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Are there any downsides to regulation?

Articles & Papers
The prospect of systemic regulation poses numerous
challenges. Systemic risk is difficult to define or measure.
The financial system is global, and many large financial
firms have far-flung international operations. Attempts to
regulate firms tightly in one country will encourage firms
to locate operations where regulation is less stringent.
Although regulation can in principle reduce risk, excessive
regulation can discourage financial innovation and
efficiency to the detriment of economic growth.

Are there any drawbacks to lender-of-last-resort

Some economists argue that central banks should use
open market operations to supply the liquidity required to
ensure the functioning of payment systems and maintain
adequate growth of the money supply, but not lend to
individual firms. The presence of a lender of last resort
can encourage banks and other financial market
participants to take excessive risks. Risk taking can be
discouraged to some extent by charging a penalty rate for
lender-of-last-resort loans, as argued for by Bagehot, and
by imposing losses in the form of deductibles ("haircuts")
on firms that receive government or central bank loans.

Are there any reasons why the Fed should not be
the systemic risk regulator?

Those who argue that the Fed should not be designated
the systemic risk regulator contend that the assignment
could interfere with the Fed's ability to conduct monetary
policy. In particular, additional regulatory authority could

threaten the Fed's political independence, which is crucial
for the conduct of sound monetary policy.

Can government policies cause systemic risk?

If the public expects that the government will protect a
firm's creditors from loss if the firm cannot meet its
obligations, the firm will have an incentive to take more
risks than it otherwise would. The prospect of
government protection of a firm's creditors enables the
firm to borrow on easier terms and hold less capital than
it otherwise could. This in turn increases the likelihood
that the firm will fail. Thus, expected government
intervention to protect the creditors of large financial
firms from losses might increase financial instability. This
is why many economists and policymakers argue for
limiting, or even eliminating, the number of firms that are
considered "too big to fail."

How are commercial bank failures resolved?

The Federal Deposit Insurance Corporation (FDIC) has the
authority to identify and dispose of insolvent commercial
banks and thrifts and is required to do so in the manner
that imposes the least cost on the deposit insurance fund
and, ultimately, the taxpayer. The one exception to this is
in the case of systemically important banks, which may
be resolved in a manner that minimizes systemic risk.
When a bank's primary federal regulator (which may be
the FDIC) identifies a bank as insolvent, the FDIC
immediately steps in and either closes the bank or
assumes responsibility for operating the bank.
Sometimes the FDIC liquidates the bank and pays off
insured deposits. However, it often sells some or all of the
bank's assets to another institution, which may assume
the bank's liabilities, usually with financial assistance
from the FDIC. The entire process is relatively
straightforward and nearly transparent to the failed bank's
insured depositors and other customers.

How are community banks faring?

Community banks face a number of challenges, including
the financial crisis and economic recession. Many
community banks are also heavily exposed to
commercial real estate. Community banks have
expressed concern about the burden of regulation and
about recent and prospective increases in deposit
insurance premiums.

Most community banks entered the recession strong and
well-capitalized. As they have been less heavily involved
in complex financial instruments and subprime mortgage
lending than their larger counterparts, community banks,
in general, have been less vulnerable to the collapse of
global financial markets. Nevertheless, community banks
now have high loan loss provisions and many have
experienced considerable losses on investment
securities, especially on holdings of Fannie Mae and
Freddie Mac equity. However, despite weakening earnings
(community banks' reported net income in 2008 is less
half the level of 2007), a striking majority of community
banks—over 95 percent—remained well capitalized as of
year-end 2008.

How did the stress tests work?

According to the SCAP White Paper released by the Board
of Governors of the Federal Reserve System on April 24,
"the SCAP is a forward-looking exercise designed to
estimate losses, revenues, and reserve needs for BHCs in
2009 and 2010 under two macroeconomic scenarios,
including one that is more adverse than expected." Each
of the 19 banking institutions conducted the forwardlooking exercises using a template provided by bank
supervisors. From this template, the banks were asked to
"forecast internal resources available to absorb losses,
including pre-provision net revenue and the allowance for
loan losses."* The BHCs were required to forecast
potential losses on their first- and second-lien mortgages,
credit cards and other consumer loans, commercial and
industrial loans, commercial real estate loans, other
loans, securities in available-for-sale and hold-to-maturity
portfolios, trading portfolio losses, and counterparty
credit risk. The forecasts were based on two scenarios
about the likely paths for U.S. GDP, unemployment, and
house prices provided by regulators: a baseline scenario
and a more adverse scenario. After the banks submitted
their initial reports, bank regulators worked with the banks
to refine their estimates of required capital. Finally,
regulators determined how much, if any, additional capital
each bank will be required to raise to comply with
regulatory minimums under the adverse economic
scenario. Banks found to be capital deficient have six
months to raise additional capital from private sources or
from the U.S. Treasury.
*Pre-provision net revenue (PPNR) is defined as net
interest income plus non-interest income less noninterest expense. According to the Board of Governors'
White Paper, PPNR is the income after non-credit-related
expenses that would flow into the firms before they take
provisions or other write-downs or losses.

How does bank supervision come into play?

A potential drawback of deposit insurance is that it can
encourage banks to take excessive risks (a phenomenon
referred to as "moral hazard"), which in turn increases the
likelihood of failure. Deposit insurance removes a
potential source of market discipline in that insured
depositors have little incentive to monitor the activities of
their banks or to force banks to pay higher interest rates if
they assume more risk. Hence, deposit insurance
encourages banks to hold less capital and take more
risks than they otherwise would, which increases the
likelihood of failure. Banking supervision can help ensure
the safety and soundness of insured banks and thrifts,
and thereby limit potential losses to the deposit insurance
funds from failures. Further, banks are subject to "prompt
corrective action" measures if their capital falls below
required minimums or regulators determine that their risk
management practices are inadequate. For example,
regulators can force banks to suspend their dividends,
replace management, or place them under
conservatorship or receivership.

