
SHELVIN SIMMONS, IT Director
JIM CROWELL, Editor
SUBCOMMITTEE
ON
FINANCIAL INSTITUTIONS
TIM JOHNSON, South Dakota, Chairman

MIKE CRAPO, Idaho, Ranking Republican Member
JACK REED, Rhode Island
ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York
MIKE JOHANNS, Nebraska
EVAN BAYH, Indiana
KAY BAILEY HUTCHISON, Texas
ROBERT MENENDEZ, New Jersey
JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii
JIM DEMINT, South Carolina
JUDD GREGG, New Hampshire
JON TESTER, Montana
HERB KOHL, Wisconsin
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
LAURA SWANSON, Staff Director
GREGG RICHARD, Republican Staff Director
(II)
CONTENTS
WEDNESDAY, OCTOBER 14, 2009
Page
Opening statement of Chairman Johnson .............................................................

Prepared statement ...................................................................................
Opening statements, comments, or prepared statement of:
Senator Crapo ...................................................................................................
Senator Merkley ...............................................................................................
Senator Bunning ...............................................................................................
Senator Warner ................................................................................................
Senator Brown ..................................................................................................
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WITNESSES
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation ....................
Prepared statement ..........................................................................................
Responses to written questions of:
Senator Crapo ............................................................................................
John C. Dugan, Comptroller of the Currency, Office of the Comptroller of
the Currency .........................................................................................................
Senator Crapo ............................................................................................
Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve
System ...................................................................................................................
Senator Crapo ............................................................................................
Senator Vitter ............................................................................................
Deborah Matz, Chairman, National Credit Union Administration .....................
Senator Crapo ............................................................................................
Timothy T. Ward, Deputy Director, Examinations, Supervision, and Consumer Protection, Office of Thrift Supervision ..................................................
Senator Crapo ............................................................................................
Joseph A. Smith, Jr., North Carolina Commissioner of Banks, on behalf
of the Conference of State Bank Supervisors ....................................................
Senator Crapo ............................................................................................
Thomas J. Candon, Deputy Commissioner, Vermont Department of Banking,
Insurance, Securities, and Health Care Administration, on behalf of the
National Association of State Credit Union Supervisors ..................................
Senator Crapo ............................................................................................
(III)
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EXAMINING THE STATE OF THE

BANKING INDUSTRY
WEDNESDAY, OCTOBER 14, 2009
U.S. SENATE,
SUBCOMMITTEE ON FINANCIAL INSTITUTIONS,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Subcommittee met in room SD538, Dirksen Senate Office
Building, Senator Tim Johnson, Chairman of the Subcommittee,
presiding.
OPENING STATEMENT OF SENATOR TIM JOHNSON
Senator JOHNSON. As Congress and this Committee continue its

work to stabilize financial institutions and promote our Nations
economic recovery, I have called this hearing today for regulators
to give us an update on the current conditions of the financial institutions in our country. It is vital that we know what continuing
challenges and concerns our Nations institutions face. Specifically,
I continue to be concerned about the lending environment for small
businesses, the capital needs of institutions, and the impact of commercial real estate and other loan portfolios on balance sheets. In
addition, while many of the large banks in our country have stabilized, the FDICs list of troubled banks, many of them small community banks, is growing.
While restructuring our Nations regulatory system is this Committees top priority, I do not think we can do that without a clear
understanding of what is happening within the sector. Concerns
and problems within individual financial institutions will still exist
even with a new regulatory structure. Continuing to ensure the
safety and soundness of viable institutions and the overall financial
stability of our Nations economy is vital to protecting all Americans pocketbooks, savings, and retirement.
I want to thank the witnesses for being here today, and I look
forward to hearing from each of you regarding any developing
trends or concerns within the banking industry or throughout the
economy, and to hear of the regulatory or supervisory steps your
agencies are taking to respond to these challenges.
I will now turn to Senator Crapo for his opening statement.
STATEMENT OF SENATOR MIKE CRAPO
Senator CRAPO. Thank you very much, Mr. Chairman, for holding this hearing to examine the current status of the banking and
credit union industry. Failures of small banks continue to grow,
(1)
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and the key trouble spots are looming, such as commercial real estate loans.
According to a recent New York Times article, about $870 billion,
or roughly half of the industrys $1.8 trillion of commercial real estate loans, now sit on the balance sheet of small and medium-sized
banks. I am interested in learning to what extent the TALF, or
Term Asset-backed Securities Loan Facility, encouraged capital to
enter the commercial real estate market and what other steps regulators can and should take to address this problem.
Many community banks and credit unions have tried to fill the
lending gap created by the credit crisis. Even with these efforts, it
is apparent that many consumers and small businesses are not receiving the lending they need to refinance their home loan, to extend or keep their current business line of credit, or to receive capital for new business opportunities.
Regulators need to be mindful that they strike the appropriate
balance to bolster capital and meet the credit needs of our economy, and FASBs new rules on off-balance sheets will create challenges on this point.
As we begin to explore options to modernize our financial regulatory structure, it is important that our new structure allows financial institutions to play an essential role in the U.S. economy
by providing a means for consumers and businesses to save for the
future, protect and hedge against risk, and promote lending opportunities.
Again, Mr. Chairman, I thank you for holding this hearing. I look
forward to working with you and others on these issues.
Senator JOHNSON. Senator Merkley. And I encourage members to
be brief since there are seven panelists and many questions to be
asked.
STATEMENT OF SENATOR JEFF MERKLEY
Senator MERKLEY. Thank you very much, Mr. Chair, for holding
this hearing on the state of the banking industry. I want to be very
clear that I am concerned about the effect of this crisis on our community banks. Our national economic crisis was sparked by the
preemption of State predatory lending laws, the sale of mortgages,
and certainly the securitization of these mortgages by Wall Street.
But it is our community banks who have been hit with repeated
FDIC assessments, who have seen asset values fall, and who have
seen their regulators tighten the noose. Unlike institutions that
were deemed too big to fail, our community banks apparently are
deemed small enough to fail.
Despite the fact that community banks had little to do with causing our crisis, our community banks have been unable to lend.
They are stuck with a Catch-22 situation where private sector investors are unwilling to deploy money unless the banks have TARP
money in them, and TARP will not go into small banks out of concern for capitalization. Instead, the small banks are told to raise
more money.
I was very skeptical of TARP when first authorized because I felt
it was focused too much on our Nations largest banks. Now, given
the crisis we are facing in Oregon and across the Nation, it is apparent that we need to speed credit access to the economy, and I
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believe that we need to support the recapitalization of our community banks as one of the best ways to get capital flowing to Main
Street and get job growth started in our economy.
Mr. Chair, over the next days and weeks, I will look forward to
working with you and members of the Subcommittee and full Committee to figure out ways to break this gridlock and get capital
flowing back to our community banks.
Senator JOHNSON. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator BUNNING. I have no opening statement. I want to get to

questions. Thank you.
Senator JOHNSON. Thank you.
Senator Warner.
STATEMENT OF SENATOR MARK WARNER
Senator WARNER. I know we have got a lot of panelists. I will

wait for my questions as well.
Senator JOHNSON. Senator Brown.
STATEMENT OF SENATOR SHERROD BROWN
Senator BROWN. Thank you, Mr. Chairman, and I will be brief.

Yesterday, I had a roundtable of 15, 16, 17 small manufacturers
in my boyhood home town of Mansfield, Ohio, a community of
50,000 that has lost a lot of manufacturing jobs, as much of the
Midwest and much of the country have. Over and over, the discussion turned to they cannot get credit. You know that. Small business generally cannot get credit. Manufacturers have even more
trouble getting credit than other small businesses, and auto chain
manufacturers, auto supply chain manufacturers have even more
trouble getting credit than other manufacturers.
They typically went around the table and blamedthey did not
blame the banks. They mostly blamed regulators, of course. I hope
that we learn in this hearing what we can do as policymakers to
increase the flow of credit, especially to manufacturers. It sort of
goes without saying that pulling us out of this recessionat least
in historical terms, what pulls us out of recessions are housing and
manufacturing, especially auto manufacturing, understanding more
in my State than some others. But it is particularly important that
manufacturing get the credit it needs. They have people to sell to
more and more. They have people that are working 30 hours that
want to work 40, and then they want to hire more people. But they
cannot do any of that. They have got skilled workers, obviously, but
they cannot do any of that unless credit is more liquid to them.
So I ask your assistance in that. I said they blame the regulators. I do not necessarily. I think banks are fearful and cautious,
for good reasons sometimes, and sometimes not so good reasons.
But we are counting on you.
Thanks.
Senator JOHNSON. Senator Tester.
[No response.]
Senator JOHNSON. I would like to welcome our witnesses. I appreciate your taking the time out of your busy schedules to be here
today.
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Today our panel of witnesses includes: Sheila Bair, Chairman of
the Federal Deposit Insurance Corporation; John Dugan, Comptroller of the Office of the Comptroller of the Currency; and Governor Dan Tarullo, member of the Board of Governors of the Federal Reserve System. We are also welcoming Debbie Matz, Chairman of the National Credit Union Administration, to the panel for
the first time since her confirmation over the summer.
I would also like to welcome Timothy Ward, Deputy Director of
Examinations, Supervision, and Consumer Protection at the Office
of Thrift Supervision; Joseph Smith, the North Carolina Commissioner of Banks, on behalf of the Conference of State Bank Supervisors; and Thomas Candon, Deputy Commissioner of the Vermont
Department of Banking, Insurance, Securities, and Health Care
Administration, and Chairman of the National Association of State
Credit Union Supervisors.
While many of you have already been before the Committee
many times this year on various topics, today we are continuing
the important conversation of the state of the banking sector. I will
ask that the witnesses please limit their testimony to 5 minutes.
Your full statements and any additional materials you may have
will be entered into the record.
Chairman Bair, please begin.
STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL
DEPOSIT INSURANCE CORPORATION
Ms. BAIR. Thank you. Chairman Johnson, Ranking Member

Crapo, and members of the Committee, I appreciate the opportunity to testify on behalf of the FDIC regarding the condition of
the banking industry and the measures being taken by the FDIC
to address the challenges facing us in the current environment. We
meet today just 1 year after the historic liquidity crisis in global
financial markets that prompted an unprecedented response on the
part of governments around the world.
The financial landscape today is more stable than a year ago.
Conditions appear to be moderating, and the liquidity of financial
markets has improved. Even as we seek to end the extraordinary
programs that were effective in addressing the liquidity crisis, we
recognize that much more work needs to be done to meet the credit
needs of households and small businesses.
There is evidence that the U.S. economy is growing once again,
but bank performance typically lags behind economic recovery, and
this cycle is no exception. High levels of distressed assets have led
to weak financial performance at many FDIC-insured institutions.
These have been concentrated in three main areas: residential
mortgage loans, construction loans, and credit cards. Continued
high unemployment threatens to keep loss rates elevated for an extended period. As the economy improves, however, loss rates should
moderate.
Looking forward, the most prominent risk during the next several quarters is commercial real estate. Property cash-flows are
falling due to declining rents and rising vacancies. Also, falling
property prices will make it difficult for some borrowers to renew
their financing.
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Given the substantial challenges faced by financial institutions,
the FDIC maintains a balanced supervisory approach that focuses
on strong oversight but remains sensitive to economic and real estate market conditions. We support banks efforts to lend to creditworthy borrowers and to work constructively with existing borrowers to restructure loans where appropriate.
I have heard reports that examiners are requiring banks to write
down sound performing loans. I can assure you that that is not the
policy of the FDIC. The Federal banking agencies are finalizing
guidance on commercial real estate loan workouts that will make
that clear.
The FDIC has expressed support for making loans to creditworthy borrowers in numerous industry forums and in last Novembers interagency statement. In particular, banks should continue
to provide credit to small businesses, an engine of growth that creates jobs.
Poor credit quality and weak earnings have led to a surge in
bank and thrift failures. So far this year, we have had 98 failures.
While we do not expect failures at the levels experienced in the late
1980s and early 1990s, our loss rates have been significant.
To address adverse market conditions, the FDIC has employed
additional resolution strategies that proved successful in the 1990s:
loss-sharing agreements and structured transactions. These arrangements allow the FDIC to quickly return assets to the private
sector, obtain better pricing, and minimize disruption to borrowers
and communities from a bank failure. They save money for the deposit insurance fund and streamline our resolution workload.
As a result of increased bank failures, the deposit insurance fund
is projected to need a new infusion of cash next year. To meet the
funds liquidity needs, we are seeking public comment on a proposal to collect $45 billion through a prepayment of deposit insurance assessments instead of a special assessment.
In addition, we are implementing a restoration plan that should
return the fund to a positive balance in 2012 and the reserve ratio
to the minimum of 1.15 percent within the statutory 8-year timeframe.
The FDIC will continue protecting insured depositors as we have
for over 75 years. No depositor has ever lost a penny of insured deposits and never will.
In closing, I would urge Congress to consider the impact of any
new legislative initiatives on the structure of the banking industry
as we emerge from this crisis. If reform measures perpetuate too
big to fail, there will be a further trend toward consolidation into
large and more complex institutions at the expense of smaller and
more transparent competitors.
I urge Congress to implement policies that will assure continuation of a robust community banking sector, and when institutions
do fail, as some inevitably will, we need a strong resolution authority that will assure market discipline on all institutions, large and
small.
Thank you very much.
Mr. Dugan.
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STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE OF THE COMPTROLLER OF THE CURRENCY
Mr. DUGAN. Thank you, Chairman Johnson, Senator Crapo, and

members of the Subcommittee. I am pleased to testify on the current condition of the national banking system, including trends in
bank lending, asset quality, and problem banks. The OCC supervises over 1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and
thrifts, holding just over 61 percent of all bank and thrift assets.
As described in my written statement, the OCC has separate supervisory programs for large, mid-sized, and community banks that
are tailored to the unique challenges faced by each.
Today I would like to focus on three key points.
First, despite early signs of the recession ending, credit quality
is continuing to worsen across almost every class of asset in banks
of almost every size. The strains on borrowers that first appeared
in the housing sector have spread to other retail and commercial
borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs. In many cases, this declining asset quality reflects risks that have been built up over
time.
While we are seeing some initial signs of improvement in some
asset classes, as the economy begins to recover, it will take time
for problem credits to work their way through the banking system
because credit losses often lag behind the return to economic
growth.
Second, it is very important to keep in mind that the vast majority of national banks are strong and have the financial capacity to
withstand declining asset quality. As I noted in testimony before
the full Committee last year, we anticipated that credit quality
would worsen and that banks would need to further strengthen
their capital and loan loss reserves. Net capital levels in national
banks have increased by more than $186 billion over the last 2
years, and net increases to loan loss reserves have exceeded $92
billion.
While these increases have considerably strengthened national
banks, we anticipate additional capital and reserves will be needed
to absorb additional potential losses in banks portfolios. In some
cases, that may not be possible, however, and as a result, there will
continue to be a number of smaller institutions that are not likely
to survive their mounting credit problems.
In these cases, we are working closely with the FDIC to ensure
timely resolutions in a manner that is least disruptive to local communities.
Third, during this stressful period, we are extremely mindful of
the need to maintain a balanced approach in our supervision of national banks. We strive continually to ensure that our examiners
are doing just that. We are encouraging banks to work constructively with borrowers who may be facing difficulties and to make
new loans to creditworthy borrowers, although it is true that in todays weaker economic environment, credit demand among businesses and consumers has significantly declined. And we have repeatedly and strongly emphasized that examiners should not dic-
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tate loan terms or require banks to charge off loans simply due to
declines in collateral values.
Balanced supervision, however, does not mean turning a blind
eye to credit and market conditions or simply allowing banks to
forestall recognizing problems on the hope that markets or borrowers may turn around. As we have learned in our dealings with
problem banks, a key factor in restoring a bank to health is ensuring that bank management realistically recognizes and addresses
problems as they emerge, even as they work with struggling borrowers.
One area where national banks are stepping up efforts to work
with distressed borrowers is in foreclosure prevention. Our most recent quarterly report on mortgage metrics shows that actions by
national bank servicers to keep Americans in their homes rose by
almost 22 percent in the second quarter. Notably, the percentage
of modifications that reduced monthly principal and interest payments increased to more than 78 percent of all new modifications,
up from about 54 percent the previous quarter. We view this as a
positive development since modifications that result in lower
monthly payments are less likely to redefault.
While many challenges lie ahead, especially with regard to the
significant decline in credit quality, I firmly believe that the collective measures that Government officials, bank regulators, and
many bankers have taken in recent months have put our financial
system on a much more sound footing. The OCC is firmly committed to a balanced approach that encourages bankers to lend and
to work with borrowers in a safe and sound manner while recognizing and addressing problems on a timely basis.
Thank you.
Senator JOHNSON. Thank you, Mr. Dugan.
Mr. Tarullo.
STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. TARULLO. Thank you, Mr. Chairman, Senator Crapo, members of the Subcommittee. Let me begin by echoing a few points
that my colleagues made in either their written or oral statements.
First, compared to the situation of 8 to 12 months ago, the financial system has been significantly stabilized. The largest banking
institutions, each of whose financial conditions was evaluated in
our stress tests and then announced to markets and the public,
have raised $60 billion in capital since last spring. We continue to
see a narrowing of spreads in some parts of the market, such as
corporate bonds, and in short-term funding markets.
Second, however, important segments of our credit system are
still not functioning effectively. Many securitization markets have
had trouble restarting without Government involvement. Lending
by commercial banks has declined through much of 2009. This decline reflects both weaker demand and tighter supply conditions,
with particularly severe consequences for small and medium-sized
businesses, which are much more dependent on banks than on the
public capital markets that can be accessed by larger corporations.
Banks will continue to suffer significant losses in coming quarters as residential mortgage markets continue to adjust. Losses on
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CRE loans, which represent a disproportionate share of the assets
of some small and medium-sized banks, are likely to climb. The
strains on these banks, when added to the more cautious underwriting typical of recessions, compound the problems of small businesses that rely on community banks for their borrowing.
Third, it is important that bank supervisors take an even-handed
approach in examining banks during these stressful times. We certainly do not want examiners to exacerbate the problems of declining CRE prices and restricted availability of credit by reflexively
criticizing loans solely because, for example, the underlying collateral has declined in value. At the same time, we do not want supervisory forbearance that will put off inevitable losses, which may
well increase over time, with attendant implications for the Federal
Deposit Insurance Fund.
So it is relatively easy to summarize the situation and state the
problem. The question on everyones mind is when and how it can
be ameliorated. There are no easy answers, but let me offer a few
observations.
We as banking regulators should certainly redouble our efforts to
ensure that the even-handed guidance we are issuing in Washington will be implemented faithfully by our examiners throughout
the country. But we should not fool ourselves that even the best
implementation of this policy will come close to solving the problems caused by significantly reduced demand for commercial properties that were in many cases highly leveraged on the assumption
of rising asset prices.
The problems lie deeper. In a weak economy that has, in turn,
weakened many of our banks, supervisory guidance is neither appropriate for, nor effective as, an economic stimulus measure. At
the most basic level, the strengthening of CRE markets and a return to a fully healthy banking system depend on growth in the
economy as a whole, and particularly on a reduction in unemployment.
I believe that the most important Federal Reserve action to promote CRE recovery is through our monetary policy. Our actions to
date have helped return the Nation to growth sooner than many
have expected. Nonetheless, because economic performance remains relatively weak, the Federal Open Market Committee indicated after our last meeting that conditions are likely to warrant
exceptionally low levels of the Federal funds rate for an extended
period.
The Federal Reserve has also taken a series of steps to increase
liquidity for financing capital of interest to consumers and small
businesses, including the TALF program, which we recently extended through March, with a longer extension for commercial
mortgage-backed securities.
I suspect, though, that more direct efforts may be needed to
make credit available to some creditworthy small businesses. Congress and the Administration may wish to consider temporary targeted programs while conditions in the banking industry normalize.
Thank you very much, Mr. Chairman.
Ms. Matz.
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STATEMENT OF DEBORAH MATZ, CHAIRMAN, NATIONAL
CREDIT UNION ADMINISTRATION
Ms. MATZ. Thank you, Chairman Johnson, Senator Crapo, and

members of the Subcommittee. I am pleased to provide NCUAs
views on the state of the industry.
As you have heard from my counterparts, the stress on the entire
financial sector has translated into a challenging time for financial
institutions, including credit unions. Nonetheless, I am confident
that credit unions can and will weather the storm.
Corporate credit unions pose the most serious challenges to the
credit union industry. Corporate credit unions are wholesale credit
unions created by retail credit unions to provide investment services, liquidity, and payment systems. For four decades, this system
worked well. However, in 2008, corporate exposure to mortgagebacked securities created tangible liquidity difficulties. In response
to a growing crisis, NCUA asked Congress to increase the borrowing ceiling on our back-up liquidity sourcethe Central Liquidity Facility. Congress granted NCUAs request, and it is clear to me
that if you had not acted in such a swift and decisive manner, the
entire credit union system, not just the corporate network, would
have been in serious jeopardy.
Despite this successful intervention, problems continued. In
March, the two largest corporates were placed into conservatorship
by NCUA due to the deterioration in their portfolios. Losses flowed
through the system and resulted in writedowns of capital not only
by other corporates but by retail credit unions that invested in
these institutions. Given the tenuous real estate market, NCUA expects additional losses to materialize.
These conservatorships permit the corporate system to continue
to function and to serve retail credit unions and, most importantly,
their 90 million members. Again, a mechanism was developed, the
Corporate Credit Union Stabilization Fund, which permitted replenishment by the industry over a 7-year period. This spreading
out of costs was critical as credit union earnings were already experiencing pressures. The Corporate Stabilization Fund has permitted NCUA to maintain its mandated equity ratio in the Share
Insurance Fund. At no point during this crisis has the equity ratio
fallen below the 1.2 percent established by Congress, and today it
stands at 1.3 percent, assuring consumers that their insured deposits are safe.
Retail credit unions have their own challenges independent of
the corporates. The good news is that, despite the troubled economy, credit union lending has increased by almost 8 percent since
2007. However, delinquencies and loan losses have also increased,
particularly in real estate lending. In 2007, about 0.3 percent of
such loans were delinquent. The figure now stands at 1.62 percent.
Industry-wide capital, while still strong, has declined from 11.8
percent in 2007 to 10 percent. On the one hand, I am encouraged
by the fact that 98 percent of the 7,700 federally insured credit
unions are at least adequately capitalized. On the other hand, 21
credit unions have failed so far this year compared to 18 in all of
2008. That number could well rise in 2010. Most troubling is the
increase in credit unions which have been downgraded to CAMEL
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4 and 5. Between December 2008 and August 2009, the assets of
credit unions in these categories have almost doubled.
Clearly, credit unions have not been spared from the harsh effects of the economic downturn. In tandem with the assessment of
corporate losses described above, this presents a difficult road for
credit unions to travel in 2010 and beyond.
NCUA has been proactive in our efforts to mitigate the situation.
NCUA examiners work with credit unions to avoid the riskiest
types of mortgage lending, and this oversight was complemented by
the fact that, as member-owned cooperatives, credit unions try to
put their members into lending products they can afford. As a result, the industry largely steers clear of exotic mortgage lending.
Only 2.3 percent of all credit union mortgage loans are exotic.
Additionally, NCUA has enhanced our supervision. We shortened
our examination cycle. We added 50 examiners in 2009 and anticipate adding 57 more in 2010, and we upgraded our risk management system to identify and resolve problems more quickly.
NCUA has an obligation to consumers. As a safety and soundness regulator, we will be successful if we preserve strong credit
unions capable of meeting the financial needs of their members.
Credit union members rightfully expect a reliable and well-capitalized deposit insurance regime. While the year ahead will be challenging, I am confident that we and the credit union industry we
regulate will be stronger in the end.
I welcome the opportunity to answer your questions.
Senator JOHNSON. Thank you, Ms. Matz.
Mr. Ward.
STATEMENT OF TIMOTHY T. WARD, DEPUTY DIRECTOR, EXAMINATIONS, SUPERVISION, AND CONSUMER PROTECTION,
OFFICE OF THRIFT SUPERVISION
Mr. WARD. Good afternoon, Chairman Johnson, Ranking Member

Crapo, and members of the Subcommittee. Thank you for the opportunity to testify today on the financial condition and performance of the thrift industry.
As of June 30, 2009, OTS regulated 794 thrift institutions with
combined assets of $1.1 trillion. We also regulated 459 savings and
loan holding companies with aggregated consolidated assets of approximately $5.5 trillion. Most OTS regulated thrifts are smaller,
community-based institutions. At the end of the second quarter, 86
percent of the thrifts had assets less than $1 billion. Three percent,
or 25 thrifts, had assets greater than $10 billion, and those 25
large thrifts held 66 percent of total industry assets.
Thrifts in general are weathering the recession fairly well. Capital overall is strong. The industrys second quarter earnings improved to break even. And loan loss reserves have been substantially bolstered to near record levels. Because additions to loan loss
reserves are direct charges to income, the industrys earnings remain weak by historical standards. Loss provisioning is expected to
continue at elevated levels until inventories of unsold homes decline, home prices stabilize, and the employment picture brightens.
Problem assets are continuing to increase, rising to 3.52 percent
of total assets in the second quarter, up from 2.68 percent 1 year
11
earlier. This compares unfavorably to an average level of 0.78 percent from 2000 to 2007.
These stresses have caused an increase in problem thrifts and a
general decline in safety and soundness ratings across the industry. As of September 30, 2009, there were 42 problem thrifts representing 5.4 percent of all OTS-regulated thrifts. A year ago, there
were 16 problem thrifts, or 2 percent of the total. Twelve thrifts
have failed this year, compared with five last year. The OTS is
working closely with problem institutions to prevent failures, but
more thrifts are expected to fail before the economy fully recovers.
Foreclosures continue to be a concern. Although sustainable loan
modifications and payment plans to avoid foreclosures are increasing, the number of seriously delinquent mortgages and foreclosures
in process are continuing to rise. Progress is being made on this
front, but when so many American families are losing their homes,
the progress certainly does not seem to be fast enough.
In summary, Mr. Chairman, it is too early for us to say we have
hit bottom and the worst is over. We believe significant challenges
lie ahead as unemployment continues to rise and the housing market continues to work its way through a significant down cycle. Despite these challenges, the overall condition of the thrift industry
is sound, with strong capital and substantially bolstered loss reserves. Recent earnings have shown signs of improvement, reflecting what we hope are indications that the nations economy is beginning to turn around.
Thank you again for having me here today. I look forward to responding to your questions.
Senator JOHNSON. Thank you, Mr. Ward.
Mr. Smith.
STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA
COMMISSIONER OF BANKS, ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS
Mr. SMITH. Chairman Johnson and Ranking Member Crapo,

members of the Subcommittee, I am Joseph A. Smith, Jr. I am
North Carolina Commissioner of Banks and Chairman of the Conference of State Bank Supervisors, on whose behalf I am testifying.
Thank you very much, as always, for the opportunity.
The members of CSBS and our Federal partners, the FDIC and
the Federal Reserve, supervise 73 percent of the banks in the
United States, accounting for approximately 30 percent of total
banking assets. Our banks are not, as a rule, systemically significant. However, they are locally significant in the markets they
serve, which includes virtually all of the United States. State chartered banks provide healthy competition in urban markets and are
often the only banks in rural and exurban markets.
While there are pockets of strength in some parts of the country,
the majority of my colleagues have characterized banking conditions in their States as, and I quote, gradually declining. This
should be no surprise, given that traditional banks are a reflection
of the overall health of the economy.
What cannot be ignored is that the return to health of our largest banks is the direct result of unprecedented, extraordinary efforts by Congress and Federal regulators to ensure their success.
12
The majority of banks, however, have not been the beneficiaries of
this assistance and are experiencing a harshly, harshly procyclical
regulatory environment, as required by Federal law. This explains
the tale of two industries you are likely hearing from banks in your
State versus the news you hear from Wall Street.
What can or should be done about this? My colleagues and I submit that the place to start is with a vision of what we, the industry,
policymakers, regulators, and other stakeholders, want the U.S.
banking market to look like after the current troubles have subsided. In our view, the desirable outcome is a banking industry
that continues to be competitive, with thousands of banks, rather
than hundreds or tens, diverse, of banks of various sizes, operating
strategies, and customer focuses, and strong, with capital, liquidity,
and risk management sufficient to meet the challenges of the marketplace.
This is not an argument for the status quo. In fact, my colleagues
and I are in general agreement with our Federal colleagues that
our banks have been too concentrated in commercial real estate
and too dependent on non-core deposits. Where we sometimes disagree with them is on the severity with which we judge banks in
a down market, the result of which is, in our view, to make bad
situations worse. I would hasten to add that our disagreements are
of degree, not kind. We generally agree with the diagnosis. The
treatment is sometimes debatable.
To address the current stress of our banks, CSBS respectfully
suggests, one, that on-the-ground supervisors be given greater latitude to assess the condition of banks based on reasonable economic
assumptions rather than assumptions of the end of the world.
Two, that clear rules of the road be established for private equity
investments and that supervisory applications by strategic investors be expedited once clearly established thresholds have been
met.
Three, that the acquisition of distressed banks by healthy banks
be expedited and at least considered for capital purchase investments under the TARP program.
Fourth, that troubled banks be allowed to reduce their dependence on brokered deposits in a gradual and orderly way.
And fifth, that Congress seriously consider revisions to the
Prompt Corrective Action and Least Cost Resolution provisions of
FDICIA, which have limited regulatory discretion in the handling
of distressed institutions.
While we dont think that our suggestions will solve all the problems of the banking industry, we do think they can reduce the
number of failures and the attendant cost to the Deposit Insurance
Fund, which is, let it be remembered, funded by healthy banks. We
believe our approach can reduce at least the pace of decline in the
commercial real estate market with potential positive effects on the
economy and the recovery. Importantly, it can help preserve the diversity of our financial system that is critical to the future health
and even viability of our State and local economies.
Once again, thank you for this opportunity to appear before you.
I would be happy to answer any questions you may have. Thank
you, sir.
Senator JOHNSON. Thank you, Mr. Smith.
13
Mr. Candon.
STATEMENT OF THOMAS J. CANDON, DEPUTY COMMISSIONER,
VERMONT DEPARTMENT OF BANKING, INSURANCE, SECURITIES, AND HEALTH CARE ADMINISTRATION, ON BEHALF OF
THE NATIONAL ASSOCIATION OF STATE CREDIT UNION SUPERVISORS
Mr. CANDON. Honorable Chairman Johnson, Ranking Member

