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SPRING 2010
Volume 1 Number 2

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

A Proposal: Using the CRA
to Fight Vacancy and Abandonment

INSIDE:
Credit for
Small Businesses
Systemic Risk
Q&A with
Economist
Anil Kashyap

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

SPRING 2010

Volume 1 Number 2

CONTENTS
1 President’s Message
2 Upfront
Land Bank Notches First-Year Win

4 The Fed’s Exit Strategy Explained

6

6 COVER STORY
A Proposal:
Using the CRA to Fight Vacancy and Abandonment
10 The CRA and the Economics of
Lending in Lower-Income Neighborhoods
16 Spotting a Financial Crisis Before It Happens

10

■

Seeing the Forest and the Trees: A Systemic Risk Identification Model

■

Can a Stock Option Predict Financial System Chaos?

20 Small Businesses:
Credit Where Credit Is Due?

22 Interview with Anil K. Kashyap
28 View
Neighborhood Stabilization: Early Reports on Policymaking in Action

16

22

The views expressed in Forefront are not necessarily those of the
Federal Reserve Bank of Cleveland or the Federal Reserve System.
Content may be reprinted with the disclaimer above and credited
to Forefront. Send copies of reprinted material to the Public Affairs
Department of the Cleveland Fed.
Forefront
Federal Reserve Bank of Cleveland
PO Box 6387
Cleveland, OH 44101-1387
forefront@clev.frb.org
clevelandfed.org/forefront

President and CEO: Sandra Pianalto
Editor-In-Chief: Mark Sniderman,
Executive Vice President and Chief Policy Officer
Managing Editor: Robin Ratliff
Editor: Doug Campbell
Associate Editors: Amy Koehnen, Michele Lachman
Art Director: Michael Galka
Designer: Natalie Bashkin
Web Managers: Stephen Gracey, David Toth
Contributors:
O. Emre Ergungor
Kyle Fee
Thomas Fitzpatrick
Lou Marich

Todd Morgano
Lisa Nelson
Anne O’Shaughnessy
AnnMarie Wiersch

Editorial Board:
Ruth Clevenger, Vice President, Community Development
Kelly Banks, Vice President, Community Relations
Stephen Ong, Vice President, Supervision and Regulation
James Savage, Vice President, Public Affairs
Mark Schweitzer, Senior Vice President, Research
James Thomson, Vice President, Research

PRESIDENT’S MESSAGE
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

Some say that major
reforms can be enacted
only after a major crisis
occurs—after conditions
become “bad enough.”
History and human nature
clearly confirm this view.
What is less obvious is that
hasty reactions following
a crisis do not always solve
the problem—in fact, they
can often create new problems. If reforms are to be successful
and enduring, they should reflect comprehensive assessments
and analyses of the factors that contributed to the crises.
I think it’s absolutely true that “you cannot reform what you
don’t understand.” In the wake of the recent financial crisis,
there is much more that we do understand—lessons built on
the front-line experiences we at the Federal Reserve Bank of
Cleveland have lived through as banking supervisors.
Through the thick of the crisis in 2008 and early 2009, our
direct involvement in the supervision of banking organizations
in the Fourth Federal Reserve District, and our knowledge of
supervisory activities throughout the country, exposed gaps in
the supervision of the financial sector that contributed to the
crisis. Since then, we have been able to step back and examine
the conditions that existed during those dark days and evaluate
the circumstances behind them.
Our experiences during the crisis reinforce the view that the
Federal Reserve should continue to supervise banking organizations of all sizes and should take on an expanded role in supervising systemically important financial institutions. Retaining
our role in the supervision of banks of all sizes is vital.
Our nation’s banks serve an extremely diverse range of customers,
industries, and geographies. Their health is critically important
to the communities and regions they serve. During the peak
periods of strains in financial markets, these institutions looked

to their Federal Reserve Banks for liquidity. As banking supervisors, we had a firsthand understanding of the safety and
soundness issues facing banking companies. This information
was critical to us in our role as lender of last resort, as we understood the particular liquidity circumstances they faced. And
as the central bank, we recognized the risks to the economy of
credit markets seizing up. Our experience enabled us to respond
quickly. We adapted our regular discount lending programs to
create an auction facility, and we provided for longer lending
terms and more collateral flexibility—not just for the largest
and most complex banking organizations, but for all banking
organizations.
In my Reserve Bank, the economists worked closely with banking
supervisors and discount window lenders to pool information,
assess situations, and make decisions. And I can tell you that
the knowledge, expertise, and direct access to information that
come from our supervision and lending responsibilities contributed to our effectiveness in monetary policy. Even today, the
intelligence I gather from my banking supervisors is extraordinarily useful to me as a monetary policymaker in helping to
identify factors that may pose risks to my economic outlook.
This collaboration extends beyond monetary policy, too. In
this issue of Forefront, we highlight how our economists are
working with bank examiners to tackle access to credit for small
businesses. These examples support my view that no other
agency has, or could easily develop, the degree and nature of
expertise that the Federal Reserve brings to the supervision of
banking organizations of all sizes.
Financial reform is not a new idea—we have seen examples of
it following crises, and we have seen reform proposals during
periods of relative calm. This financial crisis has unfortunately
provided us with compelling reasons to press on with the
regulatory reform agenda. As we do so, let’s act on our best
understanding of economic theory and the results of solid
research. But let’s also act on the basis of what we have learned
directly from our firsthand experiences. ■

This article is based on remarks President Pianalto presented at the 19th Annual Hyman P. Minsky Conference
on the State of the U.S. and World Economies Organized by the Levy Economics Institute of Bard College, April 14, 2010.
F refront

1

Upfr nt
Land Bank Notches
First-Year Win
In its first year, the Land Bank
of Cuyahoga County, Ohio, took
strides toward becoming the model
approach to the vacancy and
abandonment problem that state
lawmakers hoped it would be. No,
the Land Bank
has not magically
transformed
Cleveland’s most
blighted neighborhoods into thriving
Thomas J.
Fitzpatrick IV
beacons of hope,
but small victories in 2009 and early
2010 have formed the beginnings of
a long-term solution.
Frank Alexander, a professor at
Emory Law School and a leading
authority on land banking,
describes Ohio’s legislation as
a “national model” for others to
follow. Encouraged by the Cuyahoga
County Land Bank’s success in just
one year, state lawmakers recently
expanded to 41 the number of
counties that can create land banks.
Ohio’s Land Bank legislation seeks
to modernize land banking in ways
never before attempted. Legal transactional forms had to be created
from scratch. Multiple government
agencies had to be coordinated,
posing additional challenges. The
Land Bank’s goal is to help acquire
and amass vacant and abandoned
tax-foreclosed properties, and then
demolish, rehabilitate, or repurpose
them in keeping with long-term
plans for neighborhood stability.

2

Spring 2010

One of the Land Bank’s first accomplishments was to help the city of
South Euclid, an inner-ring suburb
of Cleveland, acquire some vacant
property as part of a redevelopment
plan. What’s the big deal? For years,
South Euclid had been trying to
acquire a particular vacant house that
had been in and out of foreclosure.
To complicate matters, the property
also had a clouded title because the
lender had walked away from the
process.
The Land Bank provided technical
assistance to South Euclid’s leaders,
who are now working with the
County Treasurer’s office to acquire
the property, which is in tax foreclosure. The Land Bank has also
helped South Euclid acquire several
vacant lots that will be turned into
community gardens this spring.
These small but deliberate steps
demonstrate the efficiency the
Land Bank brings to the process of
acquiring vacant and abandoned
property at the municipal level.
Land Bank leaders have also been
heavy hitters in raising external
funds. For example, the Land Bank
took the lead in creating a regional
application for the second round of
Neighborhood Stabilization Program
funds, which were competitively
awarded federal grants to use in
addressing issues such as vacancy
and abandonment. The target area
encompassed 2,500 housing units
in 20 neighborhoods, touching at
least eight different municipalities.

The Neighborhood Stabilization
award to the consortium totaled
almost $41 million, by far the largest
grant in Ohio.
Another win was the Land Bank’s
work with the Federal National
Mortgage Association, or Fannie
Mae, which held a large number
of mortgage loans that went into
foreclosure. When those houses
did not sell to other parties at foreclosure auctions, Fannie Mae ended
up owning many of them. Sixty
Cuyahoga County municipalities
and townships were interested in
buying some of them.
The problem? Fannie Mae wanted
to sell these properties in large
bundles, but the Cuyahoga County
municipalities were interested in
purchasing only a few houses at a
time or a few houses in total. The
solution? The Land Bank negotiated
collectively for all of Fannie’s vacant
properties in Cuyahoga County.
In the end, Fannie Mae agreed not
only to sell the Land Bank its foreclosed properties for $1 each, but
to contribute an additional $3,500
toward demolition of each property
that could not be rehabilitated.
—Thomas J. Fitzpatrick IV, economist

2010 Policy Summit

Housing Policy:
Who Pays, Who Plays, Who Wins?
The economic upheaval and damage to U.S. communities
resulting from the housing crisis has led not only to calls for
significant policy changes, but also to a reexamination of that
cornerstone of the American Dream: owning a home.
The 2010 Federal Reserve Bank of Cleveland Policy Summit
will examine how national housing policy might be reshaped
to help stabilize communities, particularly in weak-market
states. The only event of its kind in the Midwest and one
of the Federal Reserve System’s hallmark conferences, the
Policy Summit features both national and regional experts
who spur dynamic discourse on relevant, timely research
and policy perspectives.
The summit’s interactive format encourages participants to
increase their knowledge of—and challenge assumptions
about—critical issues in community development, including
the costs and benefits of housing policy and the role government should play.

June 9 – 10, 2010 | Cleveland Marriott Downtown at Key Center

Join us for this engaging one-and-a-half-day event that
annually draws hundreds of bankers, elected officials,
practitioners, academics, and policymakers from the
Great Lakes region and beyond.

Agenda highlights include:

an opening plenary session that takes a thoughtful, critical look
at the architecture of U.S. housing policy
■ research panels on neighborhood stabilization, government
financing of mortgages, and asset accumulation
■ a comparative look at reform proposals aimed at governmentsponsored enterprises
■

Please visit www.clevelandfed.org/2010PolicySummit for an updated agenda and registration information.
F refront

3

The Fed’s Exit Strategy Explained
Mark S. Sniderman
Executive Vice President
and Chief Policy Officer

Beginning in 2008, the Federal Reserve purchased
$1.25 trillion worth of mortgage-backed securities,
dramatically increasing the asset side of the central bank’s
balance sheet. The purchases helped drive down interest
rates on private market credit, especially home mortgages,
and were crucial to the effectiveness of the Federal Reserve’s
emergency efforts to save the economy.

1

the Federal Reserve the power to pay interest on reserves.
Now, the Federal Reserve can use that power to immobilize
some portion of the excess reserves until it can remove
them from the balance sheet through other means.

Trillions of dollars
2.5
Assets

1.5
1.0
.5
0
.5
1.0
1.5

Liabilities

2.0
2.5
Nov 07
■
■
■
■
■

Mar 08

July 08

Nov 08

Assets
Other assets
Large-scale asset purchase programs
Providing liquidity to key credit markets
Lending to financial institutions
Traditional security holdings
Source: Federal Reserve Board.

