Fourth Quarter 2008 September 21, 2009 Richard A. Brown Chief Economist, FDIC The Role of Economists In Prudential Supervision of Banks

Fourth Quarter 2008

September 21, 2009Richard A. BrownChief Economist, FDIC

The Role of EconomistsIn Prudential Supervision of Banks

What is Prudential Supervision of Banks?

“Prudential supervision, broadly construed, involves government regulation and monitoring of the banking system to ensure its safety and soundness.”

Mishkin (2001)

Why Supervise Banks?

• Banks are special

– Banks issue transactions accounts that are regarded as perfectly safe and perfectly liquid

– Banks are critical sources of backup liquidity

– Collectively, banks make up the payments system and facilitate end-of-day settlement

0%

10%

20%

30%

40%

50%

60%

70%

80%

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: FDIC. Based on data from Federal Reserve Board, Flow of Funds .

Share Held by Depository Institutions

Share Held by Other Financial Companies

48%

30%

22%

52%

Non-bank financial companies now hold more than twice as much U.S. credit market debt as depository institutions.

Percent of U.S. Credit Market Debt Held by the Domestic Financial Sector

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: FDIC. Based on data from Federal Reserve Board, Flow of Funds .

Over time, deposit accounts have lost market share to mutual funds and money market funds.

Composition of U.S. Retail Financial Liabilities, Percent of Total

Checkable Deposits and Currency

Time and Savings Deposits Money Market Shares

Mutual Fund Shares(at market value)

Why Supervise Banks?

• Banks are fragile

– Banks are subject to liquidity runs

– Banks are interconnected through payments system, leading to systemic risk

– Banks tend to be subject to other types of correlated risks

0

100

200

300

400

500

600

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

FSLIC-Insured, RTC Institutions (After 1980)

FDIC-Insured Institutions (BIF, SAIF and DIF)

Source: FDIC. Includes FSLIC and RTC Institutions from 1980 forward. Through September 18, 2009.

Banking risks are correlated; bank and thrift failures tend to occur in bunches.

Annual Number of Failed and Assisted Banks and Thrifts, 1934-2009

Dealing with Fragility

• Crisis Tools


• Crisis Tools

– Lender of Last Resort

TED Spread3-month Libor as Spread to 3-month Treasury Yield

09080706Source: Haver Analytics 09/13/09

3.75

3.00

2.25

1.50

0.75

0.00

3.75

3.00

2.25

1.50

0.75

0.00

Federal Reserve Liquidity Programs

• Term Auction Facility (TAF) - December 2007

• Reciprocal Currency Agreements – December 2007

• Term Securities Lending Facility (TSLF) - March 2008

• Primary Dealer Credit Facility (PDCF) – March 2008

• Asset Backed CP Money Mkt Fund Liquidity Facility (AMLF) – Sept 2008

• The Commercial Paper Funding Facility (CPFF) – October 2008

• The Money Market Investor Funding Facility (MMIFF) – October 2008

• Term Asset-Backed Securities Loan Facility (TALF) – November 2008

• Mortgage Backed Securities Program (MBS) – November 2008


• Crisis Tools


– Deposit Insurance

FDIC Temporary LiquidityGuarantee Program

• Authorized by FDIC Board in October 2008 under systemic risk finding, extended in 2009

• Two components:

1. Guarantee of senior unsecured debt issued by insured depository institutions and most depository institution holding companies

2. Guarantee of noninterest bearing transaction deposit accounts in excess of deposit insurance limits.

• Participation:

– Debt guarantee program – about half of eligible companies opted in

– Transaction account guarantee program -- 7,101 banks and thrifts

• Fees:

– Debt guarantee program – 50 to 100 basis points depending on maturity

– Transactions accounts – 10 basis points, rising to 15, 20 or 25 in 2010.

• $301.5 billion in FDIC-guaranteed debt outstanding as of Sept. 16


• Crisis Tools



– Extraordinary Support -- TARP

Troubled Assets Relief Program (TARP)

• $700 billion total authorized funding, in two tranches

• Authorizes Treasury to “purchase or insure” troubled assets

• MBS and whole loan purchase programs – shelved for now

• As of September 2009, about $364 billion has been distributed through five programs: – Capital Purchase Program

• $204.5 billion distributed to 671 depository institutions and bank holding companies

– Systemically Significant Failing Institution Program• $40 preferred equity stake in AIG, plus $3.2 billion drawn on credit line

– Targeted Investment Program• $20 billion preferred equity stake each in Citigroup and Bank of America

– Asset Guarantee Program• $12.5 billion in loan guarantees for Citigroup and Bank of America

– Automotive Industry Financing Program• $76 billion was used to assist the automotive industry


• Crisis Tools



– Extraordinary Support – TARP

• Prudential Management of the Deposit Insurance Fund (DIF)

Prudential Management of the Deposit Insurance Fund (DIF)

• Reserve adequacy of DIF

– Target reserve ratio: 1.25% of insured deposits

– Restoration plan required if below 1.15%

– Currently at 0.22%

• Risk-Based Deposit Insurance Premiums

– Currently 12-16 basis points for lowest risk categories

– Up to 50 basis points for highest risk category

• Prompt Corrective Action (PCA)

– Institutions must be closed at 2% tangible capital

• Least Cost Test for Failure Resolution

– Systemic Risk Exception


• Crisis Tools



– Extraordinary Support – TARP

• Prudential Management of the Deposit Insurance Fund (DIF)