Crapo, and members of the Subcommittee, thank you for the opportunity to testify. I am the Deputy Commissioner of Banking and
Securities for the Vermont Department of Banking, Insurance, Securities, and Health Care Administration. I appear on behalf of the
State Credit Union Regulators as Chairman of NASCUS. Today, I
will share information on the conditions of State credit unions and
areas for reform.
Like all financial institutions, State credit unions have been adversely affected by the current economy. However, at this point,
State natural person credit unions remain generally healthy and
continue to serve the needs of their members and their communities. For the most part, natural person credit unions did not engage in many of the practices that precipitated the current market
downturn. However, we have several issues to bring to your attention about the impact of the economy and the need for capital options for credit unions.
State regulators remain concerned about unemployment and its
effects on credit union members ability to meet their obligations.
We also see increases in delinquencies and charge-offs as well as
pressure on earnings, especially in smaller State credit unions. Although loan delinquency and net charge-offs have increased, State
regulators indicate that the levels remain manageable.
In response to this trend, regulators are increasing their oversight of consumer credit products, including auto loans, credit
cards, real estate and home equity loans. State regulators are also
closely monitoring member business lending in credit unions. Some
States, including my home State of Vermont, have not experienced
the fallout from commercial real estate or subprime lending because State credit unions do not engage in those activities. State
regulators continue to encourage credit unions to exercise sound
underwriting practices, proper risk management, and due diligence, as these are the practices that have kept credit unions
healthier through the economic downturn.
In anticipation of prolonged economic problems, State regulators
will closely monitor both lending and investment activities. State
regulators also emphasize strong governance standards at the credit union board level. We will continue close supervision through offsite monitoring and onsite examinations and visitations. The growing trend toward consolidation is on the minds of State regulators
as credit union mergers continue to occur, both voluntarily and for
regulatory purposes. As economic pressures continue, finding suitable merger partners may become more difficult.
In response to your question about capital needs, access to capital for credit unions is critical. Unlike other financial institutions,
credit union access to capital is limited to reserves and retained
earnings. State regulators recommend capital raising options for all
14
credit unions. Access to supplemental capital will enable credit
unions to respond proactively to changing market conditions, thereby strengthening safety and soundness and providing a buffer for
the Credit Unions Share Insurance Fund.
It is NASCUSs studied belief that a change to the Federal law
could provide this valuable tool to credit unions without altering
their nonprofit and cooperative structure. Supplemental capital will
not be appropriate for every credit union nor would every credit
union need access to supplemental capital. However, the option
should be available.
State regulators are also concerned about the impact of corporate
credit union losses on natural person credit unions. Given the severity of the losses, it is clear that enhanced regulatory standards
for capital, governance, and risk management are necessary. State
regulators are working with the NCUA to ensure the safety and
soundness of corporate credit unions and to mitigate future risk.
Last, I would like to emphasize the value of the dual regulatory
system. State regulators have demonstrated the importance of local
supervision of State-chartered institutions and the value of the
dual regulatory system. State regulators have always emphasized
consumer protection along with safety and soundness as an important part of their mission and accountability to Governors and
State legislatures. Further, State regulators have the expertise to
identify areas of risk and take enforcement actions where necessary. As regulatory modernization efforts are considered by the
Senate Banking Committee, we encourage you to retain State supervision and reaffirm State authority.
NASCUS and State regulators appreciate the opportunity to testify today. I will be pleased to respond to any questions that you
have. Thank you, Mr. Chairman.
Senator JOHNSON. Thank you, Mr. Candon.
Let us put 7 minutes on the clock for each member to ask questions of our witnesses.
Ms. Bair, so far, 98 institutions have failed this year and the
FDICs watch list has grown to 416 institutions. How many more
of the troubled institutions do you anticipate will fail? Is the FDIC
staffed up to deal with an increase in failures?
Ms. BAIR. Mr. Chairman, thank you for asking that question.
There will be more failures. We do not make our failure projections
public, but failures will continue at a pretty good pace this year
and next. We think we will have about $100 billion in losses over
a 5-year period starting at the beginning of 2009. Twenty-five billion of that has already been realized from failures this year, and
we have already reserved for another $32 billion as of the end of
the second quarter.
We are ready for this, though. We have been prepared for some
time. We started staffing up in 2007, especially in our receivership
and resolution staff, but also beefing up our examination staff. We
have 6,300 staff on board now. That number will likely go to 7,000.
We also have a significant roster of consultants that we use to help
with bank closings as well as asset valuations, asset management,
and asset marketing. The FDIC really is designed for this type of
activity. We can expand very quickly and then contract very quickly. A lot of our hires are temporary 2-year hires.
15
Overall, we have got a very good track record. These closings
have been seamless. Through using loss share, we have been able
to, more often than not, do a whole bank transaction. So another
bank that serves that same community acquires both the deposits
and the assets, which is good for bank customers. Frequently, the
depositors are also the borrowers at the bank.
Overall, it has been handled well. I think the staff have made
a tremendous effort. We are well staffed and very much prepared
for this.
Senator JOHNSON. Governor Tarullo, there has been much concern raised that commercial real estate is the next problem area for
financial institutions. What are the differences between the concerns over commercial real estate and the problems we experienced
last year with mortgages?
Mr. TARULLO. Senator, other than the fact that each presents a
significant and troubled portfolio of assets for financial institutions,
I think there are some salient differences.
First, and I think of particular interest to many Members of this
Committee, the places in which the mortgages are relatively concentrated do vary. As I noted in my opening statement, although
large financial institutions certainly do have CRA exposures on
their books, proportionately speaking the exposures are to a much
more significant extent on the books of smaller and regional institutions, and oftentimesnot always, but oftentimes, those exposures are geographically concentrated. You have a small bank that
tends to lend in a fairly small area. If the commercial real estate
market there goes bad, then there is a problem. So, that is number
one.
Number two, in commercial real estate, generally speaking you
dont have a 30-year fixed mortgage, as you do with residential
mortgages. Instead, you have loans that need to be rolled over as
a project proceeds or as a completed project is paid down, and that
means you have a refinancing problem. So this year and next, we
have got about $500 billion each year that is going to need to be
refinanced and that creates a set of challenges that are perhaps no
more serious than, but different from, the case with residential
mortgages.
Third, I would say that while there is some similarity, there are
some different ways in which the situation plays out. We had
subprime mortgages. We had Alt-A mortgages, we had prime mortgages, which as you know, Senator, presented ultimately the same
set of problems, but at different times. In the commercial real estate arena, we have got very different kinds of lending, and there
is an important distinction between construction and development
loans, where essentially the builder is just starting to put something on the property, on the one hand, and so-called income-producing properties, a completed hotel or a multi-unit residential
structure, where there is an income stream.
The most serious problems are going to be in the former category, with the construction and development loans, which have no
income stream. You are going to have problems in the second category, but that is something you can at least try to work with in
some cases.
16
Senator JOHNSON. Ms. Matz, I know that the NCUA is currently
in the process of finalizing new rules for its corporate credit unions.
Are you considering changes regarding the concentration of risks
that corporate credit unions can have?
Ms. MATZ. Thank you for asking that question. As I think you
are aware, when I was on the NCUA Board in 2002, I was the lone
member who voted against the corporate rule at that time because
I felt it didnt provide adequate parameters on investment authority and concentration of risk. So, we wont make that mistake
again.
At our Board meeting in November, we will take up the proposed
corporate rule and we will address the riskiest area, which we consider the investment authority. We will set limits on the types of
securities and the concentration of securities that corporates can
invest in. We will address capital. We will have stringent requirements for capital retention that will be comparable to Basel I. We
will set requirements for asset liability management so that asset
cash-flow and liability cash-flows match. And we will have new
governance rules, which are not included in the current regulation.
So, I believe we will address the issues that led to the problems
we are having today.
Senator JOHNSON. Ms. Bair, do you have any concerns about
smaller institutions having risk concentrated in one product area
or one geographic area?
Ms. BAIR. Getting back to some of the regulatory reform issues
that this Committee will be looking at, I think the community
banking sector is very important to our economy and very important to our country. I do worry that because of competitive pressures and uneven playing fields, that they have become highly concentrated in commercial real estate loans and small business lending. Those are their niche areas where they have been able to hold
ground against the larger banks as well as the shadow sector. I
would like to see them be able to diversify their balance sheet, especially in consumer retail, and get back into providing those financial services. So, I do think that this is important.
But in the near term, clearly, there is a lot of commercial real
estate on the books of smaller banks. For the most part, they have
managed those exposures well. Some, though, are more distressed
than others, and clearly, commercial real estate will be a bigger
driver of bank failures going forward.
Senator JOHNSON. Senator Crapo.
Senator CRAPO. Thank you very much, Mr. Chairman.
There are a lot of issues that I would like to explore with this
panel, but in my first round, at least here, I want to focus on one,
and that is, as I think everybody knows, amidst all the issues that
we are dealing with here in Congress, one of them, one of the big
ones that I expect we will be dealing with more aggressively soon
is the overall financial regulatory restructuring that is being proposed.
I would like to get the opinion of the members of the panel with
regard to their thoughts on one aspect of that, and that is the proposal that we consolidate all of the banking regulators into one single Federal banking regulatory agency. I dont know that in my 7
17
minutes I can get through the whole panel, but let us start with
you, Ms. Bair.
Ms. BAIR. Thank you, Senator. My position is out there already.
We have not liked this idea. The proposal was pushed in 2006 as
an FSA-type model, although I know some of the ideas kicked
around were a little different from FSA. We fear regulatory consolidation regardless of where it might be located. Clearly there may
be some room for streamlining of bank regulation, but concentrating all the power with a single entity is a tremendous bet. If
they do the right thing, then maybe we are OK. But if they do the
wrong thing, we are really in the soup.
In particular, taking the FDIC out of the supervisory process and
the process of setting the capital standards and the underwriting
standards, et cetera, would go in a different direction from where
this Committee would like to go. We are not perfect by any means,
but we are a conservative voice. Since we have a tremendous exposure as deposit insurer, our record shows that we are conservative
when it comes to supervisory measures.
Being an examiner also gives us a constant stream of information about banking trends, which helps us a lot in setting insurance premiums as well as helping our examiners prepare for working with the State regulators or the Federal chartering regulators
when banks get into trouble and have to be wound down and put
into resolution.
So, we are very concerned about it. We fear it would weaken the
FDIC. It could overall weaken banking regulation.
Senator CRAPO. Thank you.
Mr. Dugan, do you have an opinion on this?
Mr. DUGAN. I do. As we testified here on this very subject about
a month ago, I cant sit here and defend four separate Federal
banking regulators and a separate holding company regulator. We
dont have four food and drug agencies and the like. But I do think,
on the other hand, if you moved all the way to one single regulator,
you get some benefits in efficiency, but you also get some tradeoffs
of the kind that Chairman Bair just described, that if you take certain regulators out of their current supervision, they dont keep
their hand in it to the extent that they otherwise would.
And so if you asked me, do I think that we can have more consolidation in the industry, I would say yes. But I would say to be
careful. Each step along way, the trade-offs become more pronounced.
Mr. Tarullo, I want to hold off on you yet, because I want to get
the perspective of the State Bank Supervisors from Mr. Smith before my time runs out, and then we will come back if we can.
Mr. SMITH. We oppose it from the tops of our heads to the bottoms of our feet
[Laughter.]
Mr. SMITH.for the reasons that Chairman Bair has stated,
and we believe honestly and truly that a single regulator would
weaken or destroy the dual banking system and think that would
be a bad thing for America.
Senator CRAPO. All right. Thank you.
Mr. Tarullo.
18
Mr. TARULLO. Thank you, Senator. So, let me echo the approach
that Comptroller Dugan took, which is to say in any proposal, you
are going to have some benefits and you are going to have some
costs. I think on this one, I would just add two points, or reiterate
one point and make an additional point. The reiteration is the
point that Chairman Bair made, which is you lose something, and
part of what you lose here is the insight that the Federal Deposit
insurer or the monetary policy authority gets into the functioning
of the banking system by being an examiner, and that is something
that does require experience. It does require actually being involved in the guts of examination and supervision.
Second, in terms of priorities, again, it is certainly debatable
what model you want to have, and a lot of countries around the
world have debated it, but I dont think that the existence of multiple banking regulators at the Federal level played a particularly
important role in the genesis of this crisis. There are a lot of problems. There was a lot of blame to go around for a lot of reasons.
But I dont think it was the coexistence of the FDIC and the Comptroller that was a particular problem here.
Ms. Matz.
Ms. MATZ. The Administration proposal kept NCUA as an independent regulator, and we support that.
Senator CRAPO. So you are willing to stick with that?
Ms. MATZ. Yes.
Senator CRAPO. All right.
Mr. Ward.
Mr. WARD. We think multiple viewpoints among the regulators
fosters better decisionmaking and is a very healthy thing. We have
a tremendous working relationship with the FDIC. We dont always
see eye-to-eye on our institutions, but that is a very healthy pressure among our examiners.
Senator CRAPO. All right.
Mr. Candon.
Mr. CANDON. Thank you, Senator. I would second what Chairman Matz responded to your question. The President had recommended the NCUA be left out of the consolidation. Thank you.
Let me go back to you, Mr. Smith. As you indicated, you are very
opposed to the consolidation. Mr. Dugan indicated that although
one single regulator wouldnt necessarily be the way youif I am
correctly representing youwould go, that we dont really need
four or five. What are your thoughts about that? Is there room for
some consolidation?
Mr. SMITH. Well, far be it from we poor State regulators to tell
the Federal folks what to do with your territory. I think there could
be consolidation, I guess, among the Federal agencies, but I will
say we believe, and I agree with Governor Tarullo and Chairman
Bair, that our relationships that we have with the Fed and the
FDIC work very well, and we also agree with the Obama administrations proposal to leave that alone and unimpaired.
I am going to shift gears and come back to you, Ms. Bair, and
this really is a question on the resolution authority and the process
19
of resolution when a bank is seized or declared a failed bank. I recently have had a couple of those experiences in Idaho and I have
had those who have been borrowers from the bank contact me to
indicate that they really are not happy with the resolution authority.
Just to give you an example, there are some who have contacted
me who have indicated that they were in a position to repay much
more than their particular loan ended up being auctioned for by
the FDIC and that in that process, what happened was they were
put in a bad situation because the loan was auctioned. The person
or entity that purchased the loan immediately called it due. They
were then put in a bind. The FDIC got 30 or 40 cents on the dollar.
The one who really gained was the person who bought it at auction. The taxpayer didnt win. The FDIC didnt win. The borrower
didnt win. And the bank didnt win.
What is your reaction to that kind of an inquiry?
Ms. BAIR. I do hear this a lot and I look into it when I hear it.
I dont know what the specific situation is you referred to, but I
have found that, frequently, what has happened is a borrower may
be wanting to get a bit of a deal. We are subject to least cost resolution, and although some reasonable price could perhaps be considered that would be better than what we would get if we auctioned the pool of loans off, other times, we have been approached
by borrowers who just want a really low price for themselves50
or 60 cents on the dollar or lower. That is not something that we
can justify under least cost.
Also, sometimes they will say they want to buy their loan out,
but they dont have the cash resources to do it. So, when we ask
for verification of their financial resources or who their new lender
will be, they are not able to provide that. Sometimes the truth here
is a bit more difficult than it may appear initially.
Our policy is to offer borrowers the ability to buy back their loan
if they offer a reasonable price and have the financial capability to
do that. At my request, our ombudsman put together a Borrower
Bill of Rights, which is on our website, and I would be happy to
share with you and your staff, so that borrowers understand our
process and what they can do.
If the prices go too low, there is a question about least cost to
our Fund, also. It is very difficult, given the volume that we have
to do, to individually sell each of these loans, and at some point,
you just have to market them in bulk. But, if a borrower is offering
a reasonable price, has the financial capability and can show they
can buy the loan back, we will sit down and accommodate them.
Senator CRAPO. Thank you very much.
Senator JOHNSON. Senator Merkley.
Senator MERKLEY. Thank you very much, Mr. Chair.
Chairman Bair, I wanted to go back to your testimony. You mentioned that you do not share your forecasts on the number of banks
that might fail, and I can certainly understand that. Are you able
to give us an order of magnitude? For example, in 2008 we had 25
banks failing; in 2009, it is up to just shy of 100. Do we expect the
next year to look more like 2008 or more like 2009?
Ms. BAIR. It will look more like 2009.
Senator MERKLEY. More like 2009. Thank you.
20
Chairman, community banks hold 11 percent of the industry assets, but 38 percent of small business and small farm loans. Since
small business is a key driver of the economic recovery, would it
be fair to say that recapitalizing community banks would be a
smart way to get lending flowing back to Main Street?
Ms. BAIR. We have been in discussions with Treasury for some
time about making the TARP program work better for community
banks. The 25 largest domestic institutions that qualified 100 percent participation in the TARP program. For the smaller institutions, it is about 9 percent. So, clearly, we think the program could
be working better for the smaller institutions.
In preparation for this testimony, I went back to look at small
loan balances of larger and smaller institutions. Even though year
over year, as of June 30th, small loan balances were down 1.9 percent overall, for the community banks, those less than $1 billion in
assets, loan balances were up slightly over 2 percent. So community banks look like they are still in there trying to make these
loans, but some additional capital support would be really helpful.
Senator MERKLEY. Could you give us some sense of what that
might look like?
Ms. BAIR. While this is Treasurys program, an idea that has
been discussed is a dollar-for-dollar matching program. Right now
the viability standard puts a lot of pressure on our examiners to
try to identify the institutions that are, without the additional
money, viable. Frankly, the ones that are clearly viable without the
money do not want it. It is really the institutions where the decision is less clear that will come to us. But many times they are
worthy, we think, and can raise significant private capital. So we
have suggested a dollar-for-dollar matching program. This would
provide an additional validation of viability from the market. The
market may be willing to put additional capital in, help provide
some additional protection to Treasury, and perhaps make the
terms a little less onerous. This could perhaps be tied to increasing
small business loans.
So I think there areand I know Senator Warner has had some
thoughts on thisways to approach this that would make the program work better for the smaller banks.
Senator MERKLEY. Thank you. And would this havedid I see a
hand raised there? Oh, no. Just scratching. OK.
[Laughter.]
Senator MERKLEY. At hearings and auctions, you have to be very
careful how you are moving.
In terms of the impact upon our commercial real estate, what are
things that we can do to assist our community banks and, therefore, our small commercial real estate markets as we face a lot of
balloon loans that will be coming due in the couple years ahead?
Ms. BAIR. I think it is a problem. We are encouraging banks to
work to restructure these loans. If they have a creditworthy borrower, a restructured loan with a lower payment, can make that
a performing loan. We want them to do that. That preserves value,
just the way it does with home mortgages. It is the same principle
with commercial real estate. And we are in the process of finalizing
guidance right now that makes that very clear and provides exam-
21
ples to our examiners of what we consider prudent workouts. This
should be encouraged, not criticized.
In the near term that is the best we can do. Of course, bringing
back the securitization market for commercial mortgages is going
to be much more difficult. I know the Federal Reserve Board has
been working on that, as has Treasury. But that is going to be a
longer haul.
Senator MERKLEY. One of the things I keep hearing back home
in Oregon is from owners who have fully performed on their loans,
but as their loans come up to be rolled over, the estimate of the
value of their property has dropped enough that the bank is very
nervous about reissuing it.
Is there any form of guarantee that the Federal Government
could do for, if you will, the difference in the drop in equity on
loans that have been performing for the entire period to enable
those banks to be able to meet the regulators requirements and at
the same time be able to reissue those loans so we do not freeze
up or seize up in those commercial markets?
Ms. BAIR. I am unaware of any current programs that would do
that. That is a new idea. I would just like to think about it. Others
might want to have a comment.
Senator MERKLEY. All right. Thank you very much.
Senator JOHNSON. Senator Bunning.
Senator BUNNING. Thank you, Mr. Chairman.
This is for the primary regulators, though others may want to
answer this question also. Do you have enough power to restrict
the activities and risk taking of banks and holding companies? Do
not be bashful.
[Laughter.]
Senator BUNNING. Usually you are not.
Ms. BAIR. Well, for holding companies, no. I would defer to the
holding company regulators down the aisle here. We have no authority over holding companies.
Senator BUNNING. Well, you do have a lot of banks, though.
Ms. BAIR. That we do.
Mr. DUGAN. For the banks themselves, I think we do have adequate powers to restrict activities that we think are unsafe and unsound, but not the holding companies. Just the bank and the direct
subsidiaries of the banks.
Senator BUNNING. Fed?
Mr. TARULLO. Senator, with respect to banks, I think on an ongoing basis, the answer is yes, although when it comes to closing an
institution, we do not have the breadth of authority that the OCC
or the FDIC has for the banks for which they are the primary Federal regulators.
With respect to holding companies, there is, as you know, some
lingering ambiguity from the Gramm-Leach-Bliley Act as to the
reach of Federal Reserve authority over regulated subsidiaries.
Senator BUNNING. On in the Feds mind.
Mr. TARULLO. Well, Senator, I think it is in a number of peoples
minds, and as we have said before, we would welcome clarification
of that in any legislation that
Senator BUNNING. We clarified that in 1994, but that has not
been interpreted by the Fed.
22
Mr. TARULLO. If you look at the statute and the legislative history, there was some sense that there was supposed to be deference
to functional regulators of subsidiaries.
Senator BUNNING. Correct. And you were powered to write the
regs and did not.
Mr. TARULLO. Well, Senator, as you know, I cannot
Senator BUNNING. I am not going to get into that dispute with
you.
Mr. TARULLO. OK. So let me just leave it there, though, with
I think with respect to the bank
Senator BUNNING. Ms. Bair, would you like to comment about
your ability to regulate the banks with the power that you now
have?
Ms. BAIR. There may be certain detailed areas, for instance,
back-up authority, where through our good working relationships,
we are able to effectively use it. Although, if we ever needed to
bring an enforcement action with back-up authority, it is a fairly
protracted process.
Going forward as part of reform, we would like to see greater
consistency in standards, particularly capital standards, between
bank holding companies and banks. We think bank holding companies should be a source of strength for banks and should at least
have as strong a capital level and quality of capital as the banks.
There are a few areas where we would like to see some improvements, and that is not a secret. My fellow regulators know of our
views on that.
But, overall, I think the powers for both banks and bank holding
companies have been pretty adequate, and perhaps there are areas
where we could have used them better. Again, in terms of reform,
looking at the disparities between the bank and the non-bank sector cannot be emphasized enough. As we try to improve the robust
nature and quality of bank and bank holding company regulation,
if there is still a giant shadow sector out there that is basically beyond the reach of meaningful prudential oversight, you are going
to have the same problem that drove this crisis. Higher-risk activity will go into that shadow sector.
Senator BUNNING. That is basically what I am asking. In other
words, if there is a bank either that you are in charge of or the
OCC or the holding companies, and they are doing things that you
know that get them in trouble, can you stop it?
Ms. BAIR. Yes.
Mr. DUGAN. Yes.
Senator BUNNING. You have enough power to stop it.
Mr. DUGAN. Yes.
Ms. BAIR. Yes.
Senator BUNNING. The Fed also.
Mr. TARULLO. Ultimately, yes.
Senator BUNNING. Ultimately. OK.
Why should firms that are supported by taxpayers guarantees
and insured deposits and access to Fed windows be allowed to
make huge profits on their own trading? What restrictions have
you put on these activities?
Mr. TARULLO. Well, Senator, the restrictions that would apply to
the activities of subsidiaries of financial holding companies or bank
23
holding companies would be the capital liquidity and risk management restraints that would apply to any holding company, which
is to say there is substantially less leverage permitted for such a
company today than may have been the case before it became a
bank holding company. And so that puts non-trivial constraints on
what they can do.
But under the structure of Gramm-Leach-Bliley, they are permitted to have subsidiaries that do engage in these trading activities so long as they conform to the capital and liquidity requirements.
Senator BUNNING. If I have heard it once, I have heard it ten
times, from not only the Secretary of the Treasury but the head of
the Federal Reserve, that there are institutions in this country that
are too big to fail. Too big to fail.
Now, it is up to the people sitting at this desk or these all gathered here to stop that. I need suggestions.
Mr. TARULLO. Well, I think Chairman Bair alluded earlier to
something with which I certainly agree, that we need to have capital and other requirements that take full account of the additional
risk that may be created by very large institutions.
Senator BUNNING. The AIGs of the world.
Mr. TARULLO. The AIGs of the world for certain, Senator.
Senator BUNNING. OK.
Ms. BAIR. Well, and as we have said before, we do think
Senator BUNNING. I wanted to ask you one more question before
you get away since I only have 25 seconds. Right now the FDIC
is considering forcing banks to prepay their assessments for the
next 3 years. I have two questions about this.
First, earlier this year you asked Congress for a higher credit
line at Treasury, and we gave it to you. Why didnt you use that
credit line? Is it really because Treasury has no room under the
debt ceiling?
Ms. BAIR. No, that is not the reason. We view the credit line as
being there for emergencies for unexpected loss. Particularly, earlier this year, we thought it was very urgent to make sure we had
plenty of breathing room there.
But what we are talking about with the prepaid assessments for
losses is different.
Senator BUNNING. There is only one problem with that. The
banks that have not put you in the problem are the very banks
that are going to get assessed.
Ms. BAIR. Well, the prepaid assessment is different from the special assessment.
Senator BUNNING. I understand that, but they are the same
banks.
Ms. BAIR. They are the same banks, and at the end of the day,
that is how insurance works. The lower risk banks end up generally to some level subsidizing the higher risk banks.
Senator BUNNING. Let me finish this. Second, will that prepaid
payment be enough to cover all the losses? Or will you have to
raise more money again in the future?
Ms. BAIR. Based on our current projections, that will be more
than ample. But, again, a lot of this depends on the economy. So
24
if the economy has unforeseen troubles, that could be different. But
based on current projections this year, yes.
Senator BUNNING. I am only an economist, so I would tell you
youve got a problem.
Ms. BAIR. OK.
Senator JOHNSON. Senator Tester.
Senator TESTER. Thank you, Mr. Chairman.
I want to step back a little bit, Chairwoman Bair, to what Senator Crapo wasjust very quickly. You said that when it came to
buying back loans per se, the borrowers were often given a chance
to buy those loans back. How is the value of those determined?
Ms. BAIR. It is difficult. Certainly if they just want to buy their
loan back at what they owe
Senator TESTER. At 100 percent
Ms. BAIR. Right. Then that would be great. We would welcome
that. Again, they need to demonstrate they actually have the ability to do that.
If they want to have a discount, a couple of issues arise. If they
have the capability to keep paying on the loans, if the loan is performing, the question becomes whether we should negotiate a deal
for a borrower that is otherwise fully capable of making repayment
on the loan.
Even then, we do provide some flexibility, but we are required
to pursue least-cost resolution, which means we need to get the
best price for all the loans that we inherit in a receivership. Frequently just trying to do them one by one is not administratively
practical and would get generally lower prices than if you market
them all in bulk.
Senator TESTER. Right. So seldom do you peel one loan out and
sell it.
Ms. BAIR. I can get you numbers of how often it happens. But,
again, if they want to pay it off completely, we welcome that. Even
below that, we will work with them. But frequently they are not
able to. They say they want to, but they are not able to.
Senator TESTER. OK. The deposit insurance fund, we have about
what you are going to do in the short term. The Senator from Kentucky talked a little bit about the long term. Do you plan on permanently raising the rates on the long term, over the long term, to
handle solvency in that fund?
Ms. BAIR. Right. Well, we would bump up the rates by three
basis points beginning in 2011. That would bring the base rate up
to 15 to 19 basis points for most banks. That is still well below the
23 basis points that was assessed on the industry during the S&L
days. So as the economy recovers, as the banking sector heals, as
our losses go down, we will constantly reassess that. We will stay
within the range that Congress has prescribed, though I think perhaps Congress may want to think about giving us additional flexibility to build the fund up in good times. It is something that will
be continuously monitored, but as of our projections now, we believe with the three-basis-point bump-up in 2011, we will be able
to reestablish the fund and get it back to 1.15 within 8 years,
which is what Congress has asked us to do.
Senator TESTER. OK. Is there a point in time in which you permanently raise their rates?
25
Ms. BAIR. No, I do not think so. When the FDIC Board sets riskbased assessments, consideration is given to the risks in the banking system and the needs of the DIF to cover projected losses.
Senator TESTER. This can be for Mr. Tarullo or Mr. Dugan. Actually, you can answer it, too, Ms. Bair. But there has been a lot of
discussion about the make-up of systemic risk regulators and the
powers entrusted to that body. I guess the question isand, Mr.
Smith, you may want to jump in on this, too. Do you believe there
is a value in allowing representatives from State regulators to participate in the systemic risk regulator?
Mr. TARULLO. Senator, I think it depends, as it often does, on
how one conceives of what a systemic risk regulator is doing. I
think there have been discrete functions which sometimes get
lumped under that umbrella.
What we have thought of in terms of the Federal Reserves role
is consolidated supervision of systemically important institutions,
and so it is very much a supervisory function, making sure that
you are covering everybody who could pose a risk to the system.
And in that context, of course, if there is a State bank, the State
banking supervisor absolutely should be participating.
A second context is thinking in terms of collective efforts to identify emerging risks and figure out what can be done, and there I
think it is profitable to have people who see things from different
parts of the financial system participating.
Senator TESTER. OK. If there is a council of regulators, should
the State regulators be represented?
Mr. TARULLO. It depends, I think, Senator, on the functions of
that council. If it is a matter of analysis and scrutiny and trying
to coordinate, then I think there is a good case to be made for it.
If it is a matter of actually making some binding Federal law decisions, then it probably is not.
Senator TESTER. OK. Sheila, I have heard from banks that the
FDIC is becoming more and more concerned about AG loans. Is
that true? And I guess the question is why, even though the markets are in the tank. That probably answers it.
Ms. BAIR. Not that I am aware of, Senator. We have been monitoring it for some time, but this is the second time in a week that
somebody has asked for that so maybe I will probe a little more.
[Laughter.]
Ms. BAIR. But not that I am aware of, no. We are monitoring
this.
Senator TESTER. I appreciate that.
Ms. BAIR. Senator, could I just go back to the borrower question?
Senator TESTER. Go ahead. Sure.
Ms. BAIR. One of the reasons we do whole bank transactions with
loss share is if we can sell the whole bank, we do not run into this
problem. A new bank gets those loans, services those loans, and it
preserves the relationship with the borrower. It is only where we
cannot do the whole bank transaction that we get into this problem.
Senator TESTER. OK. Well, I understand. You are kind of between a rock and a hard place, quite honestly, because it does not
seem quite fair to let somebody else make a bunch of dough on it
when you could cut thatanyway, I do not want to go there.
26
Mr. Tarullo, there was a front-page story in the Wall Street Journalwe are going down a little different avenue here nowthat
talked about workers at the top 23 investment banks, hedge funds,
asset managers, stock and commodity exchanges can expect to earn
even more this year than they did in 2007, which was the peak
year. I guess the question is, getting right to it: Are we returning
to the attitude of greed that really occurred before the economic
downturnand that is being kindin 2008?
Mr. TARULLO. I do not know, Senator, that I can comment on
what everybody else out there is thinking. I guess here is what I
would say:
First, I do have concerns sometimes in a variety of contexts that
people in general, including in financial institutions, have not come
to grips with the fact that things have changed. Things have
changed in a basic way, and I think the presence of many of us at
this table today promises that things are going to change more.
That means business models. That means the way of assessing
risk. That means how you run your institution.
Second, with respect to the story itself, I do think that is a bit
speculative, it is a bit projecting what is about to happen, and I
think we should watch and see what, in fact, does happen and
what, in fact, these firms are doing with their capital standards,
which is ultimately of great importance to us.
Senator TESTER. OK. If I might, Mr. Chairman, you know what
the unemployment numbers.
Mr. TARULLO. I do.
Senator TESTER. And there are folks in many of these companies
that are up here right now lobbying to make sure t there is no or
very, very little regulation on a lot of the incidences that created
the economic collapse.
Do you find that somebecause they are making a ton of dough.
Do you find that somewhat ironic, troublesome?
Mr. TARULLO. What I hope is that this Committee and the Congress as a whole will pass a strong set of reforms, no matter what
other people out there are saying.
Senator TESTER. OK. Thank you very much.
Thank you, Mr. Chairman.
Senator JOHNSON. Senator Gregg.
Senator GREGG. Thank you, Mr. Chairman, and I want to thank
the panel for their excellent testimony. It has been most interesting.
First off, I want to congratulate the FDIC for deciding to forward-fund the fees. I think that is the right approach. You do a lot
of things right. You have done a lot of things right during this
problem.
You did a lot of things right when I was Governor in 1989 in
New Hampshire and five of our seven largest banks closed. Mr.
Seidman came in and basically was our white knight.
But you did say something that really concerns me, and that is,
how you interpret the TARP, this idea that the TARP should be
now used as a capital source for a lot of smaller banks that are
having problems raising capital. I think all of you basically in your
testimony have said we are past the massive systemic risk of a financial meltdown that would have caused a cataclysmic event.
27
TARP came about because of that massive potential cataclysmic
event, and its purpose was to basically stabilize the financial markets and be used in that manner in order to accomplish that. As
one of the authors, along with Senator Doddwe sat through the
negotiations of thatI think I am fairly familiar with that purpose.
That was the goal. It should not now be used as a piggy bank for
housing. It should not be used as a piggy bank for whatever the
interest of the day is that can be somehowit should not have
been used for the automobile industry, and it really should not be
used in order to have a continuum of capital available to smaller
banks who have problems, in my opinion, because then you are just
going to set up a new national program which will essentially undermine the forces of the market, and that would be a mistake.
I did hear you say, Madam Chairman, that you expect $100 billion in losses. Is that a net number? Or do you expect to recoup
some percentage of that?
Ms. BAIR. No, that is what we project our losses to be over the
next 5 years.
Senator GREGG. So that is a net number after recoupment?
Ms. BAIR. Yes.
Senator GREGG. Well, is itdo you expect of that $100 billion in
bad loans to be getting back 30 percent of
Ms. BAIR. The $100 billion would be our losses. So let us say we
had a 25-percent loss rate on our bank failures so far, so you would
be talking about $400 billion in failed bank assets.
Senator GREGG. Well, OK, so it
Ms. BAIR. That is since the beginning of 2009, though. And,
again, a lot of that has already been realized and reserved for.
Senator GREGG. And you have got $64 billion, you said, or something, that has been realized and reserved against, so you have got
about
Ms. BAIR. That is right, yes.
Senator GREGG.$36 billion to go. OK.
I have got a philosophical question here. If we look at this problemgranted, commercial real estate is now the problem, but commercial real estate, as I understand it from your testimony, is
notit is a serious problem. It is just not a systemic event. It is
not going to cause a meltdown of our industriesof our financial
industry. It may impact rather significantly especially the middlesized regional banks and some of the smaller banks, but it is not
systemic.
The systemic event was caused in large part in the banking industry by the primary residence lending activitysubprime, Alt-A,
and regular loans. And all I heard about as the proposals for getting at this is regulatory upon regulatory layers to try to figure out
a way to basically protect ourselves from having that type of excess
in this arena occur again.
But when you get down to it, it is all about underwriting. I
mean, the bottom line is this is about underwriting. It is about
somebody lent to somebody who either did not have the wherewithal to pay it back or who had an asset which was not worth
what they lent on that asset. And probably the person who lent it
did not really care because they were just getting the fee and they
were going to sell it into the securitized market anyway.
28
So if you really want to get at this issue, wouldnt it be more logical and simpler andit is not the whole solution. Clearly, there
has to be regulatory reform. But shouldnt we look at the issue of
having different underwriting standards, both of which the OCC
and the FDIC have the authority over, in the area of what percentage to asset can you lend? You know, do you have to have 90 percent, 80 percent? Shouldnt we have an underwriting standard that
says you either getthat there is recourse? Shouldnt we have underwriting standards that gives you the opportunity to either have
an 80-percent or 90-percent choice or a covered loan, something
like that? Isnt that really a simpler way from a standpoint of not
havinggranted, it would chill the ability to get a house because
people who could not afford to buy the house and could not afford
to pay the loan back probably would not be able to get the loan.
But isnt that where we should really start this exercise, with recourse and 80 percent or 90 percent equity10, 20 percent equity
value and/or, alternatively, covered funds? I would ask everybody
who actually is on the front lines of lending today.
Ms. BAIR. Certainly underwriting is key, but poor underwriting
is not necessarily the driver of future losses now. We are seeing
loans go bad now that were good when they were made. But because of the economybecause people are losing their jobs, or retailers are having to close, or hotels cannot fill upthose loans are
going bad.
The economic dynamic is kicking in in terms of the credit distress that we are increasingly seeing on bank balance sheets.
You are right, the subprime mortgage mess got started with very
weak underwriting. It started in the non-bank sector. It spilled
back into the banking sector. I think all of us wish we had acted
sooner, but we did move to tighten underwriting standards, and
strongly encouraged the Federal Reserve Board to impose rules
across the board for both banks and non-banks. This, again, is the
reason why you need to make sure that the stronger underwriting
standards going forward apply to both banks and non-banks.
Senator GREGG. Well, what should those underwriting standards
be?
Ms. BAIR. You should have to document income. You should do
teaser-rate underwriting. The Federal Reserve Board has put a lot
of these in effect now under the HOEPA rules. You have to document income. You cannot do payment shock loans. You have got to
make sure the borrower can repay the loan if it is an adjustable
rate mortgage that resets. These are just common-sense underwriting principles that have applied to banks for a long time.
Senator GREGG. Or should there be recourse?
Ms. BAIR. That has been a prerogative of the States. Some mortgage lending is recourse, some is non-recourse, depending on the
State.
Senator GREGG. Should there be a requirement that you cannot
lend to 100 percent of value?
Ms. BAIR. I think there is a strong correlation with loan-to-value
ratios (LTVs). We actually recognize that in our capital standards
that we are working on now. We would require a much higher risk
weighting of loans which have high LTVs. So through capital
charges, we are recognizing and trying to incent lower LTVs.
29
Senator GREGG. I am running out of time unfortunately.
Mr. DUGAN. Senator, I think that you are onto a very important
point that I do not think has gotten the same kind of attention that
it deserved and what got us here in the mortgage market, not just
in subprime. I think we lost our way as a country in terms of some
of our basic underwriting standards on loan-to-value and on stated
income, and I think it is worth exploring having a more common
set of minimum underwriting standards that apply across the
board with more specificity than what we have today, which I
think is what you are suggesting.
Mr. TARULLO. Senator, I think leverage on the expectation of rising asset prices was at the heart of the subprime problem, and indeed, it is at the heart of some of the other problems that we see,
to some degree, in commercial real estate, as well. So, I would try
to reinforce any instinct you have to push people toward better underwriting standards, and we, as the Chairman noted, are trying
to do that ourselves.
Mr. SMITH. I would only add, Senator, that in the most successful
period I know of in home lending in the United States, there were
mainly two, maybe three varieties of loans generally in the underwriting standards world, as you say. There was a requirement of
a downpayment, for standard documentation, and the people that
made the loans kept them. And on the basis of that lending experience, we projectedthe magicians on Wall Street did projections
about the loans that werent like that.
So, I think there isas you point out, the issue there is the issue
of access to housing, and that is what it is. There is no free lunch
and no easy answer.
Senator GREGG. Thank you. Thank you very much for your testimony.
Senator JOHNSON. Senator Bennet.
Senator BENNET. Thank you, Mr. Chairman, and I would also
like to thank the panel for your excellent testimony.
Every weekend when I go home to Colorado, what I hear from
small businesses is they have no access to capital, no access to
credit, and we are in this, as the panel has talked about, in this
remarkably difficult period where, on the one hand, the securitized
market that blew up or imploded is now gone and has not been replaced, which is probably a good thing from a leverage point of
view, but it hasnt been replaced.
On the other hand, we have got this looming commercial real estate issue that is still out there. And sort of caught in between all
that are our small businesses who need access to capital in order
to grow and in order to deal with the unemployment rate that Senator Tester talked about and sort of this folding back on top of
itself.
And I wondered, Mr. Tarullo, you mentioned in your testimony
at the beginning your view that maybe some more direct efforts
I think you described it as temporary targeted programsmight be
necessary to get our small businesses access to the credit that they
need, and I wonder if you could elaborate a little bit more on that,
because I suspect you are right. And in addition to that, I would
ask to what extent we think the current accounting regimes are
30
ones that are either helping banks extend credit to small businesses or are intruding on their ability to do that.
Mr. TARULLO. So, Senator, I dont want to step on the prerogatives of the Congress, the Administration, various agencies that
may have
Senator BENNET. You can step on my prerogatives. I
Mr. TARULLO.but here is what I think. So what did we as a
government, as a country, try to do with residential mortgages
not yet as successfully as I think many people would have wanted?
We tried to do something about people losing their homes and to
provide some mechanisms, some special mechanisms that would
address those issues specifically, even as we all tried to put a foundation under the economy and get it growing again.
And my thought was that something similar probably needs to
be done in the small business arena, because I dont think I hear
as many of the stories as you do, but I hear enough of them, because I do try to get out and talk to borrowers as well as lenders.
So, whether that is trying to streamline SBA lending and make the
direct lending possibilities more real, or whether it is a new program which tries to provide guarantees, I dont have a strong view
on that and the Federal Reserve certainly has no view on it. But
I do think that something targeted is going to be an important
complement to the macro, bank regulatory, and TALF efforts that
we have.
Senator BENNET. Does anyone else have a view on that? Mr.
Smith?
Mr. SMITH. I would say in the absence of the type of a program
of the type Governor Tarullo is talking about, it seems to me what
clearly is needed is for small and medium-sized banks to clear up
their balance sheet problems they have right now. I mean, the
problems small businesses have in part are based on the fact that
balance sheets have impaired real estate on them that has to be
dealt with some way and that they have insufficient capital to
make additional loans until that is cleared up. So until we work
throughI mean, with all due respect to Senator Gregg, until the
real estate, the follow-on problem of the commercial real estate
problem for many of our banks is that it clogs up the balance
sheets or impairs them in a way they cant make loans.
Senator BENNET. I guess I would ask, Chairman Bair, maybe you
or Mr. Smith, to what extentI mean, I am told that in the early
1980s when we ran into trouble on agriculture, we did some things
like stretch out the period of time that assets had to be marked
down. And I dont want to tread into this too much, but I wonder
whether, given how serious the commercial real estate problem is,
whether we are in a position to unclog the assets in a way that
puts banks again in a position to be able to lend to small businesses.
Ms. BAIR. You need to be careful, obviously. You want to provide
flexibility to try to restructure the loans and accommodate borrowers in a way that preserves value but is fully disclosed. You
dont want to defer losses. If the losses are there, they need to be
realized. There is this difficult balance. You would not want to go
over to the regulatory forbearance situation, which I think did get
31
us in trouble during the S&L days. So, like anything, it is an important balance.
I wish Senator Gregg was still here, because regarding the capital support for the smaller banks, the smaller banks are disproportionately a source of lending, particularly for small business. That
is what they do. They do small business lending. They do commercial real estate. I am not normally an advocate for government support programs, but I do think the tremendous disparities in TARP
between the 25 largest banks, with 100 percent participation, and
for the smaller banks, less than 9 percent participation has created
competitive disparities between large and small institutionsbetween the too-big-to-fail institutions where funding costs are going
down, and the smaller institutions where funding costs are going
up.
Again, with a matching program that provides market validation
that an institution is viable, markets are more willing to put more
capital in. Additional capital could help balance-sheet capacity to
enable more of this type of lending by the smaller banks.
Ms. MATZ. Senator, I just wanted to make the point that credit
unions make loans to small businesses, or club member business
lending, and the average loan is only about $170,000. So they really are targeted to small businesses. In the current year, the lending
is up almost $2 billion. Last year, it was up $5 billion. So, more
and more, credit unions are making more and more loans to small
businesses.
Senator BENNET. Thank you, Mr. Chairman.
Senator JOHNSON. Senator Corker.
Senator CORKER. Mr. Chairman, thank you, and as always, I
thank each of you for your testimony. I always learn something
when you are here.
I also wish Senator Gregg was here. I think we share some of
the same intuitions and concerns, and while you know I respect the
FDIC and your leadership very much, I tend to hear regulators
talking about them wanting assistance to the banks that they have
liabilities to. I know Chairman Dugan, who I also respect greatly,
very much appreciated the TARP assistance to the banks that he
regulated so they wouldnt fail, and now you very much would like
TARP assistance to the banks that you have depositor worries
with. I just hate to hear us move into that mode, and again, I respect you both very, very much and have worked with you on lots
of legislation. I do hate hearing that kind of thing.
Chairman Bair, I know you mentioned the underwriting wasnt
really the issue because loans were underwritten well in the past
today are problems. But again, I think that was driven by the fact
that we had poor underwriting in the beginning and it created a
financial system issue that has really put us into this situation. So,
I do think those are very much tied together.
I will have to say that as we have looked at the regulatory reforms, it seems like we are just sort of rearranging the deck chairs.
I mean, the issue has been always real estate in modern times. As
we have had financial crises, it has always been real estate. I
havent heard anything in the regulatory reformI know we talk
about capital requirements, but the kinds of losses we have had,
we would have blown through those capital requirements you all
32
are talking about very, very quickly. We still would have needed
a systemic bailout or some kind of mechanism. So, to me, that is
not it.
I know that we talked a little bit gratuitously about maybe we
ought to put that in regulationI mean, in laws. I cant imagine
us writing laws up here that talk about what the equity ought to
be in homes and those kind of things. You all dont really want us
to do that, do you?
So, it seems to me that actually the Fed is supposed to put out
that type of guidance, is that correct?
Mr. TARULLO. That is correct, Senator, and we have now, yes.
Senator CORKER. So you are sending out guidance
Mr. TARULLO. Well, there is
Senator CORKER.that says that loans, you have to have 20
percent down payment
Mr. TARULLO. This is on the consumer protection side. One of the
needs to underwrite is to make sure that you are going to make
an assessment based on the ability of the borrower to pay, not just
on the rising value of the real estate, for example.
Mr. DUGAN. But, Senator, more generally, it is not just the Fed.
All of us
Mr. TARULLO. Right. When it comes to safety and soundness,
every regulator
Senator CORKER. I mean, I think it would be wonderful. Let us
face it. In the desire for policymakers to make sure people at every
income level led the life of middle-class citizens, we promoted loan
making that helped destroy our system. That wasnt the whole picture, but that certainly was a part of it. Are each of you as regulators saying that you are going to put out strong standards that
really counter policymakers desire to make sure that everybody in
America has a home and a ham in their pot? Is that basically what
you are saying you are going to do, because I think that is the only
way, by the way, we are going to keep this from happening again,
is it not?
Mr. TARULLO. I think, as Chairman Bair said a little while ago
she didnt say it quite in these words, but what I heard her say
was, we have got to worry about problems in the future as well as
problems in the past. I do think that the problems with underwriting played a very central, though not the only role, in the financial crisis. I do think we need underwriting standards for residential mortgages and in other areas
Senator CORKER. And each of you can write those, is that correct?
Mr. DUGAN. Yes.
Senator CORKER. And are each of you going to write standards
that are dramatically different from those that got us into the situation? I mean, each of you agreed with Senator Greggs questions,
but I wonder if we are actually going to take action to make that
occur.
Ms. BAIR. First of all, I want to clarify, there is plenty of bad underwriting. I want to emphasize that, the kinds of new credit problems we are seeing now are more economically driven. There was
plenty of bad underwriting in both mortgage lending as well as
commercial real estate.
33
We have tightened the standards tremendously. I think we are
being criticized in other quarters. Please note that we issued commercial real estate guidance in 2006.
Senator CORKER. Well, I
Ms. BAIR. The Federal Reserve Board has issued rules that apply
to both banks and non-banks for mortgage lending that significantly tighten the standards. That already has taken place. Also,
we are working on capital rules that will require greater capital
charges against higher-risk loans, such as those with high LTVs.
The bank regulators are doing all that, and have for some time.
You still have a fairly significant non-bank sector, one that can
come back as the capital markets heal. That is why I hope that,
going forward, in terms of whatever reforms you come up with,
that those reforms will reflect the fact that there are two different
sectors, two different providers of credit in this country. We can
keep tamping down on the banks as we have been. But if the nonbank sector is left, by and large, unregulated, that is not going to
fix the problem.
Mr. DUGAN. And Senator, if I could just add, if you look at the
experience of Canada where they are our neighbors and have a
much more conservative standard for underwriting, where they
verify income and have loan-to-value ratios that are higher, you
cant get a 30-year fixed-rate mortgage, but they have very high
levels of home ownership and they didnt have any of these problems. So, they have more of a system that has a basic minimum
that cuts across the board. It may not be the right ones for us, but
I definitely think it is worth exploring.
Senator CORKER. And I would really likeI know that I am
going to run out of time here and we are not going to be able to
but we talk often, I know, all of usI would really like to see what
it is we need to do on our end. I dont think we as a country have
the political will to do the things we need to do to make sure that
this doesnt happen again. I absolutely do not see it. I mean, this
regulatory reform, again, is just moving chairs around. It is not
changing anything about the way that we go about doing this business. And I hope that as we move along, you all will help with that.
Mr. Tarullo, again, I thank you for your testimony, also, as always. I am wondering, on 13(3), as we move into regulation, should
weI mean, in essence, we are going to be talking about TARP
and resolution and all of those kind of things down the road, but
on the 13(3) issue, exigent circumstances, should we move to narrow the Feds ability to use 13(3) for specific institutions, move
away from that so that your assistance is at the system level, but
where you are not specificallyI mean, in essence, you can get
aroundI know that some people here support the Administrations proposal to sort of codify TARP. I dont. I think we should
end TARP at the end of the year. But it seems to me that under
13(3), the way you now have it, you all can work around that at
the Fed and, in essence, do the same thing at specific institutions,
and I am wondering if you feel we ought to limit that.
Mr. TARULLO. So, I would say, Senator, that I think most people
at the Federal Reserve would be happy if they were not in the position where people came to us when there was a need for resolving
or dealing with a specific financial institution, but I do think one
34
needs to have a mechanism, a mechanism in law by which some
part of the government can deal with the large financial institution
that may be in distress.
And that is why I think all three of us, certainly, have supported
moving forward with a resolution mechanism that would cover the
large financial institutions. I do think within the context of that,
you have to address the question of potential funding streams for
short-term liabilities or the sort. So, I think it needs to be addressed somewhere. It doesnt need to be in 13(3).
Senator CORKER. If I am hearing you properly, if we had a resolution mechanism in place, which we did not have for complex bank
holding companies and others, like AIG, which is not one of those
if we had a resolution mechanism that was defined and we had the
ability to fund the short term, while you are resolving that, hopefully not in conservatorship but in receivership, where you are putting them out of business, in essence, we could narrow the abilities
of the Fed and also not support the Administrations proposal for
Treasury to hold unto itself the ability to put taxpayer money into
various entities they feel might pose systemic risk. We could do
away with that if we had an appropriate resolution mechanism.
Mr. TARULLO. Well, I think you do need a mechanism that can
provide, in appropriate circumstances, for the sort of assistance
that might be needed, and if you have that, it doesnt need to be
done through 13(3), and as I said, I think the Federal Reserve
would prefer that it not be done through 13(3).
Senator CORKER. And you are perfectly satisfied we are resolving
them out of existence? You are not talking about that assistance
to conserve an institution?
Mr. TARULLO. Well, I thinkso, Senator, that is probably one of
the open questions, and exactly what do we mean, I think there
isI think what is important is that there be real prospects of
losses for shareholders and creditors when their large institution
gets in that circumstance.
Senator CORKER. Mr. Chairman, I thank you, and I am sorry we
didnt get to each of you. I do hope that what we are doing with
the smaller banks, that some assistance was being sought through
TARP here earlier, I hope that we are encouraging them, while
they can, those who can, to raise capital. I have seen this taking
place now and shareholders are being deluded and we are going
ahead and raising the capital necessary to weather this storm.
I thank each of you and I look forward to seeing you again soon.
Senator JOHNSON. Senator Schumer.
Senator SCHUMER. Thank you, Mr. Chairman. I want to thank
you for holding this hearing. I thank the witnesses.
I would like to talk a little bit about fees and consumer protection, Consumer Protection Agency. Many of the banks we know
have reacted to lost profits from their mortgage problems by raising fees on consumers, one of which is overdraft fees. There is no
transparency. They dont give consumers a real chance to decide if
they wanteven want this kind of protection.
Banks raked in about $24 billion in overdraft fees last year. That
was up 35 percent from the year before. That ought to stick out.
Even accounting for higher debit card use, a worsening credit environment due to the economy, that is a massive increase. It indi-
35
cates to me that consumers are bearing a disproportionate burden
in maintaining the health of many banks balance sheets.
They are also raising ATM fees, as you know. Bank of America
recent raised its fee for other bank customers to $3. That would
have been unheard of a few years ago. Maybe one of these fly bynight machines would have done that, but not a major bank. And
the average cost of an ATM transaction is also now over $3.
Even if you withdraw $100, that is a high fee in percentage
terms, and, of course, the overdraft fees, you buy a $2 cup of coffee
and they charge you $35 without even telling you. It makes your
blood boil.
So, my question is this. This is to really to Comptroller Dugan,
Mr. Ward. As regulators, you are responsible for not only safety
and soundness, but consumer protections. Maybe Mr. Tarullo also
has a role here. What are you doing to ensure that consumers dont
bear the brunt of banks efforts to repair balance sheets, particularly in these two instances?
Mr. DUGAN. On the area of overdraft fees, we actually dont have
the rulemaking authority in that area. The Federal Reserve has
that authority. They currently have a proposal that is out. We also
dont have authority to write rules for unfair and deceptive practices. We have done, as regulators
Senator SCHUMER. Dont you have general authority on consumer-type issues? Not at all?
Mr. DUGAN. Not on general fee regulation. Either it is mostly disclosure-based that is set by rules promulgated by others, or if it
gets to a point where it is unfair and deceptive, yes. And in answer
Senator SCHUMER. Dont you think these are unfair and deceptive
Mr. DUGAN. I think that it is absolutely the case that consumers
should be given the right to opt into have a choice about whether
to participate in these programs or not.
Senator SCHUMER. But, Mr. Dugan, if you decided that these
were unfair and deceptive, which I think average people hearing
about these, they are deceptive because you dont know, they are
unfair because they are so high, you could do something.
Mr. DUGAN. And I think that the proposal that the Federal Reserve has put out that has not yet been adopted does address the
question of consent to these programs, which is critically important.
Senator SCHUMER. OK, the Fed, tell us what you are doing.
Mr. TARULLO. That is correct, Senator. We have a proposal that
we are working on right now which would go right to the heart of
the issue of opt in/opt out. And although I cant obviously prejudge
what the Board will do, I expect that within the next month, that
is going to come up for consideration
Senator SCHUMER. Has that been made public, that proposal?
Mr. TARULLO. Yes. That has been made public.
Senator SCHUMER. OK. And what does it do, specifically?
Mr. TARULLO. This would provide for the ability of a consumer
to know that he or she was opting into a program like this and to
understand the terms under which
36
Senator SCHUMER. It would let the consumer know at the
time
Mr. TARULLO. Yes.
Senator SCHUMER.that they are in overdraft status and
Mr. TARULLO. That is actually more difficult technically, and that
is some of what is out for comment right now.
Senator SCHUMER. Well, they used to do that all the time.
Mr. TARULLO. But that is
Senator SCHUMER. It would not honor the request because you
didnt have the money.
Mr. TARULLO. Right, and with the advent of technologies like
debit cards, for example, it becomes more complicated than it was
before. But that is one of the things that is out for comment and
consideration right now, is how this might be done.
Senator SCHUMER. OK. When did you start working on this proposal?
Mr. TARULLO. Let me see. I actually dont
Senator SCHUMER. Not only you, but
Mr. TARULLO. I dont know when the staff started working on it,
Senator, and I will have to get back to you on that. I first became
aware of it a couple of months ago.
Senator SCHUMER. Right. OK. And what about on the other issue
that I mentioned?
Mr. TARULLO. On the fees issue?
Senator SCHUMER. Yes.
Mr. TARULLO. So, I dont think we have a current rulemaking on
ATM fees. That has been an issue in the past, so I would have
to
Senator SCHUMER. Do you think $3 is excessive?
Mr. TARULLO. Well, I thinkagain, there
Senator SCHUMER. Well, let me ask you another question. Has
the cost from 2 years ago to now gone up so that it would merit
a large increase in the fee?
Mr. TARULLO. Well, I doubt that the cost has gone up very much,
and so the question, as with all fees, becomes the degree to which
an institution ought to be able to make that judgment if it is fully
disclosed or not.
Senator SCHUMER. OK. As you know, I think the Fed does a good
job in many areas, but in consumer protection, I dont think the
regulatory agencies have done a good job, and here isI mean,
maybe this is a little rhetorical. It is to me, but I am going to let
you guys answer it. I mean, isnt what we have just heard a good
reason that we need a strong, independent agency to protect the interests of consumers, separate and apart from safety and soundness regulators?
Mr. TARULLO. Umm
Senator SCHUMER. I mean, I have found that in the consumer
area, the Fed and the OCC doesnt do much, although I think they
have the power to do some things. It is slow. Still in the back of
their mind is the idea of safety and soundness and bank balance
sheets. And the consumer doesnt get all the protection he or she
deserves. It is one of the reasons I believe the agency that Senator
Dodd is proposing, and original Senator Durbin and I proposed, a
Consumer Financial-Consumer Product Safety Commission, is so
37
needed. Also, they are able to deal with new issues as they come
up. They dontI suppose Mr. Dugan would have to go into rulemaking and say what is unfair, what is deceptive, and they would
figure out a way around that.
Why wouldnt it be better to have these myriad of issuesand
our financial institutions are getting better and better at coming up
with new ways to make feeswhy isnt it better to have an agency
exclusively devoted to that doing the job as opposed to a regulator
which has many other important jobs to do to deal with? I would
ask both Mr. Tarullo and Mr. Dugan, and then anyone else who
would want to comment.
Mr. DUGAN. Sure.
Mr. TARULLO. Senator, as I think you know, the Federal Reserve,
as a Board, has no position one way or the other on creation of the
CFPA, but I would make the following observations. First, I think
there are undoubted merits to having a single Consumer Protection
Agency whose sole focus is on that function.
Second, though, you will lose something if you do it. You will lose
some of the combination of understanding of safety and soundness
and consumer protection. I think there is a risk. This has not necessarily happened, but there is a risk that sometimes the impact
on credit availability wont be fully understood. These are things
that can be addressed, but I think that there would be costs.
A third point is, as you probably also know, prior to my joining
the Federal Reserve Board in January, I was quite critical of the
failure of the bank regulatory agencies generally to engage in
enough consumer protection on subprime, on credit cards, and
many other things. I will say, though, that I think in the last few
years, Chairman Bernanke has set a tone at the Fed which has
been one of looking for vigorous consumer protection and that the
rules on credit cards and the rules on home mortgages are evidence
of that. It may not be everything you think that needs to be done,
but I think it has been done.
Senator SCHUMER. Chairman Dugan?
Mr. DUGAN. Senator, I think there are two very powerful
Senator SCHUMER. Comptroller Dugan.
Mr. DUGAN. Comptroller. That is OK. There are two very good
and powerful ideas connected with the CFPA. One is to have common rules that apply to everybody, whether you are a bank or a
non-bank, and to have strong authority to do that. So I think that
is important.
Second, I think the part of the system that had the least attention paid to it were the non-banks in terms of how rules are implemented. You dont have the comprehensive regime today. So that
part, I think, can be a very good and powerful idea.
The part that I have had concerns about is implementing those
rules on banks and carrying them out through supervision, examination, and enforcement. I think that should stay with the bank
regulators. I think that you do get a benefit from things that are
interwoven together between consumer protection and safety and
soundness, like underwriting standards in subprime mortgages,
which are related to consumer protection issues. We see examples
of it all the time, which I provided to the Committee in our last
testimony. That is the part I would worry about.
38
And then, second, the notion that the new agency should focus
its implementation responsibilities on the non-banks, again, very
powerful idea.
Senator SCHUMER. Would you justI know my time has expired,
Mr. Chairmanin retrospect, do you think the regulatory agencies,
not yours in particular, but including yourshave done as vigorous
a job on consumer protection as they should have?
Mr. DUGAN. I
Senator SCHUMER. In the areas that you have jurisdiction over,
not the non-banks.
Mr. DUGAN. Well, again, you have to sort of go area by area, but
in some places, no. Other places, yes, which I think are not recognized. And I do think there has been the systemic problem that we
only have a part of the pie and there is a big chunk of it that no
one is looking at.
Senator SCHUMER. No, that is true. That is one argument for it.
Do you agree? Mr. Tarullo, how about you? Do you think your
agency and all of the agencies have done as good a job as they
should have on consumer protection?
Mr. TARULLO. Senator, I am on record saying it, so I will say it
again. I dont think the agencies, including the Federal Reserve,
did a good enough job.
Senator SCHUMER. Thank you. Thanks, Mr. Chairman.
Senator JOHNSON. I want to thank the witnesses once again for
being here today. I look forward to working with the members of
the Banking Committee as we continue to consider measures to
stabilize the banking sector and our economy as a whole.
This hearing is adjourned.
[Whereupon, at 4:29 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions follow:]
39
PREPARED STATEMENT OF SENATOR TIM JOHNSON
As Congress and this Committee continue its work to stabilize financial institutions and promote our nations economic recovery, I have called this hearing today
for regulators to give us an update on the current conditions of the financial institutions in our country. It is vital that we know what continuing challenges and concerns our nations institutions face. Specifically, I continue to be concerned about the
lending environment, particularly for small businesses, the capital needs of institutions, and the impact of commercial real estate and other loan portfolios on institutions balance sheets. In addition, while many of the large banks in our country
have stabilized, the FDICs list of troubled banks, many of them small community
banks, is growing.
While restructuring our nations regulatory system is this Committees top priority, I dont think we can do that without a clear understanding of what is happening within the sector. Concerns and problems within individual financial institutions will still exist even with a new regulatory structure unless they are addressed
as well. Continuing to ensure the safety and soundness of viable institutions and
the overall financial stability of our nations economy is vital to protecting all Americans pocketbooks, savings and retirement.
I want to thank the witnesses for being here today, and I look forward to hearing
from each of you regarding any developing trends or concerns within the banking
industry or throughout the economy, and to hear of the regulatory or supervisory
steps your agencies are taking to respond to these challenges.
PREPARED STATEMENT OF SENATOR MIKE CRAPO
Thank you, Mr. Chairman, for holding this hearing to examine the state of the
banking and credit union industry.
Failures of small banks continue to grow and key trouble spots are looming, such
as commercial real estate loans. According to a recent New York Times article,
about $870 billion, or roughly half of the industrys $1.8 trillion of commercial real
estate loans, now sit on the balance sheet of small and medium sized banks. I am
interested in learning to what extent has the Term Asset-Backed Securities Loan
Facility (TALF) encouraged capital to enter the commercial real estate market and
what other steps should regulators take to address this problem.
Many community banks and credit unions have tried to fill the lending gap
caused by the credit crisis. Even with these efforts, it is apparent that many consumers and small businesses are not receiving the lending they need to refinance
their home loan, extend their business line of credit, or receive capital for new business opportunities. Regulators need to be mindful that they strike the appropriate
balance to bolster capital and meet the credit needs of our economy. FASBs new
rules on off-balance sheets will create challenges on this point.
As we began to explore options to modernize our financial regulatory structure,
it is important that our new structure allows financial institutions to play an essential role in the U.S. economy by providing a means for consumers and businesses
to save for the future, to protect and hedge against risk, and promote lending opportunities.
Again, I thank the Chairman for holding this hearing and I look forward to working with him and other Senators on these and other issues.
PREPARED STATEMENT OF SHEILA C. BAIR
CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION
OCTOBER 14, 2009
Chairman Johnson, Ranking Member Crapo and members of the Subcommittee,
I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance
Corporation (FDIC) regarding the condition of FDIC-insured institutions and the deposit insurance fund (DIF). While challenges remain, evidence is building that financial markets are stabilizing and the American economy is starting to grow again.
As promising as these developments are, the fact is that bank performance typically
lags behind economic recovery and this cycle is no exception. Regardless of whatever
challenges still lie ahead, the FDIC will continue protecting insured depositors as
we have for over 75 years.
The FDIC released its comprehensive summary of second quarter 2009 financial
results for all FDIC-insured institutions on August 27. The FDICs Quarterly Banking Profile provided evidence that the difficult and necessary process of recognizing
40
loan losses and cleaning up balance sheets continues to be reflected in the industrys
bottom line. As a result, the number of problem institutions increased significantly
during the quarter. We expect the numbers of problem institutions to increase and
bank failures to remain high for the next several quarters.
My testimony today will review the financial performance of FDIC-insured institutions and highlight some of the most significant risks that the industry faces. In
addition, I will discuss the steps that we are taking through supervisory and resolutions processes to address risks and to reduce costs from failures. Finally, I will
summarize the condition of the DIF and the recent steps that we have taken to
strengthen the FDICs cash position.
Economy
In the wake of the financial crisis of last Fall and the longest and deepest recession since the 1930s, the U.S. economy appears to be growing once again. Through
August, the index of leading economic indicators had risen for five consecutive
months. Consensus forecasts call for the economy to grow at a rate of 2.4 percent
or higher in both the third and fourth quarters. While this relative improvement
in economic conditions appears to represent a turning point in the business cycle,
the road to full recovery will be a long one that poses additional challenges for
FDIC-insured institutions.
While we are encouraged by recent indications of the beginnings of an economic
recovery, growth may still lag behind historical norms. There are several reasons
why the recovery may be less robust than was the case in the past. Most important
are the dislocations that have occurred in the balance sheets of the household sector
and the financial sector, which will take time to repair.
Households have experienced a net loss of over $12 trillion in net worth during
the past 7 quarters, which amounts to almost 19 percent of their net worth at the
beginning of the period. Not only is the size of this wealth loss unprecedented in
our modern history, but it also has been spread widely among households to the extent that it involves declines in home values. By some measures, the average price
of a U.S. home has declined by more than 30 percent since mid-2006. Home price
declines have left an estimated 16 million mortgage borrowers underwater and
have contributed to an historic rise in the number of foreclosures, which reached
almost 1.5 million in just the first half of 2009.1
Household financial distress has been exacerbated by high unemployment. Employers have cut some 7.2 million jobs since the start of the recession, leaving over
15 million people unemployed and pushing even more people out of the official labor
force. The unemployment rate now stands at a 26-year high of 9.8 percent, and may
go higher, even in an expanding economy, while discouraged workers re-enter the
labor force.
In response to these disruptions to wealth and income, U.S. households have
begun to save more out of current income. The personal savings rate, which had
dipped to as low as 1.2 percent in the third quarter of 2005, rose to 4.9 percent as
of second quarter 2009 and could go even higher over the next few years as households continue to repair their balance sheets. Other things being equal, this trend
is likely to restrain growth in consumer spending, which currently makes up more
than 70 percent of net GDP.
Financial sector balance sheets also have undergone historic distress in the recent
financial crisis and recession. Most notably, we have seen extraordinary government
interventions necessary to stabilize several large financial institutions, and now as
the credit crisis takes its toll on the real economy, a marked increase in the failure
rate of smaller FDIC-insured institutions. Following a 5-year period during which
only ten FDIC-insured institutions failed, there were 25 failures in 2008 and another 98 failures so far in 2009.
In all, FDIC-insured institutions have set aside just over $338 billion in provisions
for loan losses during the past six quarters, an amount that is about four times larger than their provisions during the prior six quarter period. While banks and thrifts
are now well along in the process of loss recognition and balance sheet repair, the
process will continue well into next year, especially for commercial real estate
(CRE).
Recent evidence points toward a gradual normalization of credit market conditions
amid still-elevated levels of problem loans. We meet today just 1 year after the historic liquidity crisis in global financial markets that prompted an unprecedented response on the part of governments around the world. In part as a result of the
1 Sources: Moodys Economy.com (borrowers underwater) and FDIC estimate based upon
Mortgage Bankers Association, National Delinquency Survey, second quarter 2009 (number of
foreclosures).
41
Treasurys Troubled Asset Relief Program (TARP), the Federal Reserves extensive
lending programs, and the FDICs Temporary Liquidity Guarantee Program (TLGP),
financial market interest rate spreads have retreated from highs established at the
height of the crisis last Fall and activity in interbank lending and corporate bond
markets has increased.
However, while these programs have played an important role in mitigating the
liquidity crisis that emerged at that time, it is important that they be rolled back
in a timely manner once financial market activity returns to normal. The FDIC
Board recently proposed a plan to phaseout the debt guarantee component of the
Temporary Liquidity Guarantee Program (TLGP) on October 31st. This will represent an important step toward putting our financial markets and institutions back
on a self-sustaining basis. And even while we seek to end the various programs that
were effective in addressing the liquidity crisis, we also recognize that we may need
to redirect our efforts to help meet the credit needs of household and small business
borrowers.
For now, securitization markets for government-guaranteed debt are functioning
normally, but private securitization markets remain largely shut down. During the
first 7 months of 2009, $1.2 trillion in agency mortgage-backed securities were
issued in comparison to just $9 billion in private mortgage-backed securities.
Issuance of other types of private asset-backed securities (ABS) also remains weak.
ABS issuance totaled only $118 billion during the first 9 months of 2009 in comparison to $136 billion during the first 9 months of 2008 and peak annual issuance of
$754 billion in 2006.
Significant credit distress persists in the wake of the recession, and has now
spread well beyond nonprime mortgages. U.S. mortgage delinquency and foreclosure
rates also reached new historic highs in second quarter of 2009 when almost 8 percent of all mortgages were seriously delinquent. In addition, during the same period,
foreclosure actions were started on over 1 percent of loans outstanding.2 Consumer
loan defaults continue to rise, both in number and as a percent of outstanding loans,
although the number of new delinquencies now appears to be tapering off. Commercial loan portfolios are also experiencing elevated levels of problem loans which industry analysts suggest will peak in late 2009 or early 2010.
Recent Financial Performance of FDICInsured Institutions
The high level of distressed assets is reflected in the weak financial performance
of FDIC-insured institutions. FDIC-insured institutions reported an aggregate net
loss of $3.7 billion in second quarter 2009. The loss was primarily due to increased
expenses for bad loans, higher noninterest expenses and a one-time loss related to
revaluation of assets that were previously reported off-balance sheet. Commercial
banks and savings institutions added $67 billion to their reserves against loan
losses during the quarter. As the industry has taken loss provisions at a rapid pace,
the industrys allowance for loan and lease losses has risen to 2.77 percent of total
loans and leases, the highest level for this ratio since at least 1984. However, noncurrent loans have been growing at a faster rate than loan loss reserves, and the
industrys coverage ratio (the allowance for loan and lease losses divided by total
noncurrent loans) has fallen to its lowest level since the third quarter of 1991.3
Insured institutions saw some improvement in net interest margins in the quarter. Funding costs fell more rapidly than asset yields in the current low interest rate
environment, and margins improved in the quarter for all size groups. Nevertheless,
second quarter interest income was 2.3 percent lower than in the first quarter and
15.9 percent lower than a year ago, as the volume of earning assets fell for the second consecutive quarter. Industry noninterest income fell by 1.8 percent compared
to the first quarter.
Credit quality worsened in the second quarter by almost all measures. The share
of loans and leases that were noncurrent rose to 4.35 percent, the highest it has
been since the data were first reported. Increases in noncurrent loans were led by
1-to-4 family residential mortgages, real estate construction and development loans,
and loans secured by nonfarm nonresidential real estate loans. However, the rate
of increase in noncurrent loans may be slowing, as the second-quarter increase in
noncurrent loans was about one-third smaller than the volume of noncurrent loans
added in first quarter. The amount of loans past-due 3089 days was also smaller
at the end of the second quarter than in the first quarter. Net charge-off rates rose
to record highs in the second quarter, as FDIC-insured institutions continued to recognize losses in the loan portfolios. Other real estate owned (ORE) increased 79.7
percent from a year ago.
2 Source:
Mortgage Bankers Association, National Delinquency Survey, Second Quarter 2009.