4

Mar 09

Spring 2010

■
■
■
■

July 09

Nov 09

Liabilities
Currency
Reserves
Factors absorbing reserves
Other liabilities

bank reserves on balance at the Federal Reserve—that is,
more reserves than necessary to meet the minimum
requirements. Eventually, the time will come to mop up
all that cash. The Federal Reserve will have to take steps to
keep the bulk of excess reserves from entering the banking
system all at once, because the quantity is far too large to
keep inflation at bay in a healthy economy.
Figure 2. How can it do this? Congress recently granted

The Problem: A Swollen Balance Sheet and the Risk of Inflation

2.0

Figure 1. But now there is more than $1 trillion in excess

Mar 10

Here is how it would work: By increasing the interest rate
paid on reserves, the Federal Reserve can also raise the
federal funds rate while holding the same level of reserve
supply as before. That’s because the interest rate on excess
reserves puts a de facto floor under the demand for reserves
in the banking system —banks won’t want to trade with
one another at the federal funds rate, even as it rises, if
they can get a better rate by keeping excess reserves on
deposit at the Federal Reserve.

2

Figure 3. As the economy recovers, the Federal Reserve

Hypothetical Example:
Increased Interest on Excess Reserves

may want to continue increasing the federal funds rate.
To do so, the Federal Reserve could first raise the interest
paid on excess reserves. Then, to manage the supply of
bank reserves, any or all of three other tools could be put
to use:

Interest rate

Reserve demand

1) Term deposits—banks put money on deposit for
a specified term, such as three months.

Federal funds rate
0

Interest on excess reserves
Reserve supply
Reserves ($)

3
Hypothetical Example: Term Deposits, Reverse Repos,
Hypothetical
Example: Term Deposits, Reverse
Asset Sales, and Increased Interest on Excess Reserves
Repos,
Sale
of
Interest rate MBS and Increase IOER

Interest Rate

Reserve
Reserve demand
Demand

2) Reverse repos—the Federal Reserve lends out
securities from its portfolio and banks use reserves
on deposit as payment, keeping those reserves out
of the marketplace.
3) Redemption of maturing mortgage-backed
securities or their outright sale—with sales, banks
pay for the securities by having their reserve balances
debited.
The effect is that the federal funds rate moves up, reserve
supply drains from the Federal Reserve balance sheet (or
to the left, graphically), and inflation stays under control.

Federal funds rate

FFR
FFR

Figure 4. As the economy continues to recover, the reserve

0%0

Interest on excess reserves
Interest On Excess Reserves

ReserveSupply
supply
Reserve
Reserves ($)

4
Corridor System
Interest rate
Reserve demand

supply moves farther to the left, much more in line with
the level of reserve supply in the banking system before
the crisis. Now, smaller movements in the reserve supply
will trigger larger movements in the federal funds rate.
Under this “corridor system,” the federal funds rate would
tend to be bounded at the top by the primary credit rate
(or discount rate) and at the bottom by the interest rate
paid on excess reserves. ■

Primary credit rate
Federal funds rate

Interest rates stay within defined corridor

Interest on excess reserves
0

Presentation
To hear and see Mark Sniderman’s full presentation, go to

Reserve supply
Reserves ($)
Source: Federal Reserve Bank of Cleveland.

www.clevelandfed.org/forefront

Bernanke Testimony
Federal Reserve Chairman Ben Bernanke testified before the House of
Representatives on the central bank’s exit strategy on Feb. 10, 2010.
www.federalreserve.gov/newsevents/testimony/
bernanke20100210a.htm

F refront

5

A Proposal: Using the CRA
to Fight Vacancy and Abandonment
In 2009, banks became the reluctant holders of more than 1,500 foreclosed properties
in Cuyahoga County, Ohio. Most of these houses are in Cleveland, worth little to nothing,
and in danger of remaining vacant for the foreseeable future—destined to define
neighborhood decay.
Cuyahoga County is not alone. In the wake of the housing
market crisis, urban communities across the nation are
suffering under the crush of vacant homes. At first glance,
one solution seems simple enough: Banks should donate
these homes—known as real estate owned, or REO —to
community groups or land banks that would rehabilitate,
demolish, or repurpose them to help stabilize neighborhoods.
But it doesn’t often happen that way. Many times, banks
would like to hand over foreclosed houses, but community
groups don’t want them unless they come with clean titles;
that is, free from liens. Community groups also want banks

6

Spring 2010

to provide resources needed for restoration, such as loans
or charitable donations. Other times, private investors
snatch up vacant houses before community groups can
acquire them, then make cosmetic changes and put them
on the market for resale. Either way, the houses tend to
stay empty and neglected for long stretches.
A recent proposal from researchers at the Federal Reserve
Bank of Cleveland puts a new spin on decades-old policy:
modifying the Community Reinvestment Act (CRA)
rules so they increase banks’ incentives to provide community groups with loans, services, and investments that
support neighborhood recovery efforts.

The Nuts and Bolts of CRA Rules
Under CRA rules, banks are obligated to meet the credit
needs of people who live in the areas they serve. Banks
can already get some points toward higher CRA ratings by
donating properties to community groups and providing
loans for rehabbing or demolishing them. But CRA exams
put heavy emphasis on lending activities, particularly
within banks’ so-called assessment areas, the geographic
regions where they maintain branch offices.
The proposal would leverage the appeal of high CRA
ratings by awarding outstanding ratings to banks that
focus on rehabilitating and disposing of foreclosed
properties in any lower-income census tract nationwide.
What’s more, banks could earn a rating of outstanding
based exclusively on their efforts related to foreclosed
properties, as long as their other CRA activities remain
satisfactory. Banks would still need to fulfill certain
lending requirements, but they could amass extra points
for lessening the vacancy and abandonment problem.

Emre Ergungor, senior research economist with the Federal
Reserve Bank of Cleveland, advocates giving banks new
incentives to relieve this problem. For example, banks could
do a little less lending in lower-income neighborhoods so
they could give community groups more help in dealing
with the problem of vacant homes. At the same time, they
would improve their chances of earning a CRA designation
of outstanding.

Banks would still need to fulfill a certain number of lending
requirements, but they could amass extra points for lessening
the vacancy and abandonment problem.
“You could just change the test so that banks increase
their REO activities along with everything else they were
doing before,” Ergungor says. “But I think we can achieve
a path of least resistance if we do not increase the burden
on banks.”

The Proposal in Detail
The proposal recommends that regulators adopt the following changes until the stock
of foreclosed properties in the nation no longer exceeds a predetermined threshold:
■

Provide CRA consideration under the investment test for REO dispositions (REO donations
or sales to qualified community development organizations) outside a bank’s assessment
area as long as the investment needs of the assessment area are satisfactorily met.

■

Provide CRA consideration under the service test for the provision of technical assistance
to qualified community development organizations in developing guidelines and standards
for REO acquisition and rehabilitation programs outside the assessment area as long as the
service needs of the assessment area are satisfactorily met.

■

Provide CRA consideration under the lending test for community development loans to
qualified community development organizations engaged in REO rehabilitation programs
outside the assessment area as long as the credit needs of the assessment area are satisfactorily met.

■

Allow banks to attain an overall rating of outstanding based on REO-related activities
within or outside their assessment areas as long as their rating for the assessment area
is satisfactory.

■

Put these changes back into effect if the foreclosure threshold is exceeded in the future.

■

Redistribute the weight of the lending, investment, and service tests to emphasize investment
and service activities. Lending should still be an important component, but an intensified
focus on investment and service activities will address the immediate needs for community
stabilization and longer-term reinvestment.
(Note: These changes are intended to give banks more flexibility with REO dispositions and
would not prevent institutions from obtaining an outstanding rating under the existing rules.)

F refront

7

The CRA Test
Depending on their size, banks in good standing undergo
CRA compliance exams every two to four years. Regulators
evaluate large and medium-sized banks (those with more
than $258 million in assets) on the basis of their lending,
investment, and service. Small banks undergo a streamlined test that focuses on lending and receive ratings of
outstanding, satisfactory, needs to improve, or substantial
noncompliance. These ratings are especially important to
a bank that wants to expand or merge with another bank,
because regulatory approval of these activities may be
challenged by community groups if the bank receives a
less-than-stellar rating.

As Ergungor puts it, the proposal would allow banks to shift
some of the resources they usually devote to local CRA activities
to REO dispositions in the weakest housing markets across the
nation.
In 2009, 98 percent of America’s insured depository
institutions were rated satisfactory or better on their CRA
exams, but only 7 percent were certified outstanding. The
distinction is important to some banks from a marketing
perspective; for others, it demonstrates a communityminded approach to business.
Although there are no exact formulas, lending activities
tend to be given the most weight in the rating process.
The lending assessment shows whether an institution is
making loans to small businesses and, most importantly,
to low- and moderate-income borrowers in lower-income
census tracts. Loans to community development groups
can also be factored in.
As it stands, banks earn a certain number of CRA points
for activities related to the disposition of REO properties,
which tend to be included in the investment and service
tests. Donations of properties count, as do loans to

8

Spring 2010

community development organizations serving lowerincome areas (the latter fall under the lending test).
Technical assistance, which might include serving on
non­profit boards, writing grants, and advising on financial
transactions, also qualifies.
To banks, CRA compliance can seem like trying to solve
a puzzle: to obtain a high rating, they must place many
different pieces in just the right spots. On top of its complexity, compliance is seen as a burden: Some banks
complain that CRA activities are unprofitable, or less
profitable than other activities they could be pursuing.
Banks are understandably disinclined to pay for liens or
property demolition when they have already written off
the loans. For that reason, they may see CRA compliance
mostly as a regulatory tax.

The Proposal
The Federal Reserve Bank of Cleveland’s proposal aims
to modernize CRA compliance to recognize the growth
of interstate banking since the law was enacted three
decades ago.
Under the proposal, banks would be able to earn an over­
all rating of outstanding based on their activities with
vacant properties, as long as everything else remains at
least satisfactory inside their assessment areas. For example,
as long as levels of mortgage and small-business lending
were satisfactory inside a bank’s assessment area, activities
involving REO/vacant properties anywhere in the country
would be sufficient to be considered for an outstanding
rating. Examples might include credit lines to community
groups that are engaged in rehabilitating and disposing of
vacant properties or donating them to land banks.
The opportunity for banks to get CRA credit outside
their assessment areas may be particularly important for
community groups that are working with the largest banks.

These banks may not have any local branches, but they
nonetheless were very active in underwriting mortgages
during the housing boom. These institutions may have
to work with national community groups to identify local
players who have the experience and credibility to deal
with these properties once they are off the bank’s balance
sheet.

It is important to recognize that a significant percentage
of the nation’s vacant properties are held by securitization
trusts, which are not subject to CRA rules and thus
unaffected by the proposal. But there are still plenty of
foreclosed homes on bank balance sheets—more than
enough for community groups to acquire on the road to
neighborhood stabilization.

