Financial Update (Second Quarter 2008)

Fed Vice Chair Kohn Encourages Banks to Work With Less Debt

Fed Vice Chair Kohn Urging banks to look at their long-term health, Federal Reserve Vice Chairman Donald Kohn recommended that commercial and investment banks operate with less debt, saying that the cost will be outweighed in the long term by increased stability throughout the financial system.

Speaking in Charlotte, N.C., in mid-April, Kohn outlined what he termed "a formidable to-do list" for banks. "But it has been a formidable episode of financial turbulence that has revealed major weaknesses in our financial system," he said.

Changes in banking led to changes in risk taking
Kohn noted the significant changes, including technological and competitive ones, that have reshaped the banking environment and contributed to challenges the industry faces today. "Even before the recent market turmoil, it was abundantly clear that the business of banking has changed quite significantly over the past several decades," he said.

As an example of technology's effects, he cited the development and expansion of credit scoring techniques, which have allowed more credit extensions to households to be packaged into securities and sold to other entities.

As for competitive changes that affected banking, Kohn said the competition from the securities market wrought the most dramatic changes at the largest commercial banks, which have moved significantly into areas that had once been the domain of investment banks. "Competition from securities markets has also affected smaller banks significantly, though less dramatically than larger banks," Kohn said.

Text of Kohn's speechoff-site image

New financial products helped induce risky behavior
Kohn said that the introduction of new and innovative financial products such as collateralized debt obligations (CDOs) "outstripped banks' risk-management capabilities."

"The complexity of CDOs is one example of a widespread increase in the complexity of the capital market activities in which the largest banks now engage," he said. "Some banks' failure to adequately manage this complexity has weakened financial stability in the current market turmoil."

Less leverage will benefit banks despite costs
The potential pitfalls of a rapidly shifting banking environment can be mitigated, Kohn concluded, if banks develop a "liquidity backstop" that would foster a more resilient financial system, avoiding "excessive reliance" on facilities such as the Fed's emergency injection of liquidity into financial markets.

Kohn said one such approach might be substitution of longer-term sources for overnight secured funding. Kohn acknowledged the implicit costs of such a safeguard but said, "A financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability."


April 30, 2008