loans are loans 90 or more days past due or in nonaccrual status.
3 Noncurrent
42
Many insured institutions have responded to stresses in the economy by raising
and conserving capital, some as a result of regulatory reviews. Equity capital increased by $32.5 billion (2.4 percent) in the quarter. Treasury invested a total of
$4.4 billion in 117 independent banks and bank and thrift holding companies during
the second quarter, and nearly all of these were community banks. This compares
to a total of more than $200 billion invested since the program began. Average regulatory capital ratios increased in the quarter as well. The leverage capital ratio increased to 8.25 percent, while the average total risk-based capital ratio rose to 13.76
percent. However, while the average ratios increased, fewer than half of all institutions reported increases in their regulatory capital ratios.
The nations nearly 7,500 community banksthose with less than $1 billion in
total assetshold approximately 11 percent of total industry assets. They posted an
average return on assets of negative 0.06 percent, which was slightly better than
the industry as a whole. As larger banks often have more diverse sources of noninterest income, community banks typically get a much greater share of their operating income from net interest income. In general, community banks have higher
capital ratios than their larger competitors and are much more reliant on deposits
as a source of funding.
Average ratios of noncurrent loans and charge-offs are lower for community banks
than the industry averages. In part, this illustrates the differing loan mix between
the two groups. The larger banks loan performance reflects record high loss rates
on credit card loans and record delinquencies on mortgage loans. Community banks
are important sources of credit for the nations small businesses and small farmers.
As of June 30, community banks held 38 percent of the industrys small business
and small farm loans.4 However, the greatest exposures faced by community banks
may relate to construction loans and other CRE loans. These loans made up over
43 percent of community bank portfolios, and the average ratio of CRE loans to total
capital was above 280 percent.
As insured institutions work through their troubled assets, the list of problem
institutionsthose rated CAMELS 4 or 5will grow. Over a hundred institutions
were added to the FDICs problem list in the second quarter. The combined assets
of the 416 banks and thrifts on the problem list now total almost $300 billion. However, the number of problem institutions is still well below the more than 1,400
identified in 1991, during the last banking crisis on both a nominal and a percentage basis. Institutions on the problem list are monitored closely, and most do not
fail. Still, the rising number of problem institutions and the high number of failures
reflect the challenges that FDIC-insured institutions continue to face.
Risks to FDICInsured Institutions
Troubled loans at FDIC-insured institutions have been concentrated thus far in
three main areasresidential mortgage loans, construction loans, and credit cards.
The credit quality problems in 1-to-4 family mortgage loans and the coincident declines in U.S. home prices are well known to this Committee. Net chargeoffs of 1to 4-famly mortgages and home equity lines of credit by FDIC-insured institutions
over the past 2 years have totaled more than $65 billion. Declining home prices
have also impacted construction loan portfolios, on which many small and mid-sized
banks heavily depend. There has been a tenfold increase in the ratio of noncurrent
construction loans since mid-year 2007, and this ratio now stands at a near-record
13.5 percent. Net charge-offs for construction loans over the past 2 years have totaled about $32 billion, and almost 40 percent of these were for one-to-four family
construction.
With the longest and deepest recession since the 1930s has come a new round of
credit problems in consumer and commercial loans. The net charge-off rate for credit
card loans on bank portfolios rose to record-high 9.95 percent in the second quarter.
While stronger underwriting standards and deleveraging by households should
eventually help bring loss rates down, ongoing labor market distress threatens to
keep loss rates elevated for an extended period. By contrast, loans to businesses,
i.e., commercial and industrial (C&I) loans, have performed reasonably well given
the severity of the recession in part because corporate balance sheets were comparatively strong coming into the recession. The noncurrent loan ratio of 2.79 percent
for C&I loans stands more than four times higher than the record low seen in 2007,
but remains still well below the record high of 5.14 percent in 1987.
The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending. While financing vehicles
such as commercial mortgage-backed securities (CMBS) have emerged as significant
4 Defined as commercial and industrial loans or commercial real estate loans under $1 million
or farm loans less than $500,000.
43
CRE funding sources in recent years, FDIC-insured institutions still hold the largest
share of commercial mortgage debt outstanding, and their exposure to CRE loans
stands at an historic high. As of June, CRE loans backed by nonfarm, nonresidential
properties totaled almost $1.1 trillion, or 14.2 percent of total loans and leases.
The deep recession, in combination with ongoing credit market disruptions for
market-based CRE financing, has made this a particularly challenging environment
for commercial real estate. The loss of more than 7 million jobs since the onset of
the recession has reduced demand for office space and other CRE property types,
leading to deterioration in fundamental factors such as rental rates and vacancy
rates. Amid weak fundamentals, investors have been re-evaluating their required
rate of return on commercial properties, leading to a sharp rise in cap rates and
lower market valuations for commercial properties. Finally, the virtual shutdown of
CMBS issuance in the wake of last years financial crisis has made financing harder
to obtain. Large volumes of CRE loans are scheduled to roll over in coming quarters,
and falling property prices will make it more difficult for some borrowers to renew
their financing.
Outside of construction portfolios, losses on loans backed by CRE properties have
been modest to this point. Net charge-offs on loans backed by nonfarm, nonresidential properties have been just $6.2 billion over the past 2 years. Over this period,
however, the noncurrent loan ratio in this category has quadrupled, and we expect
it to rise further as more CRE loans come due over the next few years. The ultimate
scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during that time.
FDIC Response to Industry Risks and Challenges
Supervisory Response to Problems in Banking Industry
The FDIC has maintained a balanced supervisory approach that focuses on vigilant oversight but remains sensitive to the economic and real estate market conditions. Deteriorating credit quality has caused a reduction in earnings and capital
at a number of institutions we supervise which has resulted in a rise in problem
banks and the increased issuance of corrective programs. We have been strongly advocating increased capital and loan loss allowance levels to cushion the impact of
rising non-performing assets. Appropriate allowance levels are a fundamental tenet
of sound banking, and we expect that banks will add to their loss reserves as credit
conditions warrantand in accordance with generally accepted accounting principles.
We have also been emphasizing the importance of a strong workout infrastructure
in the current environment. Given the rising level of non-performing assets, and difficulties in refinancing loans coming due because of decreased collateral values and
lack of a securitization market, banks need to have the right resources in place to
restructure weakened credit relationships and dispose of other real estate holdings
in a timely, orderly fashion.
We have been using a combination of offsite monitoring and onsite examination
work to keep abreast of emerging issues at FDIC-supervised institutions and are accelerating full-scope examinations when necessary. Bankers understand that FDIC
examiners will perform a thorough, yet balanced asset review during our examinations, with a particular focus on concentrations of credit risk. Over the past several
years, we have emphasized the risks in real estate lending through examination and
industry guidance, training, and targeted analysis and supervisory activities. Our
efforts have focused on underwriting, loan administration, concentrations, portfolio
management and stress testing, proper accounting, and the use of interest reserves.
CRE loans and construction and development loans are a significant examination
focus right now and have been for some time. Our examiners in the field have been
sampling banks CRE loan exposures during regular exams as well as special visitations and ensuring that credit grading systems, loan policies, and risk management
processes have kept pace with market conditions. We have been scrutinizing for
some time construction and development lending relationships that are supported
by interest reserves to ensure that they are prudently administrated and accurately
portray the borrowers repayment capacity. In 2008, we issued guidance and produced a journal article on the use of interest reserves,5 as well as internal review
procedures for examiners.
We strive to learn from those instances where the banks failure led to a material
loss to the DIF, and we have made revisions to our examination procedures when
warranted. This self-assessment process is intended to make our procedures more
5 FDIC, Supervisory Insights, http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/article01lPrimer.html.
44
forward-looking, timely and risk-focused. In addition, due to increased demands on
examination staff, we have been working diligently to hire additional examiners
since 2007. During 2009, we hired 440 mid career employees with financial services
skills as examiners and almost another 200 examiner trainees. We are also conducting training to reinforce important skills that are relevant in todays rapidly
changing environment. The FDIC continues to have a well-trained and capable supervisory workforce that provides vigilant oversight of state nonmember institutions.
Measures to Ensure Examination Programs Dont Interfere with Credit Availability
Large and small businesses are contending with extremely challenging economic
conditions which have been exacerbated by turmoil in the credit markets over the
past 18 months. These conditions, coupled with a more risk-averse posture by lenders, have diminished the availability of credit.
We have heard concerns expressed by Members of Congress and industry representatives that banking regulators are somehow instructing banks to curtail lending, making it more difficult for consumers and businesses to obtain credit or roll
over otherwise performing loans. This is not the case. The FDIC provides banks
with considerable flexibility in dealing with customer relationships and managing
loan portfolios. I can assure you that we do not instruct banks to curtail prudently
managed lending activities, restrict lines of credit to strong borrowers, or require
appraisals on performing loans unless an advance of new funds is being contemplated.
It has also been suggested that regulators are expecting banks to shut off lines
of credit or not roll-over maturing loans because of depreciating collateral values.
To be clear, the FDIC focuses on borrowers repayment sources, particularly their
cash-flow, as a means of paying off loans. Collateral is a secondary source of repayment and should not be the primary determinant in extending or refinancing loans.
Accordingly, we have not encouraged banks to close down credit lines or deny a refinance request solely because of weakened collateral value.
The FDIC has been vocal in its support of bank lending to small businesses in
a variety of industry forums and in the interagency statement on making loans to
creditworthy borrowers that was issued last November. I would like to emphasize
that the FDIC wants banks to make prudent small business loans as they are an
engine of growth in our economy and can help to create jobs at this critical juncture.
In addition, the Federal banking agencies will soon issue guidance on CRE loan
workouts. The agencies recognize that lenders and borrowers face challenging credit
conditions due to the economic downturn, and are frequently dealing with diminished cash-flows and depreciating collateral values. Prudent loan workouts are often
in the best interest of financial institutions and borrowers, particularly during difficult economic circumstances and constrained credit availability. This guidance reflects that reality, and supports prudent and pragmatic credit and business decisionmaking within the framework of financial accuracy, transparency, and timely loss
recognition.
Innovative resolution structures
The FDIC has made several changes to its resolution strategies in response to this
crisis, and we will continue to re-evaluate our methods going forward. The most important change is an increased emphasis on partnership arrangements. The FDIC
and RTC used partnership arrangements in the pastspecifically loss sharing and
structured transactions. In the early 1990s, the FDIC introduced and used loss sharing. During the same time period, the RTC introduced and used structured transactions as a significant part of their asset sales strategy. As in the past, the FDIC
has begun using these types of structures in order to lower resolution costs and simplify the FDICs resolution workload. Also, the loss share agreements reduce the
FDICs liquidity needs, further enhancing the FDICs ability to meet the statutory
least cost test requirement.
The loss share agreements enable banks to acquire an entire failed bank franchise
without taking on too much risk, while the structured transactions allow the FDIC
to market and sell assets to both banks and non-banks without undertaking the
tasks and responsibilities of managing those assets. Both types of agreements are
partnerships where the private sector partner manages the assets and the FDIC
monitors the partner. An important characteristic of these agreements is the alignment of interests: both parties benefit financially when the value of the assets is
maximized.
For the most part, after the end of the savings and loan and banking crisis of the
late 1980s and early 1990s, the FDIC shifted away from these types of agreements
to more traditional methods since the affected asset markets became stronger and
45
more liquid. The main reason why we now are returning to these methods is that
in the past several months investor interest has been low and asset values have
been uncertain. If we tried to sell the assets of failed banks into todays markets,
the prices would likely be well below their intrinsic valuethat is, their value if
they were held and actively managed until markets recover. The partnerships allow
the FDIC to sell the assets today but still benefit from future market improvements.
During 2009, the FDIC has used loss share for 58 out of 98 resolutions. We estimate
that the cost savings have been substantial: the estimated loss rate for loss share
failures averaged 25 percent; for all other transactions, it was 38 percent. Through
September 30, 2009, the FDIC has entered into seven structured transactions, with
about $8 billion in assets.
To address the unique nature of todays crisis, we have made several changes to
the earlier agreements. The earlier loss share agreements covered only commercial
assets. We have updated the agreements to include single family assets and to require the application of a systematic loan modification program for troubled mortgage loans. We strongly encourage our loss share partners to adopt the Administrations Home Affordable Modification Program (HAMP) for managing single family
assets. If they do not adopt the HAMP, we require them to use the FDIC loan modification program which was the model for the HAMP modification protocol. Both are
designed to ensure that acquirers offer sustainable and affordable loan modifications
to troubled homeowners whenever it is cost-effective. This serves to lower costs and
minimize foreclosures. We have also encouraged our loss share partners to deploy
forbearance programs when homeowners struggle with mortgage payments due to
life events (unemployment, illness, divorce, etc.). We also invite our loss share partners to propose other innovative strategies that will help keep homeowners in their
homes and reduce the FDICs costs.
In addition, the FDIC has explored funding changes to our structured transactions to make them more appealing in todays environment. To attract more bidders and hopefully higher pricing, the FDIC has offered various forms of leverage.
In recent transactions where the leverage was provided to the investors, the highest
bids with the leverage option substantially improved the overall economics of the
transactions. The overall feedback on the structure from both investors and market
participants was very positive.
The Condition of the Deposit Insurance Fund
Current Conditions and Projections
As of June 30, 2009, the balance (or net worth) of the DIF (the fund) was approximately $10 billion. The fund reserve ratiothe fund balance divided by estimated
insured deposits in the banking systemwas 0.22 percent. In contrast, on December
31, 2007, the fund balance was almost $52 billion and the reserve ratio was 1.22
percent. Losses from institution failures have caused much of the decline in the fund
balance, but increases in the contingent loss reservethe amount set aside for
losses expected during the next 12 monthshas contributed significantly to the decline. The contingent loss reserve on June 30 was approximately $32 billion.
The FDIC estimates that as of September 30, 2009, both the fund balance and
the reserve ratio were negative after reserving for projected losses over the next 12
months, though our cash position remained positive. This is not the first time that
a fund balance has been negative. The FDIC reported a negative fund balance during the last banking crisis in the late 1980s and early 1990s.6 Because the FDIC
has many potential sources of cash, a negative fund balance does not affect the
FDICs ability to protect insured depositors or promptly resolve failed institutions.
The negative fund balance reflects, in part, an increase in provisioning for anticipated failures. The FDIC projects that, over the period 2009 through 2013, the fund
could incur approximately $100 billion in failure costs. The FDIC projects that most
of these costs will occur in 2009 and 2010. In fact, well over half of this amount
will already be reflected in the September 2009 fund balance. Assessment revenue
is projected to be about $63 billion over this 5-year period, which exceeds the remaining loss amount. The problem we are facing is one of timing. Losses are occurring in the near term and revenue is spread out into future years.
At present, cash and marketable securities available to resolve failed institutions
remain positive, although they have also declined. At the beginning of the current
banking crisis, in June 2008, total assets held by the fund were approximately $55
billion, and consisted almost entirely of cash and marketable securities (i.e., liquid
6 The FDIC reported a negative fund balance as of December 31, 1991 of approximately $7.0
billion due to setting aside a large ($16.3 billion) reserve for future failures. The fund remained
negative for five quarters, until March 31, 1993, when the fund balance was approximately $1.2
billion.
46
assets). As the crisis has unfolded, the liquid assets of the fund have been expended
to protect depositors of failed institutions and have been exchanged for less liquid
claims against the assets of failed institutions. As of June 30, 2009, while total assets of the fund had increased to almost $65 billion, cash and marketable securities
had fallen to about $22 billion. The pace of resolutions continues to put downward
pressure on cash balances. While the less liquid assets in the fund have value that
will eventually be converted to cash when sold, the FDICs immediate need is for
more liquid assets to fund near-term failures.
If the FDIC took no action under its existing authority to increase its liquidity,
the FDIC projects that its liquidity needs would exceed its liquid assets next year.
The FDICs Response
The FDIC has taken several steps to ensure that the fund reserve ratio returns
to its statutorily mandated minimum level of 1.15 percent within the time prescribed by Congress and that it has sufficient cash to promptly resolve failing institutions.
For the first quarter of 2009, the FDIC raised rates by 7 basis points. The FDIC
also imposed a special assessment as of June 30, 2009 of 5 basis points of each institutions assets minus Tier 1 capital, with a cap of 10 basis points of an institutions
regular assessment base. On September 22, the FDIC again took action to increase
assessment ratesthe board decided that effective January 1, 2011, rates will uniformly increase by 3 basis points. The FDIC projects that bank and thrift failures
will peak in 2009 and 2010 and that industry earnings will have recovered sufficiently by 2011 to absorb a 3 basis point increase in deposit insurance assessments.
We project that these steps should return the fund to a positive balance in 2012
and the reserve ratio to 1.15 percent by the first quarter of 2017.
While the final rule imposing the special assessment in June permitted the FDIC
to impose additional special assessments of the same size this year without further
notice and comment rulemaking, the FDIC decided not to impose any additional
special assessments this year. Any additional special assessment would impose a
burden on an industry that is struggling to achieve positive earnings overall. In general, an assessment system that charges institutions less when credit is restricted
and more when it is not is more conducive to economic stability and sustained
growth than a system that does the opposite.
To meet the FDICs liquidity needs, on September 29 the FDIC authorized publication of a Notice of Proposed Rulemaking (NPR) to require insured depository institutions to prepay about 3 years of their estimated risk-based assessments. The
FDIC estimates that prepayment would bring in approximately $45 billion in cash.
Unlike a special assessment, prepaid assessments would not immediately affect
the DIF balance or depository institutions earnings. An institution would record the
entire amount of its prepaid assessment as a prepaid expense (asset) as of December
30, 2009. As of December 31, 2009, and each quarter thereafter, the institution
would record an expense (charge to earnings) for its regular quarterly assessment
for the quarter and an offsetting credit to the prepaid assessment until the asset
is exhausted. Once the asset is exhausted, the institution would record an expense
and an accrued expense payable each quarter for its regular assessment, which
would be paid in arrears to the FDIC at the end of the following quarter. On the
FDIC side, prepaid assessments would have no effect on the DIF balance, but would
provide us with the cash needed for future resolutions.
The proposed rule would allow the FDIC to exercise its discretion as supervisor
and insurer to exempt an institution from the prepayment requirement if the FDIC
determines that the prepayment would adversely affect the safety and soundness of
the institution.
The FDIC believes that using prepaid assessments as a means of collecting
enough cash to meet upcoming liquidity needs to fund future resolutions has significant advantages compared to imposing additional or higher special assessments. Additional or higher special assessments could severely reduce industry earnings and
capital at a time when the industry is under stress. Prepayment would not materially impair the capital or earnings of insured institutions. In addition, the FDIC believes that most of the prepaid assessment would be drawn from available cash and
excess reserves, which should not significantly affect depository institutions current
lending activities. As of June 30, FDIC-insured institutions held more than $1.3 trillion in liquid balances, or 22 percent more than they did a year ago.7
In the FDICs view, requiring that institutions prepay assessments is also preferable to borrowing from the U.S. Treasury. Prepayment of assessments ensures
7 Liquid balances include balances due from Federal Reserve Banks, depository institutions
and others, Federal funds sold, and securities purchased under agreements to resell.
47
that the deposit insurance system remains directly industry-funded and it preserves
Treasury borrowing for emergency situations. Additionally, the FDIC believes that,
unlike borrowing from the Treasury or the FFB, requiring prepaid assessments
would not count toward the public debt limit. Finally, collecting prepaid assessments would be the least costly option to the fund for raising liquidity as there
would be no interest cost. However, the FDIC is seeking comment on these and
other options in the NPR.
The FDICs proposal requiring prepayment of assessments is really about how and
when the industry fulfills its obligation to the insurance fund. It is not about whether insured deposits are safe or whether the FDIC will be able to promptly resolve
failing institutions. Deposits remain safe; the FDIC has ample resources available
to promptly resolve failing institutions. We thank the Congress for raising our borrowing limit, which was important from a public confidence standpoint and essential
to assure that the FDIC is prepared for all contingencies in these difficult times.
Conclusion
FDIC-insured banks and thrifts continue to face many challenges. However, there
is no question that the FDIC will continue to ensure the safety and soundness of
FDIC-insured financial institutions, and, when necessary, resolve failed financial institutions. Regarding the state of the DIF and the FDIC Boards recent proposal to
have banks pay a prepaid assessment, the most important thing for everyone to remember is that the outcome of this proposal is a non-event for insured depositors.
Their deposits are safe no matter what the Board decides to do in this matter. Everyone knows that the FDIC has immediate access to a $100 billion credit line at
Treasury that can be expanded to $500 billion with the concurrence of the Federal
Reserve and the Treasury. We also have authority to borrow additional working capital up to 90 percent of the value of assets we own. The FDICs commitment to depositors is absolute, and we have more than enough resources at our disposal to
make good on that commitment.
I would be pleased to answer any questions from the members of the Subcommittee.
PREPARED STATEMENT OF JOHN C. DUGAN *