Another virtue of the Cleveland Fed’s proposal is that it
works around the profitability issue by modifying the cost
structure of CRA compliance to place increased attention
on foreclosed properties. Under the proposal, banks can
make a positive dent in the vacancy and abandonment
problem but are no worse off in CRA compliance.

The hope for the future is that the need to focus on vacant
and abandoned properties will wane along with the housing
crisis. For that reason, the proposal would apply only
until the nation’s stock of foreclosed properties no longer
exceeds a predetermined level.

In this way, banks can take a straight route to an
outstanding rating by focusing squarely on activities
that reduce the number of vacant houses. At the same
time, communities can win big. The hardest-hit housing
markets can get the extra help they need, regardless of
whether they happen to be in a given bank’s main region
of service.

The Cleveland Fed has been talking with bankers and
community groups to get their preliminary reaction.
Researchers are using the feedback to refine the proposal
and then seek more views.

The proposal doesn’t prevent institutions from obtaining
the highest rating under the existing rules—it just adds
flexibility to help banks put their swollen portfolios of
vacant houses to positive community use. What’s unique
in the proposal is that it identifies a single factor as the
determinant for an outstanding CRA rating. As Ergungor
puts it, the proposal would allow banks to shift some of
the resources they usually devote to local CRA activities
to REO dispositions in the weakest housing markets
across the nation.
Granted, this means fewer resources for other CRA
activities, but the tradeoff may be worthwhile, given the
magnitude of the foreclosure crisis. As long as the housing
decay persists, other loans and investments will struggle
to make a positive difference. Either the area lacks the
population density that a small business needs in order to
succeed, or it is deemed too risky to insure, an outcome
that hurts homeowners and businesses alike.

Next Steps

“While we don’t expect our proposal to singlehandedly
solve the vacancy and abandonment problem, we do think
it could have a material impact,” Ergungor says. “We look
forward to comments and suggestions.” ■

What do you think?
Tell us what you think about the proposal. Will it work? Under
what conditions? Send comments to forefront@clev.frb.org and put
“CRA Proposal” in the subject line. We will publish a selection of
comments in the next issue of Forefront.
Podcast with Emre Ergungor and Ruth Clevenger
Cleveland Fed researchers discuss the Bank’s proposal for recasting
the CRA to address the vacancy and abandonment problem.
www.clevelandfed.org/forefront

F refront

9

The CRA and
the Economics of Lending
in Lower-Income Neighborhoods
O. Emre Ergungor
Senior Research Economist

In 1935, a team inside the Home Owners Loan Corporation embarked on an ambitious project. Staffers of the
federal agency, whose mission was to help Depressionslammed families avert foreclosure, began to color-code
neighborhoods in 239 cities by real-estate risk level. The
resulting maps classified residential areas on a scale of one
(lowest risk) to four (highest risk). The riskiest neighborhoods were populated by low-income people, who were
more often than not African-Americans. These were
assigned the color red.
The term “redlining” wasn’t coined until more than
30 years later, but the practice was institutionalized with
the now-infamous shaded maps. Although Congress
		 passed a string of laws aimed at ending racial
		 discrimination against individuals in the early
			
1970s, no law existed to prevent
				 banks from neglecting redlined

neighbor­hoods in their entirety. Over time, these primarily
minority and lower-income communities were caught in
a vicious spiral of decline with rising crime and waning
economic prospects.
The way many saw it, banks were contributing to these
communities’ decline by stifling the flow of credit. They
were collecting residents’ savings as deposits and investing
them outside the community, even though there were
credit­worthy borrowers and profitable investment oppor­
tunities inside it.
Congress took its most decisive step to end redlining
with the Community Reinvestment Act of 1977. The
CRA obliged financial institutions to meet the credit
needs of lower-income communities in which they
collect deposits.1 Its premise was that banks must lend
to creditworthy borrowers and must not arbitrarily refuse
borrowers because of where they live.

Thirty-three years later, there is a new financial order, and
it may be time to reconsider whether the CRA needs a
twenty-first-century overhaul.

The Economics of Lending in Lower-Income Areas
The very existence of redlining implies that financial
institutions refuse loans to people who deserve credit;
that is, profitable lending opportunities are left on the
table. Why would that happen? At least three plausible
explanations exist: prejudice, imperfect information, and
unprofitability.
Prejudice against certain groups of people is an obvious

though unfortunate reality. But unless every lender in
the country is prejudiced, some should theoretically be
willing to move in and cherry-pick profitable loans in
underserved neighborhoods.
However, in the 1970s, banks were hamstrung in their
ability to move around in search of good customers because
branching across state lines (and often within states) was
prohibited. In 1977, there were about 18,000 insured
thrifts and commercial banks, and 54 percent of them had
just one office. There were also caps on how much interest
lenders could charge on loans, effectively preventing them
from competing for high-risk borrowers.
These restrictions significantly reduced competition
and turned banks into sheltered institutions, which had
no incentive to try new products or business models to
compete for low- and moderate-income customers.
In the intervening years, there was a revolution in financial
services. Banks were given the ability to branch across
state lines, making it possible for anyone to do business in
lower-income communities. This weakened the case for
institutionalized prejudice as a culprit in disinvestment.
As a result, in 2010, the reasons why credit wouldn’t
be available in lower-income communities may have
changed. Disinvestment can result from prejudice only if
unprejudiced lenders are prevented from doing business
in these neighborhoods.

Imperfect information is a second possible hindrance to

banks in evaluating borrowers’ creditworthiness. Especially
in lower-income communities, where employment histories
can be spotty and credit histories nonexistent, it might be
prohibitively expensive or practically impossible for a
loan officer to determine whether an applicant is a good
risk. Such information problems are often at the root of
malfunctioning credit markets and contraction of credit.

The CRA has brought credit and investment to lower-income
communities. For example, the number and dollar amount
of mortgage loans to lower-income borrowers have grown
dramatically since the CRA passed, and research shows that
this growth did not come in the form of poorly underwritten
subprime loans.
Why is information so important? Consider a hypothetical and highly simplified world with only two kinds
of mortgage applicants. One kind will do everything in
their power to make timely loan payments. The other
would rather not make any payments; they want to live
rent-free for up to a year, until the bank forecloses and the
sheriff serves them with an eviction notice. In this world,
neither sort of applicant makes a down payment, and the
lender cannot determine who is creditworthy by looking
at the limited financial information they can provide.
In a world of perfect information, diligent applicants
would get loans, and the others would be denied. But in
the absence of information, if the lender charges a low
interest rate on mortgages to make them affordable to
creditworthy applicants, it loses money because other
applicants will get the same rate and default. On the other
hand, if the interest rate is high enough to compensate the
lender for a possible loss, the loan becomes unaffordable
to the creditworthy applicants, and only the opportunistic
applicants benefit. Thus, the lender is in a bind: Whatever
the interest rate, creditworthy borrowers cannot get credit.
Economists refer to this problem as adverse selection.
Unprofitability is a third factor in making business

1. This article uses “lower-income” instead of the more technical term “low- and
moderate-income,” which is used to define borrowers and their neighborhoods
under the Community Reinvestment Act. Under current federal rules, a lowincome household has income of less than 50 percent of the median family
income for the area, and a moderate-income household has income of less
than 80 percent, with both adjusted for household size by the Department of
Housing and Urban Development.

decisions in lower-income areas. Even in the absence
of adverse selection, there may be so few creditworthy
customers in such areas that setting up a branch or
marketing products there does not make business sense.

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11

In a survey of bankers in 2000, 64 percent of respondents
reported that their CRA special mortgage programs were at
least marginally profitable, though less profitable than their
other business lines. Among large banks (those with more
than $30 billion in assets), about 60 percent said such
programs were not profitable. (Also, a “marginally profitable” loan could still mean a loss for the bank if that loan
takes resources away from more profitable investments.)

Profitability of CRA Programs
Percent of respondents
45
Results from survey of 500 large retail banks
40
35
30
25
20
15
10
5
0
Profitable

Marginally
profitable

Break-even

To their credit, depository institutions have shown the
creativity necessary to make CRA work. They compensated
for their lack of information by building partnerships
with local governments and nonprofits to sort out loan
applicants’ creditworthiness. Using the same connections,
banks also became better at identifying the need for various
financial services and developing the products to meet
those needs. Individual development accounts, a type of
savings account, and low-cost alternatives to payday loans
are two examples of such products.
Federal and local governments provide a multitude of
incentives to promote investment and growth in lowerincome neighborhoods. Because a single incentive is
rarely enough to make investments feasible, banks had to
learn how to pool their tax credits and subsidized funding
sources. CRA seems to have helped banks overcome their
inertia by making community investment a routine activity.

Marginally
unprofitable

Unprofitable

Source: Avery, Bostic, and Canner.

What did CRA accomplish?
The CRA has brought credit and investment to lowerincome communities. For example, the number and dollar
amount of mortgage loans to lower-income borrowers
have grown dramatically since the CRA passed, and
research shows that this growth did not come in the form
of poorly underwritten subprime loans. Institutions
covered by CRA were more likely than non-CRA lenders
to originate prime loans to lower-income individuals.
Recipients of CRA prime loans, in turn, were less likely
to default and be foreclosed upon. Evidence also suggests
that CRA contributed to increased homeownership and
fewer vacancies in lower-income areas. [See related article,
“Little Evidence that CRA Caused the Financial Crisis.”]
This is a remarkable success for a blunt tool like CRA. After
all, CRA does not try to make markets more competitive
(that problem was addressed in later years through other
legislation) or to deal with the adverse selection problem.
It only directs financial institutions to find a way to attain
certain lending goals without compromising safe and
sound banking practices.

What are CRA’s shortcomings?
Despite its many successes, the CRA has some inherent
weaknesses. For example, many large financial institutions
view complying with CRA as akin to paying a regulatory
tax. Such a tax may be justified only if the regulation’s
social benefits (more stable neighborhoods, lower crime,
and so forth) exceed the private cost to the lenders.
But taxes also have unintended consequences. To maintain
their good standing, financial institutions sign agreements,
usually with local governments in their assessment areas,
committing themselves to specified lending and investment quotas. But research suggests that some of those
institutions try to meet their perceived quotas even if
there are not enough profitable lending or investment
opportunities; that is, they may view any loss associated
with such activity as the cost of maintaining their good
standing. For them, the benefits of being in good standing
may outweigh a small loss from a loan.2
So what’s the problem? Trying to meet perceived quotas
may hurt small local lenders that cannot compete with
larger lenders, which may be pricing their loans at less-thanprofitable levels. Researchers found that small banks reduce
their lending activities if a large bank is implementing a
(continues on page 14)

2. Banks do not face lending or investment quotas in CRA exams.

12

Spring 2010

Lisa Nelson
Senior Policy Analyst

Little Evidence that CRA
Caused the Financial Crisis
High-cost lending by income and lender type, 2006
The CRA has come under scrutiny
as a suspected contributor to the
financial crisis. Under the CRA,
insured depository institutions are
evaluated on the lending they do
in low- and moderate-income (LMI)
neighborhoods and to LMI borrowers
within the banks’ assessment areas.
Critics of the CRA suggest that banks
were forced by the legislation’s
requirements to lower lending

Percent
40
Middle–upper income by county
35
30
25
20
15
10
5
0
Cuyahoga

Franklin

Allegheny

(Cleveland)

(Columbus)

(Pittsburgh)

Fourth
District

Percent
40
Low–moderate income by county
35
30
25
20
15
10
5
0
Cuyahoga

Franklin

Allegheny

(Cleveland)

(Columbus)

(Pittsburgh)

Fourth
District

Bank and affilliate lending in CRA assessment areas
Bank and affilliate lending outside CRA assessment areas
Independent mortgage company

standards and provide loans to
LMI borrowers, regardless of
creditworthiness.

