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For release on delivery 10:00 a.m. EDT June 20, 2001 Statement of Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs United States Senate June 20, 2001 Mr. Chairman and members of the Committee, I am pleased to be here this morning to discuss the condition of the U.S. banking system. In my presentation today, I would like to raise just a few issues. I have attached an appendix in which the Federal Reserve Board staff provides far more detail relevant to the purpose of these hearings. There are, I believe, two salient points to be made about the current state of the banking system. First, many of the traditional quantitative and qualitative indicators suggest that bank asset quality is deteriorating and that supervisors therefore need to be more sensitive to problems at individual banks, both currently and in the months ahead. Some of the credits that were made in earlier periods of optimism—especially syndicated loans—are now under pressure and scrutiny. The softening economy and/or special circumstances have especially affected borrowers in the retail, manufacturing, health care, and telecommunications industries. California utilities, as you know, have also been under particular pressure. All of these, and no doubt other problem areas that are not now foreseeable, require that both bank management and supervisors remain particularly alert to developments. Second, we are fortunate that our banking system entered this period of weak economic performance in a strong position. After rebuilding capital and liquidity in the early 1990s, followed by several years of post-World War II record profits and very strong loan growth, our banks now have prudent capital and reserve positions. In addition, asset quality was quite good by historical standards before the deterioration began. Moreover, in the last decade, as I will discuss more fully in a moment, banks have improved their risk management and control systems, which we believe may have both strengthened the resultant asset quality and shortened banks' response time to changing economic events. This potential for an improved reaction to -2cyclical weakness, and better risk management, is being tested by the events of recent quarters and may well be tested further in coming quarters. We can generalize from these recent events to understand a bit better some relevant patterns in banking, patterns that appear to be changing for the better. The recent weakening in loan quality bears some characteristics typical of traditional relationships of loans to the business cycle-the pro-cyclicality of bank lending practices. The rapid increase in loans, though typical of a normal expansion of the economy, was unusual in that it was associated with more than a decade of uninterrupted economic growth. As our economy expanded, business and household financing needs increased and projections of future outcomes turned increasingly optimistic. In such a context, the loan officers whose experience counsels that the vast majority of bad loans are made in the latter stages of a business expansion, have had the choice of (1) restraining lending, and presumably losing market share or (2) hoping for repayment of new loans before conditions turn adverse. Given the limited ability to foresee turning points, the competitive pressures led, as has usually been the case, to a deterioration of underlying loan quality as the peak in the economy approached. Supervisors have had comparable problems. In a rising economy buffeted by competitive banking markets, it is difficult to evaluate the embedded risks in new loans or to be sure that adequate capital is being held. Even if correctly diagnosed, making that supervisory case to bank management can be difficult because, regrettably, incentives for loan officers and managers traditionally have rewarded loan growth, market share, and the profits that derive from booking interest income with, in retrospect, inadequate provisions for possible default. Moreover, credit-risk specialists at banks historically have had difficulty making their case about risk -3because of their inability to measure and quantify it. At the same time, with debt service current and market risk premiums cyclically low, coupled with the same inability to quantify and measure risk, supervisory criticisms of standards traditionally have been difficult to justify. When the economy begins to slow and the quality of some booked loans deteriorates, as in the current cycle, loan standards belatedly tighten. New loan applications that earlier would have been judged creditworthy, especially since the applications are now being based on a more cautious economic outlook, are nonetheless rejected, when in retrospect it will doubtless be those loans that would have been the most profitable to the bank. Such policies are demonstrably not in the best interests of banks' shareholders or the economy. They lead to an unnecessary degree of cyclical volatility in earnings and, as such, to a reduced long-term capitalized value of the bank. More importantly, such policies contribute to increased economic instability. The last few years have had some of the traditional characteristics I have just described: the substantial easing of terms as the economy improved, the rapid expansion of the loan book, the deterioration of loan quality as the economy slowed, and the cumulative tightening of loan standards. But this interval has had some interesting characteristics not observed in earlier expansions. First, in the mid-1990s, examiners began to focus on banks'risk-management systems and processes; at the same time, supervisors' observations about softening loan standards came both unusually early in the expansion and were taken more seriously than had often been the case. The turmoil in financial markets in 1998, associated with both the East Asian crisis and the Russian default, also focused bankers' attention on loan quality during the continued -4expansion in this country. And there was a further induced tightening of standards last year in response to early indications of deteriorating loan quality, months before aggregate growth slowed. All of this might have been the result of idiosyncratic events from which generalizations should not be made. Perhaps. But at the same time another, more profound development of critical importance had begun: the creation at the larger, more sophisticated banks of an operational loan process with a more or less formal procedure for recognizing, pricing, and managing risk. In these emerging systems, loans are classified by risk, internal profit centers are charged for equity allocations by risk category, and risk adjustments are explicitly made. In short, the formal measurement and quantification of risk has begun to occur and to be integrated into the loan-making process. This is a sea change-or at least the beginning of one. Formal risk-management systems are designed to reduce the potential for the unintended acceptance of risk and hence should reduce the pro-cyclical behavior that has characterized banking history. But, again, the process has just begun. The federal banking agencies are trying to generalize and institutionalize this process in the current efforts to reform the Basel Capital Accord. When operational, near the middle of this decade, the revised accord, Basel II, promises to promote not only better risk management over a wider group of banks but also less-intrusive supervision once the risk-management system is validated. It also promises less variability in loan policies over the cycle because of both bank and supervisory focus on formal techniques for managing risk. In recent years, we have incorporated innovative ideas and accommodated significant change in banking and supervision. Institutions have more ways than ever to compete in -5providing financial services. Financial innovation has improved the measurement and management of risk and holds substantial promise for much greater gains ahead. Building on bank practice, we are in the process of improving both lending and supervisory policies that we trust will foster better risk management; but these policies could also reduce the pro-cyclical pattern of easing and tightening of bank lending and accordingly increase bank shareholder values and economic stability. It is not an easy road, but it seems that we are well along it. Appendix Condition o f the Banking Industry Prepared by: Staff, Board o f Governors o f the Federal Reserve System June 2 0 ,2 0 0 1 The U .S. banking industry is w ell capitalized and highly profitable by historical standards and in reasonably good shape, although there are signs o f erosion as problem loans have risen, especially in larger syndicated credits. M oreover, som e further erosion is lik ely as borrowers who have taken on heavy debt burdens experience less robust increases in profits and incom e than m ight have been anticipated not too long ago. In many cases, problem loans are a hangover from loans made in the m id-1990s when lenders evidently failed to exercise sufficient discipline. After about 1998, banks took a number o f steps to tighten lending standards and terms, w hich should help to lim it further deterioration. N evertheless, w ith a w eakening econom y, problem s could w ell worsen for som e banks and som e market segm ents, requiring vigilance by banks and their regulators. A s alw ays, the underlying issue is how to adopt and price realistic assessm ents o f likely credit risks under alternative scenarios, keeping credit flow ing to worthy borrowers at reasonable prices. Today, banking organizations and their supervisors are taking a number o f steps that w ill be necessary to ensure that our financial system continues to flourish and support long-term econom ic growth w ell into the future. K ey elem ents o f such actions are referenced in the last two sections o f this appendix. Earnings Although banking profitability has risen to historically high levels in terms o f return on assets and return on equity over the past decade, in recent periods higher loan loss provision expenses and narrowing net interest margins have placed pressures on bank profitability. D espite those em erging w eaknesses, downside risks lik ely have been -2- lim ited by the increasing diversity o f noninterest and interest sources o f revenues. The continued push by banks to diversify their revenues by expanding business lines devoted to asset management, servicing, securitization, investm ent banking, and other fee-based activities should help stabilize earnings streams. In addition, in the wake o f consolidation and interstate banking, m any larger firms are less vulnerable to downturns in particular regions or specialized business lines. N onetheless, in the past few quarters, em erging earnings w eaknesses have been pronounced at som e o f the larger banking organizations, w hich have experienced sharp increases in loan loss provision expenses, narrowing interest m argins, and significant declines in venture capital revenues. During the first quarter o f this year, those negative developm ents at large firms w ere som ewhat offset b y record trading profits and better overhead cost efficiency. W hile the net effect w as a decline in profits at m any larger banking organizations, the underlying strength in the profitability o f regional and com m unity banks, coupled w ith nonrecurring securities gains, helped the industry as a w hole achieve record first quarter earnings o f nearly $20 billion. Asset Quality The rise in nonperform ing assets at banking organizations has been pronounced over the past year, esp ecially at larger banking organizations. D espite that rise, these problem s generally remain moderate in historical term s relative to earnings, assets and capital. A ssets classified as substandard, doubtful or lo ss have also risen rapidly in recent periods, though again from a m odest base. M uch o f that