Back to Basics

Patrick K. Barron
First Vice President
Federal Reserve Bank of Atlanta

Georgia Bankers Association's Annual Convention
June 15, 2009

Patrick K. BarronThanks for that introduction, Joe. It's an honor for me to speak to the Georgia Bankers Association. I consider the Georgia Bankers Association a source of strength for our nation's banking industry.
Late last year, when I was invited to speak at your 2009 annual convention, the United States was in the midst of a severe financial crisis, probably the most severe in my adult lifetime. Since that time, the pace of change has been intense, but in spite of the "gloom and doom" we've seen some preliminary signs of economic stabilization.

Today I want to talk about how the banking industry has adjusted in this tough economy while offering some personal perspectives on lessons learned from recent experience—both for bankers and regulators. I also want to share my views on what I expect the future holds for your industry. Despite some major problems, the outlook for banking is not all bad, I believe.

I would note that these are my views and do not necessarily represent the views of the Board of Governors or any Reserve Banks.

Economic situation
To lay the groundwork for this discussion, I'd like to begin with a description of the overall economy and my take on the outlook.

As you know all too well, many of today's problems started with housing, and, by most measures, the housing market is still a major drag on the economy. Homebuilding has collapsed to record low levels, less than half a million annual housing starts in April compared with 1.4 million in 2005. Even with this collapse in residential construction, housing inventories remain elevated.

The Case-Shiller national home price index fell more than 19 percent from a year earlier during the first quarter, the biggest drop in the reading's 21-year history. Housing prices in many markets are being weighed down by a steady increase in foreclosures and other distressed properties that have entered the market.

With better affordability, housing activity in some places has started to pick up. But this improvement is largely anecdotal and is barely evident in the data.

The residential downturn has spilled over to most every sector of the economy—including state and local governments, many of which are now coping with severe budget shortfalls.

Businesses have sharply reduced spending and hiring. The national unemployment rate last month climbed to 9.4 percent.

Although the jobless rate is elevated, recent unemployment insurance claims data indicate the pace of job destruction seems to be letting up some. A slowing contraction in job loss could suggest stabilization ahead. Here in the Southeast, for example, Florida recently posted a month-to-month increase in employment. I would note that I visited with several of Florida's business leaders last week, including a couple of bankers. For the first time, I heard positive comments about the economic outlook—versus comments over the last two years that were all negative.

On the consumer side of the economy, personal consumption expenditures improved during the first quarter and were one of the few positive factors in the first quarter gross domestic product report, which came in at –5.7 percent. I would also note retail sales, which came out last Thursday, increased 0.5 percent in May. Some of the increase may be related to higher gasoline prices. But overall the report was positive and suggests retail sales are nudging up from very low levels.

Economic outlook
Given this environment, I expect the economy will begin to recover in the second half of this year. For the medium and long term, I continue to believe we will experience positive but relatively subdued growth.

However, this outlook is clouded by potential threats. The main risks on my watch list start with global economic weakness. This recession knows no borders, and economic problems in one country have the potential to spread quickly and "re-infect" banks in other parts of the world. Secondly, another trouble spot is commercial real estate in this country. Many loans are due for refinancing just as rents and values are declining, and they face an unfavorable credit climate marked by an almost nonexistent market for commercial mortgage-backed securities (CMBS).

These challenges have already claimed some well known office buildings, including the John Hancock Tower in Boston and the Equitable Building in downtown Atlanta, both of which were foreclosed and sold at auction earlier this year.

Also, I'm closely watching the spending power of American consumers. Despite the stabilization of consumer spending that I just mentioned, households continue to carry heavy debt loads and are confronted with employment uncertainty, stagnant or even declining incomes, and credit conditions that are less than favorable.

In addition to risks to the real economy, I want to stress that the Federal Reserve remains vigilant to risks on the inflation front. A renewed round of accelerating weakness could reintroduce the deflation concerns that characterized much of last year. But, unlike that period, I don't want to dismiss the possibility of emergent inflationary pressures. This risk is related in part to concerns about the large amount of monetary and fiscal stimulus that has been applied to combat the financial crisis and the recession. Policymakers must be prepared to respond, as the need for such stimulus is no longer present.