What immediately stands out is the

Even in the middle- and upper-income

large percentage of high-cost loans

areas, CRA-regulated institutions

Our analysis of CRA lending in the

being originated by independent

are doing very little of the high-cost

Fourth Federal Reserve District, like

mortgage companies in LMI areas

lending in their assessment areas. In

analyses at the national level, found

and to LMI borrowers, particularly in

both Allegheny County, Pennsylvania,

1

little evidence to support this claim.

Cuyahoga County, Ohio. More than

and in the Fourth District as a whole,

CRA-regulated institutions provided

33 percent of all high-cost loans in

a larger share of the high-cost lending

a relatively small share of all loans

Cuyahoga County were originated by

is done by banks and affiliates outside

within the District, and an even

independent mortgage companies

their assessment areas compared

smaller percentage of the riskier

to LMI borrowers or areas.

to Cuyahoga and Franklin counties,

high-cost loans. The figure shows
the distribution of high-cost lending
by lender type and borrowers’
income group.

Our analysis also reveals that the
small percentage of high-cost loans

where independent mortgage
companies are more dominant.

were originated by CRA-regulated
banks in LMI areas or to LMI borrowers in their assessment areas. This
is true across the three counties and
in the Fourth District overall. (See
arrows in figure).

1. Analysis prepared by Neil Bhutta and Glenn Canner at the Board of Governors of the Federal Reserve System:
http://www.federalreserve.gov/newsevents/speech/20081203_analysis.pdf

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13

CRA agreement in their market. However, large banks
do not maintain their level of CRA activities after their
agreements expire. The small banks that scaled down their
lending when the larger ones moved into their market
may have lost their relationships with the community.
So when the larger lenders cut back on their activities after
their CRA agreement expires, there may not be enough
providers to fill the gap.

Of course, any legislation may have unintended consequences,
but there are strong signs that CRA has not kept up with
changing times.
But if profitable business opportunities exist, why don’t
lenders move in to fill the gap after a CRA agreement
expires? First, new entrants lack the community relation­
ships that old lenders had. At the outset, this lack of connection could exacerbate the adverse selection problem.
Second, as CRA’s opponents argue, lenders may avoid
opening new branches in lower-income communities,
where they would come under the purview of CRA
and incur the associated regulatory obligations. Thus,
the argument goes, a policy to bring banking services
to lower-income communities may actually discourage
new banks from entering these communities.3
Of course, any legislation may have unintended consequences, but there are strong signs that CRA has not kept
up with changing times. For example, assessment areas
are now defined around banks’ branches, a practice that
fails to capture the realities of the current banking market.
If a group of banks from across the nation form a partnership to fund low-income housing projects using housing
tax credits, they will get CRA consideration only if the
project is built in their assessment area. A bank that partici­
pates in a housing development will not get CRA credit
unless it has a branch nearby. The CRA fails to motivate
such interstate collaborations because it was designed at
a time when banking was strictly local and banks were
constructions of bricks and mortar. And it was designed
at a time when banks provided almost all of people’s
important financial services, from checking and savings
accounts to mortgage loans, because banks were the only
show in town.
3. See Macey and Miller.

14

Spring 2010

A further problem with assessment areas is the scrutiny
they receive during a compliance exam. A bank is expected
to provide more products and services in the areas where
it collects most of its deposits. However, over the past
30 years, it has become increasingly difficult to track a
deposit’s location. For example, a large, multistate bank
may take a deposit in Ohio but report it at its New York
headquarters. As a result, the assessment area in New York
must provide more CRA-related products to its community
because that is where the deposits are counted for regulatory purposes.

Questions for the future
The goals set in CRA are worth pursuing. However, three
big issues need to be addressed.
First, how can we know a community is being served if
we cannot measure its needs? As noted in the earlier

discussion of CRA agreements, banks may have an incentive to overinvest in some neighborhoods if they do not
discover a community’s needs and regulators’ expectations
during the compliance exam. In fact, many banks complain
that the statute is vague and that they don’t know exactly
what level of lending and investment would satisfy the
community and the regulators.
This concern is a sign that lenders are not necessarily
driven by the profitability of their CRA activities but by
their desire to meet some undefined quota in each assessment area. This brings us to the second question: How
profitable are CRA products? Hard evidence is scarce.
CRA loans and investments are treated no differently than
a lender’s non-CRA activities. These loans do not carry
a CRA “flag” that would help researchers identify and
evaluate them. The cost of these loans is practically impossible to calculate, because many of these products are
cross-subsidized. For example, when the bank advertises
its checking account product, a lower-income customer
who opens an account may also take out a loan. So it is
not all that clear how a lender should allocate advertising
costs among product lines. Still, some bank surveys have
indicated that CRA business is profitable, though not
always as profitable as non-CRA activities. Tying up the
bank’s capital in less profitable endeavors is admittedly a
loss to bank shareholders. More work remains to be done
in this area.

The third issue concerns the very premise of CRA. If
there is a social benefit in bringing loans and investments
to lower-income neighborhoods, why should the bank’s
shareholders bear the entire cost?

In 1977, CRA’s champions justified it with the argument
that banks received some unique benefits from taxpayers.
For example, bank deposits are insured by the Federal
Deposit Insurance Corporation, and banks have access to
the Federal Reserve’s discount window, which provides
emergency funds if they cannot raise funds in the market.
If banks receive these benefits from taxpayers, the argument goes, they should pay for services to lower-income
communities. This line of reasoning made sense at the time
because competition in banking markets was limited and
any benefits provided to banks accrued to shareholders.
However, in today’s competitive banking markets, where
financial institutions cut their rates and fees to the bone
to stay competitive, benefits provided to banks actually
accrue to the end users of their products, that is, consumers
and businesses. As a result, banks may not have the surplus
they need to cushion potential losses from CRA activities.

References

Avery, Robert B., Raphael W. Bostic, and Glenn B. Canner. 2000.
“CRA Special Lending Programs.” Federal Reserve Bulletin 86: 711–31.
Macey, Jonathan R., and Geoffrey P. Miller. 1993. “The Community
Reinvestment Act: An Economic Analysis.” Virginia Law Review
79: 291–348.

If the quid pro quo argument is no longer valid, who should
pick up the tab? Of all the questions surrounding CRA,
this is the most urgent. ■

Recommended Readings
Find more academic resources about the Community Reinvestment Act.
www.clevelandfed.org/ forefront

Profitability of CRA Programs
Learn more about the economics of lending in low- to moderateincome communities.
www.clevelandfed.org/ forefront

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15

Spotting a Financial Crisis Before It Happens
In the fall of 2008, as big-name financial institutions toppled, policymakers focused their efforts on saving
the global economy from collapse. Now that the recovery is well under way, the nation is moving closer
to establishing a new regime for monitoring systemic risk to make sure we don’t repeat past mistakes.
It is high time, then, to discuss how we intend to do that. What could we have done differently to spot—
and then stop—the impending financial crisis of 2008?
Researchers are making headway in answering that question. Last fall, the Federal Reserve Bank of Cleveland
and the National Bureau of Economic Research sponsored a research conference on Quantifying Systemic Risk.
Viral Acharya, a research associate with the Reserve Bank, presented a paper at the conference that helped
inform the New York University Stern School of Business’s recently unveiled Systemic Risk Rankings service.
Cleveland Fed researchers are also studying a number of approaches to the systemic risk problem. Here are
two of them. As always, we’d like to hear what you think. Contact us at forefront@clev.frb.org.

Seeing the Forest and the Trees:
A Systemic Risk Identification Model
Stephen Ong,
Vice President,
Supervision and Regulation

Let’s begin with the well-supported premise that financial
crises happen when shocks to the financial system meet
structural weaknesses within that system. If we have a
strong shock but an equally strong financial system, the
danger of a crisis is low. But if the system is fragile, even
a moderate shock can wreak havoc.
To prevent a financial crisis, regulators must see both
the big picture (the financial system as a whole) and the
little picture (individual institutions). Only recently,
however, have researchers looked at ways to combine
“macroprudential” supervision of the entire financial
system with “microprudential” supervision of individual
institutions. By monitoring and analyzing both types of
information, researchers can identify signs that potential
shocks are building and compare them to potential structural weaknesses in the market.
16

Spring 2010

Toward that end, Federal Reserve Bank of Cleveland
researchers have been working on a systemic-risk identification model called SAFE, for Systemic Assessment of
the Financial Environment. SAFE is being designed to
identify early signs of emerging shocks and structural
weaknesses—a highly useful feature that enables policymakers to prevent those conditions from becoming reality.
(If policymakers had only a few days’ notice of a financial
system collapse, it would be far more difficult to develop
an effective response.) This model’s key innovation is its
use of confidential supervisory information, gleaned from
regular bank examinations, and data from supervisory
tools to identify weaknesses in the institutions that make
up the financial infrastructure.

Identifying the Shocks

Connectivity indicators measure the volatility of each

Identifying a financial shock before it happens is
difficult at best. Cleveland Reserve Bank researchers
have approached this problem by thinking of a shock as
a sudden change in investors’ expectations. In the SAFE
model, these expectations are based on three factors:

financial institution’s balance sheet compared to the
volatility of the wider financial system. When the balance
sheets of several large institutions move in concert with the
entire system, institutions and the system are considered
highly correlated. In this case, an emerging financialmarket shock will likely ripple through the country’s largest
financial institutions as well as its financial markets.

■

■

■

Return: how much an investor may expect to make
on a particular asset
Risk: the chance that an asset may lose some or all
of its value
Liquidity: the ease with which an investor may sell
or trade an asset

The model’s central assumption is that investors are
constantly making judgments about the return, risk,
and liquidity of the assets they hold—the measures that
determine the price of the assets. These measures are
continuously compared to the historical norms for their
assets. History shows that when significant, sustained
gaps emerge between current measures and their norms,
the likelihood of shocks increases.

Structural Weaknesses
The health of the financial market’s infrastructure strongly
determines the potential for systemic risk. It directly affects
financial firms’ ability to absorb shocks, which originate
in gaps in investor expectations. To gauge the financial
market’s condition, the SAFE model uses information
on the nation’s largest financial institutions to assess three
aspects of systemic structural fragility: connectivity,
concentration, and contagion.