increase is attributable to larger syndicated credits, though there are som e indications o f softening in the credit quality o f m iddle-m arket borrowers. In response to this rise, banks have written down assets to -3- estimated net realizable values and replenished reserves for expected problems through loan loss provision expenses. A common theme for m any o f the problem credits has been significant leverage em ployed to expand businesses during tim es o f ebullient econom ic and market conditions. M any o f these credits were originated during a period o f relaxed lending standards that did not adequately account for the susceptibility o f the borrower to weakening sectoral or econom ic conditions. After the reminders in 1998 from the Asian disruptions and the Russian default, lending standards w ere tightened. But, with the advent o f a softening econom y, the embedded risks o f w eaker or more vulnerable borrowers are becom ing w ell recognized. Particularly hard hit have been certain borrowers in the retail, manufacturing, health care and telecom m unications industries. In addition, unexpected developm ents in asbestos litigation as w ell as the difficulties faced by the California utilities have also added considerably to the stock o f classifications. The rapid deterioration o f credit quality in certain segm ents o f bank loan portfolios reflects the significant share o f the growth in bank lending in recent years to borrowers on the borderline betw een investm ent and noninvestm ent grade creditworthiness. W ith the presence o f active m oney and capital markets in the U nited States, and their ease o f access b y the best quality borrowers, these credit grades reflect the quality o f those w ith w hich our banks now norm ally deal. They represent the types o f borrowers that tend to require the m ore custom ized analysis, underwriting and structuring offered by banks that m ay not be as readily available or as cost-effective through the bond market. The higher m agnitude and volatility o f default rates in these types o f borrowers is w ell docum ented from decades o f experience in the below -investm ent grade -4- segm ent o f the bond market. Consequently, as conditions have w eakened and defaults have risen sharply in noninvestm ent grade bonds, a parallel increase has occurred in troubled and nonperform ing loans o f bank portfolios. Forecasts for a continued rise in defaults for low er rated bonds b y M oody’s suggest that bank corporate asset quality is also likely to deteriorate further before it im proves. Although part o f the deterioration m ay be a natural consequence o f taking normal business risk in a w eaker econom y, part also reflects a lack o f discipline by som e banks, particularly in the 1995-1997 interval. A s banking organizations relaxed their standards and the rigor o f their credit risk analysis in this period, banking supervisors responded by issuing cautionary guidance and stepped up the intensity o f review s o f lending operations at many banking firm s. In particular, supervisors pointed out the need for lenders to avoid the use o f overly optim istic assumptions that presum ed strong conditions w ould prevail indefinitely. In addition, supervisors also noted the lack o f dow nside risk analysis or stress testing as a w eakness in risk management practices at m any banks. R ecent credit losses have highlighted the im portance o f follow ing those sound lending and evaluation fundam entals and have clearly differentiated strong credit risk m anagement system s from w eak ones, prompting m any organizations to take rem edial action. For the past several years, the banking agencies have shifted their supervisory approach to focus on risk m anagem ent processes at banking organizations as a m ore effective m eans for prom oting sound banking practices. W hile bank risk managem ent practices have im proved, in part because o f supervisory efforts, recent experience has show n that m ore work needs to b e done. M ore recently, to help facilitate im provem ents underway at banks in response to current credit difficulties, the banking agencies issued -5- guidance earlier this year clarifying their expectations regarding sound practices for m anaging leveraged finance exposures. Even before recent w eaknesses, banks had begun to reevaluate their strategic direction and, with the encouragement o f supervisors, had becom e more deliberate about the need to im plem ent formal procedures for recognizing, pricing, and m anaging risk. W ithout these reforms, the recent deteriorating trends would likely have been considerably worse. In these em erging system s, loans are classified by risk, internal profit centers are charged for equity allocations by risk category, and risk adjustments are explicitly made. In addition, more advanced system s provide the m etrics that are necessary to support active portfolio management, including decisions on whether certain loans exhibiting em erging w eaknesses should be sold and at what price. The active sale o f troubled syndicated credits has been an em erging trend among larger organizations. In particular, the increasing appetite for these loans by nonbank investors has helped deepen and liquefy the market, providing an outlet for banks w ith adequate capital and reserves to sell loans at a discount to par value and to rebalance their portfolios. Today risk management system s have also helped rationalize the pricing o f risk through stricter terms and conditions for more vulnerable borrowers. Sophisticated risk management system s are also helping banks to reevaluate the profitability o f bank lending by benchmarking loans against corporate hurdle rates. In m any circum stances, banks are recognizing that without the ancillary cash management or other revenue opportunities attached to the lending relationship, it is difficult to find stand-alone lending opportunities that m eet these hurdle rates. B y using these sophisticated quantitative