How does the current financial crisis compare
with the financial crisis of the Great Depression?

The current financial crisis is certainly the most severe
since the 1930s. During the Depression, the stock market
lost over 80 percent of its value and thousands of banks
failed. Approximately one-half of all residential
mortgages were delinquent as of January 1, 1934, though
the residential mortgage foreclosure rate was a
comparatively modest 1.3 percent at its peak in 1933.
The stock market has declined sharply during the current
crisis. For example, the S&P 500 Composite Index fell 43
percent between October 2007 and December 2008,
which is similar to the decline during the bear market of
1973-74. Several large financial firms have experienced
multibillion dollar losses and a few have failed. Still, only
25 banks failed during 2008, and most of them were very
small. By contrast, more than 100 banks failed in every
year from 1985 to 1992, including 221 in 1988, and many
more savings and loan associations failed. Of course,
most of those banks and S&Ls were also small, but many
large banks also experienced substantial losses.
In the mortgage market, as of the third quarter of 2008,
12.5 percent of (conventional) subprime mortgages were
in foreclosure and another 7.2 percent were 90 or more
days past due. However, just 1.6 percent of prime
mortgages were in foreclosure and another 1.3 percent
were 90 or more days past due. Delinquency and
foreclosure rates of prime mortgages are much higher
than normal, but the problems in the smaller subprime
market remain much more acute. Unfortunately, the data
on mortgage delinquency and foreclosure rates for the

Great Depression are not strictly comparable with the
data for the current crisis. However, while severe, the
current level of distress in U.S. mortgage markets is not
as severe as the distress in those markets during the
Great Depression.

How does the current recession compare with
the Great Depression?

The Great Depression of the 1930s was the most severe
U.S. economic downturn of the 20th century. Between
1929 and 1933, the nation's production of goods and
services (GDP) fell nearly 30 percent, the unemployment
rate reached 25 percent of the labor force, and the
consumer price level also declined by some 30 percent.
Most economists do not expect the current recession to
rival the Great Depression in its severity, though some
predict a rather severe recession by recent standards.
The current recession began in the fourth quarter of 2007,
and GDP actually increased during the first half of 2008.
GDP fell at a modest 0.5 percent annual rate in the third
quarter of 2008, but at a 6.3 percent annual rate in the
fourth quarter. Many economists expect that GDP will
contract still further in the first half of 2009 before the
economy starts to expand. The unemployment rate was
7.2 percent in December 2008, a full percentage point
higher than it had been in September. Many analysts
expect that the unemployment rate will climb still higher,
but few expect the unemployment rate to reach
Depression levels, or even the 10.8 percent rate of
November-December 1982, which was the highest
monthly rate since the 1930s. Finally, the consumer price
level was essentially unchanged over the year ending in
December. Some observers expect the price level to fall in
the months ahead, but few predict deflation on the scale
of the Great Depression.
For more information about the Great Depression, geared
toward educators, see the St. Louis Fed's Great
Depression Curriculum web site.

How easy will it be to unwind the various
programs that have expanded the Fed's balance

Some programs, such as the Term Auction Facility (TAF),
would be easy to terminate. TAF loans have short, limited
terms (e.g., 84 days), and the Fed could simply choose
not to continue TAF auctions. Other programs may take
longer to eliminate. For example, it might be difficult for
the Fed to dispose of loans made under the Term Asset-

Backed Loan Facility (TALF) or the loans made to rescue
Bear Stearns or AIG. Conceivably, it might be difficult to
sell mortgage-backed securities acquired through openmarket operations. The Federal Reserve and Treasury
Department have discussed possible measures that
would enable the Fed to effectively prevent its lending
programs from expanding the monetary base. Those
discussions are continuing. On June 25, 2009, the Board
of Governors announced various changes to its programs
and facilities due to improving financial conditions and
other developments within specific markets. Some
programs were expanded; some were reduced or
stopped. For example, the size of TAF auctions was
trimmed as these auctions were undersubscribed. See
additional details in the Board’s press release at:

How has FDIC insurance coverage changed as a
result of the financial crisis?

In October 2008, Congress enacted The Emergency
Economic Stabilization Act (EESA), which temporarily
raised deposit insurance coverage limits from $100,000
to $250,000 through the end of 2009. The coverage limits
were extended through the end of 2013 under the Helping
Families Save their Homes Act of 2009, which President
Obama signed on May 20, 2009. The FDIC also
temporarily expanded its insurance coverage to provide
unlimited coverage for non-interest-bearing deposit
transaction accounts for banks participating in the FDIC's
Temporary Liquidity Guarantee Program. This expanded
coverage means that payment processing accounts such
as payroll accounts, demand deposit accounts, and lowinterest NOW accounts have unlimited insurance

How has the financial crisis affected the Fed’s
monetary policy?

The financial crisis has interfered with the Fed's ability to
operate a conventional monetary policy. Lender-of-lastresort measures have been a primary focus. The FOMC
has reduced its target for the federal funds rate
essentially to zero—"conventional" monetary policy is now
off the table. The Federal Reserve has pursued
unconventional policy options, such as the purchase of
long-term Treasury securities and mortgage-backed

How have the Fed's lender-of-last-resort
activities affected its monetary policy?