Concentration indicators measure the intensity of asset

holdings and market making—the ability to dictate
prices—within the financial system. In general, the more
concentrated the financial system’s asset holdings and
the more narrow its market making, the more fragile the
system. More specifically, when an institution or a small
subset of institutions holds a large share of a market’s assets,
its trades increasingly “make” the market, that is, move
prices. Thus, if an asset price shock occurs and these
institutions sell concentrated assets, their disproportionately large holdings overwhelm buy orders, so that the
market cannot function or does so only at very low prices.
Likewise, if a single bank or a small group of institutions
serves as the sole market maker, its failure would eliminate
a liquid market for those assets.
Contagion indicators measure the relative ability of

individual financial institutions to withstand a financial
shock and remain solvent. If individual institutions can
“internalize” the effects of a shock, it will not spill over into
the larger financial system. On the other hand, if individual
institutions cannot absorb the shock and remain solvent,
the losses they sustain will probably affect other institutions’
health and spill over into the larger financial system.
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17

The Cleveland Approach
To derive these three indicators, Bank researchers are
using confidential supervisory information, including
details about loans and liabilities that aren’t publicly
available. Researchers are also tapping outputs from
proprietary supervisory tools that are accessible to the
Federal Reserve in its role of banking supervisor. It is
this unique feature—the incorporation of supervisory
information—that distinguishes SAFE from other models
developed to identify systemic risk. Just as a weather
fore­caster uses radar tools to predict a coming storm,
the SAFE model is being designed to help spot episodes
of financial stress so as to head off a full-blown crisis.
Of course, policy actions don’t exist in a vacuum, and
it would be useful to know how they might affect the
financial climate. The short-lag variant of the SAFE model

incorporates policy actions’ effects on emerging conditions
to see if they are working as intended or if different policy
actions are required. Taken together, the long- and shortlag versions of the SAFE model are being developed to
identify the advent of systemic risk and provide valuable
feedback on policy actions that address those risks.
To validate the model’s effectiveness, researchers are
building a financial stress index to chart previous episodes
of stress in the U.S. financial system. Think of the index as
a thermometer that tells regulators how hot or cold stress
in the economy is running.
The work continues. Bank researchers are circulating the
SAFE model among economists and bank supervision
professionals in the U.S. and abroad for comment. ■

Can a Stock Option
Predict Financial System Chaos?
James B. Thomson,
Vice President
and Financial Economist

Calls for the establishment of a systemic risk supervisor
presuppose several conditions: that systemic risk can be
quantified; that it can be measured and tracked on a realtime basis; and that its changes can be reliably predicted.
At present, none of these conditions exist.
Fortunately, a number of promising efforts to construct such
a metric are under way. They draw on several academic
areas, including risk management, economic fore­casting,
banking and finance, and what’s known as contingent
claims. Ultimately, identifying and predicting systemic
risk is likely to rely on a combination of approaches.

18

Spring 2010

Martin Zambrana, a visiting scholar at the Federal Reserve
Bank of Cleveland, takes the contingent claims approach in
his proposal for a forward-looking systemic risk indicator.
Simply put, a contingent claim gives the holder the right
to something, depending on what happens in the future.
An option to buy a share of AIG at a certain price during a
certain time period is a type of contingent claim. A credit
default swap, in which the buyer collects a sum of money
if an outcome such as default occurs, is another example.
Contingent claim analysis can run all the way from defining
the valuation of claims to backing out information from
the price movements of a specific set of contingent claims.

These analyses can yield useful information. For example,
UCLA economist Richard Roll developed weather
forecasts for Orange County, Florida, using information
gleaned from futures contracts for frozen orange juice
(the very contracts that play a central role in John Landis’s
1983 movie, Trading Places). Roll’s forecasts outperformed
those of the National Weather Service. In a similar vein,
economist John Carlson at the Federal Reserve Bank of
Cleveland has backed out market forecasts of Federal
Open Market Committee policy actions using the prices
of options on federal funds futures contracts.
Zambrana uses the option-based “distance-to-default”
measure developed by Moody’s KMV, a credit analysis
firm. Distance to default is a measure of the probability
that a firm will default, so this article uses the term “probability of default.” This measure is based on estimates of the
market value of a firm’s assets, the volatility of the assets’
value, and the bankruptcy threshold (that is, the point at
which the firm will become insolvent). These estimates
are typically backed out of observed accounting data
and the price of the firm’s traded equity using an optionpricing model.
Although it may sound skull-cracking (indeed, it typically
involves sophisticated mathematics and analytic tools),
it is a fairly straightforward procedure. The probabilityof-default measure can be constructed for any firm if the
minimum information requirements are met. Moreover,
under certain assumptions, this measure can be constructed
frequently, even daily, which makes it a promising tool for
identifying systemic risk, where timeliness is paramount.
Zambrana computes probability of default both for a
traded index of European bank stocks (DJ STOXX) and
for each bank in the index. He then constructs an index
using individual banks’ probability-of-default measures.
So, he now has two probability-of-default numbers that
cover essentially the European banking system: one constructed from DJ STOXX and one from the aggregation
of the probability-of-default numbers for individual bank
stocks.
Zambrana’s innovation is to use a well-known fact in
finance: An option to buy or sell an entire portfolio of
stocks is not worth the same amount as a portfolio of
options on the individual stocks in the portfolio. (That’s

simply because the option to buy or sell an entire portfolio
of stocks does not come with the same inherent flexibility
as having an entire portfolio of options to buy or sell
stocks.) This means that his two probability-of-default
measures for the European banking system will be different,
except when there is perfect correlation between the
stocks in the portfolios. So if returns on individual bank
stocks in the DJ STOXX become more highly correlated,
that is, their prices increasingly move in lockstep, their
probability-of-default measures will converge.
Why is this important? One of the lessons learned from
the demise of the Long-Term Capital Management hedge
fund and from research by Andy Lo at MIT is that during
periods of financial stress, asset returns in the financial
system become more highly correlated. That makes increased correlation in financial markets a handy indicator
of increased systemic risk. So tracking the differences
between Zambrana’s two probability-of-default measures
for the European banking system provides a measure of
increased systemic risk.
Of course, identifying and tracking changes in systemic
risk is just the first step. The indicator must also be
forward-looking, that is, it must reliably lead changes
in market stress. A plot of each index, as well as the
difference between the European banking system’s two
probability-of-default series, leads movements in the
DJ STOXX index of European bank stocks. Hence,
Zambrana’s approach to measuring changes in systemic
risk in the financial market holds promise. A similar
measure could become an important part of the macroprudential supervisor’s regulatory toolkit. ■
Putting Systemic Risk on the Radar Screen
The Federal Reserve Bank of Cleveland’s 2009 Annual Report essay
tackles the problem of systemic risk. Economist Joseph Haubrich argues
that the first step is a program to define and measure systemic risk.
www.clevelandfed.org/about_us/Annual_Report/2009/

Measuring Systemic Risk
A Federal Reserve Bank of Cleveland Working Paper.
www.clevelandfed.org/research/workpaper/2010/wp1002.pdf

Papers and Presentations
Systemic Risk Analysis Using Forward-Looking Distance-to-Default
Series. A Federal Reserve Bank of Cleveland Working Paper by
Martín Saldías Zambrana.
www.clevelandfed.org/research/workpaper/2010/wp1005.pdf
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19

Small Businesses:
Credit Where Credit Is Due?

Across the country, small-business owners are telling the same story:
First, they need more customers for their products and services.
And second, they need banks to lend them money.

The story of Torbeck Industries, a Harrison, Ohio, manufacturer of safety equipment, has grown all too familiar.
During the recession, business at the 35-employee firm
has fallen about 50 percent, close to the industry average.
In 2009, owner Rich Torbeck approached several banks
about obtaining a new loan guaranteed by the Small
Business Administration, or SBA. His company had used
SBA programs in the past and always made good on its
payments.
Only one bank stepped up. But after doing its due diligence
analysis, that bank downgraded the firm’s collateral by half,
which killed the deal. Meanwhile, Torbeck Industries
could not pass working-capital tests when it bid on new
contracts. In March, the company was forced to turn down
a large order because it couldn’t finance its cash flow.
“This is a vicious cycle,” Torbeck said. “I don’t know where
it’s going to end.”
The Federal Reserve has paid a lot of attention to the
problem of low demand for products and services.
Near-zero interest rates and several emergency programs
have been aimed at reviving the overall economy. But
the nagging issue of access to credit—especially for small
businesses—persists. Why are banks still reluctant to lend?
To find an answer, Federal Reserve Banks across the country recently hosted forums with small-business executives
and bankers, asking for their views and hearing from many
of them. Helped by that information, researchers are now
developing proposals for unblocking the small-business
credit channel.

20

Spring 2010

Credit Tightens

The problems facing small businesses are a big deal for the
whole nation. Small businesses have created almost two
of every three new jobs over the past 15 years. During that
time, they have employed more than half of all workers
and created half of GDP. But in the recession, they have
suffered intensely, accounting for half of U.S. jobs lost versus
10 percent in the 2001 recession.
Although it is impossible to lump all small businesses in
the same bucket, it is fair to say that they share characteristics that make them vulnerable during harsh economic
times. They generally cannot tap the public markets for
capital, so they turn to commercial banks or personal
credit cards, often putting up their own property as
collateral.
These factors make small businesses far more vulnerable
than others to problems in the real estate markets, which
of course have taken their own hit with the recession.
As collateral values are written down, many small firms
suddenly find themselves in technical violation of loan
covenants.
Two major sources of credit for small businesses contracted
sharply in 2009: Commercial and industrial loans fell by
20 percent, and commercial real estate loans by 4 percent.
In all, bank lending declined by 7.4 percent in 2009—the
most since 1942. These declines occurred even though
banks’ reserves had more than doubled since 2007, aided
by the Federal Reserve’s response to the financial crisis.

The View from the Bankers’ Side

Bankers see the situation as far more complicated than
a mere credit crunch. For starters, they report that loan
demand is off, and many companies aren’t fully drawing
on existing lines of credit. And many of the small firms
that are seeking credit seem like risky bets, given their
financial condition. They are either losing money, overextended, or don’t have adequate collateral.
With their own capital positions weakened, some bankers
admit having to “button down” on lending standards. In
sum, they see more risk than reward out there. This mindset is reflected in results from the Federal Reserve’s Senior
Loan Officer Opinion Survey on Bank Lending Practices,
which recently found that banks have significantly tightened
credit standards on many loans to small firms over the past
few years.
“In 2009, it seemed as if banks pretty much stopped
lending,” says Marsha Powers, principal of Powers Financial
Group, a Pepper Pike, Ohio, firm that helps businesses
obtain financing. “I do see some positive activity in this
[first] quarter, but they still are being extremely careful in
their underwriting. And rightly so.”