COMPTROLLER OF THE CURRENCY
OFFICE OF THE COMPTROLLER OF THE CURRENCY
OCTOBER 14, 2009
I. Introduction
Chairman Johnson, Senator Crapo, and members of the Subcommittee, I am
pleased to testify on the current condition of the national banking system, including
trends in bank ending, asset quality, and problem banks. The OCC supervises over
1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and thrifts, holding just over 61 percent of all
bank and thrift assets. These nationally chartered institutions include 15 of the very
largest U.S. banks, with assets generally exceeding $100 billion; 23 mid-sized banks,
with assets generally ranging between $10 billion and $100 billion; and over 1,500
community banks and trust banks, with assets between $1.5 million and $10 billion.
The OCC has dedicated supervisory programs for these three groups of institutions
that are tailored to the unique challenges faced by each.
My testimony today makes three key points. First, credit quality is continuing to
deteriorate across almost all classes of banking assets in nearly all sizes of banks.
As the economy has weakened, the strains on borrowers that first appeared in the
housing sector have spread to other retail and commercial borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs.
In many cases, this declining asset quality reflects risks that built up over time, and
while we may be seeing some initial signs of improvement in some asset classes as
the economy begins to recover, it will generally take time for problem credits to
work their way through the banking system.
Second, the vast majority of national banks are strong and have the financial capacity to withstand the declining asset quality. As I noted in my testimony last year
before the full Committee, we anticipated that credit quality would worsen and that
* Statement Required by 12 U.S.C. 250: The views expressed herein are those of the Office
of the Comptroller of the Currency and do not necessarily represent the views of the President.
48
banks would need to further strengthen their capital and loan loss reserves.1 Net
capital levels in national banks have increased by over $186 billion over the last
2 years, and net increases to loan loss reserves have exceeded $92 billion. While
these increases have considerably strengthened national banks, we anticipate additional capital and reserves will be needed to absorb the additional potential losses
in banks portfolios. In some cases that may not be feasible, however, and as a result, there will continue to be a number of smaller institutions that are not likely
to survive their mounting credit problems. In these cases we are working closely
with the FDIC to ensure timely resolutions in a manner that is least disruptive to
local communities.
Third, during this stressful period we are extremely mindful of the need to take
a balanced approach in our supervision of national banks, and we strive continually
to ensure that our examiners are doing just that. We are encouraging banks to work
constructively with borrowers who may be facing difficulties and to make new loans
to creditworthy borrowers. And we have repeatedly and strongly emphasized that
examiners should not dictate loan terms or require banks to charge off loans simply
due to declines in collateral values.
Balanced supervision, however, does not mean turning a blind eye to credit and
market conditions, or simply allowing banks to forestall recognizing problems on the
hope that markets or borrowers may turn around. As we have learned in our dealings with problem banks, a key factor in restoring a bank to health is ensuring that
bank management realistically recognizes and addresses problems as they emerge,
even as they work with struggling borrowers.
II. Condition of the National Banking System: Credit Quality Has Replaced
Liquidity as Major Concern
Beginning in the fall of 2007 and extending through the first quarter of this year,
bank regulators and the industry were confronted with unprecedented disruptions
in the global financial markets. In the wake of severe problems with subprime mortgages, the value of various securitized assets and structured investment products
declined precipitously. Key funding and short term credit markets froze, sparking
a severe contraction in the liquidity that sustains much of our economy and banking
system, including uninsured deposit funding. The combination of these events led
to failures, government assistance, and government takeover of several major financial institutions. Through the collective efforts and programs resulting from actions
taken by Congress, the Treasury Department, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and governments around the world, there has
been significant stabilization in credit and funding markets for all financial institutions, including banks of all sizes.
As reflected in both the TED and Libor-OIS spreads,2 each of which has fallen
to less than 20 basis points after peaking at well over 300 basis points during the
crisis, the interbank funding market has vastly improved, with banks once again
willing to extend credit to counterparties. There has also been a slight rebound in
certain securitization markets. For example, non-mortgage asset-backed securities
issuance for 2Q:2009 totaled $49 billion, up 121 percent from 1Q:2009. Similarly,
syndicated market loan issuances increased to $156 billion in 2Q:2009, up 37 percent from 1Q:2009.
The drag on national banks balance sheets and earnings from the overhang of
various structured securities products has been very significantly reduced due to the
substantial write-downs that banks took on these assets in 4Q:2008 and 1Q:2009
and the overall recovery in credit markets. Losses sustained at our 10 largest banking companies for these securities reached $44 billion in 2008, but dropped to $8
billion in 1Q:2009 and $1 billion in 2Q:2009. There are some banks that still face
strains in their investment portfolios, largely due to their holding of certain private
label mortgage-backed and trust preferred securities. While most banks will be able
to absorb the losses that may arise from these holdings, there is a small population
of banks that have significant concentrations in these products that we are closely
monitoring. We expect these banks will continue to take incremental credit impairments through earnings until mortgage metrics improve.
In my financial condition testimony before the full Committee last year, I observed that, as market conditions began to stabilize, the focus of supervisors and
1 Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs,
United States Senate, June 5, 2008, page 2.
2 The TED spread reflects the difference between the interest rates on interbank loans in the
Eurodollar market and short-term U.S. Government Treasury bills. The OIS is the overnight
indexed swap rate. Both spreads are a measure of how markets are viewing the risks of financial counterparties.
49
bankers would increasingly turn to the more traditional challenges of identifying
and managing problem credits.3 That has indeed proven to be the case, as declining
asset quality has become the central challenge facing banks and supervisors today.
While there recently have been some signs of economic recovery, data through the
second quarter of this year demonstrate that asset quality across the national bank
population significantly deteriorated over the preceding twelve months, as both retail and commercial borrowers remained under stress from job losses and the overall
contraction in the economy. The percentage of noncurrent loans (loans that are 90
days or more past due or on nonaccrual) increased dramatically and reached the
highest level in at least twenty 5 years (see Chart 1).
In addition, the rate at which banks are charging off loans has also accelerated
and, for some portfolio segments, now exceeds previous peaks experienced during
the last credit cycle. Continued concerns about the economy are also affecting loan
growth and demand as businesses, consumers, and bankers themselves retrench on
the amount of leverage and borrowing they want to assume. As a result, loan
growth through 2Q:2009 has slowed across the national bank population and in various portfolio segments. (See charts 2 and 3)
3 Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs,
United States Senate, June 5, 2008, page 9.
50
A number of factors are evident for this decline in credit, including the following:
Reduction in loan demand, as reductions in consumer spending have caused
businesses to cut back on inventory and other investments;
51
Reduction in the demand for credit from borrowers who may have been able to
afford or repay a loan when the economy was expanding, but now face constrained income or cash-flow and debt service capacity;
Reductions in loan demand as households work to rebuild their net worth, as
reflected in the increased U.S. savings rate;
Actions taken by bankers to scale back their risk exposures due to weaknesses
in various market and economic sectors, and to strengthen underwriting standards and loan terms that had become, in retrospect, too relaxed. In addition,
many banks have increasingly shifted their focus and resources to loan collections, workouts, and resolutions, and some troubled banks have curtailed lending due to funding and capital constraints; and
Continued uncertainty on the part of borrowers and lenders about the strength
and speed of the economic recovery in many regions of the country.
As demonstrated in chart 4 below, businesses have significantly reduced their investments and inventories and, in an effort to strengthen their own balance sheets,
many larger businesses have replaced short-term borrowing with longer-term corporate bond issues. Similarly, chart 5 shows that consumers are repairing their personal balance sheets with significant increases in their personal savings rates.
52
This interplay of factors and their effects on lending are consistent with our recent annual underwriting survey and the Federal Reserve Boards most recent Senior Loan Officer Survey. OCC examiners report that the financial market disruption
continues to affect bankers appetite for risk and has resulted in a renewed focus
on fundamental credit principles by bank lenders. Our survey indicates that primary factors contributing to stronger underwriting standards are bankers concerns
about unfavorable external conditions and product performance.4 In its July Senior
Loan Officer Survey, the Federal Reserve reported that demand for loans continued
to weaken across all major categories except for prime residential mortgages.5
Some have also suggested that unnecessary supervisory actions may have significantly contributed to the decline in credit availability. While I do not believe the
evidence supports this suggestion, I do believe, as addressed in more detail at the
end of this testimony, that it is critical for supervisors to stay focused on the type
of balanced supervision that is required in the stressful credit conditions prevalent
today.
Finally, the combination of deteriorating credit quality, lower yields on earning
assets, and slower loan growth is the primary factor currently affecting national
banks earnings. As shown in Chart 6, there has been a marked deterioration in the
return on equity across the national banking population as modest increases in
banks net interest margins due to more favorable costs of funds have failed to offset
credit quality problems and the continued need for banks to build loan loss reserves.
4 OCC
Survey of Underwriting Practices 2009, page 3.