• Prudential Supervision

Core Tools of Prudential Supervision

• Asset Restrictions

• Capital Requirements

• Restrictions on Competition

• Consumer Protection

• On-site (and off-site) examination

• Moral Suasion

S&P/Case-Shiller Home Price Index: Composite 10SA, Jan-00=100

0908070605040302010099Source: S&P, Fiserv, and MacroMarkets LLC /Haver Analytics

240

200

160

120

80

240

200

160

120

80

0%

5%

10%

15%

20%

25%

2000 2001 2002 2003 2004 2005 2006 2007 2008

$0

$100

$200

$300

$400

$500

$600

$700

Dollars in Billions (Bar)Percent of Annual U.S. Mortgage Originations (Line)

Source: Inside Mortgage Finance, May 29, 2009

Subprime Mortgage Originations

0%

2%

4%

6%

8%

10%

12%

14%

16%

2000 2001 2002 2003 2004 2005 2006 2007 2008

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

Dollars in Billions (Bar)Percent of Annual U.S. Mortgage Originations (Line)

Source: Inside Mortgage Finance, May 29, 2009

Alt-A Mortgage Originations

Source: Mortgage Bankers Association, National Delinquency Survey.

Mortgage credit distress began in subprime portfolios, but now extends to prime portfolios as well.

0

5

10

15

20

25

30

2000 2002 2004 2006 2008

Conventional Loans In Foreclosure (%)

Subprime

All

ARMs

Prime

ARMs

All0

2

4

6

8

10

12

14

16

2000 2002 2004 2006 2008

Conventional Loans Past Due 90+ Days (%)

Subprime

All

ARMs

Prime ARMs All

0

20

40

60

80

100

120

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Note: Data are as of year-end. Source: FDIC

Construction & Development (C&D) Loan ConcentrationAs Percent of Total Risk-Based Capital, Weighted Average by Asset Size Group

Under $ 1 Billion $ 1-10 Billion

$ 10 Billion and Over

C&D loan concentrations are particularly high at small and mid-sized institutions.

0%

2%

4%

6%

8%

10%

12%

14%

16%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Construction and Development (C&D) Loans

Loans Secured by Nonfarm, Nonresidential Properties

Source: FDIC. Noncurrent loans include loans 90 days or more past due or on nonaccrual status.

Problem commercial real estate loans are quickly approaching levels of the 1989-92 banking crisis

Noncurrent Loans as Percent of Total Loans, By Category

0%

2%

4%

6%

8%

10%

12%

14%

16%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009






0%

2%

4%

6%

8%

10%

12%

14%

16%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009












• Moral Suasion







• Moral Suasion







• Moral Suasion







• Moral Suasion

48 50 47 50 5361 65

7690

117

171

252

305

416

0

50

100

150

200

250

300

350

400

450

1 2 3 4 1 2 3 4 1 2 3 4 1 2

The Number of "Problem" Institutions Is at a 15-Year HighNumber of Insured Institutions on the FDIC's "Problem List"

2006 2007 2008 2009







• Moral Suasion

Limits of Moral Suasion in Promoting Safe and Sound Financial Practices

“In 1929, a robust denunciation of speculators and speculation by someone in high authority and a warning that the market was too high would almost certainly have broken the spell. It would have brought some people back from the world of make-believe... The very effectiveness of such a measure was the problem. Of all the weapons in the Federal Reserve arsenal, words were the most unpredictable in their consequences. Their effect might be sudden and terrible. Moreover, these consequences could be attributed with the greatest precision to the person or persons who uttered the words. Retribution would follow. To the more cautious of the Federal Reserve officials in the early part of 1929, silence seemed literally golden.”

John Kenneth Galbraith, The Great Crash: 1929 (1955), p. 59.

What Was the FDIC Saying About the Risks in Housing Markets and Mortgage Lending?

“The broadening of the U.S. housing boom during 2004 may imply a growing role for national factors–including the availability, price, and terms of mortgage credit–in explaining home price trends. To the extent that credit conditions are in fact driving home price trends, the implication would be that a reversal in mortgage market conditions could contribute to an end of the housing boom.”

Angell and Williams, “U.S. Home Prices: Does Bust Always Follow Boom?” FDIC: FYI, February 10, 2005.

What Was the FDIC Saying About the Risks in Housing Markets and Mortgage Lending?

“In addition, as our previous FYI report discussed, there have been a number of changes in mortgage markets that could have an influence on home prices, including the emergence of high loan-to-value lending and subprime lending.”

“Another evolving trend that has not been tested in a housing market downturn is the increasing market penetration of innovative mortgage products, such as interest-only (I/O) and option ARMs…While financially savvy borrowers using these products are more likely to be prepared for the possibility that their monthly payments may jump sharply, marginal borrowers may face greater difficulties adjusting as their monthly payments inevitably rise.”

Angell and Williams, “FYI Revisited -- U.S. Home Prices: Does Bust Always Follow Boom?” FDIC: FYI, May 2, 2005.

New Challenges in Prudential Supervision

• Financial Innovation

• Incentive Structures

• Jurisdictional Gaps

• Macro-Prudential Supervision

Macro Prudential Supervision

“A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early, 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated.”

John Kenneth Galbraith, The Great Crash: 1929 (1955), p. 52.

Questions

Documents

Fourth Quarter 2008 September 21, 2009 Richard A. Brown Chief Economist, FDIC The Role of Economists In Prudential Supervision of Banks