The Federal Reserve began to ease monetary policy in
late 2007 when it became apparent that financial market
strains threatened the broader economy. The FOMC
reduced its target for the federal funds rate in a series of
steps to its current near-zero level. Before September
2008, however, the Fed did not permit the operations of
the various lending facilities to increase the size of the
Fed's balance sheet or growth of the monetary base.
Since then, however, continued expansion of some of the
special lending facilities and open market purchases of
Treasury and other securities authorized by the FOMC
have caused the size of the balance sheet and the
monetary base to increase sharply.

How is the FDIC’s special assessment

Banks will be required to pay the 5-basis-point special
assessment in September 2009 based on June 2009
deposits. The amount of the assessment, however,
cannot exceed 10 basis points times the institution's
assessment base for its regular second quarter 2009 riskbased assessment.
The FDIC Board also allowed for the possibility of
charging additional emergency 5-basis-point
assessments after June 2009 if the Board determines
that assessments are necessary to maintain public
confidence in the deposit insurance system. The FDIC
has indicted that at least one additional 5-basis-point
assessment before January 1, 2010 is "probable."*
In reducing the special assessment, the FDIC also
changed how the assessment would be calculated by
imposing the charge based on a depository institution's
assets minus Tier 1 capital (as of June 30, 2009) rather
than on its deposit base. Smaller banks have argued that
larger banks that pose greater risks to the entire banking
system should be required to pay a higher premium. The
change in calculation for this special assessment is being
viewed by smaller banks as accomplishing this.
*See the May 22, 2009, FDIC Financial Institution Letter
FIL-23-2009 "Special Assessment Final Rule."

How large is the Fed's balance sheet?

In mid-2008, the balance sheet (total assets) was
approximately $900 billion. For the week ending July 8,
2009, the balance sheet stood at close to $1.99 trillion.
Balance sheet information is updated every Thursday
afternoon in the H.4.1 report, which can be found on the
Board's web site at

How large is the monetary base?

The monetary base as of mid-2008 was approximately
$800 billion. As of the two-week period ending July 1,
2009, the base stood at close to $1.62 trillion. The latest
monetary base data are available on the Board's web site
*As of July 1, 2009, the base totaled $1.618 trillion. (View
a chart of the monetary base at
The monetary base, adjusted for changes in reserve
requirements, totaled $1.622 trillion. (View a chart of the
monetary base adjusted for changes in reserve
requirements at

If Bear Stearns and AIG were deemed too big to
fail, why was Lehman Brothers allowed to fail?

The Federal Reserve and Treasury Department have
intervened to prevent the failure of firms that posed
significant systemic risks to the financial system and
broader economy. In the case of American International
Group (AIG), Chairman Bernanke has noted that "at best,
the consequences of AIG's failure would have been a
significant intensification of an already severe financial
crisis and a further worsening of global economic
conditions. Conceivably, its failure could have resulted in
a 1930s-style global financial and economic meltdown,
with catastrophic implications for production, income,
and jobs." By contrast, Bernanke has stated, "the troubles
at Lehman had been well known for some time, and
investors clearly recognized ... that the failure of the firm
was a significant possibility. Thus, we judged that
investors and counterparties had time to take
precautionary measures." It should also be noted,
however, that the Federal Reserve and Treasury
Department did try to facilitate an acquisition of Lehman
Brothers by another bank, but ultimately were
unsuccessful. Lehman Brothers filed for Chapter 11
bankruptcy protection on September 15, 2008. Chairman
Bernanke has since stated that "Lehman proved that you
cannot let a large internationally active firm fail in the
middle of a financial crisis."*

*The source is the 60 Minutes interview that aired on
March 15, 2009. Bernanke went on to say that the Fed
could not have prevented Lehman's failure at the time
because it could not have injected capital in Lehman—
only Treasury could do that. Rather, the Fed was
restricted to making loans collateralized by high-quality
financial assets, such as U.S. Treasury securities or
agency securities.

Is it important that bank deposits at the Fed now
are the Fed's largest liability?

The Fed extends credit under its new programs by
increasing the deposits of banks and other depository
institutions at the Federal Reserve. The Fed pays interest
on these deposits at approximately the overnight market
rate on federal funds to reduce the burden on banks of
holding these deposits. As long as the economy is weak
and demand for loans is low, the extra deposits held at
the Fed carry little risk of igniting inflation. However, the
Fed must seek ways to reduce these deposits as
economic activity rebounds to limit the potential risk they
pose for causing an undesirably large increase in bank
lending and growth of the nation’s money supply.

Is it possible to measure systemic risk?

Economists, regulatory agencies, and institutions such as
the International Monetary Fund (IMF) have attempted to
develop forward-looking indicators designed to warn
policymakers of developing instabilities that could pose a
systemic risk to the financial system. One common
measure of risk is the difference between the yield on a
U.S. Treasury security (considered free from default risk)
and the yield on an asset that is not free from default risk,
such as a corporate bond or commercial paper. Known as
credit risk spreads, these indicators typically increase
during times of financial market stress. Other measures
of risk in financial markets include measures of volatility
in stock and bond markets, and the prices of credit
default insurance contracts for individual firms.*
*These and other measures are discussed in the IMF’s
Global Financial Stability Report issued in April 2009.

Is my bank deposit safe?

The Federal Deposit Insurance Corporation protects
depositors against loss of their insured deposits if an
FDIC-insured bank or savings association fails. If a
depositor's accounts at one FDIC-insured bank or savings
association total $250,000 or less, the deposits are fully
insured. A depositor can have more than $250,000 at one
insured bank or savings association and still be fully
insured provided the accounts meet certain requirements.
Share accounts at federally insured credit unions are
similarly insured by the National Credit Union
Administration. For more information, see the web site and NCUA's Share
Insurance Toolkit.

