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Thursday, July 31, 2014

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SRC Insights: First Quarter 2009

Supervision Spotlight on: Credit Market Stress and the Real Economy

Although some financial markets have exhibited signs of improved functioning, overall, financial market conditions remain strained. Financial institutions have tightened their lending terms and show signs of needing more capital at the same time that volatile stock markets have made raising capital more difficult.

Research shows that economic slowdowns follow closely on the heels of periods of financial crisis. As the health of institutions deteriorates, the cost of borrowing increases. To compensate for rising credit costs in a declining interest rate environment, institutions may adjust pricing for risk, raise the rates for loans, or set a floor and tighten lending standards. As the cost of credit increases and becomes harder to obtain, businesses are more likely to decrease investment spending, negatively affecting economic activity.

Evidence of credit tightening is apparent in the latest Federal Reserve Senior Loan Officer Survey. While bankers have stated that they continue to make loans to creditworthy borrowers, the standard for a creditworthy borrower has shifted, and many banks are constraining the credit offered to consumers and businesses. In many cases, the illiquidity in securitization markets and high-priced deposits are also limiting banks' lending capacity. As the economy contracts, there is also lower demand for credit, as firms see no need to expand.

As credit conditions have tightened for both households and businesses, the lack of credit and capital continues to slow the economy. Analysts are worried that the economy's troubles could trigger a major retrenchment by consumers that will make the current recession, already the longest in a quarter-century, even worse. A decline in household wealth resulting from large drops in equity and housing prices, together with tighter credit conditions, higher unemployment, and deteriorating consumer sentiment, is contributing to a sharp contraction in consumer spending. Consumer spending comprises roughly 70 percent of gross domestic product, or GDP, so the sharp pullback in spending will have an outsize impact on the economy.

As consumers curtail spending, many businesses have turned to practices employed during the Great Depression to conserve resources, such as reducing or freezing salaries and initiating extended plant closures. Ultimately, credit crises like the one we are experiencing now can lead to severe recessions when they block businesses' access to capital long enough to generate widespread corporate failures.

With the migration of the financial turmoil to the real economy, banks will be exposed to a more traditional credit cycle. Recent industry data show declining asset quality and equity prices and weak earnings. The erosion of asset quality that was primarily evident in residential mortgages and construction and development loans is now spreading across all asset classes. Although institutions are increasing their allowance for loan losses, the rise in problem loans is outpacing loan loss provisions.

Defaults, distressed debt, and deleveraging will be evident through 2009, adversely impacting banks. Capital and liquidity will remain strained, and the market for credit derivatives will be tested as more businesses fail. Rising credit costs, restructuring charges, and the poor economy will negatively affect bank earnings, as will declining values and write-downs for mortgage-related assets. In some cases, the rapid deterioration of bank assets is outpacing the government's efforts to provide capital to banking organizations while private capital sources are constrained.

The current financial crisis has required large-scale government intervention to stabilize the financial system. This is not an unusual policy response during severe financial crises. Government intervention typically is based on principles that the intervention should be temporary and should be structured so that taxpayers have upside risk and shareholders have downside risk. In an effort to shore up the financial system, last fall Congress passed the U.S. Treasury's Troubled Asset Relief Program, or TARP. Under the program, injections of new capital into the banking system are designed to moderate the powerful pressures that otherwise would have caused the financial institutions receiving the funds to deleverage by selling assets and pulling back from new lending.

As of January 13, 2009, the Treasury has invested $192 billion of the $250 billion TARP Capital Purchase Program. Institutions appear to be using the money for four general purposes: increased lending, absorbing losses, bolstering capital, and making opportunistic acquisitions. The disbursement of TARP funds has created much controversy, and in 2009, there will be more scrutiny of how funds are being used. It will be increasingly important that institutions receiving capital have some accountability with regard to how they are using these funds, although it is also just as important that the government limit its involvement in the decisions of individual institutions receiving the funds.

The combination of factors associated with this crisis has transformed the structure of the financial services industry. The global nature of the downturn has spurred the intervention of central banks around the world with aggressive and creative responses to restore confidence in financial markets. Policymakers and industry experts are analyzing the contributing factors—lack of transparency, misaligned incentives, rating agencies, excessive leverage, poor risk management, financial innovation, regulatory gaps—in an effort to better understand the root causes of the crisis and fix upon a broad range of solutions, including regulatory reform.

Despite the turbulence we see today, our financial system is likely to emerge stronger and more resilient as a result of the crisis. Banks will return to fundamentals, and businesses and consumers are likely to exhibit less leverage. National and international regulators and policymakers will engage in more coordination, and future regulatory regimes are likely to evolve around a firm's functions and products rather than by how it is chartered. A key objective as reforms are implemented will be to ensure that the regime allows for innovation—an important engine for growth—while employing a prudent and flexible regulatory system. This approach suggests an emphasis on a mix of government and private responses to reform.

Recessions and financial crises provide a period of reflection for businesses and consumers, and they accelerate implementation of processes and practices that had been considered previously but were postponed. Policymakers are moving from individual responses to problems in the marketplace to more strategic and holistic approaches. While the actions that policymakers and central bankers around the world have taken to date have provided some measure of stability to the financial system, more remains to be done to improve consumer and business confidence in the financial markets. 2009 will be the year that begins to reshape the global financial system, and, for financial institutions, this includes restoring their capital base and their customer trust.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.