The Central Bank’s Response

Although poor sales loom as small businesses’ biggest
problem, there is strong anecdotal evidence that tight credit
is also holding back the recovery. The Federal Reserve
has tackled the problem from several angles. Besides its
efforts to buoy the economy with low interest rates and
emergency lending programs, the central bank has joined
the nation’s other bank regulatory agencies in issuing new
guidance for small-business and commercial real estate
lending. This guidance encourages bankers to work with
their customers during periods of stress. Its goal is to
prevent overzealous supervision from creating additional
problems for bankers and their customers. At the Federal
Reserve Bank of Cleveland, discussions have begun about
how banks’ perception of regulators’ increased stringency
may affect access to credit for small businesses.
Another new focus at the Federal Reserve Bank of
Cleveland, largely motivated by conversations with small
business owners and bankers, is the potential for expanding
other government and public programs. For some time,
SBA-guaranteed loans have served as a backstop option
for small firms in need of credit. In normal times, those
loans account for only about 5 percent of outstanding
credit to small business. But in times of crisis, that’s not

enough to meet the needs of creditworthy small businesses
in this country, especially when banks need a taller backstop to safeguard against risk.
SBA programs provide good options for some borrowers
in some circumstances, but there can be impediments.
A persistent story among businesspeople is that SBA loans
are attractive in theory but difficult to secure in practice.
Often, the problem is just a matter of paperwork; at other
times, it is a matter of borrowers’ inability to find a banking
partner to underwrite the loan.
Federal Reserve research suggests that as currently
structured, SBA lending is too narrowly focused on startups, and the scale of lending is too limited to deal with the
shortfalls in credit that small businesses are reporting.
The Administration, for its part, has taken steps to address
this issue by proposing legislation to allow higher caps on
certain kinds of SBA loans and to allow refinancing of
certain kinds of owner-occupied commercial real estate.
The Administration has also proposed allotting $30 billion
of Troubled Asset Relief Program funds that community
banks can use for loans to small businesses. Meanwhile, the
SBA has embarked on its own effort to examine product
enhancements and streamline the application process.
Even so, it would be a mistake to rely on the SBA as a
cure-all for the problem. Researchers at the Cleveland
Federal Reserve have met with SBA officials this spring to
discuss wider opportunities to further unblock channels
for small-business credit. ■

What do you think?
Researchers at the Cleveland Fed are collecting public comments as
they develop proposals to widen access to credit for small businesses.
Future meetings with small-business owners, community development
groups, and bankers will be aimed at identifying promising solutions.
We also want to hear from you. What are your ideas for solving the
small-business credit crunch? What changes would give bankers more
confidence about lending to small businesses? Send your comments
to forefront@clev.frb.org.
President’s Speech
Cleveland Fed President Sandra Pianalto described the importance
of small businesses and efforts to open up access to credit in her
February 25, 2010, speech, “When the Small Stuff is Anything But Small.”
www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/
2010/Pianalto_20100225.cfm

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21

Sniderman: Everybody has a version
of what caused the financial crisis.
Every newspaper story, every magazine
article, has its own take on it. I’d like
you to share your views on this with us.
Kashyap: Ken French [Dartmouth

economist], a good friend of mine,
has a good analogy: If you investigate
an airplane crash, you usually find
10 things that failed. Seven of them
could have happened and there would
have been no problem. It would
probably take nine or 10 to happen
simultaneously to take the plane down.
That’s the way I think of the financial
crisis. I don’t think there was just one
thing or even two things. It was a
combination of problems.

CHRIS STRONG PHOTOGRAPHY

Interview with Anil K. Kashyap
Some say that the financial crisis has launched a thousand Ph.D. dissertations and
perhaps just as many books. Anil Kashyap was on the case from the very beginning.
In September 2008, as troubles in the financial markets spun into a full-blown crisis,
he dashed off one of the earliest and most coherent explanations of what was
happening. “Everything You Need to Know about the Financial Crisis”—which
Kashyap wrote with fellow University of Chicago economist Douglas Diamond—
became the most circulated post ever on the New York Times’s “Freakonomics”
blog. Later, Kashyap joined the Squam Lake Working Group on Financial Regulation,
a veritable who’s who of top thinkers in financial economics, and he helped prepare
several of the group’s policy briefs.
Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the
University of Chicago’s Booth School of Business. Before joining the Chicago
faculty in 1991, he worked as a staff economist with the Federal Reserve Board
of Governors. His research on financial markets has earned him several awards,
including a Sloan Research Fellowship and the Nikkei Prize for Excellent Books in
Economic Science. Among his other activities, Kashyap co-founded the annual
U.S. Monetary Policy Forum and co-organizes the National Bureau of Economic
Research’s Working Group on the Japanese Economy.
Mark Sniderman, executive vice president and chief policy officer at the Federal
Reserve Bank of Cleveland, interviewed Kashyap on February 15, 2010, at the
Booth School. An edited transcript follows.

22

Spring 2010

There were a lot of bad incentives
all through the financial system:
The ratings agencies, the regulators,
the politicians, and the traders inside
a lot of the financial institutions—
they all had bad incentives. It was
a combination of actions by many
different actors and failures of many
different parts of the system.
Sniderman: A lot of people look at the
housing sector and say it’s the epicenter
of everything. But if I understand the
way you describe it, perhaps six months
to a year later, some other sector might
have shown the stresses and strains.
Kashyap: The financial institutions

were so highly leveraged—it was like
a Ferrari that hits a pebble and crashes.
The system was so fragile that, yes,
it turned out to be housing, an initial
set of losses related to subprime
mortgages. But, as we saw, the damage
was much broader.
And then you say, where did that
leverage come from? People could tell
that there were some problems with
financial institutions, so they were not
interested in putting in equity financing,
and were only willing to fund the
banks with debt. Then funding became
increasingly short-term because people
knew that they might want to get out,
and keeping terms short is a good
way to keep financial institutions on
a leash. But then, of course, when
trouble comes, it’s all the worse.

Sniderman: Now that we have some
insights into these half-dozen or more
weak spots in the system, most of the
attention is focused on how we fix them.
Here again, there are many versions of
what needs to be done. I know you are
a member of a group of economists and
finance professionals who are taking a
very comprehensive look at this —the
Squam Lake Working Group on Financial
Regulation. I wonder if you might tell
us how this group was formed and the
directions you are headed in.
Kashyap: Right after Lehman Brothers

failed, a number of finance faculty
were talking to each other about what
this would mean. Many people were
worried that there would be an overreaction, an immediate jump for
scapegoats, and not a lot of wellthought-out regulatory responses.
So Ken French started calling around
and saying, we have to get together
and come up with something much
more technical and focused on the
real set of problems. We wanted to
make recommendations that would
consider the possibility of unintended
consequences from the reforms. This
group was formed with the idea of
being very nonpartisan, not to ascribe
blame to any one cause but to come
up with a much more academically
grounded set of recommendations
about what might be done.

Sniderman: Before we get into
particulars, let’s broaden the scope
a bit. This financial crisis was actually
global. Does it turn out that some of
the regulatory reform proposals that
make sense for the United States also
make sense internationally? Or is there
something different about the way you
are looking at the U.S. situation?
Kashyap: The Squam Lake proposal,

along with most of my thinking, carries
across borders. The legal and political
problems vary from country to country,
so to get the same package passed
in each country, the political deals
needed might vary. But I don’t think
the international dimension was so
unusual that you would get a different
diagnosis for us than for Europe.

Sniderman: Let’s get into particulars.
What are the top three to five places to
focus for financial reform that you and
your colleagues are recommending?
Kashyap: I would say the single biggest

thing would be a resolution authority.
Let’s suppose Greece, which just had
all this trouble, had somehow spectacularly failed and then we discovered
that a financial institution connected
to it had a lot of exposure, and now had
its solvency threatened. We’d have all
the same bad choices that we had with
Lehman, and I think that’s terrible.

Most of the response to the crisis postLehman amounted to giving guarantees
to different actors to get them to go
along. We provided access to different
types of support, loosened the rules
here and there, and there was basically
no way to say credibly that we were
going to fail an institution. That’s a
huge problem. That’s by far the single
biggest priority.

CHRIS STRONG PHOTOGRAPHY

I think the single biggest issue is
just getting the rules in place so you
could actually take an institution over
without having to sell it in one shot.
And then there are a bunch of complementary ideas that make failure less
likely. Everybody is talking about
changing capital standards, liquidity
standards. Living wills are an idea that
would allow firms approaching bankruptcy to get a bit better informed
before something happens. But to me,
the central thing has got to be if a large
organization gets in trouble, there has
to be a way to actually shut it down.

Anil K. Kashyap
Position:

Edward Eagle Brown Professor of Economics and Finance,
University of Chicago Booth School of Business
Books:

Corporate Financing and Governance in Japan: The Road to the
Future, with Takeo Hoshi (Cambridge, Mass: MIT Press, 2001).
Structural Impediments to Growth in Japan, jointly edited
with Magnus Blomström, Jennifer Corbett, and Fumio Hayashi
(Chicago: NBER and University of Chicago Press, 2003).
Monetary Policy Transmission in the Euro Area, jointly edited
with Ignazio Angeloni and Benoît Mojon (Cambridge, England:
Cambridge University Press, 2003).
Japan’s Bubble, Deflation, and Long-term Stagnation, jointly
edited with Koichi Hamada and David E. Weinstein (Cambridge,
Mass.: MIT Press, forthcoming).

Selected Papers:

“ Banks as Liquidity Providers: An Explanation for the Co-Existence
of Lending and Deposit-Taking” with Raghuram Rajan and
Jeremy Stein, 2002, Journal of Finance, 57 (1), pp. 33–74.
(2002 Brattle Prize Distinguished Paper.)
“ Leveraged Losses: Lessons from the Mortgage Market Meltdown”
with David Greenlaw, Jan Hatzius, and Hyun Shin, 2008,
U.S. Monetary Policy Forum Report No. 2, Rosenberg Institute,
Brandeis International Business School; and Initiative on Global
Markets, University of Chicago Graduate School of Business.
“ Will the U.S. Bank Recapitalization Succeed? Eight Lessons
from Japan,” with Takeo Hoshi, Journal of Financial Economics,
forthcoming.
Education:

Massachusetts Institute of Technology, Ph.D., 1989
University of California at Davis, B.A., 1982
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23

Sniderman: Is this largely a matter of
legally creating an entity to do it, or a
matter of figuring out how the financing
would take place?
Kashyap: I think the single biggest issue
is just getting the rules in place so you
could actually take an institution over
without having to sell it in one shot.
The FDIC rules we have in the United
States make it possible to walk into
an institution on Friday and have it
running in some form on Monday that
leaves people largely able to function.
You just couldn’t do that with the
20 biggest financial institutions in the
world. We need an intermediate thing
that’s not going to create panic that
then spreads to the next one.

The week Lehman failed, Merrill had
to be sold, and Morgan Stanley and
Goldman were in trouble because
their funding was at risk. We need a
way to stop that, where you can say,
“OK, this organization is in trouble.
We are going to carve it up and sell
off some parts of it and operate some
parts for awhile.” And that process
must be understood well enough so
there won’t be complete panic that
shuts down the entire sector. That’s
where I think the attention needs to
be focused.
Sniderman: Sometimes I hear two
schools of thought about these financial
crises. Some people say we should turn
the clock back to Glass-Steagall restrictions, when commercial banks were just
commercial banks, and we had more lines
of demarcation. Other people say that
if you go back hundreds of years across
countries, you will always see financial
crises. There’s no hope, basically, of
preventing these things in the future.
Where do you place yourself?
Kashyap: I’m closer to the latter view.

The number of systemic banking
crises in just the last 25 years is huge.
Most of them didn’t involve activities
that were so different than those that
would have been permitted under
Glass-Steagall. So I’m pretty skeptical
that just by containing things for awhile
we could avoid all this instability.

