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winter 2012/2013


N e w s a n d V i e w s f o r E i g h t h D i s t r i ct B a n k e r s

Featured in this issue: Third-Quarter 2012 Banking Performance | The Big Banks: Too Complex To Manage?

Trends in OREO: Community Banks
Still Have a Long Way To Go
By Daigo Gubo and Gary Corner


REO (other real estate owned)
at community banks increased
sharply during the 2007-2009 recession because of high loan default
levels—the result of a deterioration in
economic conditions and what appears
to be a relaxation of underwriting
standards before the financial crisis.1
Increases in OREO on bank balance sheets, however, continued well
beyond the official end of the recession, peaking between 2010 and 2011.
Consistent with a legacy concentration
of real estate loans, community banks
have experienced the highest ratios
of OREO-to-assets on their books.
Today many banks are still working on reducing their elevated levels

of OREO. Liquidating properties,
however, is proving to be a significant
challenge to community bankers given
the current soft real estate market
As illustrated in Figure 1 below,
community banks nationally and
across the District experienced a peak
in their OREO holdings in the second
quarter of 2010. OREO holdings then
appeared to plateau until the middle of
2011. Since the third quarter of 2011,
OREO levels have declined. Despite
these recent declines in OREO, the
current volume of these properties is
much higher than what it was before
the start of the financial crisis. As of
the third quarter of 2012, community
continued on Page 6

figure 1

Community Bank* OREO/Total Assets Trends

Eighth District





Source: Call Reports
*Community banks are
those with assets of less
than $10 billion.








2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q

T h e F e d e r a l R e s e r v e B a n k o f St . L o u i s : C e n t r a l t o A m e r i c a ’ s Ec o n o m y ®


Central view

Vol. 22 | No. 4

The Financial Crisis and
Household Balance Sheets:


A New Research Effort at the St. Louis Fed

News and Views for Eighth District Bankers

Scott Kelly
Central Banker is published quarterly by the
Public Affairs department of the Federal
Reserve Bank of St. Louis. Views expressed
are not necessarily official opinions of the
Federal Reserve System or the Federal
Reserve Bank of St. Louis.
Subscribe for free at to
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Follow the Fed on Facebook, Twitter and more
The Eighth Federal Reserve District includes
all of Arkansas, eastern Missouri, southern
Illinois and Indiana, western Kentucky and
Tennessee, and northern Mississippi. The
Eighth District offices are in Little Rock,
Louisville, Memphis and St. Louis.

Selected St. Louis Fed Sites
Dodd-Frank Regulatory Reform Rules
FRED (Federal Reserve Economic Data)
Community Development’s Household
Financial Stability Initiative

By James Bullard


he Great Recession set in motion
numerous adverse repercussions,
with damage to household balance
sheets being especially pronounced.
As reported by the St. Louis Fed’s Bill
Emmons and Bryan Noeth in a recent
study, household wealth declined nearly
$17 trillion in inflation-adjusted terms,
or 26 percent, from mid-2007 to early
2009, with only about two-fifths of that
James Bullard is
loss recovered by early 2012. Emmons
president and CEO of
and Noeth found that wealth losses hit
the Federal Reserve
older, wealthier Americans (who had
Bank of St. Louis.
the most to lose) the hardest in terms
of absolute dollars but affected younger, less educated and
minority households the most in terms of percentage.1
Not surprisingly, the adjustments required by the damage
to household balance sheets are ongoing and are likely to
take years to complete. In fact, this is the first U.S. recession
in which household “deleveraging”—the slow, painful process
of families paying down their debts and rebuilding their savings—has played a key role. Steep declines in housing prices,
along with historically high levels of household debt before
the crash, made this recession particularly severe. The
International Monetary Fund recently reported that “housing
busts preceded by larger run-ups in gross household debt are
associated with significantly larger contractions in economic
activity.”2 The unprecedented debt overhang leaves the
Federal Reserve with a seemingly paradoxical policy, at least
with respect to many households: Monetary policy has kept
interest rates low to encourage borrowing in the context of an
economy with too much borrowing.
As Fed policymakers continue to work through this
paradox, a clear challenge remains to define mechanisms
whereby Americans, especially low- and moderate-income
Americans, can rebuild their balance sheets, which will help
both struggling families and the stagnant economy move
forward. Too many Americans were unbanked or underbanked, too many did not save enough, too many ran up
their debts or accumulated risky debt, and too many did not
diversify their assets beyond housing. How can we turn each
of these balance sheet failures around? How can we help
families consider their entire balance sheet?
To help meet these challenges, the St. Louis Fed has begun
the Household Financial Stability research initiative, which
focuses on three key questions:
• What is the state of household balance sheets in this
country—what can we say, quantitatively, about the health
of household balance sheets in aggregate but especially
by age, race, education level, income and other demographic factors?