Should regulators attempt to control systemic

There is scope for government intervention to limit risk
taking by firms whose failure would impose significant
losses on other firms or markets. When the losses
resulting from the failure of a firm extend beyond the
firm's shareholders and creditors, the firm will have an
incentive to assume more risk than is socially desirable.
Private solutions to mitigate systemic risk may be
infeasible or undesirable.

Should the Federal Reserve be the systemic risk

Those who advocate lodging responsibility for systemic
regulation within the Federal Reserve note that the Fed's
responsibilities, experience, and resources make it
uniquely suited to be a systemic risk regulator.
Importantly, the Federal Reserve is the lender of last
resort for the banking system and exercises considerable
oversight of the nation's payments system. Further, the
Federal Reserve already monitors broad economic and
financial trends in carrying out its monetary policy

Should the United States have a systemic risk

Currently, there is no single regulatory agency with
authority to supervise or regulate all systemically
important firms and markets, and many economists and
policymakers have argued for the creation of a systemic

risk regulator to assume that responsibility. Most
proposals are not specific about the authority and
responsibility that would be assigned to the systemic
regulator. However, many argue that a regulator should
have the authority to resolve systemically important
insolvent nonbank financial firms (similar to the authority
that the FDIC has to close and resolve insolvent banks
and thrifts), as well as authority to monitor and regulate
practices that pose systemic risks to the financial
system. On June 17, 2009, the U.S Treasury Department
released a proposal for reforming the financial regulatory
system. The proposal called for the creation of a
Financial Services Oversight Council and for new
authority for the Federal Reserve to supervise all firms
that pose a threat to financial stability, including firms
that do not own a bank. See the proposal at:

What are community banks?

Any bank with assets of $1 billion or less is commonly
referred to as a community bank. There is considerable
variety among this group of banks, however, in terms of
their size, location (e.g., urban vs. rural), and scope of
Community banks play a key role in the provision of credit
to small businesses and retail customers across the
nation and are therefore important to the U.S. economy.
They are particularly important in rural communities and
smaller cities—and in the Eighth Federal Reserve District.
Most community banks generate a higher percentage of
their earnings from traditional banking activities—i.e.,
taking deposits and offering loans—than do larger banks.
Their business model, known as "relationship lending,"
emphasizes ongoing bank-client personal interactions.
Community banks usually have a good understanding of
the communities they serve and build on their reputation
and personalized service.

What are some examples of how the Federal
Reserve has served as lender of last resort
during the current financial crisis?

The Federal Reserve has taken several measures to
ameliorate the financial crisis. In addition to providing
loans to banks and other depository institutions through
its discount window lending programs, the Fed has
established several new facilities to provide liquidity to
banks and primary dealers since the fall of 2007,
including the Term Auction Facility, the Primary Dealer
Credit Facility, and the Term Securities Lending Facility.*

The Fed has also established programs to provide
liquidity to various markets, including the Commercial
Paper Funding Facility, the Money Market Investor
Funding Facility, and the Term Asset Backed Loan Facility.
Finally, under authority granted in Section 13(3) of the
Federal Reserve Act, the Fed has provided loans to
support specific institutions in order to avert their
disorderly failures, which could have led to severe
dislocations and strains in the financial system as a
whole and harmed the U.S. economy.**
*Primary dealers are banks and securities broker-dealers
that trade in U.S. government securities with the Federal
Reserve Bank of New York.
**Section 13(3) of the Federal Reserve Act authorizes the
Federal Reserve to lend in "unusual and exigent
circumstances" to any individual, partnership, or
corporation, provided that the party is unable to obtain
adequate credit from other banking institutions.

What are the possible implications of
Commercial Real Estate (CRE) exposures to
community banks?

Community banks tend to have limited opportunities for
diversification due to the narrower scope of their
businesses. For the past two decades, community banks
have demonstrated a steady increase in exposure to
commercial real estate loans, with the average share of
CRE loans out of total loans rising from about 21 percent
in 1989 to about 46 percent in 2008. At the same time,
consumer lending has gradually diminished in
importance, with the average share of consumer loans
out of total loans decreasing from about 21 percent in
1989 to 5 percent in 2008.
Credit quality data indicate a continued worsening in the
fundamentals for the commercial real estate sector
(occupancy, rental rates, etc.) and challenging liquidity
environment. Delinquency rates and watch-list loans are
increasing. As CRE property prices are likely to follow the
residential real-estate cycle by about a year, community
banks' CRE exposures may become a serious problem in
the near future.

What are the stress tests?

Formally known as the Supervisory Capital Assessment
Program (SCAP), the stress tests were designed as
forward-looking exercises to inform banks and their
federal regulators if the banks had sufficient capital in
place to weather a normal recession or a relatively severe

recession—in short, they were "what if" scenarios. Under
current regulations, the ratio of a bank's capital—its net
worth, or equity capital—to its risk-weighted assets
(designated either Tier 1 or Tier 2) must exceed 10
percent for the bank to be considered well capitalized. A
bank's capital ratio must exceed 6 percent to avoid
supervisory intervention ("prompt corrective action").*
*To be considered well capitalized, Tier 1 capital must
exceed 6 percent of total risk-weighted assets, and to
avoid prompt corrective action, Tier 1 capital must
exceed 3 percent of assets.

What assets does the Federal Reserve own?

In normal economic conditions, the Federal Reserve's
largest asset class is securities issued by the Treasury.
Other assets may include securities issued by federal
agencies, loans to depository financial institutions, and
foreign currencies. In extraordinary times, other assets
may be held, including loans to private firms and loans to
special purpose corporations that are owned by the
Federal Reserve to reduce stress in certain credit

What caused the financial crisis?