24

Spring 2010

It’s important to realize that a lot of
the trouble in the current crisis came
through price contagion, where there
were fire sales and we saw markets
drying up, prices becoming uninform­
ative, and illiquidity making it difficult
for people to transact. The collapse,
say, of asset-backed commercial paper
and lots of other securitized forms
of financing transmitted this shock
from the financial sector into the
real economy. So I worry that even if
you did go in the direction of GlassSteagall, you would just crowd out
a lot of activities from the formal,
better-regulated, and better-managed
sector into parts of the system you
can’t see. And then when it blows up,
you have all of the same problems but
many fewer tools.
Sniderman: A lot of books about the
financial crisis have raised the question
about the nature of the market system,
and whether we really will have to rely
more on government intervention and
regulation. It’s the very problem that we
worried about when Squam Lake was
getting started—that there would be
too much regulation as an overreaction.
Yet a number of people have said,
“Well, the free market school (including
Chicago Booth) has led us down a primrose path by suggesting that markets can
do more than they really can.” I want
to ask you about that because I know
you are teaching a new class about the
analytics of the financial crisis.
Kashyap: That’s a hard question. I think

markets work reasonably well. But
markets require regulation, rules of
the game. Many aspects of the crisis
involved fraud that nobody condones.
In the U.S., our regulatory system
was so fragmented. It was really ripe
for having these problems emerge.
Two days before Bear Stearns fails,
its primary regulator­— the SEC—
says there’s no problem. That’s just
unbelievable. You saw the Fed, which
was late on subprime concerns,
eventually put out guidance, but it
took a long time. And what happens is
the banks that are most worried about
changing their charter go where they
can’t be supervised by the Fed. The
regulators that were supposed to be
on top of AIG had no clue.

There were so many loopholes in
our regulatory system that I think
made things worse. Some of these
things were widely discussed for years
and years. Others were problems we
didn’t appreciate adequately. On the
other side, the United Kingdom tried
to consolidate supervision and that
didn’t work so well either. Its Financial
Services Authority ended up not
covering itself in glory.
So I don’t think there’s some best
practice that we all mindlessly adopt
that’s going to work very well. But we
need to design regulations that would
cover both the formal banking system
and the so-called shadow banking
system so we avoid big discontinuities
in the rules you have to follow (or the
capital you have to hold) if you restructure transactions and move them
out of the formal system. I think that
has been the least researched and
discussed aspect of the crisis. My
current fear is that we are going to do
something that might be somewhat
draconian and punitive to the banks
and push a lot of stuff that has been
inside the banking system to outside
the banking system, where we won’t
have the regulatory apparatus in place
to follow things very well.
Sniderman: How comfortable (or
uncomfortable) are you about the idea
of having a macroprudential supervisor
that would be able to spot all of these
things happening in the broader financial
marketplace?
Kashyap: I think we need to try to

do that. People talk about capital
standards as an important part of that,
and many people talk about liquidity
as a second thing. I want to focus more
on leverage as a third consideration,
because deleveraging was very costly.
Everybody decided to shrink their
balance sheets at once, and the
economy suffered. That doesn’t have
to happen in the banking system. If
the shadow system stops securitizing,
it has all the same pernicious effects.
I want to make sure if we are going the
route of macroprudential supervision,
it involves some tool that gets all three
legs—liquidity, capital, and leverage.

Sniderman: So is it fair to say some of
your research and current thinking is
on these issues?
Kashyap: I have been trying to think

about this. I don’t know if we’ll ever
succeed, but Dick Berner at Morgan
Stanley, Charles Goodhart [former
member of the Bank of England’s
monetary policy committee], and
I are trying to write up a macroprudential toolkit. I am also working
with some people at the Chicago
Fed on trying to write a living will
for Lehman and to explain how that
would have mattered. Jeremy Stein
[Harvard economist] and I have been
working on several projects.

Sniderman: You have been a student of
Japan and the Japanese banking system
and a student of monetary transmission
mechanisms more generally. Has this
crisis gone by the playbook, or have
aspects of it turned out to be surprising
even for people who have studied these
things?
Kashyap: I think the hardest thing for

academics and a lot of central banks is
the workhorse way of thinking about
the financial system—it’s very loose.
Three years ago, most macroeconomic
models didn’t have a financial system.
So if we went back and read central
bankers’ speeches or even if we just
went to conferences where academics
were talking, there was no uniform way
of discussing if your financial system
gets sick, what it’s going to mean and
how it’s going to matter. I think that’s
been a real handicap for people who
have studied financial crises.
In the U.S., the amount of reliance on
the informal shadow system wasn’t
so well understood at first. Just seeing
how fast the market evaporated and
how that tightened credit conditions
was something different. But it looks
a lot like the other big financial crises
we had and a lot of recent emerging
market problems.

Sniderman: What about lessons from the
Great Depression for central bankers?
Kashyap: Here’s something funny.

Three years ago, as I mentioned, the
workhorse model didn’t include the

financial system. What are the two
biggest macroeconomic catastrophes
over the past 75 years? The Depression, and you’d probably say Japan.
Both were cases where the collapse
of the banking system was absolutely
central, yet even the models that did
describe how financial conditions
matter tended to rely on borrowerside frictions.
[Federal Reserve Chairman Ben]
Bernanke, [New York University
economist Mark] Gertler, and [Boston
University economist Simon] Gilchrist
proposed a starting point for addressing these phenomena. They say the
fundamental friction in the economy
is that borrowers can disappear with
funds and lenders are concerned with
that. I take a different view. The fundamental thing that can go wrong in the
financial system is that the supply of
credit contracts because of funding
problems for banks. This credit supply
channel is understudied. It was really
important in the Depression and in
Japan. I think it’s been really important
in this crisis, and I bet that when it’s
over, most macroeconomic models
will have a financial system, and the
credit supply will be the primary way
it will matter.
Sniderman: And that will come in
through frictions in supply?
Kashyap: I think it will have something

to do with the funding that’s available to
the banks to intermediate. If the banks
can’t get their own funding, then they
pull that from the borrowers. So many
creditworthy borrowers still want
funding, but changes in the lenders’
condition make them unable to give it.

Sniderman: It sounds like it’s not strictly
either/or. These external finance
premiums are what we are seeing a lot,
particularly with small and mediumsized businesses that have a lot of
problems in finding access to credit.
Kashyap: In many cases, they are

suffering because their lenders have
problems. There’s a nice paper by
[Harvard economists] David
Scharfstein and Victoria Ivashina,

which I think is the best study of the
current crisis. The final draft [to appear
in the Journal of Financial Economics],
which most people won’t have read
because an earlier draft got a lot of
attention a year and a half ago when
it was first circulated, includes a neat
experiment where they look at which

My current fear is that we are going to
do something that might be somewhat
draconian and punitive to the banks
and push a lot of stuff that has been
inside the banking system to outside
the banking system, where we won’t
have the regulatory apparatus in place
to follow things very well.
banks tended to be part of loan syndicates with Lehman. Once Lehman
went away, not surprisingly a lot of
people who were borrowing from
those syndicates immediately said,
boy, we’re not going to be able to get
credit, so they took down a lot of that
credit. What Scharfstein and Ivashina
show is that those banks saw a
disproportionate drawdown of credit
that cut their new lending. This is
almost a natural experiment, because
people who were syndicating with
Lehman were not selecting very different
kinds of borrowers. The people who
got cut off were really exposed to the
contagion and second-round effects
of the Lehman failure.

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25

Sniderman: One topic we haven’t talked
about is consumers in the marketplace.
In this particular episode—you mentioned
fraud earlier—there has been a lot of
concern about consumers not being able
to compete on an equal footing in the
financial services marketplace. And
there are a number of recommendations
on how to deal with that. Have you
thought much about the consumer
side of this and where there may be
opportunities?
Kashyap: That’s probably the part I’ve

studied the least and that’s because
costs during the really acute phase
of the crisis—say from September
2008 to April or May of 2009—didn’t
change much on the consumer side.
People were comfortable taking out
these mortgages that they must have
known they didn’t understand. Many
of them probably thought this deal was
too good to be true, and it was. But
we didn’t have as many breakdowns
on consumer protection across all
countries, and yet the crisis was still
very, very bad when the financial institutions themselves got into trouble
and that spread. I think we could try
to do more on consumer protection.

A lot of the regulatory proposals
put too little weight on the liquidity
provision. There’s a limit to how much
immediately demandable funds the
market can produce.
That’s a place where I’d be very careful
because we know from past experience
that something can start out wellintentioned but have really strange
consequences once it gets enacted.
You could easily end up restricting the
supply of credit to groups because you
think, well, they’re not sophisticated
so we need to protect them, but that
could get them redlined out of the
financial system. The details matter
in a lot of these proposals.

26

Spring 2010

Sniderman: You mentioned the commercial banking system and the shadow
banking system and how we need to be
careful about not driving business from
one to the other if we over-regulate.
Banks have been considered special for
quite a while in the literature. Some
people say banks are inherently special;
other people say banks are only special
because we regulate them that way and
choose to make them special. Has the
time now come to stop thinking about
the commercial banking system and the
shadow banking system as two separate
systems? Should we be thinking about
this in a much more integrated way?
Or are the banks in fact special?
Kashyap: There are two theories of

banking. At the 30,000-foot level,
some people think the banks monitor
firms or customers that are difficult to
evaluate and for whom getting market
credit would be hard without the
monitoring. Others emphasize the
fact that banks do liquidity provision.
A lot of the regulatory proposals put
too little weight on the liquidity
provision. There’s a limit to how much
immediately demandable funds the
market can produce. Part of the reason
why the shadow system collapsed is
that way at the end of many of these
chains of market transactions was a
liquidity guarantee from a bank. Those
became in doubt, and the whole chain
imploded. I don’t think you’ll ever be
able to set up the market system to
necessarily do a lot of liquidity creation.
You might be able to do a certain
amount of the monitoring, but I think
the liquidity creation fundamentally
resides in banks.
You ask why. Again, two theories.
One is that anyone who has access to
the discount window in the end can
get central bank funding, and that’s
what allows them to give funding. But
I also think there’s a reason why there’s
a natural amount of liquidity creation
because banks are in the business
of giving people checking accounts,
which is something people want. Then
managing that kind of risk of liabilities

going away is very similar to measuring
the kind of risk you need to appreciate
if you are going to give somebody a
loan agreement. A checking account
and a loan commitment are really
almost the same thing from the organi­
zation that’s providing them. Either
way, you wake up one day and all of a
sudden more money has gone out the
door. So if you have the infrastructure
in place to manage the checking
accounts, it’s natural that you are
going to go in the loan commitment
business. But now, of course, we’re
into liquidity creation.
In the end, you might say the access
to the discount window is what allows
you to get into this franchise. But I
don’t think that’s quite true because
you see in lots of other countries in
other time periods that there is always
somebody that provides checking
accounts, and this was before we had
central banks. And almost invariably,
the people doing that and allowing
what was called overdraft protection
were in the business of giving loan
commitments. So I think that synergy
is real. It’s not just because of the
central bank guarantee. The central
bank guarantee must help it, but I
think that’s the sense I would say that
banks are special. This perspective
delivers a bunch of propositions about
regulations, including whether they
will be effective and whether they will
be costly.
Sniderman: Systemic risk has become
a very, dare I say, popular topic these
days. When we get into macroprudential
supervision and look at systemic risk,
we need some definitions of systemic
risk so that we don’t just say yes, we’re
going to do this. That may require some
additional theory, then some measurements and tools, and maybe some new
data. How, as a practical matter, might
we do this?
Kashyap: It’s unbelievably challenging

because we don’t measure well so many
things that we know are important.