2 | Central Banker

Q u a r t e r ly R e p o r t

Third-Quarter 2012 Banking Performance1
2011: 3Q 2012: 2Q 2012: 3Q
Return on Average Assets 2

All U.S. Banks
All Eighth District
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks






















Compiled by Daigo Gubo




SOURCE: Reports of Condition and Income for Insured Commercial Banks





Net Interest Margin

All U.S. Banks
All Eighth District
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks

2011: 3Q 2012: 2Q 2012: 3Q
nonperforming Assets Ratio3

All U.S. Banks
All Eighth District
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks



















Loan Loss Coverage Ratio 4

All U.S. Banks
All Eighth District
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks

Loan Loss Provision Ratio

All U.S. Banks
All Eighth District
Arkansas Banks
Illinois Banks
Indiana Banks
Kentucky Banks
Mississippi Banks
Missouri Banks
Tennessee Banks

• Why does it matter—what are the
economic and social outcomes, at
both the household and macro levels,
associated with varying levels of savings, assets and net worth?
• What can we do to improve household balance sheets—what are the
implications of our research for public policy, community practice, financial institutions and households?
Many in the Federal Reserve System
have been studying family balance
sheets for years. What we hope to
offer is a broad conceptual framework,
a common table where those throughout the System and beyond learn and
work together. We plan to publish
research offering new perspectives
on balance sheets and why they matter.





Because all District banks except one have assets of less than $15 billion, banks
larger than $15 billion have been excluded from the analysis.
All earnings ratios are annualized and use year-to-date average assets or average
earnings assets in the denominator.
Nonperforming loans plus OREO are those 90 days past due or in nonaccrual status
or other real estate owned.
The loan loss coverage ratio is defined as the loan loss reserve (ALLL) divided by
nonperforming loans.

See for full
details on the initiative’s team, In the
Balance publication, research and
other activities.
As we continue to recover from the
economic crisis, we are challenged to
innovate and to think about new ways
to help American families and the U.S.
economy thrive. We are excited about
the contribution that our new Household
Financial Stability research initiative
can make to this important challenge.
1 “Household Financial Stability: Who Suffered the
Most from the Crisis?” The Regional Economist,
July 2012.
2 International Monetary Fund, World Economic
Outlook: Growth Resuming, Dangers Remain, April
2012, p. 91.
Central Banker Winter 2012/2013 | 3


Will Money Market Mutual Funds
Get an Extreme Makeover?
By Michelle Neely



he regulatory response to the 200708 financial crisis is far from over,
as much of the rulemaking stemming
from the Dodd-Frank Act remains
incomplete. Money market mutual
funds (MMMFs) were subject to some
modest regulatory changes in 2010, but
many observers argue that the industry
is in need of a more substantial overhaul. The $2.9 trillion MMMF industry
is objecting, pointing out that the effects
of the 2010 reform should be thoroughly
examined before further changes are
adopted and that radical changes would
threaten the industry’s survival.
Although the problems experienced
by the money market industry during
the financial crisis were not widely
known by the public, the government
felt compelled to intervene. Just one
day after Lehman Brothers declared
bankruptcy in September 2008, the
Reserve Primary Fund’s share price
fell below a dollar because the fund’s
holdings of Lehman-issued commercial
paper became worthless. Investors
swamped the fund with redemption

What They’re Saying about MMMFs

“Additional steps to increase the resiliency of money market funds
are important for the overall stability of the financial system.”
Federal Reserve Chairman Ben Bernanke, April 2012

“Never again should policymakers be forced to choose between a
financial meltdown or a taxpayer bailout of money market funds.”
Former FDIC Chairperson Sheila Bair, November 2012

“Investors are telling us loud and clear that any of the SEC’s
concepts—floating the funds, requiring capital buffers or imposing asset freezes—will drive them out of money market funds and
essentially kill the product.”
Karrie McMillan, General Counsel for the
Investment Company Institute, May 2012

“Four years after the instability of MMMFs contributed to the worst
financial crisis since the Great Depression, with the failure of the
SEC to act, (the FSOC) should now move forward with the tools
provided by Congress.”
Treasury Secretary Timothy Geithner, September 2012
4 | Central Banker

requests, causing the fund to be closed
and eventually liquidated. Analysts at
the Boston Fed conservatively estimate
that at least 20 other funds would have
“broken the buck” if not for direct support from fund sponsors during the
financial crisis.1 The U.S. Treasury
also stepped in, setting up a guarantee
program for MMMF investors to stem
redemptions at other prime money
funds and shore up the industry; that
program expired in September 2009.

SEC Attempts Revamp
In 2010, the Securities and Exchange
Commission (SEC) adopted a number of regulatory changes meant to
strengthen the industry by reducing
risk. Portfolio quality, stress-testing,
liquidity and diversification requirements were imposed, along with limits
on portfolio maturity and mandates
for disclosure and reporting. A recent
analysis by SEC staffers of the 2010
reforms indicates that MMMFs are less
likely to “break the buck” now than
they were before the reforms because
the SEC-mandated maximum weighted
average maturity (WAM) of portfolios
has fallen from 90 days to 60 days. The
staffers found that the 2010 changes
have made funds more resilient to
portfolio losses and investor redemptions but that none of the reforms
would have prevented the 2008 meltdown of the Reserve Primary Fund.
Although the 2010 reforms have
seemingly lessened the risk of losses to
investors, many observers believe they
did not go far enough to prevent runs.
SEC Chairman Mary Schapiro, who
recently left the agency, spearheaded
an internal effort to impose more stringent requirements on money market
mutual funds. The most controversial
reform effort she championed was to
allow the net asset value (NAV) of an
MMMF share to float, reflecting its
market value, rather than being fixed
at $1, as is currently the practice. A
floating NAV would put money market funds on par with other types of
mutual funds. Schapiro abandoned

that effort and others in August 2012
when she could not produce the three
votes necessary to enact those changes.

