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Friday, May 22, 2015

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SRC Insights: Second Quarter 2009

Supervision Spotlight: Restoring Confidence in the Banking System

We are living through a transformative period in our nation's history, and, as in any period of great change, the challenges can seem overwhelming. Confidence in U.S. and global financial institutions has been badly shaken. The combination of mounting losses, falling asset prices, and a deep economic downturn has severely impaired the financial system. The striking loss of confidence at the heart of this crisis has elicited a flood of government-sponsored programs and initiatives extraordinary in their scope, scale, and inventiveness. Consequently, we are seeing public intervention in the financial system on a scale not seen for decades. Policymakers, meanwhile, are debating sweeping changes regarding the way the financial sector will ultimately function and be regulated.

The crisis has also prompted a debate on the respective roles and costs of capitalism, innovation, and regulation. As a general principle, financial innovation is good for the economy, but, as demonstrated in the current crisis, the benefits of innovation are usually understood well before the risks come to light. Where some see the bad behavior of individual actors and poor governance at fault, others attribute the current turmoil to serious defects in our economic and financial architecture. As the debate continues, one thing is clear: the American public has lost confidence in the integrity and ethics of our nation's institutional leadership. Questions have arisen around the public and private sectors and the availability and transparency of information, as well as the professional ethics of some who were responsible for managing the business risks that all organizations face.

The financial crisis was triggered by the turn in the U.S. housing market in the spring of 2007. The subprime-related write-downs that led to the collapse and near-collapse of several large and, in some cases, systemically important institutions precipitated the credit freeze that led to the deep economic contraction that continues to have serious repercussions throughout the banking industry. Very few Third District banking organizations, however, participated in those subprime lending practices and exotic products that helped to create the conditions for this crisis.

Several bankers in the Third District have expressed to me their concern and frustration about the damage that has been done to the image of the banking industry due to the questionable choices made by some financial institutions and about the consequent feeling of all banks being painted by the same broad brush. Community and regional banks by and large have consistently engaged in prudent lending practices and have served as a vital source of credit for small businesses and consumers in their communities. Banking organizations across the board, including those that have behaved responsibly before and during the crisis, are facing steep increases in FDIC insurance premiums and will be affected by the profound financial and regulatory reforms that are now being considered.

As regulators and policymakers grapple with the larger issues, banking organizations are struggling in a fundamentally altered landscape with business models that may no longer make sense in some cases. Banking organizations are using this period of change to reevaluate their core missions. Many appear to be returning to banking fundamentals. Meanwhile, locally focused community and regional banks are leveraging their in-depth local knowledge and strong community ties to step in and make loans to creditworthy borrowers where nonbanks and larger banks have stepped back, fulfilling an important need and, in doing so, helping to pave the way to recovery.

For its part, the Federal Reserve has been focusing on a number of areas for reform, some of which may benefit smaller banks, such as the need to regulate institutions with the potential to create systemic risk differently from institutions that do not pose this risk. The regulatory system must also cast a wider net to capture previously unregulated corners of the financial system, often referred to as the shadow banking system. These changes, if formulated and implemented in a thoughtful and prudent way, should lead to a more level playing field for institutions of all sizes and help avoid a repeat of the last crisis, while positioning the U.S. to compete effectively in a global economy.

As we move forward, the emphasis will be on restoring stability to the financial system to repair lending, structuring financial regulations to rebuild trust, and reforming and building strong domestic and global institutions. Banking organizations and other firms will be more cognizant of the need to protect their reputations and add value, rather than to extract value in their interactions with other firms and consumers. Ultimately, these steps should lay the groundwork for reestablishing trust and confidence in the banking system, a key component for economic recovery.

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.