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SRC Insights: Third Quarter 2008

Supervision Spotlight: Bank Performance During Economic Downturns

Economic downturns are an integral component of the business cycle and may be defined as alternating periods of economic expansion and contraction—or "boom and bust"—that beleaguer market economies of the modern age. During downturns, credit is harder to come by, as banks and other financial intermediaries tighten lending standards and investors shift from riskier investments to safer havens, such as cash and government securities. A severe enough contraction can lead to a period of financial turmoil, much like what we are experiencing now.

Viewed through the lens of history, periods of financial stress frequently reveal commonalities. Many factors contributing to the current episode, such as weakened underwriting standards, excessive leverage, speculation, and regulations that failed to keep pace with financial innovation, were also present during the Great Depression of the 1930s and, more recently, the Savings and Loan Crisis of the 1980s/1990s. Each episode, however, plays out in its own unique way, setting it apart from those that preceded it.

So what is different this time around? A long period of low volatility and ample liquidity, the misaligned incentives of the originate-to-distribute model, and technical innovations that led to a virtual explosion in the structured products market helped set the stage. In this period, there was the belief that financial innovation insulated the financial system from major shocks due to the broader dispersion of risk. Banks felt encouraged to venture into unfamiliar products and geographic areas. As actual and projected losses associated with housing-related assets mounted, however, a loss of confidence in the securitization process and the ability of credit ratings agencies to assess the risk associated with complex, structured products resulted in last August's liquidity shock, which has been described as a global margin call on virtually all leveraged positions.1 The loss of confidence that began with the structured products market has since manifested itself as a widespread loss of confidence in the actual architecture of the financial markets themselves.

The current situation, which reflects the unwinding of a prolonged interlude of excesses, will take time, effort, and patience to fix. The market's capacity to absorb risk has been tested by the seizing up of capital markets and a contraction in lending. The liquidity crunch has resulted in banks deleveraging and tightening underwriting standards. During such periods, banks typically cut costs, seek to increase spreads, bolster fixed income, restructure their product mix, and expand business with profitable customers. Serious deterioration in the loan portfolio or strained capital ratios may lead to more severe actions, such as cutting dividends and raising capital.

While we are certainly going through a very challenging period, it's important to point out that banks have proven remarkably resilient during times of great stress. By some accounts, the United States has suffered through 12 downturns since the Great Depression.2 With the exception of that episode, banks have managed to remain profitable throughout this period—and even during the height of the Savings and Loan Crisis from 1987 to 1991, when bank failures averaged 388 per year.

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As economists continue to debate the whys and wherefores of today's financial turmoil and regulators and policymakers grapple with the appropriate response, financial industry participants are focused on riding out the storm while looking for strategies that will better position them to weather future downturns. Enhanced risk management is essential to this effort. Banks are encouraged to review risk management practices to ensure that risk is aligned across the organization, matches up with business strategies, optimizes capital allocation, and facilitates regulatory compliance.

As part of this process, banks should perform due diligence to understand the risks inherent in new or complex products and conduct robust independent stress testing that considers low probability but highly adverse conditions. The current turmoil also highlights the importance of diversification and capital buffers to provide protection during challenging economic conditions. Historical evidence supports that banks, especially small community banks, that are not diversified and that are exposed to serious risk can quickly deplete equity accumulated during better times.3 At the same time, banks that rely on core deposits versus wholesale funding are better able to withstand downturns.

Regulators, policymakers, and market participants are working together in an effort to restore the markets to normal functioning and to strengthen the financial infrastructure to limit the frequency and intensity of future shocks. The Federal Reserve is attempting to relieve funding pressures and increase overall market liquidity by easing the primary credit rate (by reducing the spread between the primary credit rate and the fed funds target)and introducing several new lending facilities designed to make credit more readily available to depository institutions and primary securities dealers.

On the consumer protection side, the Federal Reserve issued new rules under the Home Ownership and Equity Protection Act (HOEPA) that apply to all mortgage lenders and that address many of the questionable lending practices that played a role in the housing meltdown. Most recently, Congress enacted a comprehensive housing rescue package that will provide aid to homeowners facing foreclosure, create new licensing standards for the mortgage industry, modernize the federal housing authority, and institute other measures aimed at improving the overall functioning of the mortgage industry.

Experts agree that significant strain in the financial markets may persist for quite some time, and banks will continue to feel the impact. As we work through this market correction, bankers, regulators, and bank supervisors have important roles to play. Regulators must improve the financial infrastructure without inhibiting the financial innovation needed to spur future growth, while bank supervisors need to improve their knowledge of the range of financial market activities and their implications for bank balance sheets. For their part, bankers should reevaluate their business models and focus on strengthening their capital, liquidity, and risk management practices. As bankers navigate the market turmoil, they should also remain aware of long-term strategic opportunities and position their firms accordingly. Long-term success depends on how well they steer their way through the current downturn and how well they position their organizations to participate in the 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.