Enter the FSOC
The Financial Stability Oversight
Council (FSOC) took up MMMF
reform following the SEC impasse.
In November, the FSOC voted unanimously to put out for public comment
three reform options that align with
those proposed by the SEC; while the
FSOC is prepared to enact reforms, the
FSOC has made it clear that it would
prefer that the SEC took action. The
three proposals are 1) require funds’
NAVs to float; or 2) require funds to
hold a capital buffer to manage losses
plus place restrictions on the number
of shares redeemable at one time; or
3) require funds to have capital buffers of 3 percent in addition to some
other measures. The FSOC noted that
the final proposal could be a mix of the
three options suggested, with the goal
of maximizing industry stability. The
comment period for the proposal closes
in mid-February. Based on comments
received, the FSOC will provide a recommendation to the SEC, which then
has 90 days to respond. The SEC can
agree with the FSOC recommendation,
propose its own or explain in writing
why it won’t do either.
Since the FSOC’s proposals came
out in mid-November, two events have
heightened the pressure on the SEC
and the MMMF industry. As part of its
recommended overhaul of the shadow
banking system, the Financial Stability Board (FSB)—an umbrella organization of central bankers—called
for the MMMF industry to eliminate
its stable pricing mechanism, where
feasible, to stanch runs.2 Functionally
equivalent measures to a floating NAV
should be adopted, according to the
FSB, in cases where stable pricing is
deemed necessary. The FSB’s stance
adds an international regulatory voice
to that of U.S. banking and financial
markets regulators.
More recently, the FSOC has discussed the idea of designating MMMFs
or their sponsors as systemically
important financial institutions (SIFIs),
thus posing a potential threat to U.S.
financial stability.3 A SIFI designation
under Section 113 of the Dodd-Frank
Act would lead to tighter regulation
of the money market industry, as well

as direct supervision by the Federal
Reserve. Individual bank regulators
could also act on their own by imposing capital charges on MMMFs that
are bank-sponsored.

Industry Resists Remodel
The money market fund industry has
for the most part opposed the reform
proposals suggested by the SEC, the
FSOC and the FSB. The Investment
Company Institute (ICI), the trade
group for the mutual fund industry,
has criticized all three primary regulatory changes suggested—floating NAVs,
capital requirements and redemption
holdbacks. The ICI maintains these
changes would not necessarily make
the industry safer but would put money
funds at a competitive disadvantage
relative to other cash management
products. Some of the larger mutual
fund companies have offered proposals
of their own to head off what they view
as more draconian changes.
U.S. financial regulatory authorities
are united in their desire to impose
tighter regulations on money market
mutual funds. If the SEC does not pass
a reform package, Treasury Secretary
Timothy Geithner has said the FSOC
will.4 Most observers believe some sort
of reform effort will be approved by
the end of 2013. With the money fund
industry so firmly against floating share
prices, the most likely outcome will
be some sort of capital requirement,
perhaps coupled with limits on redemptions in times of financial stress.
Michelle Neely is an economist at the Federal
Reserve Bank of St. Louis.
1 “The Stability of Prime Money Market Mutual
Funds: Sponsor Support from 2007 to 2011,”
Steffanie Brady, Ken Anadu and Nathaniel
Cooper, Working Paper RPA 12-3, Federal
Reserve Bank of Boston, Aug. 13, 2012.
2 “Strengthening Oversight and Regulation of
Shadow Banking,” Financial Stability Board,
Nov. 18, 2012.
3 “FSOC Eyes New Option on Money Funds,
Weighs Mortgages, Derivatives Transactions,”
Chris Bruce, Bureau of National Affairs Banking
Daily, Dec. 14, 2012.
4 “Regulators Set Mandate for Reform of MoneyMarket Mutual Funds,” Donna Borak, American
Banker, Nov. 14, 2012.

Central Banker Winter 2012/2013 | 5

figure 2

Eighth District Community Bank* OREO/Total Assets Trends by Loan Category







1-4 Family Residential


Nonfarm Nonresidential










2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q

figure 3

U.S. Community Bank* OREO/Total Assets Trends by Loan Category







1-4 Family Residential


Nonfarm Nonresidential




OREO Trends
continued from Page 1

banks headquartered in the District
had 1.06 percent of their assets in
OREO. Nationwide, community banks
had only 0.85 percent of their assets
in OREO.

OREO Composition
Loans initially collateralized by
construction and land development
(CLD) properties represent the highest share of OREO properties on bank
balance sheets, followed by nonfarm
nonresidential properties. This is
understandable given that CLD and
nonfarm nonresidential properties
make up most of the commercial real
estate held on community bank balance sheets. Figures 2 and 3 above
show OREO composition at community
banks nationwide and at community
banks headquartered in the District.
The general composition of OREO at
both groups of banks is very similar.
The key difference is that District
6 | Central Banker








SOURCE: Call Reports
*Community banks are
those with assets of less
2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q than $10 billion.

institutions remain burdened by a
higher ratio of OREO as a percentage
of their total assets.