5 Board of Governors of the Federal Reserve System, The July 2009 Senior Loan Officer Survey on Bank Lending Practices, page 1.
53
III. Trends in Key Credit Portfolios and Capital and Reserve Positions
Against this backdrop, let me now describe trends in major credit segments and
in capital and loan loss reserve levels.
A. Retail Credit
Although retail loansmortgages, home equity, credit cards, and other consumer
loansaccount for just over half of total loans in the national banking system, they
currently account for two-thirds of total losses, delinquencies, and nonperforming
credits. To a large extent, however, these problems are confined to the largest 15
national banks, which hold almost 91 percent of retail loans in the national banking
system.
1. First and Second Mortgages
The residential mortgage sector was the epicenter of the financial turmoil and
continues to figure prominently in the current condition of the banking industry. As
the economy has worsened, problems that started in the subprime market have
spread to the so-called Alt A market, and increasingly, to the prime market. While
over-leverage and falling housing prices were the initial drivers of delinquencies and
loan losses, borrower strains resulting from rising unemployment and underemployment are an increasingly important factor. In the first mortgage market, the June
30, 2009 Mortgage Bankers Associations National Delinquency Survey shows continued growth in foreclosure inventory, but a relatively flat rate of new foreclosure
starts overall between the first and second quarter of this year. The rate of prime
foreclosures, however, continues to increase, with starts at about 1 percent of the
surveyed population as of the end of the second quarter. Although this percentage
is still relatively small, the impact is significant given the much larger size of the
prime market segment compared to the markets for subprime and Alt-A loans.
While it is true that many first mortgages were sold to third party investors via
the securitization market, and the loan quality of such mortgages retained by banks
is generally higher than those sold to third parties, it nevertheless remains the case
that a number of larger banks have significant on-balance sheet exposure to first
mortgage losses from portfolios that continue to deteriorate.
The same is true of second mortgageshome equity loans and lines of credit
except that the overwhelming majority of these loans reside on bank balance sheets.
There were some positive signs in the second quarter showing home equity loan de-
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linquency rates falling, and the pace of increase in second lien charge-off rates slowing. But the hard fact is that losses on these loans through the first half of this
year nearly equaled total losses for all of 2008, and loss rates are expected to continue to climbthough at a slower ratethrough at least the middle of 2010.
In short, deterioration in the first and second residential mortgage markets continue to dominate the credit quality performance in national banks retail portfolios,
as it has since the second half of 2008. Total delinquent and nonperforming residential real estate loans (mortgage and home equity) in national banks now hover
around 9.4 percent, with a loss rate of just over 2.5 percentthe highest level since
we have been collecting this data.
There have been some positive indicators in the housing market in recent months
that could slow the pace of losses in residential mortgages, including increased home
sales in June and July, and slight increases in the Case-Shiller composite index for
certain metropolitan areas. While these signs are encouraging, it is too early to determine whether they signal a true turning point in this sector. For example, the
increase in home sales this summer is consistent with seasonal trends and may not
be sustainable. In addition, sales may be enjoying a temporary boost from the FirstTime Homebuyer Tax Credit program which, unless extended, will end in November. Much will depend, of course, on the extent to which economic recovery takes
hold and truly stabilizes the housing market.
In terms of mortgage modifications, all of the major national bank mortgage
servicers are actively participating in the Administrations Making Home Affordable
Program. Servicers have been significantly expanding their staff levels in the loss
mitigation/collection areasdoubling and tripling customer contact personnel, and
requiring night and weekend overtime work. Servicers have also been ramping up
their training efforts, customer service scripts, and automated qualification and underwriting systems to improve the processing of loan modification requests. The
OCC is closely monitoring these and other home modification efforts through onsite
examinations and other ongoing supervisory initiatives, as well as through our
Mortgage Metrics quarterly reporting program. And examiners continue to monitor
modification programs for compliance with all applicable fair lending and consumer
compliance laws.
Our latest Mortgage Metrics report shows that actions to keep Americans in their
homes grew by almost 22 percent during 2Q:2009.6 Notably, the percentage of modifications that reduced borrowers monthly principal and interest payments continued
to increase to more than 78 percent of all new modifications, up from about 54 percent in the previous quarter. We view this as a positive development, as modifications that reduce borrowers monthly payments generally produce lower levels of redefaults and longer term sustainability than modifications that either increase payments or leave them unchanged.
2. Credit Cards
Credit card performance began to deteriorate sharply in the latter part of 2008
and has continued to weaken further this year, with record levels of losses and delinquencies. As with second lien mortgages, there have been some encouraging signs
recently in the form of declining early stage delinquency rates, but loss rates continue to climb. As of June 30, the overall loss rate was 10.3 percent for national
banks, and more recent data shows continued deterioration-with industry analysts
predicting even higher loss rates into 2010.
In response to these trends and the overall deterioration in the economy, many
credit card issuers are adjusting their account management policies to reflect and
respond to the increased risk in these accounts. In some cases these actions have
resulted in credit lines being reduced or curtailed. In other cases, they have led to
increased interest rates, effectively increasing the minimum payment to cover the
higher finance charges. In still other cases they have resulted in an increase in minimum payments to extinguish the outstanding debt more quickly. Many credit card
issuers are also re-evaluating certain credit card product features, such as no annual fees or various reward programs, and are offering cards with simpler terms
and conditions, in part due to the recently enacted Credit CARD Act.
We are monitoring these changes in credit card account terms to ensure that they
comply with all applicable limit and notice requirements, including those mandated
by the Credit CARD Act. For example, in July we notified national banks that, effective August 22, 2010, they must conduct periodic reviews of accounts whose interest
rates have been increased since January 1, 2009, based on factors including market
conditions and borrower credit risk. More recently, we issued a bulletin advising national banks abut the interim final rules issued by the Federal Reserve under the
6 See
OCC News Release 2009118, September 30, 2009.
55
Credit CARD Act that became effective on August 20, 2009. The Federal Reserves
rules require lenders to notify customers 45 days in advance of any rate increase
or significant changes in credit card account terms and to disclose that consumers
can have the right to reject these changes. Under the rules, the new rates or terms
can be applied to any transaction that occurs more than 14 days after the notice
is providedeven if the customer ultimately rejects those terms. To address the risk
of consumer confusion, the OCC directed national banks to include an additional
disclosure not required by the rules to alert consumers, if applicable, to the imposition of the new terms on transactions that occur more than 14 days after thenotice
is provided, regardless of whether the consumer rejects the change and cancels the
account.
As with residential mortgages, we are encouraging national banks to work with
consumers who may be facing temporary difficulties and hardships, and more banks
are reaching out to assist customers before they become delinquent. Banks have a
number of viable default management options to assist in this endeavor, although
it is important that, as they do so, they continue to appropriately account for losses
as they occur.
Card issuers are also reevaluating the size of unused credit lines in response to
current credit conditions, recent regulatory changes, and recent adoption by the Financial Accounting Standards Board (FASB) of two new accounting standards,
Statement No. 166, Accounting for Transfers of Financial Assetsan amendment of
FASB Statement No. 140 (FAS 166) and Statement No. 167, Amendments to FASB
Interpretation No. 46(R) (FAS 167). These standards become effective for an entitys
first fiscal year beginning after November 15, 2009, and will have a significant impact on many banking institutions. In particular, many securitization transactions,
including credit card securitizations, will likely lose sales accounting treatment,
prompting the return of the securitized assets to banks balance sheets. Although
we are still evaluating the impact of these changes, we anticipate that they will
have a material effect on how banks structure transactions, manage risk, and determine the levels of loan loss reserves and regulatory capital they hold for certain assets, including credit cards. The net effect of these changes is that banks will most
likely face increased funding and capital costs for these products.
The combination of all these factors has resulted in a decline in overall credit card
debt outstanding andespeciallyoverall unfunded credit card commitments, reflecting pullbacks by both consumers and lenders. For national banks, managed
card outstandings (i.e., funded loans both on and off banks balance sheets) declined
by 4 percent thus far this year, or roughly $27 billion. Unfunded credit card commitments (lines available to customers) have declined more precipitously, by 14.8 percent or $448 billion. These trends are consistent with overall industry data.
In summary, retail credit quality issues continue to be an area of concern, especially for the larger national banks. Although there are some early signs of delinquency rates declining, with some bankers telling us they are beginning to see adverse trends leveling off, sustained improvements in this sector will largely depend
on the length and depth of the recession and levels of unemployment.
B. Commercial and Industrial Loans
The fallout from the housing and consumer sectors to other segments of the economy is evident in the performance of national banks commercial and industrial
(C&I) loan portfolios. Adverse trends in key performance measures, including 30-day
or morepast due delinquencies, non-performing rates, and net loss rates, sharply accelerated in the latter part of last year and have continued to trend upward in 2009.
For example, the percentage of C&I loans that are delinquent or nonperforming has
risen from a recent historical low of 1.02 percent in 2Q:2007 to 3.90 percent in
2Q:2009. Although this is the highest rate since the ratio peaked at 4.15 percent
in 2Q:2002 during the last recession, it is still well below the 1991 recession peak
of 6.5 percent.
In contrast to retail loans, which primarily affect the larger national banks, the
effect of adverse trends in C&I loans is fairly uniform across the national bank population. This segment of loans represents approximately 20 percent of total loans
in the national banking system, with levels somewhat more concentrated at larger
institutions than at community banks, where C&I loans account for approximately
16 percent of total loans. While credit quality indicators are marginally worse at the
larger national banks, the trend rate and direction are fairly consistent across all
sizes of national banks.
One measure of C&I loan quality comes from the Federal banking agencies
Shared National Credit (SNC) program, which provides an annual review of large
credit commitments that cut across the financial system. These large loans to large
borrowers are originated by large banks, then syndicated to other banks and many
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types of nonbank financial institutions such as securitization pools, hedge funds, insurance companies, and pension funds.7 This years review, which was just recently
completed, also found sharp declines in credit quality. The review, which covered
8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers, found
a record level of $642 billion in criticized assetsmeaning loans or commitments
that had credit weaknessesrepresenting approximately 22 percent of the total
SNC portfolio. Total loss of $53 billion identified in the 2009 review exceeded the
combined loss of the previous eight SNC reviews and nearly tripled the previous
high in 2002. Examiners attributed the declining credit quality to weak economic
conditions and the weak underwriting standards leading up to 2008.8
C. Commercial Real Estate Loans
The greatest challenge facing many banks and their supervisors is the continued
deterioration in commercial real estate loans (CRE). There are really two stories
here, with one related to the other.
The first involves residential construction and development (C&D) lending, especially with respect to single family homes. Not surprisingly, given the terrible
strains in the housing sector over the last 2 years, delinquency rates have already
climbed tohigh levels, with significant losses already realized and more losses continuing to work their way through the banking system. For national banks as of
June 30, total delinquent and nonperforming rates were at just over 34 percent in
the largest national banks; 23.4 percent in mid-size banks; and 17.5 percent in community banks. The relative size of these loss rates is somewhat misleading, however, because many community banks and some mid-size banks have much greater
concentrations in residential C&D loans than the largest banks. As a result, the
concentrated losses in these smaller institutions has had a much more pronounced
effect on viability, with concentrated residential C&D lending constituting by far the
single largest factor in commercial bank failures in the last two years. At this point
in the credit cycle, we believe the bulk of residential C&D problems have been identified and are being addressed, although a number will continue to produce losses
that result in more bank failures.
The second story involves all other types of commercial real estate loans, including loans secured by income producing properties. Credit deterioration has spread
to these assets as well, and trend lines are definitely worsening, but thus far the
banking system has not experienced anywhere near the level of delinquency and
loss as it has in C&D lending.
Still, the signs are troubling. Declining real estate values caused by rising vacancy rates, increasing investor return requirements, falling rental rates, and weak
sales are affecting all CRE segments. For example, Property and Portfolio Research
reports that apartment vacancy rates have hit a 25-plus year high at 8.4 percent
nationally, and there are similar patterns for retail, office, and warehouse space as
demand falls across all segments. But unlike the CRE markets in 1991, much of
the current fallout is driven more by a decrease in demand than from an oversupply
of properties.
The outlook for these markets over the near term, especially for the income producing property sector, is not favorable. In general, deterioration in performance for
these CRE loans lags the economy as borrowers cash-flows may be sufficient during
the early stages of a downturn, but become increasingly strained over time. There
are alsogrowing concerns about the refinancing risk within the commercial mortgage-backed securities market (CMBS) where there is a currently moderate-butgrowing pipeline of loans scheduled to mature. Permanent or rollover refinancing of
these loans may be difficult due to the declines in commercial property values coupled with the return to more prudent underwriting standards by both lenders and
investors. While this is an area that we are monitoring, the largest proportion and
more problematic of these mortgages will not mature until 2011 and 2012.
As with C&I loans, trends in total delinquent and nonperforming CRE rates (including C&D loans) have been fairly consistent across all segments of the national
bank population, climbing to roughly 8.3 percent in 2Q:2009. While C&D losses will
continue to be most problematic for the banks that have the largest concentrations
in these assets, theextent to which other types of CRE loan losses will continue to
climb will depend very much on the overall performance of the economy.
7 In fact, nonbanks hold a disproportionate share of classified assets compared with their total
share of the SNC portfolio, owning 47 percent of classified assets and 52 percent of nonaccrual
loans, whereas FDICinsured institutions hold only 24.2 percent of classified assets and 22.7 percent of nonaccrual loans.
8 See OCC News Release 200911, September 24, 2009.
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D. Capital and Reserve Levels
Perhaps the most critical tools for dealing with and absorbing credit losses are
substantial levels of capital and reserves. As a result, in anticipation of rising credit
losses over the last 2 years, the OCC has directed banks to build loan loss reserves
and strengthen capital. In aggregate, the net amount of capital in national banks
(i.e., the net increase after items such as losses and dividends and including capital
as a result of acquisitions and net TARP inflows) has risen by over $186 billion over
the last 2 years, and the net build to loan loss reserves (i.e., loan loss provisions
less net credit losses) has been over $92 billion. These increases in loss-absorbing
resources are critical contributors to the overall health of the national banking system.
As illustrated by the dotted line in the chart below, the level of reserves to total
loans in the national banking system has increased dramatically to a ratio of 3.3
percent, the highest in over 25 years. While such high reserves are imperative for
dealing with the high level of noncurrent loans, the solid line in the chart below
shows that more provisions may be needed, because the ratio of reserves to noncurrent loans has continued to decline, to under 100 percentreflecting the fact that
the substantial growth in reserves is not keeping pace with the even greater growth
in noncurrents.
Substantially building reserves at the same time as credit conditions weaken is