Many analysts blame the financial crisis on at least three
interrelated causes: 1) Rapid growth and subsequent
collapse of U.S. house prices; 2) a general decline in
mortgage underwriting standards, reflected in a growing
proportion of home purchases financed by nonprime
mortgages; and 3) widespread mismanagement of
financial risks by firms engaged in originating,
distributing, and investing in mortgages, mortgagebacked securities, and derivative financial instruments.
Mortgage delinquencies and foreclosures rose sharply
after U.S. house prices peaked and began to fall in early
2007. Banks and other financial intermediaries then
began to experience large losses on their holdings of
nonprime residential mortgages and mortgage-backed
securities. By August 2007, these losses sparked a
widespread loss of confidence in banks and other
financial intermediaries, as investors suddenly became
much less willing to bear credit risks. Banks tightened
their lending standards, which reduced the availability of
loans and increased their cost. As investors retreated to
the safety of government bonds and other low-risk
securities, the market yields on risky debt securities were
driven up relative to yields on U.S. Treasury securities.
Investor concerns intensified during 2008 as financial
losses continued to mount. The crisis reached a boiling
point in September 2008 when the bankruptcy of Lehman

Brothers and near-bankruptcy of American International
Group (AIG) sparked panic selling in the stock market and
drove the yields on risky securities sharply higher relative
to those on risk-free securities.

What causes increases and decreases in the size
of the monetary base?

In normal times, the monetary base increases and
decreases roughly dollar-for-dollar with changes in the
amount of assets held by the Federal Reserve because,
when the Federal Reserve purchases an asset such as a
Treasury security, it writes a check drawn on itself. Unless
the amount of at least one liability changes on the Federal
Reserve's balance sheet, the monetary base does not
(and cannot) change; that is, actions of households,
businesses, and financial institutions alone cannot
change the size of the monetary base. The recipient
deposits the check at his bank, which sends the check to
the Fed so that the check's amount may be credited to its
Federal Reserve account. The funds at the Fed are
valuable because they may be used to pay debts due, on
behalf of customers, to other banks.

What explains the enormous increase in the total
assets and liabilities of the Federal Reserve
System since September 2008?

The Federal Reserve has supported the financial system
in part by lending to a variety of banks and other firms.
These loans, which are assets of Federal Reserve Banks,
increase the deposits of banks and other depository
institutions held at Federal Reserve Banks. Those
deposits are liabilities of the Federal Reserve Banks. In
the absence of offsetting transactions, such as openmarket sales of government securities from the Federal
Reserve System portfolio, these loans increase the stock
of bank reserves.,

What happens to a bank that fails a stress test?

Banks cannot "fail" the stress test. However, those
determined to have insufficient capital to weather likely
losses under the adverse economic scenario are required
to raise additional capital, either privately or by converting
preferred stock held by the federal government under the
Treasury's Capital Purchase Program. The latter funds

would take the form of mandatory convertible preferred
shares that can be converted to common equity (at the
bank's discretion but with regulatory approval) at a
conversion price set at a 10 percent discount from the
prevailing price of the BHC's stock price as of February 9,

What impact does regulation have on community

The cost of regulation is particularly high for community
banks with their small asset bases and income streams.
Although large institutions have in-house experts and
departments dedicated to risk management and
compliance, a community bank may have only one person
responsible for addressing these issues. Some
community banks outsource technology and experts at
great cost.

What impact will increased assessment rates
have on banks?

The FDIC determined that a one-time 5-basis-point
special assessment on insured institutions would reduce
equity capital for the industry as a whole by
approximately 0.2 percent. The FDIC also determined that
the assessment would cause two institutions' equity-toassets ratios to fall below 4 percent (the ratio below
which an institution is considered undercapitalized by
regulators), with one falling below 2 percent. The FDIC
also determined that the special assessment would
reduce 2009 pre-tax income for profitable institutions by
5.1 percent, and increase average pre-tax losses for
unprofitable banks by 2 percent.

What is "credit easing"?

Federal Reserve Chairman Ben Bernanke describes the
Fed's monetary policy as "credit easing."* This approach
emphasizes the composition of the Fed’s balance sheet,
as well as its size. Proponents of credit easing argue that
the Fed can have more impact through targeted lending
to specific institutions and markets than it can simply by
adding to the size of its balance sheet by purchasing
Treasury securities. For example, purchases of mortgagebacked securities may have more impact on mortgage
rates and the housing market than do purchases of
Treasury securities. There is limited evidence, however,

that changes in the composition of the Fed balance sheet
have significant effects apart from changes in the total
size of the balance sheet, and some economists have
questioned the efficacy of targeted lending programs.*
*"The Crisis and the Policy Response," The Stamp Lecture,
London, England, Jan. 13, 2009

What is meant by the term "lender of last

A lender of last resort is the ultimate source of credit for a
country's banking or financial system. The 19th century
British banker and journalist Walter Bagehot asserted that
in a financial crisis, a lender of last resort should lend
freely against collateral at a penalty rate—that is, an
interest rate higher than the market rate. The Federal
Reserve System and other central banks were established
in part to serve as lender of last resort to the banking
system by providing liquidity when banks are unable to
obtain funds from other banks or in credit markets.
Traditionally, central banks carried out the lender-of-lastresort function by lending directly to banks. However, in
modern times, the lender-of-last-resort role has expanded
to include the provision of emergency liquidity through
various channels such as open market operations to
ensure the continued functioning of financial markets and
payments systems.

What is meant by "too big to fail"?

