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SRC Insights: Second Quarter 2007

Supervision Spotlight on Maintaining Balance Between Risk and Innovation

An important goal for business and banking organizations is to find ways to sustain superior performance in the face of rising complexity, intense competition, rapid advances in technology, increasing globalization, and the growing struggle to find skilled workers.

Banks remain an integral part of the larger financial system, which includes other rapidly evolving financial intermediaries, such as securities, insurance, and private equity firms, as well as hedge funds. The large number of participants and the wide variety of products and services offered have made the financial system fertile ground for rapid change and innovation. Success in this environment requires an effective risk management approach, a balanced regulatory framework, and an awareness of major trends in banking and financial markets.

Recent history suggests that the banking industry is managing operating challenges quite well, and the strong performance of the banking industry over the past several years may correlate directly to strong and continually improving risk management practices. Other drivers of bank performance include sound economic conditions, solid creditworthiness in corporate and household sectors, ample liquidity, lower loan losses, diversity of revenue sources, a strong focus on the customer, innovation in credit markets and risk management, and sound capital.

There are signs, however, that the industry has reached an inflection point. A moderating economy, emerging weaknesses in residential real estate markets, continued net interest margin compression, and intense competition are creating headwinds. To continue to flourish in this environment, the banking industry should ensure that risk management practices and techniques are commensurate with the complex exposures introduced through many of the new products, services, and markets that have proliferated in recent years. As the highly accomplished CEO, Lee Iacocca, once put it, "Every business and every product has risks. You can't get around it." However comfortable the market is with statistical management of risks, and despite innovation, the underlying risks will always remain. And, as always, these risks must be managed properly.

Perhaps the most telling current example of the continued presence of risk despite mitigants is the current state of the subprime mortgage market. We are seeing evidence that the originate-to-distribute approach to lending deployed by banks in subprime loans is slowing, as capital markets are less accepting of subprime and Alt-A loans. While the banking industry is not unduly exposed in the subprime lending market, banks may hold subprime mortgages backed by securities in their investment portfolio. The economic impact on banks is manageable, but there are significant social implications to the rising trend in delinquencies and foreclosures, which is resulting in material reputational risk for banking organizations.

The issues that are affecting the subprime market bear the hallmarks of previous credit cycles, such as credit overexpansion; a belief that asset prices will continue to rise; over-optimism followed by delinquencies, defaults, and failures; rising evidence of fraud; imbalance in credit-risk markets; and the risk of overreaching legislative and regulatory solutions. Several bankers we spoke with have voiced concerns that as regulators and legislators design solutions for the growing foreclosure problem, the solution will stretch too far and impact all lenders, including banks that do not engage in subprime lending. Bank supervisors, however, are aiming to achieve a balance between the costs and benefits of regulation and guidance.

Consistent with this goal, banking supervisors expect regulated institutions to be mindful of the risks posed by new and expanding business activities. Over the years, we have issued several pieces of guidance on sound lending practices to address weaknesses in underwriting and risk management and concerns about abusive practices. The proposed guidance on subprime lending issued in 2006, for example, recommends that repayment capacity include an evaluation of borrowers' ability to repay debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. The guidance also reminds institutions that they should clearly communicate the risks and features of these products to consumers in a timely manner, before consumers have applied for a loan.

Even more recently, supervisors have issued a statement that encourages institutions to work with mortgage borrowers who are unable to make their payments. The interagency Statement on Working with Mortgage Borrowers encourages financial institutions to consider prudential workout arrangements with distressed borrowers and provides guidelines for doing so in a safe and sound manner.

Going forward, we can expect to see corrective tightening of underwriting to persist in response to the current turbulence in the subprime and Alt-A markets. Banks will continue to face challenges, such as coping with a continually changing business model, dealing with hyper-competition, and attracting and retaining critical talent. To meet these challenges successfully, banks must have a strong risk management culture and agility and resilience at multiple levels within their organizations. Successful banks will be those that can achieve growth with profitability, implement effective enterprisewide risk management, and integrate the strengths that knit an organization together.

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.