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SRC Insights: Second Quarter 2008

Supervision Spotlight on Subprime Lending: Lessons Learned and the Regulatory Response

A confluence of factors has led to the recent financial turmoil and significant strain in the U.S. financial markets, involving material subprime-related write-offs exceeding $232 billion (and counting) at financial institutions globally.1 Currently, there is ongoing concern about counterparty risk, a lack of confidence in rating agencies, and significant financial pain for millions of consumers facing a cascade of foreclosures.

This quarter's expanded "Supervision Spotlight" will provide a brief perspective on the origin of the subprime mortgage problem, which has evolved into this financial crisis, encompassing falling U.S. house prices, rising delinquencies and foreclosures, and severe strains in capital markets. The private and public response to current conditions and ways to move forward that promote market discipline complemented by effective regulation will also be discussed.

Although financial crises often seem to happen overnight, they usually have long roots. Our financial services sector has enjoyed a long period of growth. Our sector's share of corporate profits, for example, grew from an average of 10 percent in the early 1980s to 40 percent in 2007, while the share of stockholder value grew from about 6 percent to 19 percent during that same period.2 In the last decade, growth was spurred by an expanded use of leverage, a substantial increase in risk taking, a shift away from sound credit fundamentals, and the widespread adoption of financial innovation.

While rising defaults in the subprime housing markets clearly played an important role in the current crisis, they were just one piece of a complex interaction of factors involving market forces. The consumer protection infrastructure, private-sector risk management, financial disclosure, and supervision and regulation have all lagged behind rapid innovation and changing business models. With financial innovation, the benefits are often immediately apparent, while the potential problems can remain hidden until stressed conditions force them to surface. Innovation, misaligned incentives, and the accelerated revenue growth associated with new products can frequently overwhelm sound governance and risk management until obvious adjustments are needed.

The cracks in the façade began to show up in late 2006 as the housing market cooled and subprime borrowers began to default in larger-than-anticipated numbers. The subsequent meltdown of the U.S. subprime mortgage market led to widespread financial instability, evidenced by a severe credit crunch, a dramatic repricing of risk, a drop in valuations of structured credit products, and a severe retraction in liquidity.

The private-sector response to the recent financial turmoil has varied considerably by organization, reflecting broad dispersion in risk management capabilities. Some financial institutions have moved promptly to repair their balance sheets and secure funding, while others have curtailed dividend payments. Those that have fared better overall to date generally had stronger risk management practices in place, including a process to capture cross-disciplinary risks firmwide and the appropriate communication channels to ensure that aggregate risk information flowed up the management chain in a timely manner.

Firms whose senior managements were heavily engaged in this process and set the tone for risk tolerance by enforcing controls and actively working to understand and mitigate material risks also have had significantly better outcomes to date. These firms tended to have risk management functions that worked independently and had sufficient authority within the organization. Many organizations are also considering how their compensation and incentives are structured and whether they provide the appropriate balance between short-term gain and long-term outcomes that are in the best interest of the organization.3

Policymakers are working to develop an appropriate response that strikes the right balance between consumer protection, regulation, supervision, and market discipline to restore order to and confidence in our financial system.

There are typically three phases in resolving significant financial crises. Initially, there is a containment phase designed to address and contain problems in the financial markets, such as central bank intervention to alleviate interbank liquidity strains. A second step centers on loss recognition, restructuring, and recapitalization, in which many institutions are currently engaged. Banking supervisors are pushing for rapid write-downs for losses and encouraging banks to bolster capital. A third stage seeks to implement fundamental reforms. This is a long process, but it should ultimately strengthen the financial system and improve the way the system responds to future crises.

To this end, the Treasury Department has released a blueprint for a modernized financial regulatory structure. The ultimate goal of any enhancements will be to reinforce the relationship between consumer protection and market stability while providing the regulatory incentives and infrastructure for robust financial markets in a global economy.

Policymakers, meanwhile, are considering various longer-term fixes to address the root causes of the crisis. The Federal Reserve, for example, is strengthening consumer protection rules, issuing rules on unfair and deceptive practices, promoting more robust liquidity and capital contingency planning, and encouraging enhanced risk management capability.

A key area that will be explored in these discussions is the future form of supervision. Although the terms supervision and regulation are often used interchangeably, they are, in fact, two distinct, although complementary, functions. Bank regulation refers to the laws and rules that govern the industry, while bank supervision involves the monitoring, inspecting, and examining of banking organizations to assess their condition and compliance with relevant laws and regulations. Both are essential to a safe and sound financial system. Today, supervisors and policymakers are reviewing existing supervisory policies, guidance, and regulation while conducting lessons-learned exercises in an effort to strengthen oversight of the financial system.

A significant challenge that supervisors face is how to adapt supervision to a rapidly changing financial landscape. We cannot return to the days of highly segmented financial regulation based on a strict interpretation of rules and regulations. Accordingly, a key question for supervisors and policymakers is: When is the appropriate time for intervention to protect consumers and restrain excessive risk-taking across all financial institutions and the entire balance sheet?

Financial institutions are getting bigger and becoming more integrated and interconnected with each other and the markets in which they participate. Supervisors, as a result, will be increasingly challenged by a wider range of risks stemming from this integration of financial participants and markets.4 In addition, we cannot lose sight of the regulatory burden that falls unevenly on regional and community banks, given the important role they play in the regional and national economy.

So, how do we move forward? To ensure that markets are transparent and function well and to restore investor and consumer confidence, we need new ways to think about financial markets and the risks they face. First, we need a stronger set of protections for consumers that balances an effective system of firmwide regulation and risk management with sufficient education so consumers can make informed decisions. This does not necessarily mean more regulation, but better regulation and consistent enforcement of regulation. Second, our policy responses must promote market discipline in ways that reduce our vulnerabilities to systemic risk and cost to the public, while at the same time minimize moral hazard.

Third, investors and regulators should not depend exclusively on credit ratings when evaluating risk in new products and complex instruments. The rating agencies themselves are changing their methodologies to reflect differences in the performance of AAA-rated corporate securities and AAA-rated structured securities. Fourth, we need to consider how to introduce more transparency when transferring risks off-balance sheet. Finally, our supervisory and regulatory framework must address the increasing array of players in the market that are subject to vastly differing rules.

Past and present financial crises highlight the fact that risk management challenges will always be with us. Although we can never completely eliminate risk, we must attempt to better understand and manage it.

As our financial system continues to become more complex and interconnected, financial industry participants must focus on strengthening their risk management practices, and policymakers must assist them in their efforts. Promoting strong risk management practices can be an effective means of public policy, taking the form of guidance, regulation, dissemination of best practices, and adherence to minimum standards. The challenge of the Federal Reserve and other regulators will be to manage the balance between effective regulation that allows the markets the freedom to innovate and creates the appropriate incentives that will encourage market discipline and self-correction.

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.