A firm is deemed too big to fail (TBTF) if its failure would
likely cause significant damage to the financial system
and broader economy. Such firms are often referred to as
"systemically important" because of their size or
complexity. In practice, TBTF implies that the government
will protect a firm's creditors from loss if the firm is
unable to meet its obligations. A joint statement by the
U.S. Treasury Secretary and the heads of the federal bank
regulatory agencies on February 10, 2009, indicated that
"the U.S. government remains committed to preventing
the failure of any financial institutions where that failure
would pose a systemic risk to the economy."* The 19
bank holding companies subjected to the "stress test" are
among those firms widely thought to be too big to fail.
TBTF does not necessarily imply that the firm's
shareholders, management, or employees will be
protected from loss. During the recent period of financial
turmoil, the Federal Reserve and Treasury Department
have intervened to prevent the failure of Fannie Mae,
Freddie Mac, and AIG; to facilitate the acquisition of Bear

Stearns by JPMorgan Chase; and to assist Citigroup and
Bank of America. In several cases the shareholders of the
firm lost most or all of their investment and the firm's
senior executives were dismissed. However, officials
believed that it was necessary to protect the creditors of
these firms to avoid imposing severe losses on other
firms and seriously disrupting financial markets, which
would threaten the broader economy.

What is "moral hazard" and is it related to TBTF?

Moral hazard refers to the incentive for increased risktaking created by insurance. For example, a firm would
more likely locate in a flood plain if it expects that the
government will protect it from flood losses. Similarly,
creditors are more willing to lend to a firm when they
expect to be protected from loss if the firm is unable to
meet its financial obligations. When investors expect that
a firm is too big to fail, they expect that the government
will protect the firm's creditors from loss. As a result,
other firms will be more willing to lend to the firm or
purchase the firm's debt than if they do not anticipate
such protection. Very large financial firms are able to
issue more debt at lower cost than smaller firms because
the public expects government protection from loss. An
explicit or implicit government guarantee enables (and
encourages) very large financial firms to finance their
operations with debt to a much greater extent than they
could without a government guarantee, which in turn
makes them more likely to fail. Many economists are
concerned about the incentive for excessive risk taking
created by TBTF and thus argue that TBTF must be
limited to avoid future crises.

What is "quantitative easing"?

Quantitative easing refers to a monetary policy of
increasing the growth of a monetary aggregate. Some
economists, including some Federal Reserve economists
and policymakers, advocate using open market
purchases of U.S. Treasury securities to systematically
increase the size of the monetary base. The Fed has
continued to purchase Treasury and other securities
since the intended fed funds rate was cut to zero. Such
purchases increase the size of the Fed's balance sheet
and thus the monetary base. St. Louis Fed President
James Bullard has advocated a policy of systematically
expanding the "permanent" components of the Fed's
balance sheet and monetary base to reduce the likelihood
of deflation, and then slowing base growth as deflation
risks recede.*

*President Bullard’s views are elaborated in "Dial 'M' for
Monetary Policy," remarks before the New York
Association for Business Economics, New York, Feb. 17,
The permanent components include long-term Treasury
securities, agency debt, mortgage-backed securities, and
other assets that the Fed will likely hold over several
years. By contrast, short-term loan programs, such as
credit extended under the Term Auction Facility (TAF),
can be terminated quickly and thus are considered
temporary components.

What is systemic risk?

There is no universally accepted definition of systemic
risk. However, the general idea is that systemic risk
reflects the potential for some sudden, unforeseen
economic event—what economists call a shock—to cause
considerable disruption and turmoil in financial markets.
The shock may be the failure of a large bank or other
financial firm, a default by a country on its outstanding
debt, an act of war, or a natural disaster. The ensuing
turmoil spreads to the broader economy through changes
in interest rates, stock prices, lending activity, and
expectations about future economic growth that
influence spending decisions by households and firms.

What is systemic risk, and what role has it
played in the responses of the Federal Reserve
and other agencies to the financial crisis?

Systemic risk refers to a risk to an entire financial market
or system, not just to a single or small number of firms.
Systemic risk reflects the potential for the failure of one
firm or market to severely impair or even cause the failure
of other healthy firms or markets-and possibly the entire
economy. The failure of a large financial firm is more
likely to pose systemic risk than the failure of a large
nonfinancial firm for several reasons, including 1) the
large volume and speed of financial transactions that
large financial firms engage in with each other, 2) the high
leverage (i.e., high level of debt relative to total assets) of
many large financial firms, and 3) their tendency to fund
holdings of long-term assets with short-term debt. In
providing loans and other assistance to stabilize certain
troubled firms (such as Bear Stearns and AIG), the
Federal Reserve and Treasury acted to avoid systemic
risks associated with the disruptions that the failure of
those firms could have had on financial markets and the

What is the Federal Reserve balance sheet?

Similar to other businesses, the Federal Reserve System
has assets and liabilities. The balance sheet lists the
Fed’s assets and liabilities. The term “balance sheet”
refers to the fact that total assets equal the sum of
liabilities plus capital. This is true no matter how the
various items on the balance sheet change. For example:
If the Fed purchases an asset, no other asset changes,
and capital is unchanged, then one or more liability items
must change. Or, in some cases, one asset might
increase and another decrease, or one or more liability
items might increase and others decrease. Regardless of
which items change, accounting rules force the balance
sheet to “balance” with total assets equal to the sum of
total liabilities plus capital.

What is the Fed’s role in supervising community

The Federal Reserve is responsible for supervising statechartered community banks that are members of the
Federal Reserve System, as well as all bank holding
companies. As of the third quarter of 2008, the Fed
supervised 783 community banks across the nation,
accounting for about 12 percent of all community banks.
The Fed strives to promote safety and soundness among
state-member community banks through effective
inspections, monitoring of risk and management
practices, rule-making, and issuing guidelines.