often described as unduly pro-cyclical, because bank earnings decline sharply from
provisioning well before charge-offs actually occur. That is certainly an accurate
characterization under the current accounting system for loan loss reserving, although there will always be a need to build reserves to some extent as credit losses
rise. The issue is really about how much; that is, if reserve levels are high going
into a credit downturn, then the need to build reserves is far lower than it is when
the going-in levels are low. Unfortunately, our current accounting standards tend
to produce very low levels of reserves just before the credit cycle turns downward,
especially after prolonged periods of benign credit conditions as we had in the first
part of this decade. In such periods, the backward-looking focus of the current accounting model creates undue pressure to decrease reserve levels even where lenders believe the cycle is turning and credit losses will clearly increase. I strongly believe that a more forward looking accounting model based on expected losses would
both more accurately account for credit costs and be less pro-cyclical. This is an
issue that I have been working on as co-chair of the Financial Stability Boards
58
(FSB) Working Group on Provisioning, and I continue to be hopeful that accounting
standard setters will embrace this type of change as they consider adjustments to
loan loss provisioning standards.
IV. Most National Banks Have Capacity to Weather This Storm
The credit conditions I have just described are stark and will require considerable
skills by bankers and regulators to work through. Despite these challenges, I believe
the vast majority of national banks are and will continue to be sound, and that they
have the wherewithal to manage through this credit cycle. Notwithstanding the negative trends and earnings pressures that banks are facing, we should not lose sight
that, as of June 30, 2009,97 percent of all national banks satisfied the required minimum capital standards to be considered well capitalized, and 76 percent reported
positive earnings.
As previously described, the OCC has separate supervisory programs for Large
Banks (assets generally exceeding $100 billion); Mid-Sized Banks (assets from $10
billion to $100 billion); and Community Banks (assets below $10 billion). Let me
summarize our general assessment of the condition of each group.
A. Large Banks
In some respects, large banks faced the earliest challenges, with the disruptions
in wholesale funding markets, the significant losses they sustained on various structured securities. and the pronounced losses that emerged earlier in their retail credit portfolios. As I mentioned, there are some preliminary indicators that the rate of
increased problems in the retail sector may have begun to slow, but as with credit
conditions in general, much of this will depend on the timing and strength of the
economy, and in particular, on unemployment rates. C&I and CRE loan exposures
remain a concern for these banks, but they have more diversified portfolios and exposures than many smaller banks and thus may be in a better position to absorb
these problems. Collectively, the fifteen banks in our Large Bank program raised
$132 billion in capital (excluding TARP funding) in 2008 and, over the past twenty
4 months, their net build to loan loss reserves totaled approximately $85 billion.
Earlier this year we and the other Federal regulators conducted a detailed stress
test of the largest U.S. banks as part of the Supervisory Capital Assessment Program (SCAP) to examine their ability to withstand even further deterioration in
market and credit conditions. I believe that was an extremely valuable exercise for
four reasons. First, the one-time public assessment of individual institution supervisory resultswhich was only made possible by the U.S. Government backstop
made available by TARP fundingalleviated a great deal of uncertainty about the
depth of credit problems on bank balance sheets, which a number of analysts had
assumed to be in far worse condition. Second, the reduction of uncertainty allowed
institutions to access private capital markets to increase their capital buffer for possibly severe future losses, instead of requiring more government capital. Third, the
additional capital required to be raised or otherwise generated nowover $45 billion
in common stock alone has already been issued by the nine SCAPinstitutions with
national bank subsidiariesprovides these banks with a strong buffer to absorb the
severe losses and sharply reduced revenue associated with the adverse stress scenario imposed under SCAP for the 2-year period of 2009 and 2010, should that scenario come to pass. Fourth, as we track banks actual credit performance against
the SCAP adverse stress scenario to ensure that capital levels remain adequate, we
have found that, through the first half of 2009which constitutes 25 percent of the
overall 2-year SCAP stress periodactual aggregate loan losses were well below 25
percent of the aggregate losses projected for the full SCAP period, and actual aggregate revenues were well above 25 percent of the aggregate projected SCAP revenues.
While those trends could change as the stress period continues, the early results are
promising.
B. Mid-Size Banks
Although mid-size national banks engage in retail lending, the scope and size of
their exposures are not as significant as those of the largest national banks. Midsize banks also did not have the significant losses that larger banks did from various structured investment products. Nevertheless, loan growth at these banks
turned negative in 2Q:2009, and although they experienced modest improvements
in net interest margins in the second quarter, they still face downward earnings
pressures, primarily due to increasing loan loss provisions. Given their exposures
to the C&I and CRE markets, we expect these pressures will persist, notwithstanding the $3.5 billion in net reserve builds over the last twenty four months.
These banks have also had success in attracting new capital, raising close to $5 billion thus far this year.
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C. Community Banks
Nearly all national community banks entered this environment with strong capital bases that exceeded regulatory minimums. As a group, they have been less exposed to problems in the retail credit sector that have confronted large and midsize banks, and the vast majority of these banks remain in sound financial condition. As noted earlier, there is a small number of community banks that have concentrations in trust preferred and private label mortgage-backed securities that we
are closely monitoring.
Of more significance are the exposures that many community banks have to commercial real estate loans. As I noted in my June 2008 testimony, we have been concerned for some time about the sizable concentrations of CRE loans found at many
smaller national banks. While national banks of all sizes have significant CRE exposures, as shown in Chart 8, CRE concentrations are most pronounced at community
and mid-size banks.
Because of this, the OCC began conducting horizontal reviews of banks with significant concentrations about 5 years ago. As credit conditions worsened, our efforts
intensified in banks that we believed were at high risk from downturns in real estate markets. Our goal has been to work with bankers to get potential CRE problems identified at an early stage so that bank management can take effective remedial action. In most but not all cases, bank management teams are successfully
working through their problems and have adequate capital and stable funding bases
to weather additional loan losses and earnings pressures.
V. Resolution of Problem Banks
Given the strains in the economy and banking system, it is not surprising that
the number of problem banks has increased from the recent historical lows. In the
early 1990s, the number of problem national banksthose with a CAMELS composite rating of 3, 4 or 5reached a high of 28 percent of all national banks. Thereafter, the number of problem national banks relative to all national banks dropped
dramatically and then fluctuated in a range of three to 6 percent until 2007. Since
then, however, the number of problem banks has risen steadily, and it is now approximately 17 percent of national banks.
As would be expected, this upward trend in problem banks also has resulted in
an increased number of bank failures. In January, 2008, we had the first national
bank failure in almost 4 years, the longest period without a failure in the 146-year
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history of theOCC. That began the current period of significantly increased failures.
In total, since January 1 of 2008, there have been 123 failures of insured banks and
thrifts. Of these, 19 have been national banks, accounting for 11 percent of the total
projected loss to thedeposit insurance fund from all banks that failed during this
period. All of the 19 failed national banks have been community banks, although
the total obviously does not include the two large bank holding companies with lead
national banks that were the subject of systemic risk determinations and received
extraordinary TARP assistance on an open-institution basis.
While the vast majority of national banks have the financial capacity and management skills to weather the current environment, some will not. Given the real
estate concentrations in community banks, the number of problem banks, the severe
problems in housing markets, and increasing concern with CRE, we expect more
bank failures in the months ahead. Some troubled banks will be able to find strong
buyersin some instances with our assistancethat will enable them to avoid failure and resolution by the FDIC. But that will not always be possible. When it is
not, our goal, consistent with the provisions of the Federal Deposit Insurance Corporation Improvement Act, is to effect early and least cost resolution of the bank
with a minimum of disruption to the community.
VI. OCC Will Continue to Take a Balanced Approach in Our Supervision of
National Banks
Finally, I want to underscore the OCCs commitment to provide a balanced and
fair approach in our supervision of national banks as bankers work through the
challenges that are facing them and their borrowers. We recognize the important
roles that credit availability and prudent lending play in our nations economy, and
we are particularly aware of the vital role that many smaller banks play in meeting
the credit needs of small businesses in their local communities. Our goal is to ensure that national banks can continue to meet these needs in a safe and sound manner.
I have heard some reports that bankers are receiving mixed messages from regulators: on one hand being urged to make loans to creditworthy customers, while at
the same time being subjected to what some have characterized as overzealous
regulatory examinations. In this context, let me emphasize that our messages to
bankers have and continue to be straight-forward:
Bankers should continue to make loans to creditworthy borrowers;
But they should not make loans that they believe are unlikely to be repaid in
full; and
They should continue to work constructively with troubled borrowersbut recognize repayment problems in loans when they see them, because delay and denial only makes things worse.
Let me also underscore what OCC examiners will and will not do. Examiners will
not tell bankers to call or renegotiate a loan; dictate loan structures or pricing; or
prescribe limits (beyond regulatory limits) on types or amounts of loans that a bank
may make if the bank has adequate capital and systems to support and manage its
risks. Examiners will look to see that bankers have made loans on prudent terms,
based on sound analysis of financial and collateral information; that banks have sufficient risk management systems inplace to identify and control risks; that they set
aside sufficient reserves and capital to buffer and absorb actual and potential losses;
and that they accurately reflect the condition of their loan portfolios in their financial statements.
Nevertheless, balanced supervision does not mean that examiners will allow bankers to ignore or mask credit problems. Early recognition and action by management
are critical factors in successfully rehabilitating a problem bank. Conversely, the
merepassage of time and hope for improved market conditions are not successful
resolution strategies.
We have taken a number of steps to ensure that our examiners are applying these
principles in a balanced and consistent manner. For example, we hold both regular
meetings and periodic national teleconferences with our field examiners to convey
key supervisory messages and objectives. In our April 2008 nationwide call, we reviewed and discussed key supervisory principles for evaluating commercial real estate lending. In April of this year we issued guidance to our examiners on elements
of an effective workout/restructure program for problem real estate loans. We noted
that effective workouts can take a number of forms, including simple renewal or extension of the loan terms, extension of additional credit; formal restructuring of the
loan terms; and, in some cases, foreclosure on underlying collateral. We further reiterated these key principles in a nationwide call with our mid-size and community
bank examiners earlier this month.
61
Through the FFIEC, we are also working with the other Federal and state banking agencies to update and reinforce our existing guidance on working with CRE
borrowers and to help ensure consistent application of these principles across all
banks. This guidance will reaffirm that prudent workouts are often in the best interests of both the bank and borrower and that examiners should take a balanced
approach in evaluating workouts. In particular, examiners should not criticize banks
that implement effective workouts afterperforming a comprehensive review of the
borrowers condition, even if the restructured loans have weaknesses that result in
adverse credit classification. Nor should they criticize renewed or restructured loans
to borrowers with a demonstrated ability to repay, merelybecause of a decline in collateral values. Consistent with current policies, loans that are adequately protected
by the current sound worth and debt service capacity of the borrower, guarantor,
or the underlying collateral generally will not be classified. However, deferring
issues for another day does not help the CRE sector or banking industry recover.
It is important that bankers acknowledge changing risk and repayment sources that
may no longer be adequate.
VII. Conclusion
I firmly believe that the collective measures that government officials, bank regulators, and many bankers have taken in recent months have put our financial system on a much more sound footing. These steps are also crucial to ensuring that
banks will be ableto continue their role as lenders and financial intermediaries.
Nonetheless, it is equally clear that there are still many challenges ahead, especially
with regard to the significant deterioration in credit that both supervisors and bankers must work through. There are no quick fixes to this problem, and there is the
real potential that, for a large number of banks, credit quality will get worse in the
months ahead. Notwithstanding the significant loan loss provisions that banks have
taken over the past 2 years, more may be needed as provisions and resulting loan
loss reserves have not kept pace with the rapid increase in nonperforming assets.
The OCC is firmly committed to taking a balanced approach as bankers work
through these issues. We will continue to encourage bankers to lend and to work
with borrowers. However, we will also ensure that they do so in a safe and sound
manner and that they recognize and address their problems on a timely basis.
PREPARED STATEMENT OF DANIEL K. TARULLO
MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
OCTOBER 14, 2009
Chairman Johnson, Ranking Member Crapo, and members of the Subcommittee,
thank you for your invitation to discuss the condition of the U.S. banking industry.
First, I will review the current conditions in financial markets and the overall economy and then turn to the performance of the banking system, highlighting particular challenges in commercial real estate (CRE) and other loan portfolios. Finally,
I will address the Federal Reserves regulatory and supervisory responses to these
challenges.
Conditions in Financial Markets and the Economy
Conditions and sentiment in financial markets have continued to improve in recent months. Pressures in short-term funding markets have eased considerably,
broad stock price indexes have increased, risk spreads on corporate bonds have narrowed, and credit default swap spreads for many large bank holding companies, a
measure of perceived riskiness, have declined. Despite improvements, stresses remain in financial markets. For example, corporate bond spreads remain quite high
by historical standards, as both expected losses and risk premiums remain elevated.
Economic growth appears to have moved back into positive territory last quarter,
in part reflecting a pickup in consumer spending and a slight increase in residential
investmenttwo components of aggregate demand that had dropped to very low levels earlier in the year. However, the unemployment rate has continued to rise,
reaching 9.8 percent in September, and is unlikely to improve materially for some
time.
Against this backdrop, borrowing by households and businesses has been weak.
According to the Federal Reserves Flow of Funds accounts, household and nonfinancial business debt contracted in the first half of the year and appears to have
decreased again in the third quarter. For households, residential mortgage debt and
consumer credit fell sharply in the first half; the decline in consumer credit continued in July and August. Nonfinancial business debt also decreased modestly in the
first half of the year and appears to have contracted further in the third quarter
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as net decreases in commercial paper, commercial mortgages, and bank loans more
than offset a solid pace of corporate bond issuance.
At depository institutions, loans outstanding fell in the second quarter of 2009.
In addition, the Federal Reserves weekly bank credit data suggests that bank loans
to households and to nonfinancial businesses contracted sharply in the third quarter. These declines reflect the fact that weak economic growth can both damp demand for credit and lead to tighter credit supply conditions.
The results from the Federal Reserves Senior Loan Officer Opinion Survey on
Bank Lending Practices indicate that both the availability and demand for bank
loans are well below pre-crisis levels. In July, more banks reported tightening their
lending standards on consumer and business loans than reported easing, although
the degree of net tightening was well below levels reported last year. Almost all of
the banks that tightened standards indicated concerns about a weaker or more uncertain economic outlook, and about one-third of banks surveyed cited concerns
about deterioration in their own current or future capital positions. The survey also
indicates that demand for consumer and business loans has remained weak. Indeed,
decreased loan demand from creditworthy borrowers was the most common explanation given by respondents for the contraction of business loans this year.
Taking a longer view of cycles since World War II, changes in debt flows have
tended to lag behind changes in economic activity. Thus, it would be unusual to see
a return to a robust and sustainable expansion of credit until after the overall economy begins to recover.
Credit losses at banking organizations continued to rise through the second quarter of this year, and banks face risks of sizable additional credit losses given the
outlook for production and employment. In addition, while the decline in housing
prices slowed in the second quarter, continued adjustments in the housing market
suggest that foreclosures and mortgage loan loss severities are likely to remain elevated. Moreover, prices for both existing commercial properties and for land, which
collateralize commercial and residential development loans, have declined sharply
in the first half of this year, suggesting that banks are vulnerable to significant further deterioration in their CRE loans. In sum, banking organizations continue to
face significant challenges, and credit markets are far from fully healed.
Performance of the Banking System
Despite these challenges, the stability of the banking system has improved since
last year. Many financial institutions have been able to raise significant amounts
of capital and have achieved greater access to funding. Moreover, through the rigorous Supervisory Capital Assessment Program (SCAP) stress test conducted by the
banking agencies earlier this year, some institutions demonstrated that they have
the capacity to withstand more-adverse macroeconomic conditions than are expected
to develop and have repaid the governments Troubled Asset Relief Program (TARP)
investments.1 Depositors concerns about the safety of their funds during the immediate crisis last year have also largely abated. As a result, financial institutions
have seen their access to core deposit funding improve.
However, the banking system remains fragile. Nearly 2 years into a substantial
recession, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as lingering weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital
ratios are considerably higher than they were at the start of the crisis for many
banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the
crisis, recessionary economic conditions, and a focus on working out problem loans
have also limited the degree to which banks have added high quality loans to their
portfolios, an essential step to expanding profitable assets and thus restoring earnings performance.
These developments have raised the number of problem banks to the highest level
since the early 1990s, and the rate of bank and thrift failures has accelerated
throughout the year. Moreover, the estimated loss rates for the deposit insurance
fund on bank failures have been very high, generally hovering near 30 percent of
assets. This high loss level reflects the rapidity with which loan quality has deterio1 For more information about the SCAP, see Ben S. Bernanke (2009), The Supervisory Capital Assessment Program, speech delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/
newsevents/speech/bernanke20090511a.htm.
63
rated during the crisis and suggests that banking organizations may need to continue their high level of loan loss provisioning for some time. Moreover, some of
these institutions, including those with capital above minimum requirements, may
need to raise more capital and restrain their dividend payouts for the foreseeable
future. Indeed, the buildup in capital ratios at large banking organizations has been
essential to reassuring the market of their improving condition. However, we must
recognize that capital ratios can be an imperfect indicator of a banks overall
strength, particularly in periods in which credit quality is deteriorating rapidly and
loan loss rates are moving higher.
Comparative Performance of Banking Institutions by Asset Size
Although the broad trends detailed above have affected all financial institutions,
there are some differences in how the crisis is affecting large financial institutions
and more locally focused community and regional banks. Consider, for example, the
50 largest U.S. bank holding companies, which hold more than three-quarters of
bank holding company assets and now include the major investment banks in the
United States. While these institutions do engage in traditional lending activities,
originating loans and holding them on their balance sheets like their community
bank competitors, they also generate considerable revenue from trading and other
fee-based activities that are sensitive to conditions in capital markets. These firms
reported modest profits during each of the first two quarters of 2009. Second-quarter
net income for these companies at $1.6 billion was weaker than that of the first
quarter, but was still a great improvement over the $19.8 billion loss reported for
the second quarter of last year. Net income was depressed by the payment of a significant share of the Federal Deposit Insurance Corporations (FDIC) special deposit
insurance assessment and a continued high level of loan loss provisioning. Contributing significantly to better performance was the improvement of capital markets
activities and increases in related fees and revenues.
Community and small regional banks have also benefited from the increased stability in financial markets. However, because they depend largely on revenues from
traditional lending activities, as a group they have yet to report any notable improvement in earnings or condition since the crisis took hold. These bankswith assets of $10 billion or less representing almost 7,000 banks and 20 percent of commercial bank assetsreported a $2.7 billion loss in the second quarter. Earnings remained weak at these banks due to a historically narrow net interest margin and
high loan loss provisions. More than one in four of these banks reported a net loss.
Earnings at these banks were also substantially affected by the FDIC special assessment during the second quarter.
Loan quality deteriorated significantly for both large and small institutions during the second quarter. At the largest 50 bank holding companies, nonperforming
assets climbed more than 20 percent, raising the ratio of nonperforming assets to
4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and
credit card loans also experienced rising delinquency rates. Results of the banking
agencies Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration
in commercial loans.2 At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than
six times the level for this ratio at year-end 2006, before the crisis started. Home
mortgages and CRE loans accounted for most of the increase, but commercial loans
have also shown marked deterioration during recent quarters. Importantly, aggregate equity capital for the top 50 bank holding companies, and thereby for the banking industry, increased for the third consecutive quarter and reached 8.8 percent of
consolidated assets as of June 30, 2009. This level was almost 1 percentage point
above the year-end 2008 level and exceeded the pre-crisis level of midyear 2007 by
more than 2 percentage points. Risk-based capital ratios for the top 50 bank holding
companies also remained relatively high: Tier 1 capital ratios were at 10.75 percent,
and total risk-based capital ratios were at 14.09 percent. Signaling the recent improvement in financial markets since the crisis began, capital increases during the
first half of this year largely reflected common stock issuance, supported also by reductions in dividend payments. However, asset contraction also accounts for part of
the improvement in capital ratios. Additionally, of course, the Treasury Capital Pur2 See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of
the Currency, and Office of Thrift Supervision (2009), Credit Quality Declines in Annual
Shared National Credits Review, joint press release, September 24, www.Federalreserve.gov/
newsevents/press/bcreg/20090924a.htm.
64
chase Program also contributed to the increase in capital in the time since the crisis
emerged.
Despite TARP capital investments in some banks and the ability of others to raise
equity capital, weak earnings led to modest declines in the average capital ratios
of smaller banks over the past yearfrom 10.7 percent to 10.4 percent of assets as
of June 30 of this year. However, risk-based capital ratios remained relatively high
for most of these banks, with 96 percent maintaining risk-based capital ratios consistent with a well capitalized designation under prompt corrective action standards.
Funding for the top 50 bank holding companies has improved markedly over the
past year. In addition to benefiting from improvement in interbank markets, these
companies increased core deposits from 24 percent of total assets at year-end 2008
to 27 percent as of June 30, 2009. The funding profile for community and small regional banks also improved, as core deposit funding rose to 62 percent of assets and
reliance on brokered deposits and Federal Home Loan Bank advances edged down
from historically high levels.
As already noted, substantial financial challenges remain for both large and small
banking institutions. In particular, some large regional and community banking
firms that have built up unprecedented concentrations in CRE loans will be particularly affected by emerging conditions in real estate markets. I will now discuss the
economic conditions and financial market dislocations affecting CRE markets and
the implications for banking organizations.
Current Conditions in Commercial Real Estate Markets
Prices of existing commercial properties are estimated to have declined 35 to 40
percent since their peak in 2007, and market participants expect further declines.
Demand for commercial property has declined as job losses have accelerated, and
vacancy rates have increased. The higher vacancy levels and significant decline in
the value of existing properties have placed particularly heavy pressure on construction and development projects that generate no income until completion. Developers
typically depend on the sales of completed projects to repay their outstanding loans,
and with the volume of property sales at especially low levels and with prices depressed, the ability to service existing construction loans has been severely impaired.
The negative fundamentals in the CRE property markets have caused a sharp deterioration in the credit performance of loans in banks portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of
2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held
on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion.
Also at the end of the second quarter, about 9 percent of CRE loans on banks books
were considered delinquent, almost double the level of a year earlier.3 Loan performance problems were the most striking for construction and development loans, especially for those that finance residential development. More than 16 percent of all
construction and development loans were considered delinquent at the end of the
second quarter.
Almost $500 billion of CRE loans will mature each year over the next few years.
In addition to losses caused by declining property cash-flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks earnings, especially those of smaller regional and community banks
that have high concentrations of CRE loans.
The current fundamental weakness in CRE markets is exacerbated by the fact
that the CMBS market, which had financed about 30 percent of originations and
completed construction projects, has remained virtually inoperative since the start
of the crisis. Essentially no CMBS have been issued since mid-2008. New CMBS
issuance came to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE-specific risk and the general lack of liquidity in structured debt markets. Increases in credit risk have significantly softened demand in
the secondary trading markets for all but the most highly rated tranches of these
securities. Delinquencies of mortgages backing CMBS have increased markedly in
recent months. Market participants anticipate these rates will climb higher by the
end of this year, driven not only by negative fundamentals but also by borrowers
difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has
3 The CRE loans considered delinquent on banks books were non-owner occupied CRE loans
that were 30 days or more past due.
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generated significant stresses on the balance sheets of financial institutions that
must mark these securities to market, further limiting their appetite for taking on
new CRE exposure.
Federal Reserve Activities to Help Revitalize Credit Markets
The Federal Reserve, along with other government agencies, has taken a number
of actions to strengthen the financial sector and to promote the availability of credit
to businesses and households. In addition to aggressively easing monetary policy,
the Federal Reserve has established a number of facilities to improve liquidity in
financial markets. One such program is the Term Asset-Backed Securities Loan Facility (TALF), begun in November 2008 to facilitate the extension of credit to households and small businesses.
Before the crisis, securitization markets were an important conduit of credit to the
household and business sectors; some have referred to these markets as the shadow
banking system. Securitization markets (other than those for mortgages guaranteed by the government) have virtually shut down since the onset of the crisis,
eliminating an important source of credit. Under the TALF, eligible investors may
borrow to finance purchases of the AAA-rated tranches of certain classes of assetbacked securities. The program originally focused on credit for households and small
businesses, including auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. More recently, CMBS were added to the
program, with the goal of mitigating a severe refinancing problem in that sector.
The TALF has had some success. Rate spreads for asset-backed securities have
declined substantially, and there is some new issuance that does not use the facility.
By improving credit market functioning and adding liquidity to the system, the
TALF and other programs have provided critical support to the financial system and
the economy.
Availability of Credit
The Federal Reserve has long-standing policies in place to support sound bank
lending and the credit intermediation process. Guidance issued during the CRE
downturn in 1991 instructs examiners to ensure that regulatory policies and actions
do not inadvertently curtail the availability of credit to sound borrowers.4 This guidance also states that examiners should ensure loans are being reviewed in a consistent, prudent, and balanced fashion to prevent inappropriate downgrades of credits. It is consistent with guidance issued in early 2007 addressing risk management
of CRE concentrations, which states that institutions that have experienced losses,
hold less capital, and are operating in a more risk-sensitive environment are expected to employ appropriate risk-management practices to ensure their viability.5
We are currently in the final stages of developing interagency guidance on CRE
loan restructurings and workouts. This guidance supports balanced and prudent decisionmaking with respect to loan restructuring, accurate and timely recognition of
losses and appropriate loan classification. The guidance will reiterate that classification of a loan should not be based solely on a decline in collateral value, in the absence of other adverse factors, and that loan restructurings are often in the best interest of both the financial institution and the borrower. The expectation is that
banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition.
On one hand, banks have raised concerns that our examiners are not always taking a balanced approach to the assessment of CRE loan restructurings. On the other
hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash-flows and collateral values in their assessment of the potential loan repayment. This new guidance, which should be finalized
shortly, is intended to promote prudent CRE loan workouts as banks work with
their creditworthy borrowers and to ensure a balanced and consistent supervisory
review of banking organizations.
4 See Board of Governors of the Federal Reserve System, Division of Banking Supervision and
Regulation (1991), Interagency Examination Guidance on Commercial Real Estate Loans, Supervision and Regulation Letter SR 9124 (November 7), www.Federalreserve.gov/BoardDocs/
SRLetters/1991/SR9124.htm; and Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of Thrift Supervision (1991), Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,
joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/SRLetters/1991/
SR9124a1.pdf.
5 See Board of Governors of the Federal Reserve System, Division of Banking Supervision and
Regulation (2007), Interagency Guidance on Concentrations in Commercial Real Estate, Supervision and Regulation Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/
2007/SR0701.htm.
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Guidance issued in November 2008 by the Federal Reserve and the other Federal
banking agencies encouraged banks to meet the needs of creditworthy borrowers, in
a manner consistent with safety and soundness, and to take a balanced approach
in assessing borrowers ability to repay and making realistic assessments of collateral valuations.6 In addition, the Federal Reserve has directed examiners to be
mindful of the effects of excessive credit tightening in the broader economy and we
have implemented training for examiners and outreach to the banking industry to
underscore these intentions. We are aware that bankers may become overly conservative in an attempt to ameliorate past weaknesses in lending practices, and are
working to emphasize that it is in all parties best interests to continue making
loans to creditworthy borrowers.
Strengthening the Supervisory Process
The recently completed SCAP of the 19 largest U.S. bank holding companies demonstrates the effectiveness of forward-looking horizontal reviews and marked an important evolutionary step in the ability of such reviews to enhance supervision.
Clearly, horizontal reviewsreviews of risks, risk-management practices and other
issues across multiple financial firmsare very effective vehicles for identifying
both common trends and institution-specific weaknesses. The SCAP expanded the
scope of horizontal reviews and included the use of a uniform set of stress parameters to apply consistently across firms.
An outgrowth of the SCAP was a renewed focus by supervisors on institutions
own ability to assess their capital adequacyspecifically their ability to estimate
capital needs and determine available capital resources during very stressful periods. A number of firms have learned hard, but valuable, lessons from the current
crisis that they are applying to their internal processes to assess capital adequacy.
These lessons include the linkages between liquidity risk and capital adequacy, the
dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent
assumptions, limitations, and shortcomings. Addressing this uncertainty is one
among several reasons that firms should retain substantial capital cushions.
Currently, we are conducting a horizontal assessment of internal processes that
evaluate capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for
these processes could impair firms abilities to estimate capital needs. Using findings from these reviews, we will work with firms over the next year to bring their
processes into conformance with supervisory expectations. Supervisors will use the
information provided by firms about their processes as a factorbut by no means
the only factorin the supervisory assessment of the firms overall capital levels.
For instance, if a firm cannot demonstrate a strong ability to estimate capital needs,
then supervisors will place less credence on the firms own internal capital results
and demand higher capital cushions, among other things. Moreover, we have already required some firms to raise capital given their higher risk profiles. In general, we believe that if firms develop more-rigorous internal processes for assessing
capital adequacy that capture all the risks facing those firmsincluding under
stress scenariosand maintain adequate capital based on those processes, they will
be in a better position to weather financial and economic shocks and thereby perform their role in the credit intermediation process.
We also are expanding our quantitative surveillance program for large, complex
financial organizations to include supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that
may affect multiple institutions, as well as emerging risks to specific firms. Periodic
scenario analyses across large firms will enhance our understanding of the potential
impact of adverse changes in the operating environment on individual firms and on
the system as a whole. This work will be performed by a multidisciplinary group
composed of our economic and market researchers, supervisors, market operations
specialists, and accounting and legal experts. This program will be distinct from the
activities of onsite examination teams so as to provide an independent supervisory
perspective, as well as to complement the work of those teams. As we adapt our internal organization of supervisory activities to build on lessons learned from the cur6 See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of
the Currency, and Office of Thrift Supervision (2008), Interagency Statement on Meeting the
Needs of Creditworthy Borrowers, joint press release, November 12, www.Federalreserve.gov/
newsevents/press/bcreg/20081112a.htm.
67
rent crisis, we are using all of the information and insight that the analytic abilities
the Federal Reserve can bring to bear in financial supervision.
Conclusion
A year ago, the world financial system was profoundly shaken by the failures and
other serious problems at large financial institutions here and abroad. Significant
credit and liquidity problems that had been building since early 2007 turned into
a full-blown panic with adverse consequences for the real economy. The deterioration in production and employment, in turn, exacerbated problems for the financial
sector.
It will take time for the banking industry to work through these challenges and
to fully recover and serve as a source of strength for the real economy. While there
have been some positive signals of late, the financial system remains fragile and key
trouble spots remain, such as CRE. We are working with financial institutions to
ensure that they improve their risk management and capital planning practices,
and we are also improving our own supervisory processes in light of key lessons
learned. Of course, we are also committed to working with the other banking agencies and the Congress to ensure a strong and stable financial system.
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PREPARED STATEMENT OF JOSEPH A. SMITH, JR.
NORTH CAROLINA COMMISSIONER OF BANKS,
ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS
OCTOBER 14, 2009
INTRODUCTION
Good afternoon, Chairman Johnson, Ranking Member Crapo, and distinguished
members of the Subcommittee. My name is Joseph A. Smith, Jr. I am the North
Carolina Commissioner of Banks and the Chairman of the Conference of State Bank
Supervisors (CSBS).
Thank you for the opportunity to testify today on the condition of the banking industry. In the midst of a great deal of discussion about reform and recovery, it is
very important to pause to assess the health of the industry and the factors affecting it, for good and ill.
My testimony today will present the views of state bank supervisors on the health
of the banking industry generally and the banks we oversee in particularthe overwhelming majority of which are independent community banks. The states charter
and regulate 73 percent of the nations banks (Exhibit A). These banks not only
compete with the nations largest banks in the metropolitan areas, but many are
the sole providers of credit to less populated and rural areas (Exhibit B). We must
remember 91 percent of this countrys banks have less than $1 billion in assets but
share most of the same regulatory burdens and economic challenges of the largest
banks which receive the greatest amount of attention from the Federal Government.
Community and regional banks are a critical part of our economic fabric, providing
an important channel for credit for consumers, farmers, and small businesses.
I will address: the key challenges that state-chartered banks face, regulatory policies that we are pursuing to improve supervision and the health of the industry,
and recommendations to improve the regulation of our banks and ultimately the
health of the industry.
CONDITION OF THE BANKING INDUSTRY
While the economy has begun to show signs of improvement, there are still many
areas of concern. Consumer confidence and spending remains low, deficit spending
has soared, and unemployment rates continue to slowly tick upward. The capital
markets crisis, distress in the residential and commercial real estate markets, and
the ensuing recession have greatly weakened our nations banking industry. And despite recent positive developments, the banking industry continues to operate under
very difficult conditions. While there are pockets of strength in parts of the state
bank system, the majority of my fellow state regulators have categorized general
banking conditions in their states as gradually declining. Not surprisingly, the
health of banks is directly affected by the economic conditions in which they operate. Times of economic growth will usually be fueled by a banking industry with
sufficient levels of capital, a robust and increasing volume of performing loans,
ample liquidity, and a number of new market entrants, in the form of de novo institutions. Conversely, this recession is characterized by a banking industry marred by
evaporating capital levels, deteriorating and increasingly delinquent loans, liquidity
crunches, and a steady stream of bank failures.
The Federal Deposit Insurance Corporation (FDIC) reports in its most recent
Quarterly Banking Profile that the banking industry suffered an aggregate net loss
of $3.7 billion in the second quarter of 2009. These losses were largely caused by
the increased contributions institutions made to their loan-loss provisions to counter
the rising number of non-performing loans in their portfolios and realized losses.
Further, additional writedowns in the asset-backed commercial paper portfolios and
higher deposit insurance assessments impacted banks earnings significantly.1
Across the country, my colleagues are experiencing deteriorating credit quality in
their banks, which is straining earnings and putting extreme pressure on capital.
Deterioration in credit quality is requiring greater examination resources as regulators evaluate a higher volume of loans. Concentrations in commercial real estate
(CRE) loans in general, and acquisition, development, and construction (ADC) loans
in particular, are posing the greatest challenge for a significant portion of the industry. This is an important line of business for community and regional banks. Banks
with less than $10 billion in assets comprise 23 percent of total bank assets, but
originate and hold 52 percent of CRE loans and 49 percent of ADC loans by volume.
Reducing the concentrations that many of our institutions have in CRE lending is
1 FDIC Quarterly Banking Profile, Second Quarter 2009: http://www2.fdic.gov/qbp/2009jun/
qbp.pdf.
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an important factor in restoring them to health; however, it is our view that this
reduction needs to be done in a way that does not remove so much credit from the
real estate market that it inhibits economic recovery. Striking an appropriate balance should be our goal.
Deteriorating credit quality has a direct and destructive effect on bank capital.
Reduction in capital, in turn, has a direct and destructive effect on a banks liquidity, drying up its sources of funding from secondary sources, including capital markets, brokered deposits, home loan and bankers banks and the Federal Reserve.
This drying up of liquidity has been a significant challenge for a substantial number
of the failures.
CAPITAL IS KING
As we entered the financial crisis, we touted the overall strong capital base of the
industry, especially compared to previous periods of economic stress. While this was
true, banks are highly leveraged operations, and when losses materialize, capital
erodes quickly. While this is true for all institutions, it is more pronounced in our
largest banks. According to the FDIC, as of December 31, 2007, banks over $10 billion in assets had an average leverage capital ratio of 7.41 percent. This was 200
basis points (b.p.) less than banks with assets between $1 billion and $10 billion;
256 b.p. less than banks with assets between $100 million and $1 billion; and an
astonishing 610 b.p. less than banks with assets less than $100 million. As the financial crisis was unfolding and the serious economic recession began, these numbers show our largest institutions were poorly positioned, leading to the extraordinary assistance by the Federal Government to protect the financial system. Even
with this assistance, this differential continues today with the largest institutions
holding considerably less capital than the overwhelming majority of the industry.
Last year, the Federal Government took unprecedented steps to protect the financial system by providing capital investments and liquidity facilities to our largest
institutions. Financial holding company status was conferred on a number of major
investment banks and other financial concerns with an alacrity that was jaw-dropping. We trust the officials responsible took the action they believed necessary at
that critical time. However, Federal policy has not treated the rest of the industry
with the same expediency, creativity, or fundamental fairness. Over the last year,
we have seen nearly 300 community banks fail or be merged out of existence, while
our largest institutions, largely considered too big to fail, have only gotten bigger.
State officials expect this trend to continue, with an estimated 125 additional unassisted, privately negotiated mergers due to poor banking conditions.
Additional capital, both public and private, must be the building block for success
for community and regional banks. While TARP has provided a source of capital for
some of these institutions, the process has been cumbersome and expensive for the
community and regional banks, whether they actually received the investment of
funds or not. There has been a lack of transparency associated with denial of a
TARP application, which comes in the form of an institution being asked to withdraw. This should of deep concern to Congress. If TARP is to be an effective tool
to strengthen community and regional banks, the Treasury must change the viability standard. We should provide capital to institutions which are viable after the
TARP investment. Expanded and appropriate access to TARP capital will go a long
way to saving the FDIC and the rest of the banking industry a lot of money. To
date, this has been a lost opportunity for the Federal Government to support community and regional banks and provide economic stimulus.
There are positive signs private capital may be flowing into the system. For the
6 months ending June 30, 2009, over 2,200 banks have injected $96 billion in capital. While capital injections were achieved for all sizes of institutions, banks with
assets under $1 billion in assets had the smallest percentage of banks raising capital at 25 percent.
There has been and, to our knowledge, there still is a concern among our Federal
colleagues with regard to strategic investments in and acquisitions of banks, both
through the FDIC resolution process and in negotiated transactions. While these
concerns are understandable, we believe they must be measured against the consequence of denying our banks this source of capital. It is our view that Federal policy should not unnecessarily discourage private capital from coming off the sidelines
to support this industry and in turn, the broader economy.
SUPERVISION DURING THE CRISIS
There are very serious challenges facing the industry and us as financial regulators. State regulators have increased their outreach with the industry to develop
a common understanding of these challenges. Banks are a core financial intermediary, providing a safe haven for depositors money while providing the necessary
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fuel for economic growth and opportunity. While some banks will create-and have
created-their own problems by miscalculating their risks, it is no surprise that there
are widespread problems in banks when the national economy goes through a serious economic recession.
We will never be able, nor should we desire, to eliminate all problems in banks;
that is, to have risk-free banking. While they are regulated and hold the public
trust, financial firms are largely private enterprises. As such, they should be allowed to take risks, generate a return for shareholders, and suffer the consequences
when they miscalculate. Over the last year, we have watched a steady stream of
bank failures. While unfortunate and expensive, this does provide a dose of reality
to the market and should increase the industrys self-discipline and the regulators
focus on key risk issues. In contrast to institutions deemed too big to fail, market
discipline and enhanced supervisory oversight can result in community and regional
banks that are restructured and strengthened.
Recognizing the Challenges
The current environment, while providing terrific challenges with credit quality
and capital adequacy, has also brought an opportunity for us to reassess the financial regulatory process to best benefit our local and national economies. To achieve
this objective, it is vital to step back and make an honest assessment of our regulated institutions, their lines of business, management ability, and capacity to deal
with economic challenges. This assessment provides the basis for focusing resources
to address the many challenges we face.
With regard to financial institutions, as regulators we must do a horizontal review
and engage in a process of triage that divides our supervised entities into three
categories:
I. Strong
II. Tarnished
III. Weak
Strong institutions have the balance sheets and management capacity to survive,
and even thrive, through the current crisis. These institutions will maintain stability and provide continued access to credit for consumers. Further, these institutions will be well-positioned to purchase failing institutions, which is an outcome
that is better for all stakeholders than outright bank failure. We need to ensure
these institutions maintain their positions of strength.
Tarnished institutions are under stress, but are capable of surviving the current
crisis. These institutions are where our efforts as regulators can make the biggest
difference. Accordingly, these institutions will require the lions share of regulatory
resources. A regulators primary objective with these institutions should be to fully
and accurately identify their risks, require generous reserves for losses, and develop
the management capacity to work through their problems. We have found that
strong and early intervention by regulators, coupled with strong action by management, has resulted in the strengthening of our banks and the prevention of further
decline or failure. By coordinating their efforts, state and Federal regulators can
give these banks a good chance to survive by setting appropriate standards of performance and avoiding our understandable tendencies to over-regulate during a crisis.
Weak institutions are likely headed for failure or sale. While this outcome may
not be imminent, our experience has shown that the sooner we identify these institutions, the more options we will have to seek a resolution which does not involve
closing the bank. It simply is not in our collective best interest to allow an institution to exhaust its capital and to be resolved through an FDIC receivership, if such
an action can be avoided. Institutions we believe are headed toward almost certain
failure deserve our immediate attention. This is not the same as bailing out, or
propping up failing institutions with government subsidies. Instead, as regulators
our goal is an early sale of the bank, or at least a soft landing with minimal economic disruption to the local communities they serve and minimal loss to the Deposit Insurance Fund.
AREAS REQUIRING ATTENTION
This is the time for us to be looking forward, not backwards. We need to be working to proactively resolve the problems in the banking industry. To do this, we need
to ensure our supervisory approach is fair and balanced and gives those banks
which deserve it the chance to improve their financial positions and results of operations. The industry and regulators must work together to fully identify the scope
of the problems. However, I believe we need to consider the response which follows
the identification. We should be tough and demanding, but the response does not
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need to send so many banks toward receivership. A responsive, yet reasonable approach, will take a great deal of time and effort, but it will result in less cost to
the Deposit Insurance Fund and benefit communities and the broader economy in
the long-run. I would like to highlight a few areas where I have concerns.
Increase Access to Capital
First, as discussed earlier, we need to allow capital to flow into the system. There
is a significant amount of capital which is seeking opportunities in this market. We
need to encourage this inflow through direct investments in existing institutions
and the formation of new banks. To the extent that private investors do not themselves have bank operating experience or intend to dismantle institutions without
consideration of the social and economic consequences, such shortcomings can and
should be addressed by denial of holding company or bank applications or through
operating restrictions in charters or regulatory orders. Where private equity groups
have employed seasoned management teams and proposed acceptable business
plans, such groups should be granted the necessary regulatory approvals to invest
or acquire. While we cannot directly fix the capital problem, we should ensure the
regulatory environment does not discourage private capital.
Expedite Mergers
Second, we need to allow for banks to merge, especially if it allows us to resolve
a problem institution. Unfortunately, we have experienced too many roadblocks in
the approval process. We need more transparency and certainty from the Federal
Reserve on the process and parameters for approving mergers. To be clear, I am not
talking about a merger of two failing institutions. Facilitating the timely merger of
a weak institution with a stronger one is good for the system, good for local communities, and is absolutely the least cost resolution for the FDIC.
Brokered Deposits
Third, over the last several years the industry has explored more diversified funding, including the use of brokered deposits. Following the last banking crisis, there
are restrictions for banks using brokered deposits when they fall below well capitalized. I appreciate the efforts of FDIC Chairman Bair in working to provide more
consistency and clarity in the application of this rule. However, I am afraid the current approach is unnecessarily leading banks to fail. We allowed these banks to increase their reliance on this funding in the first place, and I believe we have a responsibility to assist them in gradually unwinding their dependency as they work
to clean up their balance sheet. My colleagues have numerous institutions that
could have benefited from a brokered deposit waiver granted by the FDIC. As noted
above, many of the recent failures of community and regional banks have been the
result of a sudden and precipitous loss of liquidity.
Open Bank Assistance
Fourth, the FDIC is seriously constrained in providing any institution with open
bank assistance. We are concerned that this may be being too strictly interpreted.
We believe there are opportunities to provide this assistance which do not benefit
the existing shareholders and allows for the removal of bank management. This is
a much less disruptive approach and I believe will prove to be much less costly for
the FDIC. The approach we suggest was essentially provided to Citibank and Bank
of America through loan guarantees without removing management or eliminating
the stockholders. As discussed previously, we believe that the Capital Purchase Program under TARP can be a source of capital for transactions that restructure banks
or assist in mergers to the same effect. We are not suggesting that such support
be without conditions necessary to cause the banks to return to health.
Prompt Corrective Action
Finally, Congress should also investigate the effectiveness of the Prompt Corrective Action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act in dealing with problem banks. We believe there is sufficient evidence that
the requirements of PCA have caused unnecessary failures and more costly resolutions and that allowing regulators some discretion in dealing with problem banks
can assist an orderly restructuring of the industry.
LOOKING FORWARD
There will be numerous legacy items which will emerge from this crisis designed
to address both real and perceived risks to the financial system. They deserve our
deliberate thought to ensure a balanced and reasoned approach which provides a
solid foundation for economic growth and stability.
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The discussions around regulatory reform are well underway. We would do well
to remember the instability of certain firms a year ago which put the U.S. financial
system and economy at the cliffs edge. We must not let the bank failures we are
seeing today cloud the real and substantial risk facing our financial systemfirms
which are too big to fail, requiring extraordinary government assistance when they
miscalculate their risk.
We need to consider the optimal economic model for community banks, one that
embraces their proximity to communities and their ability to engage in high-touch
lending. However, we must ensure lower concentrations, better risk diversification,
and improved risk management. We need to find a way to ensure banks are viable
competitors for consumer finance and ensure they are positioned to lead in establishing high standards for consumer protection and financial literacy.
We must develop better tools for offsite monitoring. The banking industry has a
well established and robust system of quarterly data reporting through the Federal
Financial Institutions Examination Councils Report of Condition and Income (Call
Report). This provides excellent data for use by all regulators and the public. We
need to explore greater standardization and enhanced technology to improve the
timeliness of the data, especially during times of economic stress.
Over the last several years, the industry has attracted more diversified sources
of funding. This diversification has improved interest rate risk and liquidity management. Unfortunately, secured borrowings and brokered deposits increase the cost
of resolution to the FDIC and create significant conflicts as an institution reaches
a troubled condition. We need to encourage diversified sources of funding, but ensure it is compatible with a deposit insurance regime.
We need to consider how the Deposit Insurance Fund can help to provide a countercyclical approach to supervision. We believe Congress should authorize the FDIC
to assess premiums based on an institutions total assets, which is a more accurate
measure of the total risk to the system. Congress should revisit the cap on the Fund
and require the FDIC to build the Fund during strong economic times and reduce
assessments during period of economic stress. This type of structure will help the
entire industry when it is most needed.
CONCLUSION
The banking industry continues to face tremendous challenges caused by the poor
economic conditions in the United States. To move through this crisis and achieve
economic stability and growth, Members of Congress, state and Federal regulators,
and members of the industry must coordinate efforts to maintain effective supervision, while exercising the flexibility and ingenuity necessary to guide our industry
to recovery.
Thank you for the opportunity to testify today, and I look forward to any questions you may have.
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ON
PREPARED STATEMENT OF THOMAS J. CANDON