OREO Concentrations by State
As illustrated on the map on Page
7, community banks headquartered
in states in the Eighth District have,
on average, fairly moderate ratios of
OREO to assets. Community banks
in Indiana and Kentucky have ratios
of less than 1 percent. The remaining
five states—Arkansas, Illinois, Missouri, Mississippi and Tennessee—
each have average OREO-to-assets
ratios of 1 percent to 1.49 percent.
On a state level, Georgia has the highest average ratio of OREO to assets
on its community banks’ balance
sheets. This is not surprising, as it
also is the state with the largest number of bank failures.
As would be expected, lower OREO
ratios are correlated with lower problem asset ratios. Problem asset ratios
at community banks headquartered in
Indiana and Kentucky are the lowest

among District states at 3.18 percent
and 3.69 percent, respectively.2

Policy Statement and Risk
Management on OREO
With the rise in foreclosures, the cost
of maintaining and disposing of OREO
property can become a significant drag
on a bank’s performance. Through
the third quarter of 2012, community
banks across the nation incurred $1.38
billion in annualized OREO expenses,
which effectively trims 6 basis points
off their return on average assets. District community banks fared slightly
worse, losing $0.35 billion on an annualized basis on OREO, which trims 7
basis points off their return on average
assets. The impact of OREO on asset
quality and earnings highlights how
important it is that banks appropriately
market their OREO holdings to prospective investors.
On April 5, 2012, the Federal
Reserve issued a Policy Statement
on Rental of Residential OREO Properties (SR 12-5/CA 12-3) to clarify that
banking organizations are permitted
to rent OREO properties as part of an
orderly disposition strategy. The move
was aimed at providing more flexibility in OREO marketing and improving
the sales value of properties. On June
28, 2012, the Federal Reserve issued
Questions and Answers for Federal Reserve-Regulated Institutions
Related to the Management of OREO
(SR 12-10/CA 12-9) to help address
questions regarding the management
of OREO by institutions regulated
by the Federal Reserve. Generally
speaking, the Federal Reserve permits bank holding companies to hold
an OREO asset for up to five years,
with an additional five-year extension
available under certain circumstances.
However, the policy statement emphasizes that bank management must
have sound strategies and processes
in place for the management and disposal of OREO properties.

Long Way To Go on OREO
Foreclosed properties spiked significantly during the financial crisis. As a result, many community
banks now have significant holdings
of foreclosed-upon construction and
land development properties on their
balance sheets. Since CLD loans

proved to be one of the riskiest asset
classes for community banks, naturally
it holds that effectively disposing of
such properties from OREO inventories is challenging. Despite the recent
clarification from the Federal Reserve
regarding the rental of OREO as part
of an orderly disposition strategy, the
stubbornly elevated levels of OREO on
bank balance sheets suggest that community banks still have a long way to
go before these levels return to where
they were prior to the financial crisis.
Gary Corner is a senior examiner and Daigo
Gubo is a policy analyst at the Federal
Reserve Bank of St. Louis.
1 Properties that are classified as other real
estate owned (OREO) are those held by banks
as the result of a foreclosure or a deed in lieu
of foreclosure.
2 Problem asset ratios are nonperforming loans
and OREO to total loans and OREO.

Figure 4

Average OREO Concentrations by State

0% to

0.50% to

1% to

1.50% to

2% or

SOURCE: Call Reports


Supervision and Regulation Letters
SR 12-5/CA 12-3
SR 12-10/CA 12-9

Central Banker Winter 2012/2013 | 7


The Big Banks: Too Complex To Manage?

he phrase “too big to fail” reentered common use in 2008 after
Fannie Mae and Freddie Mac were
put into government conservatorship
on Sept. 6; the government rescued
the large insurance firm AIG starting on Sept. 16; and nine major banks
announced on Oct. 14 their intention to
subscribe to the Troubled Asset Relief
Program (TARP), in which the Treasury would purchase the banks’ preferred stock. More unflattering phrases
have become associated with megabanks over the past couple of years.
“Misbehaviors” connected to the big
banks magnified the problems already
posed by such large, complex financial
organizations, which have concerned
legislators and regulators for years.
Have they successfully created game
plans for “too-big-to-fail” firms? Are
big banks needed, or do the misbehaviors indicate that such megabanks
should not even exist? These and more
questions were explored during the
Oct. 1 Dialogue with the Fed, part of the
St. Louis Fed’s ongoing evening discussion series for the general public.
St. Louis Fed economist William
Emmons led the Dialogue, titled “Robosigning, the London Whale and Libor
Rate-Rigging: Are the Largest Banks
Too Complex for Their Own Good?”
Joining Emmons for the Q&A that
followed were Mary Karr, senior vice
president and general counsel of the
St. Louis Fed; Steven Manzari, senior
vice president of the New York Fed’s
Figure 1

Which Forms of Governance Appear
To Be Effective for Complex Banks?
Corporate Governance Mechanisms
Internal governance mechanisms

In the best corporations

Corporate culture
Board oversight
Managerial self-interest
External governance mechanisms

Product-market discipline
Shareholder discipline
counterparty discipline
Supervision and regulation
Overall effectiveness of governance

8 | Central Banker

Among U.S. megabanks

Complex Financial Institutions unit;
and Julie Stackhouse, senior vice
president of Banking Supervision and
Regulation at the St. Louis Fed. See
the videos and Emmons’ presentation
slides at

Why Were Big Banks Rescued During
the Crisis?
The financial crisis reinvigorated the
active debate on the “social good” of
megabanks—whether they alone can do
things smaller financial organizations
can’t and whether they truly are more
effective and efficient. (See “Economies of Scale and Scope” on Page 10
for some details.) The primary point of
contention, however, is systemic risk.
Very large and complex banks are
considered to have systemic risk
because the failure of a megabank
would hurt not just the company itself,
its creditors and its employees but
potentially the entire financial industry and the economy. In other words,
they are “too big to fail” without creating dire consequences for the economy.
“Sometimes institutions need to fail.
That is essentially what capitalism is
about: that when a firm is no longer
viable it should be able to leave the
market (e.g., fail),” Emmons said.
“But we were caught flat-footed in 2008
when the financial system almost collapsed and we had no safe, effective
way to wind down failing megabanks.”
Consequently, the federal government
propped up many large and complex
financial institutions—including AIG,
Fannie Mae and Freddie Mac—to
avoid the damage of chaotic collapses.
The lack of a structure to deal with a
megabank failure has troubled many
policymakers and lawmakers who, as
discussed later, are attempting to craft
such a mechanism.