What is the monetary base?

The monetary base is the narrowest measure of money
used by economists. It consists of deposits held at the
Federal Reserve by depository financial institutions
(including commercial banks, savings banks and credit
unions) plus all coin and currency held by households and
businesses, including depository institutions.

What liabilities does the Federal Reserve have?

The Fed's largest liability is Federal Reserve notes; that is,
currency held by banks and the public. Other liabilities

include deposits held at the Fed by depository institutions
and by the Treasury.

What might be done about TBTF?

Fixing TBTF is a difficult problem. Several proposals have
been suggested for discouraging financial firms from
growing too large or complex, including progressive
capital requirements and increased supervision.
Minneapolis Fed President Gary Stern has argued that
"systemic focused supervision" is necessary to address
systemic risks posed by very large financial firms. In his
view, this would include (i) early identification of possible
problems through initiatives such as stress tests, (ii)
enhanced prompt corrective action that would allow
supervisors to take specific action against an institution if
its capital fell below certain standards, and (iii) explicit
communication from policymakers to the capital
markets. Another proposal calls for requiring all
systemically important firms to have a "shelf-ready"
bankruptcy plan in place that would require them to track
and document their potential losses and counterparty risk
in the event a quick dissolution of the company was
required (say, over a weekend).* However, because many
large financial firms have global operations, any
comprehensive regulation is difficult if not impossible.
* See the 2008 Homer Jones Memorial Lecture by Raghu
Rajan on the St. Louis Fed’s web site:

What role has deposit insurance played in the
current financial crisis?

Deposit insurance has been a stabilizing influence during
the financial crisis. Before the advent of federal deposit
insurance in 1933, the U.S. banking system had suffered
several banking panics and crises. In many instances, the
failure of a major bank or other firm triggered runs on all
banks by frightened depositors. Bank runs sometimes
forced banks to curtail lending or close altogether, and
reduced the nation's money supply. Many economists
believe that banking panics were a principal cause of the
financial crisis and economic depression of the early
1930s. The Banking Act of 1933 established a temporary
system of federal deposit insurance, which was later
made permanent and extended to thrift institutions and
credit unions. There have been no major banking panics
in the United States since 1933.

What were the results of the stress test?

The assessment found that, as of December 31, 2008,
nine of the 19 firms examined had adequate capital to
maintain Tier 1 capital in excess of 6 percent of total
assets and common equity capital in excess of 4 percent
under the more adverse economic scenario. However, the
remaining 10 firms must raise a total of $75 billion of
additional capital to establish the capital buffer required
under the program. These banks must raise the additional
capital by early November 2009.

Where can I learn more about home mortgage
foreclosures, especially what is being done to
assist homeowners facing foreclosure?

For information about mortgage foreclosures, including
data, analysis, and consumer information, see the St.
Louis Fed's Foreclosure Resource Center.

Which financial institutions were subject to a
stress test?

The SCAP was limited to the 19 largest bank holding
companies (BHCs) in the United States with assets that
exceed $100 billion. As of December 31, 2008, these
institutions collectively held about two-thirds of the
banking assets and more than half of the loans in the U.S.
banking system.
The following BHCs were subject to the stress test:
JP Morgan Chase & Co.
Bank of America Corp.
Wells Fargo & Co.
Goldman Sachs Group
Morgan Stanley
PNC Financial
Services Group
US Bancorp
Bank of NY Mellon Corp.
SunTrust Banks Inc.
State Street Corp.
Capital One
Financial Corp.
BB&T Corp.
Regions Financial Corp.
American Express Co.
Fifth Third Bancorp

Which firms are "systemically important"?

Systemically important firms are those whose failure
would likely impose severe losses on other firms or
markets. The failure of a large financial firm is more likely
to pose systemic risk than the failure of a large
nonfinancial firm for several reasons, including: (i) the
large volume and speed of financial transactions that
large financial firms engage in with each other; (ii) the
high leverage—that is, high level of debt relative to total
assets—of many large financial firms; and (iii) their
tendency to fund holdings of long-term assets, such as
residential or commercial mortgages, with short-term
debt such as commercial paper and demand deposit

Why did the FDIC increase its deposit insurance

With 25 bank failures in 2008, the FDIC's Deposit
Insurance Fund (DIF) had dropped to $18.7 billion by the
end of 2008, its lowest level since 1993. These failures
caused the DIF reserve ratio to decline from 1.19 percent
as of March 30, 2008, to 0.40 percent as of December 31,
2008. To ensure that the DIF reserve ratio is restored to at
least 1.15 percent, and anticipating between 100 and 500
failures in 2009, the FDIC's Board voted in February 2009
to set the quarterly initial base assessment rate at 12 to
45 basis points beginning in the second quarter of 2009.
The previous base rate ranged from 2 to 40 basis points
depending on the risk category of the institution. In
general, banks with a rapid asset growth and significant
reliance on brokered deposits will pay premiums on the
higher end of the range since these factors tend to make
bank resolutions more costly for the FDIC.
The FDIC Board also voted in February to impose a 20basis-point special assessment on insured institutions to
prevent the Fund from running out of money. The
assessment was lowered to 5 basis points by the FDIC's
Board on May 22, 2009, following an increase in the
FDIC's borrowing authority with the U.S. Treasury.*
*The Helping Families Save Their Homes Act of 2009
increases the FDIC's borrowing authority with the U.S.
Treasury to $100 billion from $30 billion (where it has
stood since 1991). The Act also creates a mechanism by
which the FDIC's borrowing authority could be temporarily
increased to $500 billion. Although the FDIC has never
used its borrowing authority in its more than 75-year
history, FDIC Chairwoman Sheila Bair has testified before
the Senate that this increase would allow the FDIC to
reduce the extra premiums banks would have to pay to
replenish the insurance fund.