State of banking
Many of those policies have been geared to restoring banking health and functioning credit markets, which are vital to economic growth.

So what is the condition of the banking sector?

The good news is profitability has returned to banking. The banking industry reported a profit of $7.6 billion in the first quarter, compared with a $37 billion loss in the fourth quarter.

But, on the negative side, regulators so far this year have seized more than 36 institutions. The number of problem banks identified by the Federal Deposit Insurance Corp. (FDIC) has climbed sharply this year to 305—the highest level in 15 years.

Georgia has the dubious distinction of leading the nation in bank failures during this crisis. As you are well aware, 11 Georgia banks have been closed since the beginning of 2008 with the potential for more to come.

Large and small banks alike remain saddled with nonperforming real estate loans, and the state of the housing and commercial property markets do not signal any quick recovery in the quality of those credits. Also, credit problems have expanded beyond real estate to credit card and other consumer and commercial debt, much of which also resides on banks' balance sheets. Banks in the first quarter set aside nearly $61 billion to cover loan losses, compared with $37 billion in the prior quarter.

I'm particularly concerned with bank capital, which is needed during tough times as a backstop against potential losses. To get a better reading on the health of the largest banks from a capital perspective, as you know, the Federal Reserve, working with the Treasury Department and other supervisory agencies, recently implemented the Supervisory Capital Assessment Program, or simply put, the "stress tests."

The completion of those assessments seemed to remove some of the uncertainty from the market regarding the solvency of the nation's largest banks. More importantly, the early results of banks' capital-raising efforts have been positive, with most able to raise capital through public stock offerings.

Along with the stress test results, I've found some encouraging signs in credit markets. Markets for short-term funding have improved, including the interbank lending markets and commercial paper markets. With confidence returning to these and other private capital markets, usage of several short-term Federal Reserve credit and liquidity facilities has decreased because of crowding out by more robust private activity—clearly, a desired effect.

Also, bond issuance has improved recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed somewhat, indicating that market participants are more willing to take on credit risk than in late 2008.

All in all, I would say that Fed policy actions to provide liquidity have helped to ease credit strains, although much more progress is needed before many banks are strong enough to provide sufficient credit to the economy without the increased government backing.

While these are positive signs, I think we would all agree, the credit market healing process will require a bit more time. The Fed has said that it will extend its credit facilities as needed. And at its last meeting on April 29, the Federal Open Market Committee (FOMC) said that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. Also, the FOMC is in the midst of an effort to strengthen mortgage lending and housing markets by purchasing a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. We are at roughly the halfway point in those initiatives.

Lessons learned
Overall, despite some improvement, I would say the banking industry at present remains dependent on the increased liquidity programs and FDIC guarantees. Further, it is likely that industry has a ways to go before we would be in a position to declare it in good health.

The current financial crisis, dating back to the emergence of subprime mortgage problems in the summer of 2007, bears a certain resemblance to prior episodes that were associated with slow and protracted economic recoveries.

As with the savings and loan episode of about 20 years ago, this financial crisis offers painful lessons in the perils of rapid growth, concentrations of risk, and excess leverage. It appears that many of the lessons of the '80s are being relearned in today's crisis, albeit they occurred in a very different financial market structure. Unlike the 1980s, when most loan originations remained on bank balance sheets, the modern credit market had become dominated by securitization and the movement of risk off balance sheet—to free up capital and generate liquidity to make new loans.

Before the crisis, investors around the globe had an almost endless appetite for highly rated mortgage-backed securities. Financial intermediaries had a strong demand for mortgages of just about any type because they could generate profits by packaging them into highly marketable securities. In hindsight, that seemingly unlimited supply of capital artificially boosted home sales and price appreciation, which led to increased speculation by parties all along the "food chain."

Securitization is mostly a Wall Street, big-bank business, so why are so many community banks on Main Street now suffering? Again with the benefit of hindsight, it now seems clear that the demand for mortgages and mortgage securities helped push home sales to levels that were not sustainable had more attention been paid to the borrower's ability to repay, versus a forecast that home prices could increase indefinitely.