Misbehaviors: A Failure of Discipline?
The revelations of recent controversies such as robo-signing, the
London Whale and Libor rate-rigging—
explored in “Big Bank Misbehaviors”
in the online version of this article at—as well as other
problems not mentioned here indicate

that something critical was lacking in
the discipline of large, complex banks.
“Discipline” is a combination of an
institution’s internal and external governance. Internal governance includes
corporate culture, oversight by the
bank’s board and managerial self-interest, while external governance comes
via supervision and regulation, as
well as discipline by product markets,
shareholders, depositors, bondholders
and counterparties.
Was the internal discipline effective?
Not really, Emmons explained: “Some
of those misbehaviors point in this
direction, that the internal corporate
cultures at the largest banks are not an
effective mechanism for keeping the
banks on the straight and narrow.” As
indicated in Figure 1 on Page 8, internal discipline generally appears to work
well in the best corporations but not as
well among the U.S. megabanks, while
external governance generally seems
to have worked better for megabanks,
Emmons said. “The basic message is
that there are some real weaknesses on
the internal side, and to the extent that
we can be effective as supervisors and
regulators, we can probably provide
fairly effective external sources of
discipline,” he said.
“I think it’s also true that board oversight is often lacking,” Emmons said.
It’s a perennial issue at small banks
and a bigger issue for midsized banks
but seems especially challenging for
megabanks, as their board members
are nonexperts recruited from other
economic sectors yet are expected to
provide effective oversight of very large
and complex organizations. “It’s true
that the megabanks operate in very
competitive product and labor markets,
which pushes them to be more efficient.
But the other internal governance
weaknesses noted above and their
overwhelming complexity appear to
make them ‘too big to manage effectively,’” he said.
Both Emmons and Manzari
addressed shareholders in response to
a question from the Dialogue audience.
They noted that small shareholders
are exerting some discipline through
selling their stock but that there are
restrictions on what large shareholders
can do and that the type of governing
influence that shareholders can have
on firms has yet to play out in this
changing regulatory environment.

“We were caught flat-footed in
2008 when the financial system
almost collapsed and we had no
safe, effective way to wind down
failing megabanks.”
Economist William Emmons

Dealing with Large, Complex Banks
But why didn’t federal regulators
catch the misbehaviors and other
issues before they became major
problems? Complexity. For example,
Manzari, responding to a Dialogue
audience question, said that supervising a handful of megabanks is
definitely more complicated than
supervising hundreds or thousands
of smaller institutions.
• Numerous regulators for one
megabank – “Every jurisdiction
has some sort of prudential supervisory agencies. A firm that does
business in the United States, the
U.K., Europe and Asia will have a
range of different entities involved
in the supervision of that firm. That
puts a big premium on communication and collaboration of those different agencies.”
• No uniform set of rules across
agencies – A nationally chartered
bank in the U.S. faces a uniform set
of rules, and you don’t have stateto-state differences. However, there
is no globally unified regulatory
framework for all international firms.
“There is an effort to harmonize
capital standards (and) liquidity standards, but still you get different rules
in different regimes,” Manzari said.
Illustrating Emmons’ prior exposition on megabank discipline, Manzari
added that “The very complexity of
megabanks often creates relationships
inside the firm that become apparent
only after the problem manifests itself.”
Addressing supervision of smaller
banks, Stackhouse noted that while the
supervisory process is easier, there is
also a very clear resolution mechanism.
Since the financial crisis, more than
400 small banking organizations have
continued on Page 10
Central Banker Winter 2012/2013 | 9

Big Banks
continued from Page 9

failed. “A recent failure in St. Louis hit
the papers for exactly one day, and I
think it’s pretty much forgotten about
because that’s how well (the resolution
process) worked,” she said. “We’re not
there yet with large institutions.”

How To (Maybe) End “Too Big To Fail”
So, how will we deal with the megabanks? Emmons outlined two basic
approaches: radical and incremental.
The radical approach involves structural

changes imposed on the banks themselves or the creation of a different legal
definition of what a bank is and what it
can do. Radical proposals include:
• Reduce their complexity and size –
Revive the 1933 Glass-Steagall Act
(partially repealed by the 1999
Gramm-Leach-Bliley Act) prohibiting
combining commercial banking with
investment banking or insurance
underwriting. Also, reduce their size
by placing limits on banks’ assets or
deposits. However, Emmons said
this proposal likely wouldn’t succeed
because combining commercial and