DEPUTY COMMISSIONER, VERMONT DEPARTMENT OF BANKING, INSURANCE,
SECURITIES, AND HEALTH CARE ADMINISTRATION
BEHALF OF THE NATIONAL ASSOCIATION OF STATE CREDIT UNION SUPERVISORS
OCTOBER 14, 2009
Introduction
Honorable Chairman Johnson, Ranking Member Crapo and the distinguished
members of the Financial Institutions Subcommittee of the Senate Banking, Housing and Urban Affairs Committee, thank you for the opportunity to testify before
this Subcommittee on the State of the Banking Industry. I am Thomas J. Candon,
Deputy Commissioner of Banking and Securities for the Vermont Department of
Banking, Insurance, Securities and Health Care Administration. I am pleased to be
here on behalf of state credit union regulators as Chairman of the National Association of State Credit Union Supervisors 1 (NASCUS). In this prepared testimony, I
will share state credit union regulators perspectives on the condition of state-chartered credit unions and areas for reform.
NASCUS has been committed to enhancing state credit union supervision and advocating for a safe and sound state credit union system since its inception in 1965.
NASCUS is the sole organization dedicated exclusively to the promotion of the dual
chartering system and advancing the autonomy and expertise of state credit union
regulatory agencies.
The state credit union system is 100 years old. Today, there are 3,065 state-chartered credit unions with a combined $404 billion in assets.2 State-chartered credit
unions represent 40 percent of the nations nearly 7,700 credit unions.
At this hearing, the Subcommittee is assessing the state of financial institutions,
areas of concern as well as capital and lending needs. In this testimony, I will detail
information from state regulators on the following:
Condition of state-chartered credit unions
Corporate credit union impact
Credit union capital needs
Regulatory considerations for member business lending
Trends and regulatory response
Value and strength of state supervision
Condition of state-chartered credit unions
Like all financial institutions, state credit unions have been adversely affected by
the economic downturn. However, at this point, state natural person credit unions
remain generally healthy and continue to serve the needs of their members and
their communities. For the most part, natural person credit unions did not engage
in many of the practices that have precipitated the current market downturn.
Nationally, the average credit union net worth is down to 10.03 percent, with 96
percent of all federally insured credit unions having more than 7 percent in capital
as of June 30, 2009. Further, the percentage of delinquent loans is 1.58 percent for
all credit union loans.
State-chartered credit unions in my state of Vermont have the capability to lend
due to an increase in deposits that we attribute to a flight to safety. Consumer loans
are available to members although underwriting continues to be based on a members ability to repay. At this time, Vermont credit unions do not make many member business loans and have nominal commercial real estate loans on their balance
sheets. Our regulatory focus is on the amount of capital held by some of our credit
unions and the impact of the growing unemployment picture on delinquencies.
The capital of Vermont credit unions is affected by the growth of deposits which
were up 24.73 percent in Vermont as of June 30, 2009, and the impact of the corporate credit union losses (which I will discuss later). Income is also being reduced
as margins are squeezed and credit union members are struggling to make loan
payments.
In Vermont, our small credit unions like many around the country are not only
affected by a downturn in the economy but also by increasing regulatory burden.
We continue to see mergers as long-time managers retire and volunteer boards cannot keep up with the increased demands. As state regulators we monitor our credit
1 NASCUS is the professional association of the 48 state credit union regulatory and territorial
agencies that charter and supervise the nations 3,100 state-chartered credit unions.
2 As of June 30, 2009.
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unions closely. If there is any sign of distress, we have an examiner communicating
with the credit union to make sure we understand what needs to be done to correct
the problems.
As the Subcommittee knows, the effect of the economy on financial institutions
varies from region to region. Some regions are weathering significant impacts from
the destabilized real estate market, while others are addressing more localized economic issues. In many cases, state regulators are concerned about unemployment
and its impact on members ability to meet their obligations. State regulators are
also concerned about the growing number of delinquencies, charge-offs and pressures on earnings, especially in smaller state-chartered credit unions. While loan delinquency and net charge-offs have generally increased for state-chartered credit
unions, state regulators indicate that the levels remain manageable.
State regulators also report increased scrutiny on consumer credit products, including auto loans, credit cards and other consumer credit portfolios given the nations economic condition. State credit union regulators are cognizant of credit
unions future financial performance as commercial credit problems begin to affect
consumer credits. The weak economy creates a tightening of commercial credit, an
issue being closely monitored by state regulators.
Some states, including my home state of Vermont, have not experienced the fallout from commercial or subprime lending as our state-chartered credit unions did
not engage in those activities. State regulators continue to encourage their credit
unions to exercise sound underwriting, proper risk management and due diligence,
the elements that have kept credit unions in a better position throughout this economic downturn. Further, state regulators are monitoring red flags closely, fully utilizing offsite monitoring and using early warning systems to detect risk.
The growing trend toward consolidation is also on the minds of state regulators
as credit union mergers continue to occur, both voluntarily and for regulatory purposes. As economic pressures persist, finding suitable merger partners may become
more difficult. State regulators recognize this dilemma and see merger issues as an
ongoing concern in 2010.
In addition, growth is an issue state regulators are paying close attention to in
todays environment. The National Credit Union Administration (NCUA) reported
in its Financial Trends in federally Insured Credit Unions for JanuaryJune 2009
an annualized asset growth rate of 14.53 percent. This growth gives rise to concerns
about interest rate risk and the need to ensure quality asset/liability and balance
sheet management among credit unions.
Corporate Credit Union Impact
As I noted earlier, one of the issues affecting both state and Federal credit unions
is the impact of problems in the corporate credit union network. Allow me to elaborate. In addition to direct economic pressures, credit unions are addressing indirect
economic pressures by way of the impact of losses from corporate credit unions. The
deterioration of asset-backed securities held by two Federal corporate credit unions
(U.S. Central Corporate Federal Credit Union and Western Corporate Federal Credit Union) and their consequent conservatorship by the NCUA have resulted in considerable balance sheet impact on natural person credit unions.
For the first time in nearly 20 years, the NCUA Board approved a credit union
premium in September 2009 with the assessment of 0.15 percent of insured shares.
The premium will both restore the National Credit Union Share Insurance Fund
(NCUSIF) equity to 1.30 percent and begin to repay a portion of the Temporary Corporate Credit Union Stabilization Fund borrowings from the U.S. Treasury.
State regulators, in consultation with Federal regulators, are working to address
the impact of corporate losses and to make regulatory improvements to mitigate recurrence. As the NCUA develops its proposed rule for regulation of corporate credit
unions, state regulators continue to stress the following principles:
Enhance supervision and tighten regulatory standards
Properly assess risk problems
Preserve equal opportunity for all corporates to compete as long as they remain
safe and sound and retain the support of their members
Guard against preemption of state authority and homogenization of the corporate system
State regulators have also cautioned the NCUA against regulation that would unnecessarily or adversely impact safe and sound corporate credit unions that have
properly managed their investments and remain fully supported by their members.
NCUA has been working cooperatively with state regulators to institute revisions
to the agencys Part 704 corporate credit union regulations to strengthen the safety
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and soundness of the corporate system. Regulators should continue to focus on ensuring any credit union, natural person or corporate, has robust risk management
and mitigation policies in place to balance its investment portfolios. Such policies
should include adequate reserves, requisite expertise, meaningful shock testing and
valuation mechanisms as well as concentration limits. NASCUS believes there is no
question that after recent events corporate credit unions must retain higher capital
reserves. NCUA should work with NASCUS and state regulators to develop more
comprehensive capital requirements, including risk-based capital.
The regulatory capital program for corporate credit unions should consider an institutions status as a wholesale or retail corporate, its mix of products and services
(investment, payment systems, pass through, etc.) and establish parameters of actions for state and Federal regulators if capital falls below defined thresholds.
Capital is important to both the corporate credit union system and the natural
person credit unions that support the corporate credit unions. During the corporate
stabilization process, supplemental capital may have mitigated some of the unintended consequences to net worth categories at natural person credit unions. Further, access to a risk-based capital system would foster safety and soundness for the
entire credit union system.
Credit Union Capital Needs
The majority of credit unions are weathering conditions today; however, as stated
previously, credit unions earnings are suffering and credit unions are losing money.
We need to act now to ensure credit unions remain as safe and sound as possible.
NASCUS has long supported comprehensive capital reform for credit unions and believes that given the current economic climate, reform in this area is critical and
timely. Credit unions need more ways to raise capital, notably access to supplemental capital. NASCUS continues to encourage the Senate Banking Committee to
consider credit union capital reform as part of its financial reform efforts.
Unlike other financial institutions, credit union access to capital is limited to reserves and retained earnings from net income. Since net income is not easily increased in a fast-changing environment, state regulators recommend additional capital-raising capabilities for credit unions. Access to supplemental capital will enable
credit unions to respond proactively to changing market conditions, enhancing their
future viability and strengthening their safety and soundness. Supplemental capital
would serve as an extra layer of protection for the credit union deposit insurance
fund as well.
Allowing credit unions access to supplemental capital with regulatory approval
and robust oversight will improve their ability to react to market conditions, grow
safely into the future and serve their members in this challenged economy. It would
also provide a tool for credit unions to use if they face declining net worth or liquidity needs. We feel strongly that now is the time to permit this important change.
NASCUS follows several guiding principles in our quest for supplemental capital
for credit unions. First, a capital instrument must preserve the not-for-profit, mutual, member-owned and cooperative structure of credit unions. Next, it must provide for full disclosures, investor protection and robust safeguards. Prudential safety
and soundness requirements must be maintained for these investments and supplemental capital must preserve credit unions tax-exempt status. Finally, regulatory
approval would be required before a credit union could access supplemental capital.
It is NASCUS studied belief that a change to the Federal Credit Union Act could
provide this valuable tool to the credit union system without altering the not-forprofit, mutual, cooperative structure of credit unions as tax exempt member owned
financial institutions. We realize that supplemental capital will not be appropriate
for every credit union, nor would every credit union need access to supplemental
capital. This is why NASCUS supports regulator approval as a pre-condition for
credit unions issuing supplemental capital.
A task force of NASCUS state regulators is currently studying supplemental capital for credit unions with the NCUA. This regulatory group is researching the appropriate regulatory parameters for supplemental capital for credit unions.
As this Subcommittee addresses regulatory reform and other legislation this fall,
NASCUS encourages favorable consideration of access to supplemental capital for
credit unions.
Regulatory Considerations for Member Business Lending
Credit union member business lending, when conducted within proper regulatory
controls, has proved beneficial for credit unions, their members, and their communities. However, while some credit unions are actively engaged in member business
lending, many are not. As Congress considers changes to credit unions member
business lending capabilities, state regulators will work with the NCUA in its capac-
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ity as the insurer to build regulatory parameters for proper oversight through the
examination and supervision process. Further, credit unions must have a thorough
understanding of member business lending and be diligent in their written policies,
underwriting and controls for the practice to be conducted in a safe and sound manner. From a prudential regulator view, an arbitrary cap on member business lending
is less important than proper underwriting and thorough reporting of all business
loans.
Trends and Regulatory Response
I would like to respond to the Subcommittees request for information regarding
developing trends, concerns and state regulatory responses to todays challenges.
Rising unemployment continues to be a concern and we expect that it will continue
to negatively impact state credit unions well into 2010 as delinquencies and bankruptcies continue to increase.
Some state regulators have seen a marked increase in loan delinquencies and net
charge-offs at June 2009; however, the levels remain manageable. Earnings pressures continue so credit unions are seeking ways to reduce overhead expenses. Loan
demand has slowed somewhat in the mid-to smaller credit unions; a contrast to the
increased indirect lending activities experienced in the larger credit unions. State
regulators are closely monitoring both lending and investment activities within their
credit unions and continue to stress the importance of sound underwriting and due
diligence at the board level. State regulators also continue to supervise their institutions closely through offsite monitoring and onsite examinations and visitations.
Credit unions need to understand their portfolio makeup and the impact that an
increasing rate environment will have on their institutions.
Another economic stressor affecting small credit unions is the uncertainty of losing their core field of membership if comprised of select employee groups. Because
some small credit unions still rely on one or two employers for their members, if
those businesses do not survive, the credit union will not survive either.
Value and Strength of State Supervision
In this challenged economic environment, state regulators have demonstrated the
importance of local supervision of state-chartered institutions and the value of a
dual regulatory regime. State regulators are properly tuned into both their institutions and the specific needs of local consumers. Further, state regulators have the
expertise to identify risk areas and take enforcement actions where necessary. With
respect to consumer protection, state regulators are directly accountable to Governors and state legislatures, who in turn are directly accountable to their consumer
citizens. It is for this reason that many states have always emphasized consumer
protection along with safety and soundness in financial services oversight. As regulatory modernization efforts are considered by the Senate Banking Committee, we
encourage you to retain state supervision and uphold state authority. Further, we
ask you to recognize the essential value of dual chartering to financial institutions
ability to innovate.
Finally, as we talk about dual chartering, I wanted to note our regulatory partners, the National Credit Union Administration. In my state of Vermont, all of my
credit unions are federally insured, and therefore subject to share insurance oversight from NCUA in addition to state safety and soundness and compliance regulation and supervision. We work extremely well with NCUA, and I believe our strong
cooperative relationship has contributed substantially to the stability of the credit
union system in my region. Indeed, this cooperative relationship between state regulators and the NCUA exists throughout the Nation as well.
NASCUS would be pleased to provide any additional information you deem appropriate as you work through these matters. While the current economic climate has
an unquestionable adverse impact on the state credit union system, I remain confident that the generally sound management of credit unions combined with ongoing
vigilant state regulatory oversight has enabled the credit union system to prudently
meet their members needs. Thank you for your attention.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM SHEILA C. BAIR
Q.l. According to a recent New York Times article, about $870 billion, or roughly half of the industrys $1.8 trillion of commercial
real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to
enter the commercial real estate market and what other step
should regulators be taking to address this problem?
A.l. Small and medium-sized financial institutions hold a significant dollar amount of commercial real estate loans on their balance
sheets. Many of these smaller institutions were not active in the
commercial real estate mortgage securitization market because of
the comparatively small dollar amount of the loans and the nature
of customer-focused relationships in community banking. Therefore, we do not believe the TALF has had a significant effect on the
availability of credit for smaller commercial real estate loans.
In terms of encouraging commercial real estate lending, the Federal banking agencies issued a policy statement on October 30,
2009, titled Prudent Commercial Real Estate Loan Workouts. The
Statement encourages banks to continue making good loans to commercial real estateborrowers and work with borrowers experiencing
difficulties in their repayment capacity because of the economic
downturn.
The TALF was designed to increase credit availability for businesses and consumers by facilitating renewed issuance of securities
backed by loans to consumers and businesses at more normal interest rate spreads. Based on recent TALF transactions involving commercial real estate mortgage loans, the program appears to have
encouraged capital to enter the securitization market. As the Federal Reserve Bank of New York is facilitating the TALF program,
the Senator may want to consult with the Reserve Bank on the
programs performance and success in encouraging capital to return
to the commercial real estate market.
Q.2. How will FASBs new rules on off-balance sheet accounting
impact financial institutions ability to lend and how do you intend
to implement the changes?
A.2. Following publication of the Notice of Proposed Rulemaking on
September 15, 2009, the bank regulatory agencies received 41 comments from banks, bank holding companies, banking industry associations, mortgage companies, investment and asset management
firms, and individuals. A number of commenters indicated that implementation of FAS 166 and FAS 167 without changes to the
Agencies risk-based capital rules would negatively impact financial
markets and curtail lending due to higher regulatory capital requirements resulting from the consolidation of significant amounts
of assets onto banking organizations balance sheets. Commenters
also argued that such implementation would inappropriately align
capital requirements with GAAPs control-based approach to consolidation, in contrast to the credit risk focus of the Agencies riskbased capital rules. The commenters overwhelmingly supported a
delay or phase-in of the regulatory capital requirements resulting
from the implementation of FAS 166 and FAS 167.
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In response the FDIC, working with the other Federal bank regulatory agencies, developed a final rule to better align regulatory
capital requirements with the actual risks of certain exposures.
Banks affected by the new accounting standards generally will be
subject to higher minimum regulatory capital requirements. The
final rule provides an optional delay and phase-in for a maximum
of 1 year for the effect on risk-based capital and the allowance for
loan and lease losses related to the assets that must be consolidated as a result of the accounting change. The final rule also
eliminates the risk-based capital exemption for asset-backed commercial paper assets. The transitional relief does not apply to the
leverage ratio or to assets in conduits to which a bank provides or
has provided implicit support.
The Final Rule was passed by the FDIC Board of Directors on
December 15, 2009. The rule provides temporary relief from riskbased measures in order to avoid abrupt adjustments that could
undermine or complicate government actions to support the provision of credit to U.S. households and businesses in the current economic environment. Banks will be required to rebuild capital and
repair balance sheets to accommodate the new accounting standards by the beginning of 2011. The optional delay and phase-in provides capital relief to ease the impact of the accounting change on
banks regulatory capital requirements, and enable banks to maintain consumer lending and credit availability as they adjust their
business practices to the new accounting rules.
FROM JOHN DUGAN
enter the commercial real estate market and what other steps
A.l. The Federal Reserves Term Asset-Backed Securities Loan Facility (TALF) is intended to help make credit available to consumers and businesses by facilitating the issuance of asset-backed
securities (ABS) and by improving the conditions for ABS more
generally. Until recently, most of the financing conducted with
TALF facilities has been concentrated in automobile and credit
card ABS securities. The use of TALF to help restart the commercial mortgage-backed securities (CMBS) markets has lagged due to
the complexity and level of due diligence required for these types
of transactions.
The use of the TALF program to assist the CMBS market took
a positive step forward on November 16, 2009, when U.S. mall
owner Developers Diversified Realty Corp sold $400 million of securities with the help of TALF financing. The $323 million TALF eligible AAA-rated portion was priced at under 4 percent, a much better rate than originally anticipated. This issuance is indicative of
a key potential benefit of CMBS TALF: it provides a reasonable
cost for senior debt, allowing liquidity to flow back into the market.
However, it does not by itself solve the problem of overleveraged
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borrowers. Since TALF financing is only available for AAA-rated
debt, it would likely not directly benefit many of the problem borrowers sitting on the books of the banks today. However, there is
an indirect benefit in that it provides market liquidity. Investors
will likely use this initial deal as a benchmark, which could encourage other capital into the commercial real estate market. Because
of this potential benefit, many market participants would like to
see the current deadlines for the TALF program extended beyond
the current deadlines of June 30, 2010, for newly issued CMBS and
March 31, 2010, for legacy CMBS (i.e., deals issued before 1/1/09).
Although there has been some modest improvement in liquidity
within the CMBS market, the underlying fundamentals for many
commercial real estate segments are still weak with delinquency,
nonaccrual, and loss levels still increasing. Ultimately, the credit
fundamentals of the industry need to stabilize in order for investors, bankers, and borrowers to fully understand pricing of commercial real estate assets.
Banking regulators have a limited ability to directly encourage
capital investment into the commercial real estate industry. We are
mindful, however, that our actions must not put up unreasonable
barriers to take flow of capital. At the OCC, we are encouraging
bankers to work with their borrowers, and we continue to stress to
examiners the need to take a measured, balanced approach when
evaluating loan and borrower performance in this economic environment. We have stressed that we expect and encourage bankers
to work with borrowers who may be facing financial difficulty, and
to extend new credit to creditworthy borrowers when these actions
are done in a prudent and safe and sound manner. In an effort to
promote clarity and consistency in the industry, the OCC, in conjunction with the other Federal banking agencies and the FFIECs
State Liaison Committee, recently issued a Policy Statement on
Prudent Commercial Real Estate (CRE) Loan Workouts. The policy
statement reiterates the agencies view that prudent CRE loan
workouts are often in the best interest of the financial institution
and the borrower, and establishes clear regulatory expectations for
the industry when working with borrowers. The statement notes
that examiners should not criticize banks for engaging in an effective workout program even if the restructured loan has a weakness
that results in an adverse credit classification. The statement also
reiterates our policy that loans should not be classified simply because the underlying values have declined to amounts that are less
than the current loan balance. Instead, classifications must be
based on an analysis of the borrowers ability and capacity to
repay. To help promote greater consistency both within and across
the agencies in making such determinations, the policy statement
provides real world examples that our examiners are seeing, and
provides guidance on when classification and write-downs are and
are not warranted.
impact financial institutions ability to lend, and how do you intend
A.2. Upon implementing FAS 166 and FAS 167, banking organizations will be required to consolidate certain assets and liabilities
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that are currently held in variable interest entities (VIEs)1 that
these organizations do not consolidate under current generally accepted accounting principles (GAAP) standards. Certain banking
organizations have reported that the consolidation of variable interest entities will result in a significant increase in assets reported
on-balance sheet at the time the new accounting standards become
effective, which will be January 1, 2010, for banking organizations
with a calendar year end. Moreover, except for VIEs that a banking
organization consolidates at fair value, consolidation will require
the banking organization to recognize an allowance for loan and
lease losses for loans held in consolidated VIEs.
On September 16, 2009, the Federal banking agencies (Agencies)
published in the Federal Register a notice of proposed rulemaking
(NPR) regarding the effect of the accounting changes under FAS
166 and FAS 167 would have on capital requirements under the
regulatory capital rules. The NPR noted that banking organizations
had provided non-contractual support to VIEs that they sponsored
in order to prevent senior securities in the structure from being
downgraded, thereby mitigating reputational risk and the associated alienation of investors, and preserving access to cost-effective
funding. In light of these actions taken by banking organizations,
the NPR stated that the Agencies believe that the broader accounting consolidation requirements of FAS 166 and FAS 167 will result
in a regulatory capital treatment that more appropriately reflects
the risks to which banking organizations are exposed. For these
and other reasons, the NPR did not propose changing the regulatory capital rules to mitigate the effect of FAS 166 and FAS 167
on banking organizations minimum regulatory capital requirements.2
Before issuing the NPR, the Agencies carefully considered the
probable effect on banking organizations financial regulatory capital ratios and financial condition that will result from implementing FAS 166 and FAS 167. Among other sources, the Agencies
considered information obtained through the Supervisory Capital
Assessment Program (SCAP)the recent stress test of the nineteen
largest U.S. banking organizations. The SCAP directly considered
the likely on-boarding of assets resulting from changes in accounting standards in the assessment of risk-weighted assets and the associated ALLL needs of the stress-tested banks. Moreover, the NPR
sought information and comments on a number of questions, including the effect of the accounting changes on banking organizations financial position and lending, as well as the effect on finan1 A VIE is a business structure that allows an investor to hold a controlling interest in the
entity, without that interest translating into possessing enough voting privileges to result in a
majority. VIEs generally are thinly capitalized entities and include many special purpose entities, or SPEs.
2 The NPR proposed the following three changes to the agencies regulatory capital rules: (1)
eliminate provisions in the agencies risk-based capital rules that allow banking organizations
to exclude consolidated asset-backed commercial paper (ABCP) program assets from risk-weighted assets and instead assess a risk-based capital requirement against contractual exposures of
the organization to such ABCP programs (ABCP exclusion); (2) eliminate a provision in the riskbased capital rules that excludes from tier 1 capital the minority interest in a consolidated
ABCP programs subject to the ABCP exclusion; and (3) add a new reservation of authority for
the agencies risk-based capital rules to permit a banking organizations primary Federal supervisor to treat entities not consolidated under GAAP as if they were consolidated for risk-based
capital purposes, commensurate with the risk relationship of the banking organization to the
entity.
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cial markets. The NPR also solicited comments on whether there
are significant costs or burdens associated with implementing FAS
166 and FAS 167, and whether the Agencies should consider a
phase-in of the capital requirements that would result from the
GAAP changes.
Based on an analysis of available information, including comments received on the NPR, the Agencies have finalized work on
this rulemaking and expect to publish a final rule in the Federal
Register shortly. The Agencies have long maintained that banking
organizations should hold capital commensurate with the level and
nature of the risks to which they are exposed. The Agencies use
risk-based capital rules, supplemented by a leverage capital rule
(collectively, regulatory capital rules) to evaluate capital adequacy
of banking organizations. In the regulatory capital rules, the Agencies use GAAP as the initial basis for determining whether an exposure is treated as an on- or off-balance sheet asset. In the final
rule, the Agencies continue to make use of GAAP concepts within
the regulatory capital regime by recognizing VIEs consolidated
under FAS 167, and the risks associated with those assets, in their
risk-based capital ratios. However, in order to avoid abrupt adjustments that could undermine or complicate government actions to
support the provision of credit to U.S. households and businesses
in the current economic environment, the Agencies are providing
banking organizations with an optional two-quarter implementation delay followed by an optional two-quarter partial implementation of the effect of FAS 167 on risk-weighted assets and ALLL includable in tier 2 capital.
During this rulemaking process, the Agencies have determined
that while regulatory capital ratios at banking organizations most
effected by implementation of FAS 166 and FAS 167 would decline,
those ratios would remain significantly above regulatory minimums
subsequent to the implementation of FAS 166 and FAS 167. In addition, the Agencies continue to believe that the new GAAP consolidation standards of FAS 167 more closely align the risk banking
organizations face with respect to VIEs with which they are involved than current GAAP standards.3 The Agencies are aware,
however, that several government programs supporting the
securitization market are scheduled to terminate in the first quarter of 2010. In addition, Congress and the regulatory agencies are
considering a number of legislative and regulatory changes that
would affect the securitization activities. Given that the Agencies
cannot precisely assess the combined effect of these changes on the
securitization market, and because securitization activities remain
an important source of funding for banking organizations, the
Agencies are providing banking organizations a delay or phase-in
period in the final rule.
Q.3. What is the impact of the proposed action by the Office of the
Comptroller of the Currency and the Office of Thrift Supervision to
3 Determining whether a company is required to consolidate a VIE under FAS 167 depends
on a qualitative analysis of whether the company has a controlling financial interest in the
VIE. A company has a controlling financial interest if it has (1) the ability to direct matters
that most significantly impact the activities of a VIE and (2) either the obligation to absorb
losses of the VIE that could be significant to the VIE, or the right to receive benefits from the
VIE that potentially could be significant to the VIE, or both.
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end no payment deferred interest financing promotions on consumers and businesses? I understand the impact to be very large
and I would appreciate the agencies working to clarify that no
payment deferred interest financing promotions can be used in the
future albeit perhaps with revised disclosures and marketing.
A.3. In January 2003, the OCC, the Office of Thrift Supervision,
the Board of Governors of the Federal Reserve System, and the
Federal Deposit Insurance Corporation (the Agencies), issued the
Credit Card Account Management and Loss Allowance Guidance
(AMG). This guidance addressed regulatory concerns with the easing of minimum payment requirements as well as concerns with
other account management practices. The AMG states, in part, that
the Agencies expect lenders to require minimum payments that
will amortize the current balance of the account over a reasonable
period. The guidance does not differentiate between general purpose and private label card programs.
The receipt of regular monthly payments is important in consumer lending for several reasons. For borrowers, well designed
payment structures promote a fundamental understanding of their
debt burden in terms of monthly cash-flow and total income. Regular, budgeted payments help avoid the potential pitfalls associated
with payment shock when payments begin or significantly increase
under the loan amortization schedule. Regular payments also allow
borrowers to demonstrate to existing and prospective lenders the
willingness and capacity to repay their debts while systematically
reducing those debts.
For lenders, regular payments are an efficient way to monitor
borrowers willingness and ability to repay without the operational
expense associated with requiring ongoing payment capacity information. Regular payment streams also allow the identification of
early warning measurements such as delinquencies, roll rates, payment rates, and credit scores to be effective. Furthermore, they
help lenders manage Portfolio risk by providing important inputs
into the determination of adequate capital and reserve levels.
On June 18, 2009, the OCC issued a Supervisory Memorandum
to remind our examiners that the increased use of No Payment
programs being offered by banks, and their retail partners, are not
consistent with the AMG. We asked our examiners to ensure that
national banks cease any No Payment programs by February 22,
2010. This gives national banks, and their retail partners, time to
make necessary changes and coincides with the implementation
date for other changes dictated by the Credit CARD Act.
As a matter of clarification, the OCC does not object to No Interest programs. These promotions are very attractive to consumers
and often provide real, tangible benefits. However, the OCC believes that any benefits associated with No Payment programs
are outweighed by the negative impacts, including the loss of discipline associated with a regular payment stream, potential payment shock, a prolonged repayment schedule, and bank safety and
soundness concerns.
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FROM DANIEL K. TARULLO
A.l.A.2. At the end of the second quarter of 2009, approximately
$3.5 trillion of outstanding debt was associated with commercial
real estate (CRE), including loans for multifamily housing developments. Of this amount, $1.7 trillion was held on the books of banks
and thrifts, and an additional $900 billion represented collateral for
commercial mortgage-backed securities (CMBS), with other investors holding the remaining balance of $900 billion.
Before the crisis, securitization markets were an important conduit of credit to the household and business sectors. Securitization
markets (other than those for mortgages guaranteed by the government) closed in mid-2008, and the TALF was developed to promote
renewed issuance. Under the TALF, eligible investors may borrow
to finance purchases of the AAA-rated tranches of various classes
of asset-backed securities (ABS). The program originally focused on
credit for households and small businesses, including auto loans,
credit card loans, student loans, and loans guaranteed by the Small
Business Administration. Investors may also use the TALF to purchase both existing and newly issued CMBS, which were included
to help mitigate the refinancing problem in that sector.
The TALF has been successful in helping restart securitization
markets. Issuance has resumed and rate spreads for asset-backed
securities have declined substantially. The TALF program has
helped finance 2.5 million auto loans, 750,000 student loans, more
than 100 million credit card accounts, 480,000 loans to small businesses, and 100,000 loans to larger businesses. Included among
those business loans are 4,700 loans to auto dealers to help finance
their inventories. Perhaps even more encouraging, a substantial
fraction of ABS is now being purchased by investors that do not
seek TALF financing, and ABS-issuers have begun to bring nonTALF-eligible deals to market.
The TALF program provided financing to investors in the first
new CMBS deal, totaling $400 million, since June 2008 on November 16. Significant investor demand drove down the spread on the
AAA-rated TALF-eligible portion, with demand for the non-TALF
eligible AA and A-rated tranches also higher than anticipated. The
strong demand from cash investors and resulting low yield discouraged some TALF investors, resulting in the request for only $72.2
million in TALF loans for the purchase of $85.0 million of the
$323.4 million AAA-rated TALF-eligible portion of the deal. However, without the availability of TALF financing, it is unlikely that
the deal would have come to market. Since then, we have seen another CMBS deal come to market, totaling $460 million, which did
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not apply for TALF support. There are reports of a third deal,
which would also not apply for TALF financing, totaling $600 million, due to be priced in December. We believe that the demonstration of investor demand for the DDR deal has encourage other
lenders to bring similar conservatively underwritten single-borrower deals to market irrespective of the availability of TALF financing. Both non-TALF deals reportedly declined TALF financing
in order to structure the securities with terms that are longer than
the TALF loans.
The Federal Reserve continues to inject liquidity into the commercial real estate market through the TALF program, and is
working with market participants to increase transparency and investor protections in this market. We have issued guidance to
banks to encourage modifications of maturing CRE loans on properties with sufficient rental income to continue to service the debt
payments, but due to the continuing credit crunch are unable to obtain refinancing. And we continue to support broad economic
growth that would improve the fundamentals of commercial real
estate.
As part of the lessons learned process, the Presidents Working
Group on Financial Markets and the Securities and Exchange
Commission encouraged the FASB to re-assess its accounting
standards for off-balance sheet vehicles. In response, and following
a period of public comment on the proposal, FASB recently modified FAS 166 and 167.
Under these modifications, an enterprise (e.g., company, individual, or group of bond holders) is required to consolidate certain
special purpose entities (SPEs) whenever it has a controlling financial interest in the SPE, that is, the enterprise has the power
to direct the SPEs most significant activities and the right to receive benefits from, or obligation to bear losses of, the SPE. The accounting standards also require disclosure of the enterprises involvement with such SPEs and any significant changes in risk exposure that result.
Whether an enterprise will be required to consolidate an SPE
will depend on the specific facts and circumstances of each transaction. Beginning in 2010, many banking organizations that sponsor securitizations will be required to consolidate the associated
SPEs. Certain asset-backed commercial paper conduits, revolving
securitizations structured as master trusts (such as credit card
securitizations), mortgage loan securitizations not guaranteed by
the U.S. Government or a U.S. Government-sponsored agency, and
term loan securitizations (such as auto and student loan
securitizations), are among the types of securitization SPEs that
will likely require consolidation by their sponsoring banking organization. In almost all cases, the SPE consolidation requirements
will not apply to investors in the asset-backed securities, because
such investors generally do not have power to direct the SPEs
most significant activities.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
FROM DANIEL K. TARULLO
Q.l. Mr. Tarullo, I am concerned about the Federal Reserve overstepping the authority Congress has granted. News reports about
the Federal Reserve giving itself the authority to veto pay packages
is beyond the pale.
Can you please submit for the record, where in the Federal Reserve Act the Fed [is] given the authority to regulate compensation agreements?
Why should the Federal Reserve be allowed to veto pay agreements that are approved by a companys board of directors?
How involved has Chairman Bernanke been in drafting this illegal rulemaking?
Which Federal Reserve Governor has been pushing the Federal
Reserves policy on this issue?
A.l. The Federal Reserves proposed supervisory guidance and related supervisory initiatives regarding incentive compensation
practices derive from our statutory mandate to protect the safety
and soundness of the banking organizations we supervise. The proposed guidance was developed in consultation with all Board members and all Board members voted in favor of issuing the proposed
guidance for public comment.
Recent events have highlighted that improper compensation
practices can contribute to safety and soundness problems at financial institutions and to financial instability. Compensation practices
were not the sole cause of the crisis, but they certainly were a contributing causea fact recognized by 98 percent of the respondents
to a 2009 survey conducted by the Institute of International Finance of banking organizations engaged in wholesale banking activities.1 The Federal Reserve and the other Federal banking agencies regularly issue supervisory guidance to identify practices that
the agencies believe would ordinarily constitute an unsafe or unsound practice, or to identify risk management systems, controls,
or other practices that the agencies believe would ordinarily assist
banking organizations in ensuring that they operate in a safe and
sound manner.
The proposed supervisory guidance, which currently is out for
public comment,2 is based on three key principles: (1) incentive
compensation arrangements at a banking organization should not
provide employees incentives to take risks that are beyond the organizations ability to effectively identify and manage; (2) they
should be compatible with effective controls and risk management;
and (3) they should be supported by strong corporate governance,
including active and effective oversight by the organizations board
of directors. Consistent with these principles, the Federal Reserves
efforts are focused on ensuring that the way in which banking organizations structure their incentive compensation arrangements
do notintentionally or unintentionally encourage excessive risktaking, and that banking organizations have the types of policies,
1 See The Institute of International Finance, Inc. (2009), Compensation in Financial Services:
Industry Progress and the Agenda for Change (Washington: IIF, March).
2 Board of Governors of the Federal Reserve System (2009), Federal Reserve Issues Proposed
Guidance on Incentive Compensation, press release, October 22, 2009.
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procedures, internal controls, and corporate governance structures
to promote and maintain sound incentive compensation arrangements.
Importantly, the proposed guidance does not mandate that banking organizations follow any particular method for achieving appropriately risk-sensitive incentive compensation arrangements. In
fact, the guidance expressly recognizes that the methods used to
achieve risk-sensitive compensation arrangements likely will differ
across and within firms, and that use of a single, formulaic approach is unlikely to consistently promote safety and soundness.
Q.2. Is it the Federal Reserves official position that executive compensation is a cause of systemic risk?
If so, can you please provide this Committee with documentation to support this position?
A.2. Pay practices for risk-taking employees at many levels in
banking organizations, not just top executive pay practices, were
one among many contributors to the crisis. The role of compensation practices in the crisis has been widely recognized by both industry and supervisors, both here and overseas. For example, in
their responses to a survey conducted by the Institute of International Finance, a global association of major financial institutions, 36 of 37 large banking organizations engaged in wholesale
activities agreed that compensation practices were a factor underlying the crisis.3 The Senior Supervisors Group, which is composed
of senior financial supervisors from seven major industrialized
countries (the United States, Canada, France, Germany, Japan,
Switzerland, and the United Kingdom), also reported that many
firms and their supervisors had determined that failures of incentives and controls throughout the industry, including those related
to compensation, contributed to systemic vulnerability during the
crisis.4 Moreover, the Financial Stability Board, a group composed
of senior representatives of national financial authorities, international financial institutions, standard setting bodies, and committees of central bank experts, has identified compensation practices as a factor contributing to the crisis.5
Q.3. What comments has the Federal Reserve received on this proposal from the banks it regulates?
A.3. The comment period closed on November 27, 2009. The Board
has received 29 comments on the proposed guidance, four of which
were submitted on behalf of individual banking organizations, five
of which were submitted on behalf of groups representing multiple
banking organizations, and two of which were submitted on behalf
of groups representing both banking and nonbanking organizations.
Public comments on the proposal are made available on the Boards
website at http://www.federafreserve.gov/generalinfo/foia/index.
cfin?doclid=OPpercent2D1374&doclver=l.
Q.4. Mr. Tarullo, regarding the specifics of the proposal:
3 See The Institute of International Finance, Inc. (2009), Compensation in Financial Services:
Industry Progress and the Agenda for Change (Washington: IFF, March).
4 See Senior Supervisors Group (2009), Risk Management Lessons from the Global Banking
Crisis of 2008.
5 See Financial Stability Board (2009), Principles for Sound Incentive Compensation Practices.
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Would the Federal Reserve require companies to clawback
money thats already been paid to employees?
Is there a threshold a bank must meet to qualify for a review
of executive compensation arrangements?
A.4. The proposed guidance provides that incentive compensation
arrangements should not encourage excessive risk-taking, and describes several methods that are currently used by banking organizations to make compensation more sensitive to risk. These methods can be broadly described as risk adjustment of awards, deferral
of payment, longer performance periods, and reduced sensitivity to
short-term risk. As noted in the proposed guidance, the deferral of
payment method is sometimes referred to in the industry as a
clawback. The term clawback also may refer specifically to an
arrangement under which an employee must return incentive compensation payments previously received by the employee (and not
just deferred) if certain risk outcomes occur.
Importantly, the proposed guidance does not require a banking
organization to use any particular method, including those described in the guidance, to ensure that its incentive compensation
arrangements do not encourage employees to take excessive risks.
In fact, the proposed guidance expressly recognizes that the methods discussed in the guidance have their own advantages and disadvantages, and that banking organizations will need flexibility in
determining how best to achieve balanced incentive compensation
arrangements in light of the particular activities, structure, and
other characteristics of the organization.
The proposed supervisory guidance would apply to all banking
organizations that are supervised by the Federal Reserve. These organizations are primarily responsible for ensuring that their incentive compensation arrangements do not encourage excessive risktaking or pose a threat to the safety and soundness of the organization. To help promote and monitor the development of safe and
sound incentive compensation arrangements, the Federal Reserve
also has announced two, separate supervisory initiatives. These
two separate programs are designed to reflect the differences
among the universe of banking organizations supervised by the
Federal Reserve. The first initiative involves a special, horizontal
review of incentive compensation practices at large, complex banking organizations (LCBOs). LCBOs warrant special supervisory attention because they are significant users of incentive compensation arrangements and because flawed practices at these institutions are more likely to have adverse effects on the broader financial system.
A separate program will apply to the thousands of other organizations supervised by the Federal Reserve, including community
and regional banking organizations. Supervisory staff will review
incentive compensation arrangements at these organizations as
part of the regular risk-focused examination process. These reviews, as well as our supervisory expectations for these organizations, will be tailored to reflect the more limited scope and complexity of these organizations activitiesa fact also recognized in
various aspects of our guidance.
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FROM DEBORAH K. MATZ
Q.1. According to a recent New York Times article, about $870 billion, or roughly half of the industrys $1.8 trillion of commercial
A.2. For the most part, credit unions have not participated in
TALF. As cooperatives, many credit unions maintain a whole membership philosophy and seek to retain all of their members financial business in-house. While federally insured credit unions hold
less than 1.5 percent of all commercial real estate loans, the credit
union industrys involvement in commercial lending has increased.
Loans to members for business purposes have more than quintupled from December 2002 to June 2009, rising from $6.7 billion
to $33.7 billion. Of the $33.7 billion member business loan portfolio, 76 percent are secured by real estate.
The credit union industry has continued to grant member business loans even when most other financial service providers are
contracting. For the first half of 2009, member business loans experienced 11.9 percent growth.
NCUA is encouraging the flow of credit in these difficult economic times. Below are some examples of recent actions taken to
promote balancing safety and soundness issues with the credit
unions desire to meet their members financial needs. This month,
NCUA hosted a webcast for credit unions and examiners entitled
Member Business Lending: Regulators Perspective, which provided guidance, best practices, and insight into the underwriting
and examination of member business lending. This webcast provided a balanced view of the needs of the industry with safety and
soundness considerations.
Additionally, NCUA recently released a joint policy statement
with the Federal Financial Institutions Examination Council
(FFIEC) supporting prudent commercial real estate (CRE) loan
workouts. This statement provides guidance for examiners and financial institutions that are working with CRE borrowers who are
experiencing diminished operating cash-flows, depreciated collateral values, or prolonged delays in selling or renting commercial
properties. This guidance discusses another component of the current lending environment that the financial industry is currently
facing.
In order to further encourage credit union involvement in commercial lending, Congress could consider raising or removing the
current statutory limitation on member business lending. The Federal Credit Union Act currently limits federally insured credit
unions to 1.75 times the actual net worth of the credit union or
1.75 times the minimum net worth required for the credit union to
be considered well capitalized. Raising or eliminating this limitation on member business loans will increase credit unions ability
to generate and hold more loans to small businesses served by
those credit unions, while providing NCUA with the ability and obligation to set standards and benchmarks for this activity based on
the needs of the industry. NCUA understands an increase or elimi-
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nation of this limitation without prudent regulatory oversight could
pose significant risk to individual credit unions, and is prepared to
provide the necessary oversight.
NCUA is also aware of the importance of increasing lending in
the commercial real estate market in order to stimulate the economy, while ensuring the safety and soundness of the institutions
the NCUA regulates and insures. There is a fine balance between
these two objectives that the NCUA is encouraging the credit union
industry to find. In fact, a Letter to Credit Unions that promotes
best practices of member business lending is currently in process.
NCUA will continue to issue guidance to examiners and the credit
union industry to address issues related to the current financial
and economical environment.
A.2. The FASBs new rules will make it more difficult for credit
unions to sell loans or portions of loans and gain the benefit of removing those assets from their books through sales treatment. For
a small number of credit unions who engage in securitization transactions, the new rules will make it difficult to avoid consolidation
accounting with the securitization trust. In either case, the net
worth ratio will be diluted by the transferred financial assets that
must remain on the credit unions books even though sold. In the
former case, NCUA anticipates that credit unions will restructure
legal transfer agreements to conform loans sales and partial loan
sales to the participating interest rules of the new standard and
proceed with business as usual. In the latter case, the small number of credit unions that engage in securitization structures will
most likely cease and desist from this activity.
The larger and more onerous impact of the new accounting rules
will fall on the NCUA Board and the Funds it oversees. The NCUA
Board oversees the National Credit Union Share Insurance Fund
(NCUSIF), the Corporate Credit Union Stabilization Fund (Stabilization Fund), the Central Liquidity Facility (CLF), the NCUA
Operating Fund, and the Community Development Revolving Loan
Fund. NCUA prepares its financial statement under U.S. generally
accepted accounting principles (GAAP) for commercial enterprises.
As the NCUA Board acts under its statutory authorities to
workout troubled credit unions with the least cost to the NCUSIF
and the Stabilization Fund, the new accounting rules will most
likely require NCUSIF to consolidate with the Stabilization Fund
as well as conserved, troubled credit unions under the NCUA
Board oversight. Financial statement consolidation of the NCUSIF,
the Stabilization Fund, and troubled, conserved credit unions solely
due to the NCUA Board exercising its statutory powers as it acts
within its mission under moral obligation to protect credit union
and taxpayer resources is not a plausible outcome of applying accounting rules. The new rules assume a profit making incentive
behind NCUAs actions when, in fact, its actions are statutory in
naturesupervision and Federal deposit insurance.
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The primary readers of the NCUSIF financial statementscredit
union members, the public, and the U.S. Treasury Department
are not better served by the consolidated presentation of governmental with non-governmental entities. A scope exception for government entities from consolidating with the entities it supervises
and insures would be the optimal outcome. The FASB has not been
receptive to such a scope exception primarily because it would not
have wide applicability and there is an existing scope exception
within the standard for non-profit entities.
FROM TIMOTHY WARD
real estate loans, now sit on the balance sheet of small- and medium-sized banks. To what extent has TALF encouraged capital to
A.1. The Term Asset-Backed Securities Loan Facility (TALF) program was primarily created to help restore liquidity in the assetbacked securities markets. Since the Federal Reserve Board (the
FRB) announced an expansion of the TALF to include commercial
mortgage-backed securities (CMBS), the Federal Reserve Bank of
New York (FRBNY) has received loan requests totaling $6.5 billion
to help fund the purchase of legacy CMBS (those created prior to
January 1, 2009).
Improvements in CMBS market liquidity and confidence have occurred since the severe dislocations in these markets during late
summer/early fall of 2008. Most notably, the yield spreads between
CMBS and 10-year Treasury securities have narrowed significantly
from over 10 percent in late summer/early fall 2008 to about 4.5
percent in November 2009. Though still wider than typical spreads
of about 1.5 percent, the narrowing of spreads is evidence of normalization of the CMBS markets. And it is likely the TALF program contributed to these improvements.
It is important to note that only a small percentage of commercial real estate loans are in CMBS. According to estimates from the
Commercial Mortgage Securities Association, only about 25 percent
of total commercial real estate loans are held in CMBS. This may
point to the need to expand TALF, or similar programs, beyond the
CMBS markets to help address rising problems in commercial real
estate. And this is especially true for small- and medium-sized
banks and thrifts.
A.2. As a result of the FASB accounting changes, generally effective the beginning of 2010 for most institutions, many
securitizations previously off-balance sheet will come on-balance
sheet and many new securitizations will stay on-balance sheet.
Consequently, higher regulatory capital requirements will result
from the larger balance sheets and some institutions may need to
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raise additional capital or shrink their balance sheet size, which
could result in a downward pressure on lending activity and increase the costs of borrowing.
The Federal banking agencies require that regulatory reports
comply with Generally Accepted Accounting Principles (GAAP). By
law, reports filed with the Federal banking agencies must be uniform and consistent with and no less stringent than GAAP (as required by Section 37 of the FDI Act). Consequently, securitization
accounting must be reported by financial institutions in accordance
with GAAP. GAAP serves as the starting point for regulatory capital treatment.
Due to these GAAP accounting changes, an Interagency Notice of
Proposed Rulemaking (NPR) for the regulatory capital treatment of
securitizations was issued. The comment period for the NPR closed
on October 15, 2009. The NPR proposed to follow the new GAAP
treatment for regulatory capital purposes as, unless determined
otherwise based upon information provided through the comment
process, the agencies believe the new GAAP more appropriately reflects the securitization risks to which financial institutions are exposed. The comments are currently being evaluated by the banking
agencies with the expectation of issuing a final rule before the regulatory reporting of these accounting changes.
Q.3. What is the impact of the proposed action by the Office of the
Comptroller of the Currency and the Office of Thrift Supervision to
end no payment deferred interest financing promotions on consumers and businesses? I understand the impact to be very large
and I would appreciate the agencies working to clarify that no
payment deferred interest financing promotions can be used in the
future albeit perhaps with revised disclosures and marketing.
A.3. Over the past year, OTS and OCC have worked closely to develop their respective policy statements, which are substantially
identical. On September 24, 2009, OTS issued CEO Letter 321
No Interest, No Payment Credit Card Programs to remind savings associations of certain requirements contained in the 2003
interagency Account Management and Loss Allowance Guidance
for Credit Card Lending. That guidance articulated sound account
management, risk management, and loss allowance practices for all
institutions engaged in credit card lending.
CEO Letter 321 reminds savings associations of OTSs longstanding position that minimum monthly payments are a key tenet
of safe and sound retail lending and should be required on credit
card accounts. It states that regular monthly payments add structure and discipline to the lending arrangement, provide regular
and ongoing contact with the borrower, and allow the borrower to
demonstrate and the bank to assess continued willingness and ability to repay the obligation over time. Conversely, the absence of a
regular payment stream may result in protracted repayment and
mask true portfolio performance and quality. Further, in accordance with the OTS Examination Handbook, it indicates that the
minimum monthly payment should cover at least a 1-percent principal reduction plus all assessed monthly interest and finance
charges. CEO Letter 321 neither prohibits nor discourages the
practice of no interest credit card promotions.
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Finally, the CEO Letter states that savings associations will be
given a reasonable time to implement any changes to their existing
programs as a result of the policy clarification. All savings associations are expected to be in full compliance for all new credit card
transactions no later than February 22, 2010.
OTS has no precise data on the expected impact of the OTS and
OCC ending the no payment programs offered by banks and savings associations. Because of the increased delinquencies associated
with certain customers of no-pay accounts, we expect a decline in
loan delinquencies and chargeoffs. While there may be a curtailment in the number of purchases that these programs facilitate,
OTS believes that the primary affect will be for borrowers who cannot afford the purchases.
In arriving at the decision to issue a letter on these programs,
OTS considered, among other things, that recent examinations of
OTS-supervised savings associations that offer no interest, no payment credit card programs revealed increasing past due and losses
related to these accounts. OTS examination staff noted that:
No payment promotions present substantially higher credit risk (unexpected loss) to banks than regular revolving accounts. This is not necessarily because the accounts/customers themselves are riskier; but because
the structure of the promotion results in an inability to adequately monitor
and assess risk. These promotions also present problems for customers who
are less adept at managing their finances. The best way to address these
problems is to require some level of minimum monthly payments.
No payment promotions are most prevalent on big ticket purchases such as furniture, or big screen televisions. These types of
purchases often result in balances of $5,000 or more. Many view
promotional programs that offer no payments until next year as
being designed to entice customers into making a large purchase
that they may not otherwise have considered or thought they
couldnt afford. It allows customers to acquire these items without
worrying about paying for them for a long period of time. For those
customers who are not as adept at managing their finances, it may
be very difficult to make a $5,000 payment at the end of the promotionat which time they will incur high financing costs, in some
cases (back-billing) all of the costs they thought they were avoiding.
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FROM JOSEPH A. SMITH
A.1. Did not respond by printing deadline.
A.2. Did not respond by printing deadline.
FROM THOMAS J. CANDON
A.1. The financial institutions supervised by NASCUS members
state-chartered credit unionsdo not have access to TALF.
A.2. State-chartered credit unions have not made substantive use
of the new FASB provisions related to off-balance sheet accounting
and accordingly, it is not anticipated that these changes by FASB
will have a material impact on the ability of credit unions to lend
to their members. Credit unions will be minimally impacted, if at
all. The two areas of primary structural constraint regarding credit
union lending continue to be field of membership restrictions and
the limitations imposed by Federal restrictions on member business lending. FASBs new rules regarding off-balance sheet accounting are likely to have a more substantial impact on large commercial banks which may have utilized off-balance sheet structures
to mitigate on-balance sheet risk.