An active area of research is to try
to come up with ways to summarize networks and linkages. I think
you’re right; it’s going to require all
three things you mention. Some new
theory, some new data probably, and
then some changes in
regulations. I’m hoping
the Fed can do its bit by
publishing some of the
statistics that you are
probably collecting.
I keep pushing on this
deleveraging idea, but
haircuts and margins are
something the Fed, by
virtue of acting in the
marketplace, is already
seeing in those prices.
I’d love to see the Fed publish, once
a week, a set of statistics about indicative margins that indicates something
about the ability to get leverage. That’s
the type of thing I suspect we’re going
to need, because those types of factors
matter a lot for the securitized markets.
And the condition of the repurchase
markets is something we need to learn
more about. Measuring that isn’t so
easy but it’s an important task.
Sniderman: Do you mean that having
more information in the public domain
will help markets discipline behavior?
Kashyap: I was thinking even more

selfishly. It will help academics write
papers that will teach the regulators.
The Squam Lake group wrote a memo
pointing out that if you just disclose
more stuff to the regulators on all
kinds of dimensions, that’s probably
not going to be enough. We need to
think about ways to put information
into the regulatory system but also so
that it can come out and others in the
system can learn more. I think you’re
right, the chance of getting market
discipline going depends on people
believing that they understand what’s
happening in the system as well as
having confidence that regulators can
do the right thing.

Sniderman: One element of financial
reform that seems to be getting rave
reviews is the idea of creating some
exchanges, clearing houses, and new
ways for derivative markets and other
markets to clear and settle. Why do
people view that as such a promising
direction, and are there pitfalls we need
to watch out for?
Kashyap: On exchanges, I think one

thing we learned from Lehman’s case
was that unwinding all the positions
that were open at the time of the
liquidation or failure was incredibly
complicated. And there was no obvious reason why all these transactions
had to be over the counter and why
many couldn’t be standardized. You
mentioned the pitfalls of exchanges—
especially what happens if the exchange
itself fails. Hopefully, that is not going
to be a problem. Exchanges have
proven to be very robust in the past.
It’s probably going to be a good idea to
say, look, things don’t absolutely have
to be traded over an exchange. But if
you do trade over an exchange, you
don’t have to hold as much capital,
and you’re subject to extra supervision
and regulation on over-the-counter
transactions.
The fear with exchanges, besides failure,
is that you might stifle innovation.
Not all of the structured products we
saw were serving a great purpose, but
many of them were designed for good
reasons. And if we go toward a world
where we have more specialized derivative contracts, they invariably have
to start out highly customized. Only
after you learn about them can you get
them standardized enough to trade
them over an exchange.
So I think it would be a big mistake
to say everything has to be traded over
an exchange. There’s not enough discussion about the differences between
centralized clearing and exchange
trading. You can get a lot of advantages
just by clearing trades differently,
even if you don’t trade them over an
exchange. So I’m usually in favor of
centralized clearing as a minimum
condition. And if stuff migrates to an
exchange, that’s fine. But you really
need a lot of infrastructure supporting
the centralized counterparty.

Sniderman: In the area of supervision,
for understandable reasons, conditions at
individual institutions are not revealed,
but are there other opportunities to
benefit the financial system by improving
information flow?
Kashyap: You’re right in saying that it

would be desirable to do more to get
the markets to appreciate the intent of
the regulation and to reinforce some
of the actions that would come out of
supervision. There are huge discussions
as to whether anyone actually believed
Lehman could fail. Some organizations
didn’t think there was any chance it
could happen, which made it all the
messier when it did. If there had been
some way to disclose policy rules and
discuss them ahead of time, it might
have made a difference.
More generally, if macroprudential
supervision is doing its job, it is going
to include writing some reports on
market conditions and warning about
stuff. That’s why I think it’s really
important that the macroprudential
supervisor has some tools to follow
up. One thing we learned about this
process is that having many officials
talk about something for a really long
time doesn’t matter. Fannie and Freddie
were slow-moving train wrecks. Every
single official in the Treasury and
the Fed had been talking about the
problem for years, but they didn’t
have a way to do anything about it.
And the result was that it was allowed
to fester. So disclosing information to
the market can help, but there’s got to
be some scope for following up if the
actions you want to be taken aren’t
taken and if the untoward or reckless
behavior continues, so that there are
consequences. Information is good,
but you’ve got to be able to follow
through. ■
Watch video clips of this interview
www.clevelandfed.org/forefront

Related link
Visit the Squam Lake Working Group’s
website to learn more about its views on
regulatory reform.
www.squamlakeworkinggroup.org
F refront

27

View: Neighborhood Stabilization:

Early Reports on Policymaking in Action
Anne O’Shaughnessy,
Community Development
Project Manager

Many neighborhoods bear visible scars of the housing
crisis in the form of vacant and abandoned homes. These
properties attract crime, drag down the values of neighboring properties, and erode a neighborhood’s sense
of community. On a larger scale, widespread vacancies
threaten the stability of regional and national housing
markets. Help for the hardest-hit areas has come through
the federal Neighborhood Stabilization Program, or NSP,
one of the largest infusions of federal housing dollars in
the past decade. The program is three-fourths of the way
through the first phase. Is it working? And how can the
NSP1 experience help inform NSP2?
The main goal of the Neighborhood Stabilization Program
is precisely what its name suggests. Enacted in July 2008,
NSP funneled close to $4 billion in grants to neighborhoods severely battered by the foreclosure crisis. Money
is targeted to areas that have the highest concentrations
of vacant and foreclosed properties. The housing crisis is
still a virulent force, and unemployment now fuels many
new foreclosure starts. So while a community works to
return some vacant properties to productive reuse, many
more homes may emerge from foreclosure, then quickly
deteriorate and be abandoned.
This is the challenge faced by weak-market states like
Ohio, where Cuyahoga County alone has seen more
than 13,000 new foreclosure starts annually for the past
four years.1 Can a program like NSP effect meaningful
change in such communities? Will NSP2, in which grant
money will be awarded to consortia of local governments
and nonprofits working together, yield better outcomes
than NSP1?
1. From Policy Matters Ohio and NEO CANDO (Northeast Ohio Community
and Neighborhood Data for Organizing).

28

Spring 2010

At the Federal Reserve Bank of Cleveland, we’ve been
assessing NSP as a tool for improving neighborhood
stability here in the Fourth District. Focusing on 10
communities, we documented how each plans to use its
allocation of NSP1 dollars and, through outreach visits,
investigated the barriers and challenges administrators
grapple with in spending those funds.
We’ve learned two key things to date. One is that communities define “neighborhood stabilization” in different ways.
Thus some flexibility in how grant money can be spent
is critical. The second is that partnerships—particularly
long-established ones—have been a vital element of
communities’ NSP successes.
We first shared these findings as a learning tool with
communities receiving NSP funds. We have also used
them to help inform policy. In early 2010 we, along with
several other Reserve Banks, state NSP administrators,
the National Vacant Properties Campaign, and the Federal
Reserve Board of Governors, met with Housing and
Urban Development (HUD) officials in Washington
to share our collective findings on NSP1. While it is
too early for a definitive answer on the program’s overall
success, our assessment suggests that the first phase is
yielding mixed results.
Critics have called the program too rigorous and inflexible.
Complaints range from the heavy administrative burden
on communities, especially smaller ones, to the narrow
time frame allowed for spending the dollars. NSP rules
also severely limit the uses to which officials may direct
these dollars. And some feel that NSP1 allocations are
simply too little.

Money aside, implementation challenges abound.
Some officials are finding that although areas targeted
in their original plans as “most needy” are still worthy of
stabilization efforts, other areas in their communities are
now worse off. Grant money, however, must be spent in
the areas targeted by the original plans.
Another challenge lies in purchasing the properties
specified in a community’s plans. Program administrators
tell us that private investors often scoop up these properties
before public entities can. The reasons vary: a cumbersome administrative process for securing legal approval
to buy the house with NSP funds; a seller unwilling to
accept less than fair market value for the house; or an able
and willing investor—able to move quickly and willing
to pay fair market value—who beats the community to
it. While competition from private investors can certainly
indicate a market is working, it has nevertheless been
problematic for some communities. Moreover, private
investors often do nothing with their purchases but wait,
leaving the properties to fall into further disrepair.
To its credit, HUD is addressing these complaints. In its
most recent move, the agency announced on April 2 that it
is relaxing some of its NSP rules to smooth communities’
path to redeveloping some of their vacant properties using
the grant monies. These changes are the direct result of
feedback HUD received from sources across the country,
including the Federal Reserve Bank of Cleveland. But not
every problem can be resolved. Final deadlines loom. Some
money will undoubtedly have to be returned because a
community, despite its great need, could not fulfill all the
program requirements and commit its funds within the
prescribed 18 months.
Despite the challenges, there have been positives to report.
In Lima, Ohio, where manufacturing has declined and
population has dwindled in recent years, the plan is to
demolish 210 properties in less than three years; previously,
the city averaged between five and 10 demolitions a year.
Cooperation among several departments, including public
works, economic development, and legal, was the critical
element in the city’s success with NSP.

Greater flexibility would allow communities
to adapt plans to shifting market conditions.
In Montgomery County, Ohio, rehabbing homes has
been an essential part of the NSP plan. But to make it work,
administrators needed to develop a pool of potential home
buyers. Tapping local realtors, they set up a website, posted
video clips of homes for sale, and generated neighborhood
support through online transformation stories of local
properties. Neighbors then told others about rehabbed
houses available on their streets. County administrators
cite this buy-in and word-of-mouth marketing as crucial to
helping them sell properties enhanced with NSP1 dollars.
Key lessons so far: Greater flexibility would allow
communities to adapt plans to shifting market conditions.
Not every community has the same needs, and rural areas
seem to have had a tougher time with NSP program
requirements. Extending the time frame might enable
communities, especially those with fewer resources, to
take fuller advantage of programs like NSP. Technical assistance before the program launches could help get the
right players and partnerships in place to succeed. And
ongoing process improvements are a must.
HUD’s responsiveness to feedback about NSP1 demonstrates adaptive policymaking in action. A community’s
circumstances can and do change over time. Every community has its own definition of neighborhood stabilization. Weak markets face different challenges than do
stronger ones. In considering the government’s neighborhood stabilization goal on a national level, then, the policy
message from our study of NSP thus far is clear: Flexibility
supports sustainability. ■

A Look at the NSP
Find profiles of how some Fourth District communities are spending
their NSP dollars.
www.clevelandfed.org/Community_Development/topics/nsp/

HUD Ideas in Action
The agency lays out its five-year strategic plan and invites public
feedback via online forums. http://hudideasinaction.uservoice.com

F refront

29

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