Economies of Scale and Scope
To help explain why the misbehaviors
matter and how they illuminate “too big to
fail,” Emmons explored why certain banks
became global giants. Given that all banks
perform payments and credit, big banks
argue that they need to be large and complex because they can better take advantage of economies of scale and scope:
• Economies of scale – The average cost
per unit of doing one thing declines as
the scale of operation increases, such as
diversifying default risk in the loan portfolio or paying only the net amount owed
on payments clearing and settlement.
• Economies of scope – The average costs
per unit of doing different things decline
as a result of doing them together, such
as one-stop financial shopping, banking
and insurance; commercial and investment banking; or market-making and
trading on a bank’s own accounts.
But does a bank need to be large and
complex to succeed? Not necessarily,
according to what ongoing St. Louis Fed
research suggests. Emmons explained
that most scale economies appear to be
captured by banks that have between $30
billion and $50 billion in assets, banks that
are much smaller than those shown in the
first two columns of Figure 2 above.
Emmons said the research suggests that
big banks’ scope efficiencies may be good
for the firms themselves, but not necessarily for the rest of society. Granting that
big banks dispute such research as flawed
10 | Central Banker

Figure 2

Size and Complexity of the Seven Largest
U.S. Financial Holding Companies
As of 2011: Q4
JPMorgan Chase & Co.
Bank of America Corp.
Citigroup Inc.
Wells Fargo & Co.
Goldman Sachs Group Inc.
Metlife Inc.
Morgan Stanley
All 4,660 bank holding

Total Assets
(in billions)

of Total

Number of

of Total

SOURCE: “A Structural View of U.S. Bank Holding Companies,” D. Avraham, P. Selvaggi and
J. Vickery, New York Fed Economic Policy Review, July 2012.

because it doesn’t have enough data from megabanks, Emmons said
that the megabanks’ claim that they “passed a market test” during
and after the crisis is “simply not true.”
Returns to big-bank shareholders have been poor over time, as
bank stocks experienced a 90 percent decline from the beginning of
financial crisis, much more than the overall stock market. “There has
been some recovery, but they are trailing the market,” Emmons said.
“So, whether using 2000 or 2007 as the starting point, bank stocks
have vastly underperformed the rest of the market—even with
government support.”
Emmons said, “Most, if not all, of the megabanks would have
failed without government support during the financial crisis. In
other words, in a truly free market, most or all of those banks would
have exited.” And large companies are at best lukewarm supporters
of big banks, he said.
For a fuller discussion, see the presentation slides and videos
as well as “Too Big To Fail: The Pros and Cons of Breaking Up Big
Banks” at in
the October 2012 The Regional Economist.

investment banking was not the main
source of problems; in fact, many of
the “too-big-to-fail” institutions that
caused problems during the crisis
would have been allowed to operate
under Glass-Steagall.
• Create “narrow banks” – Separate
payments functions from all other
financial activities. Such a bank
would take deposits and make payments but not make loans except
those that have very little default
risk. Emmons said this proposal
wouldn’t be successful either because
such banks are not likely to be viable.
Narrow banks likely would seek to
make riskier loans to improve their
profitability, while non-narrow banks
would seek to enter the payments
business in one way or another.
“In fact, we have chosen not to
pursue radical approaches to solving
the ‘too-big-to-fail’ problem,” he said.
“Instead, we’re implementing incremental—albeit significant—reforms of
the existing legal, regulatory and governance frameworks in which banks
operate.” Meanwhile, bankers, regulators and legislators won’t know whether
the regulatory reform efforts will actually work until they are actually used.
Those efforts, which have sparked a
lot of profound debate throughout the
financial industry, include:
• The 2010 Dodd-Frank Act – The law
includes living wills for orderly dissolution, capital requirements, stress
tests, risk-based assessments on
deposit insurance, FDIC orderly liquidation authority, the Volcker Rule
and investor protections. “These are
all pushing banks to be more effective in internal discipline,” Emmons
said. (See, our Dodd-Frank Act site.)
• Basel III Accord – The third round
of the Basel Accords is looking to
improve the quality of bank capital
and make other changes related to
capital so that big banks demonstrate
that they “have more skin in the
game,” Emmons said.
Emmons also offered another proposal: Make a strictly enforced “death
penalty” regime, a law mandating
that any bank requiring government
assistance would be nationalized, with
a plan to sell it back to new shareholders at some point in the future. “The
crux of the matter would be carrying

through this pledge to re-privatize the
institution,” he said. “It should reduce
the incentives to take risk because
the ‘death penalty’ is such a severe
penalty that it would act as a deterrent.” Emmons noted that TARP (the
Troubled Asset Relief Program) was
a half-step in this direction, in which
the federal government took noncontrolling equity positions in megabanks—preferred instead of common
equity—and didn’t wipe out shareholders or management.
“It’s not so radical of a proposal
because we did impose a ‘death penalty’
on Fannie Mae and Freddie Mac: Their
shareholders and management were
wiped out. General Motors and Chrysler
were forced into bankruptcy, and AIG
was effectively nationalized,” he said.
“If this were to be the plan, we would
need (to continue the metaphor) an
undertaker standing by—an institution
that would be ready to exact this discipline on the firms,” he said, pointing
to other nations’ permanent “sovereign
wealth funds” that can take equity positions in firms.

