Banking

Problems with commercial real estate loans and other short-term challenges will unfortunately overwhelm a number of community banks, said Federal Reserve Governor Daniel K. Tarullo in a recent speech. However, "the vast majority will survive the present downturn," he added.

Banks must adapt to new environment
The surviving banks will be operating in a different environment and as a result will have to significantly adjust their operations, Tarullo said. This new operating environment will, among other things, include an overhauled regulatory regime and fresh efforts by community banks to avoid high loan concentrations. Two approaches banks can take to avoid such concentrations, he explained, are to operate with higher capital ratios or expand into lower-risk business areas, both of which could dent returns.

All banks must grapple with the tradeoff between risk and reward, noted Tarullo, and their decisions will ultimately affect their safety and soundness. Thus, he emphasized the need for banks to be aware of how changes in their business activities, such as a new business line or lending product, can affect risk levels.

Fed not yet at the exit
The Fed has been evaluating a number of tools that will allow it to tighten policy, such as raising the interest rate paid on bank reserves held at the Fed and conducting reverse repurchase transactions. These preparations "will allow us to move with confidence when the time is right," Tarullo said. "They do not push us toward the door."

He urged caution as the Fed exits from its extraordinary lending and monetary policies, noting that "the relatively modest pace of recovery, the continued high rate of unemployment, subdued inflation trends, and well-anchored inflation expectations together suggest that the need for highly accommodative monetary policies will not diminish soon."

April 26, 2010