Nonetheless, demand for housing kept increasing, creating what looked to some like a supply shortage in housing and residential lots. And that's where community banks come in. Residential acquisition, development, and construction lending became the core business of many small banks, especially here in the Southeast. And many more banks were chartered and opened in the first half of this decade to get in on the housing construction boom. In fact, Georgia has consistently been among the leaders nationally in de novo banking, having opened more than 100 new banks since 2000.

The problem is that the demand for mortgage securities was largely liquidity driven, and, as you know, demand can change quickly.  But supply takes a longer period of time to adjust. Unfortunately, many community banks are on the supply side of the housing market. When housing demand suddenly dried up, banks held finished inventory that couldn't be sold, unfinished subdivisions that no longer made economic sense, and, worst of all, hundreds or thousands of vacant developed lots—now known simply as dirt.

I don't have to tell you that even if the economy stabilizes and begins a very modest recovery, as I believe it will, it is going to take quite a while to work through the excess inventory of houses and lots that now burden many of our community banks.

Along with concentration of risk, another lesson of this cycle pertains to liquidity. Banks that depended on short-term borrowing for liquidity have not fared well in the past two years. The importance of liquidity has been apparent at large and small banks alike. As you recall, the interbank lending market dried up with the collapse of confidence associated with failures in subprime and other risky loan securitization. Concerns about bank liquidity drove down stock prices for highly leveraged investment banks in 2008 and since that time have led to several high-profile bank failures.

In fact, one of the main reasons that remaining investment banks elected to become bank holding companies was to gain access to liquidity. They sought liquidity in the form of FDIC insured deposits, TARP funding, and permanent access to the Federal Reserve discount window. Likewise, community banks that relied heavily on Internet deposits or brokered CDs rather than traditional core funding, are generally finding it more difficult to navigate this turbulent period.

Let me emphasize that it's not just banks that have learned lessons from recent experience. The entire regulatory community needs to make important adjustments. The crisis exposed inadequacies in risk management for many financial institutions and in regulatory oversight. In response examiners have stepped up efforts to work with banks to improve risk-identification practices. For instance, the Fed has emphasized the importance of stress testing to help detect risks not identified by more typical statistical models.

So we are trying to do a better job of taking into account potential hazards such as large market moves, evaporation of liquidity, prolonged periods of market distress, or structural changes in the market. As it has turned out, this financial crisis has brought about all of these changes, and more, and all in a very short time period. So we should prepare for the worst and make the adjustments needed to an eventual economic recovery and a return to a new normal.

Back to basics
What do I mean by a new normal? To begin with, I expect this crisis will open doors of opportunity. Yes, there will be fewer banks. But the strongest banks in the future will be the ones that build market share during this time of adjustment.

A key ingredient for success in this new normal of banking will be, quite simply, hard work. That is, the days of raising Internet deposits and funding real estate projects with little oversight—or simple underwriting—are gone. To succeed in the future, banks will have to spend substantial effort and time, first on closely evaluating potential credits and second on administering and monitoring those credits once they've been made. In addition to managing risks, the challenge facing some banks will be finding profitable lending opportunities more so than finding the funding.

Future growth will come from those banks that master the fundamentals. Successful banks, most likely, will have a stable core of deposits, they will focus relentlessly on cutting costs and improved efficiency, and they will probably resist the temptation to make easy profits on products they don't fully understand. They will need to have heightened awareness and skill when it comes to risk selection and risk management.

The winners will, in my opinion, follow tried and true strategies to cultivate relationships in the grassroots of their respective communities. They will distinguish themselves through outstanding service and value for their customers—both depositors and borrowers. They will excel at building relationships by attracting new customers and retaining old ones.

In my 42 plus years with the Federal Reserve, I have seen banking evolve from a highly regulated and low-risk endeavor to one less regulated and dominated by high margin business models that ultimately proved unsustainable.

After the dust settles from the financial crisis—and that may be awhile—I expect the future lies somewhere between the two extremes I just described. For those of you who have what it takes to adjust to a new and probably more difficult reality, the future of banking is yours for the taking!

Contact: Jean Tate 404-498-8035