The Jury Is Still Out
While investigations and lawsuits
continue, regulations are written for
new laws, and the industry wrestles
with proposed capital and other standards, the question remains: Will any
of this solve “too big to fail,” successfully rein in systemic risk or prevent
future “misbehaviors”? Simply put,
we don’t know yet.
“I think it’s really important to realize
that these are the early days in terms of
the reform efforts for the financial system, and many firms still have to navigate a pretty complex set of changes
to the regulatory landscape, how the
world is unfolding and how they’re
going to generate profits,” Manzari said
during the Q&A portion.
Stackhouse noted that of the 400 or
so regulations and rules required by the
Dodd-Frank Act, only about one-third
are actually in place. “The financial
community, large banks in particular—
those with over $50 billion in assets—
have a lot ahead of them,” she said. “The
Dodd-Frank Act right now is the mechanism on the table to deal with these very
large firms. The jury is still out on how
that particular rule making will take
place and how effective it will be.”

Central Banker Winter 2012/2013 | 11

Central Banker Online
S ee the online version of the W inter 2012/2 0 1 3
C entra l B an k er at www. s t lo u i s f e d. o r g/C b
for regulatory spotlights and recent S t. Louis
F ed research .

ISSUE 2 | 2012

Perspectives on Household Balance Sheets

Unsteady Progress: Income Trends in the
Federal Reserve’s Survey of Consumer Finances
By William Emmons, assistant vice president and economist, and Bryan Noeth, policy analyst,
Federal Reserve Bank of St. Louis


he Federal Reserve’s 2010 Survey of
Consumer Finances revealed a decline
in the income of many Americans
between 2007 and 2010.1
Among the middle decile (10 percent)
of all families, the average pre-tax family
income in 2010 was $45,951, falling 5.6
percent from the 2007 level of $48,669.2
(All figures are expressed in terms of 2010
purchasing power.)
Detailed comparisons of income and
wealth trends over both short and long
periods for a number of subgroups lead us
to conclude that some types of families are
doing noticeably better than others.3
For example, the average older family
(headed by someone 55 or older) in the

middle ten percent of such families had a
pre-tax income 3.5 percent higher in 2010
than a similar family had in 2007.
In stark contrast, the average younger
family (headed by someone under 40) had
a pre-tax income 12.6 percent lower in
2010 than in 2007.
Meanwhile, a family headed by someone
between the ages of 40 and 54 had pre-tax
income that was about 8.3 percent lower in
2010 than such a family in 2007.

—A Research Initiative

This analysis of the Federal Reserve’s
Survey of Consumer Finances is but one
aspect of a recently launched research
initiative now under way at the Federal
Reserve Bank of St. Louis. Through
research, publications, web-based data
tools and public events, the HFS initiative
aims to help rebuild the balance sheets
of struggling American households. For
more information, see the Household
Financial Stability site at www.stlouisfed.

Ne w S t. Lo uis Fed Pub li c ati o n


• Mortgage Borrowing: The Boom and Bust

Read short essays related to
research on understanding and
strengthening the balance sheets of
American households.
The online publication is part
of the St. Louis Fed Community
Development’s Household Financial
Stability initiative, which includes
research, web-based data tools and
public events.
Short- and Longer-Term Income Trends

Table 1 provides information on typical
pre-tax family incomes at various times for

(continued on Page 2)


• Global European Banks and the Financial Crisis
• State and Local Debt: Growing Liabilities
Jeopardize Fiscal Health
• Unemployment Insurance: Payments, Overpayments
and Unclaimed Benefits
• Latest Agricultural Finance Monitor
• Latest Housing Market Conditions Report

• Appraisal Requirements among Several Newly
Effective Dodd-Frank Act Rules

printed on recycled paper using 10% post-consumer waste

Average family income of the middle decile of families ranked by income in 2010 dollars



1992-95 average



Percent Change

Percent Change
1992-95 average to 2010







1 All families


2 Historically disadvantaged minority
(African-American or Hispanic origin)






3 White, Asian or other minority






4 Young (family head under 40)





5 Middle-aged (between 40 and 54)






6 Old (55 or older)







7 No college degree






8 College degree (two-year or four-year degree)

















9 Middle-aged and college degree and white,
Asian or other minority

1 0 Old and college degree and white, Asian or other minority

SOURCE: Federal Reserve Survey of Consumer Finances and authors’ calculations.


>> Read or download In the
Balance and see subscription
options at:


New St. Louis Fed Banking and Economic
Mortgage Borrowing: The Boom and Bust
The mortgage boom and bust have had profoundly different effects on different age groups and birth-year
cohorts. Younger families generally experienced the most volatility, while older families have emerged with the
largest net increases in mortgage debt in percentage terms. Read why in this article by William R. Emmons
and Bryan J. Noeth in the January 2013 The Regional Economist.

Global European Banks and the Financial Crisis
In the November/December 2012 Review, economists Bryan J. Noeth and Rajdeep Sengupta review some of
the recent studies on international capital flows with a focus on the role of European global banks. They
present a revision to the commonly held “global saving glut” view that East Asian economies (along with oilrich nations) were the dominant suppliers of capital that fueled the asset price boom in many parts of the world
in the early 2000s. They also argue that the role of funding costs and a “liberal” regulatory regime that allowed
for an unprecedented expansion of the balance sheets of European banks was no less important. Finally, they
describe the aftermath of the crisis in terms of some of the challenges faced by Europe as a whole and
European banks in particular.