Why did the Federal Reserve provide loans to
American International Group (AIG) but not to
Lehman Brothers?

The Federal Reserve has made loans to prevent the
failure of firms that posed significant systemic risks to
the financial system and broader economy. In the case of
AIG, Chairman Bernanke has noted that "at best, the
consequences of AIG's failure would have been a
significant intensification of an already severe financial
crisis and a further worsening of global economic
conditions. Conceivably, its failure could have resulted in
a 1930s-style global financial and economic meltdown,
with catastrophic implications for production, income,
and jobs." By contrast, Bernanke states, "the troubles at
Lehman had been well known for some time, and
investors clearly recognized ... that the failure of the firm
was a significant possibility. Thus, we judged that
investors and counterparties had time to take
precautionary measures."

Why has the Federal Reserve balance sheet
increased so rapidly since September 2008?

Since December 2007, the Fed has introduced a number
of programs to assist depository institutions facing
difficulty raising funds in private markets, and credit
markets outside the banking system stressed by extreme
investor uncertainty regarding future economic
conditions. Prior to mid-September 2008, Fed actions
under these programs that tended to increase the balance
sheet were offset by the Fed selling Treasury securities
from its portfolio. Since mid-September, it has not been
possible to offset the effects of additional programs, and
the balance sheet has expanded. More recently, the Fed
has begun a program to purchase large amounts of U.S.
Treasury and agency (Fannie Mae and Freddie Mac)
securities. Each purchase is made with funds drawn
against Federal Reserve Bank accounts. When these are
cleared and presented to the Fed, bank deposits held at
the Fed increase dollar-for-dollar.

Why has the monetary base grown during the
past year?

During the past year and a half, the Federal Reserve has
introduced a number of programs to reduce stress in
financial markets. These programs have greatly increased
the amount of assets held by the Federal Reserve—and, in

turn, the monetary base. The assets in these
nontraditional programs have been paid for with deposits
at the Federal Reserve. Paying for purchased assets with
deposits at the Fed causes increases in the monetary
base dollar-for-dollar.

Why is the government reluctant to let large
financial firms file for bankruptcy protection?

Federal Reserve and Treasury officials believe that
bankruptcy is not a viable option for resolving very large
financial firms because, under current law, bankruptcy
proceedings can be protracted and entail considerable
uncertainty, which would tend to exacerbate a financial
crisis. FDIC Chairman Sheila Bair recently argued that "the
legal features of a bankruptcy filing itself triggered asset
fire sales and destroyed the liquidity of a large share of
claims against Lehman ... The liquidity and asset fire sale
shock from the Lehman bankruptcy caused a marketwide liquidity shortage."* Federal Reserve and Treasury
officials have asked Congress to enact legislation for new
authority and procedures for resolving failures of large
financial institutions.
*Congressional testimony, May 6, 2009. See

Why is the monetary base important?

Financial assets included in the monetary base are used
for "final" settlement of transactions in the economy—
currency for hand-to-hand payment among persons and
businesses and deposits at the Fed for bank-to-bank
settlement that is irrevocable (including check clearing
and wire payments—hence, the label of "base" (that is,
basic) money. The components of the monetary base
also may be used to satisfy statutory reserve
requirements. Historically, too rapid an increase in the
monetary base during periods of economic prosperity has
been followed by increased inflation. Economic models
suggest that, during financial crises, the monetary base
may expand greatly without generating higher inflation.

Why were the stress tests performed?

The stress tests were conducted to identify the likely
capital needs of the 19 large banking organizations under
alternative economic scenarios, including a scenario
involving worse economic conditions than are presently

forecast. Uncertainty about the value of real estate loans
and other impaired assets (mostly asset-backed
securities) in bank portfolios has made it difficult for
supervisors and market participants to assess the true
condition of the largest banks.

Will the large increase in the Fed's balance sheet
and monetary base cause inflation?

Many economists consider deflation to be a greater risk
than inflation in the current environment, and a
systematic expansion of the Fed's balance sheet and the
monetary base is one approach that could help reduce
the risk of deflation in the short term. However, base
growth must be slowed as deflation risks abate to ensure
price stability in the long run. Monetary policymakers
cannot lose sight of the longer-term effects of their
policies. Monetary policy should address current financial
and economic risks, but not compromise long-run price
stability and maximum economic growth. The experience
of the 1970s showed that the cost of unduly
expansionary policies in the short run is higher inflation
and greater economic instability in the long run.

Will the stress tests become the new capital

The stress test does not represent a new capital standard
and it is not expected to be maintained on an ongoing

With the federal funds rate near zero, is
monetary policy still relevant?

Monetary policy remains potent. Even with the fed funds
rate at zero, the Fed can continue to influence financial
markets and the economy through open market
operations and various lending programs. The Federal
Reserve's balance sheet expanded rapidly in the fall of
2008, reflecting the Fed's lending initiatives to combat the
financial crisis. Fed lending has declined somewhat in
2009, but could increase again if the Term Asset Backed
Loan Facility (TALF) or other programs expand. In
addition, the Fed has committed to further purchases of
long-term Treasury securities, agency debt (i.e., securities
issued by Fannie Mae and Freddie Mac), and mortgage-

backed securities, which will further expand the Fed's
balance sheet.*
*The monetary base is the sum of currency in circulation
and the deposits of banks and other depository
institutions with Federal Reserve Banks ("reserves"). The
"adjusted monetary base" reflects an adjustment to the
monetary base for changes in legal reserve requirements.

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