Senate Hearing, 111TH Congress - Examining The State of The Banking Industry

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Senate Hearing, 111TH Congress - Examining The State of The Banking Industry

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S. HRG.

EXAMINING THE STATE OF THE

OCTOBER 14, 2009

For sale by the Superintendent of Documents, U.S. Government Printing Office

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

TIM JOHNSON, South Dakota, Chairman

Opening statement of Chairman Johnson .............................................................

EXAMINING THE STATE OF THE

Senator JOHNSON. As Congress and this Committee continue its

Senator BUNNING. I have no opening statement. I want to get to

Senator WARNER. I know we have got a lot of panelists. I will

Senator BROWN. Thank you, Mr. Chairman, and I will be brief.

Ms. BAIR. Thank you. Chairman Johnson, Ranking Member

Mr. DUGAN. Thank you, Chairman Johnson, Senator Crapo, and

Ms. MATZ. Thank you, Chairman Johnson, Senator Crapo, and

Mr. WARD. Good afternoon, Chairman Johnson, Ranking Member

Mr. SMITH. Chairman Johnson and Ranking Member Crapo,

Mr. CANDON. Honorable Chairman Johnson, Ranking Member

Mortgage Bankers Association, National Delinquency Survey, Second Quarter 2009.

PREPARED STATEMENT OF JOHN C. DUGAN *

Survey of Underwriting Practices 2009, page 3.

OCC News Release 2009118, September 30, 2009.

Substantially building reserves at the same time as credit conditions weaken is

PREPARED STATEMENT OF THOMAS J. CANDON

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