State and Local Debt: Growing Liabilities Jeopardize Fiscal Health
Not only are nations (and individuals) wrestling with growing debt levels, but so are state and local
governments, including those in the seven states that make up the Eighth District. To understand how
burdensome the debt is to states, Lowell R. Ricketts, research associate, and Christopher J. Waller, director of
Research, explore how the financial obligations of states extend beyond the bonds issued by state
governments. They combined state and local government debt with unfunded pension and retiree healthbenefit obligations, and combining them with existing indebtedness to provide a more accurate comparison of
fiscal health. They then measured these financial obligations as a percentage of gross state product (GSP),
which shows debt totals relative to the size of the state economy. Read more in the October 2012 Regional

Unemployment Insurance: Payments, Overpayments and Unclaimed
Not everyone who is eligible for unemployment benefits actually collects them. Over the longer horizon, these
unclaimed benefits are much larger than the overpayments that have received recent media attention.
Economists David L. Fuller, B. Ravikumar and Yuzhe Zhang investigate why in this October 2012 Regional
Economist article.

Latest Agricultural Finance Monitor
District farm income and capital spending were down significantly in the third quarter of 2012 relative to yearago levels, though there was some disparity across zones, as reported in the St. Louis Fed’s Agricultural
Finance Monitor. The St. Louis Zone showed the largest drop-off from one year ago, while bankers in the Little
Rock and Louisville zones also reported declines from a year earlier. By contrast, bankers in the Memphis
Zone reported both higher income and capital spending relative to 2011. Household spending across the
District was more mixed; bankers in the St. Louis and Little Rock zones reported lower levels of household
spending compared with a year earlier, and bankers in the Louisville and Memphis zones reported higher
levels. The next issue comes out in mid-February.

Latest Housing Market Conditions Report
House prices in five of the seven states that comprise the Federal Reserve's Eighth District rose slightly in the
third quarter of 2012, according to the St. Louis Fed’s latest Housing Market Conditions report. At the same
time, the percentage of seriously delinquent mortgages fell in most Eighth District states, (Arkansas and parts
of Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee).


Rules and Regulations: Appraisal Requirements
among Newly Effective Dodd-Frank Rules
Appraisal Requirements for Higher-Priced Mortgage Loans Now Set
Higher-priced mortgage loans now have new appraisal requirements per a final rule issued by six federal
regulators in mid-January. Creditors are now required to use a licensed or certified appraiser who prepares a
written appraisal report based on a physical visit of the interior of the property. The rule also requires creditors
to disclose to applicants information about the purpose of the appraisal and provide consumers with a free
copy of any appraisal report.
If the seller acquired the property for a lower price during the prior six months and the price difference exceeds
certain thresholds, creditors will have to obtain a second appraisal at no cost to the consumer. This
requirement for higher-priced home-purchase mortgage loans is intended to address fraudulent property
flipping by seeking to ensure that the value of the property legitimately increased.
Exemptions: The rule exempts several types of loans, such as qualified mortgages, temporary bridge loans
and construction loans, loans for new manufactured homes, and loans for mobile homes, trailers and boats
that are dwellings. The rule also has exemptions from the second appraisal requirement to facilitate loans in
rural areas and other transactions.
Implementation and future supplements: The rule implements amendments to the Truth in Lending Act
made by the Dodd-Frank Act, which defines mortgage loans as higher-priced if they are secured by a
consumer’s home and have interest rates above certain thresholds.
In response to public comments, the six agencies (the Fed, CFPB, FDIC, FHFA, NCUA and OCC) plan to
publish a supplemental proposal to request additional comment on possible exemptions for “streamlined”
refinance programs and small dollar loans, as well as to seek clarification on whether the rule should apply to
loans secured by existing manufactured homes and certain other property types.

Stress Testing Implemented, Results Coming in March
Publicly disclosed results are due in March for annual stress testing by large financial organizations, per the
Dodd-Frank Act. Smaller companies will not need to disclose publicly the results of their tests, which are to
begin in October 2013.
The Fed started conducting supervisory stress tests for the 19 bank holding companies that participated in the
2009 Supervisory Capital Assessment Program and subsequent Comprehensive Capital Analysis and
Reviews. The final rules also required these companies and their state member bank subsidiaries to conduct
their own Dodd-Frank Act company-run stress tests last fall, with the results to be publicly disclosed in March

In general, other companies subject to this stress testing are required to comply with the final rule beginning in
the fall of 2013. State member banks, bank holding companies and savings and loan holding companies with
between $10 billion and $50 billion in total assets that begin conducting their first company-run stress test in
the fall of 2013 will not have to disclose publicly the results of that first stress test.

Proposed and Out for Comment Rules
Proposed rule regarding enhanced prudential standards and early remediation requirements for
foreign banking organizations and foreign nonbank financial companies—The proposed rule requests
comment on specified enhanced prudential standards for companies that the Financial Stability Oversight
Council (FSOC) has determined pose a grave threat to financial stability. Additionally, certain foreign banking
organizations would be required to form a U.S. intermediate holding company that would generally serve as a
U.S. top-tier holding company for the U.S. subsidiaries of the company. The proposed rule would affect foreign
banking organizations with total consolidated assets of $50 billion or more and foreign nonbank financial
companies supervised by the Board. Comments are due by March 31.
Rule summary
Proposed policy statement on the scenario design framework for stress testing—The Fed is seeking
comments on a proposed policy statement outlining the approach to scenario design for stress testing that
would be used in connection with the annual supervisory and company-run stress tests. The proposed policy
statement outlines the characteristics of the stress test scenarios and explains the considerations and
procedures that underlie the formulation of these scenarios. Comments are due by Feb. 15.
Rule summary