risk management tools to support their decision-m aking, banks are better - 6 - able to distinguish profitable versus unprofitable relationships and determ ine whether a particular custom er is com patible w ith the bank’s appetite for risk. At present, the tightening o f terms and standards at banks and the bond market has not inhibited the flow o f funding to sound borrowers, though borrowers appear to be increasingly tapping the bond market, and lenders and the bond market also are requiring higher spreads for marginal credits. W hile tightening can be over done, so far banks seem to be making balanced decisions on the tradeoff betw een risk and returns. This is a favorable outcom e, because it assists in directing capital flow s to their highest and best use in the econom y. Much focus has been placed on the dynam ics w ithin the corporate loan book, w hich is currently experiencing the majority o f problem s, but banks and supervisors should continue to be vigilant for other potential risks. In particular, though retail credit quality has been fairly stable in recent years, consum ers, lik e corporations, have also increased leverage, m aking their ability to perform under stressful circum stances less reliable. In recent years, buoyant econom ic conditions raised expectations for continued growth in incom e and em ploym ent for consum ers, w hich along w ith rising lev els o f w ealth, has led to growth in household debt that has outstripped growth in disposable personal incom e over the past five years. That expansion o f debt has pushed consum er debt service burdens to new highs. W ith the recent slow dow n in d ie econom y, rising personal bankruptcies, an increasing unem ploym ent rate, and a m odest deterioration in loan quality, lenders have tempered their outlook, tightening their standards som ewhat for credit cards and -7installm ent loans. A t the same tim e, w hile consumer spending has leveled out as the econom y has weakened, demand for credit has strengthened in recent periods. Over the past decade, banking organizations have taken advantage o f scoring m odels and other techniques for efficiently advancing credit to a broader spectrum o f consumers and sm all businesses than ever before. In doing so, they have made credit available to segm ents o f borrowers that are more highly leveraged and that have less experience in managing their finances through difficult periods. For the m ost part, banks appear to have tailored their pricing and underwriting practices to various segm ents o f their consumer portfolios to account for the unique risks related to each. Som e institutions have also tailored lending towards segm ents w ith troubled credit histories, the so-called subprime market. Such lending can be favorable both to borrowers and lenders. Subprime borrowers benefit by gaining access to credit and the opportunity to build a sound credit history that m ay eventually allow them to achieve prime status. For lenders, subprime lending affords the opportunity for higher returns provided the necessary infrastructure is in place to closely track and monitor the risk related to individual borrowers, w hich can be labor intensive and costly. Lenders m ust also recognize the additional capital and reserve needs to support such lending, particularly i f they have concentrations in subprime loans. Banks that have not understood the subprime market have had significant difficulties. To ensure that banks entering this business properly understand these risks, the agencies have encouraged banks to adopt strong risk management system s tailored to the challenges posed b y these loan segm ents. Beyond poor risk management, there have also been instances in w hich certain lenders have charged fees and structured loans - 8 - designed not to protect against risk, but rather to deceptively extract a borrower’s net worth. Such predatory lending practices, though rare, are a cause for concern and exam iners are w atchful for programs that w ould violate the law in this regard. Another area o f supervisory focus, o f course, is com m ercial real estate. The exceptional demand for office and other com m ercial real estate in recent years has led to a rebound in the volum es o f loans secured by these properties. This tim e, how ever, as demand has grown, larger banking organizations have managed to keep their holdings m odest relative to their asset bases either through securitizations, sales or by avoiding originations altogether. In contrast, many sm aller com m ercial banks have raised their com m ercial real estate concentrations relative to assets and capital. W hile underwriting practices appear to be m uch healthier today than they w ere in the 1980s and standards have tightened som ewhat recently, supervisors are paying particular attention to com m unity banks w ith concentrations that m ake them m aterially vulnerable to a downturn in this market. W hile for the past several years there have been few real estate markets w ith material im balances in supply and demand, em erging signs o f w eakness m ake die need for vigilance m ore pressing. In die first quarto: o f this year, there has been a pronounced increase in nationwide vacancies that has resulted in a negative net absorption o f office space in the U nited States. That poor perform ance, the w orst in tw enty years, has been attributed b y som e market observers to the abrupt return o f o ffice space to the market by technology firm s and to delays by prospective tenants hoping that softening conditions w ill low er rents further. In this environm ent, noncurrent com m ercial real estate loans have edged up som ewhat in the first quarter. W hether the first quarter represents a -9- temporary phenom enon or the beginning o f a longer term trend remains to be seen, but the need for institutions to continue a realistic assessm ent o f conditions and stress test their portfolios is paramount. In addition to real estate, agricultural lending is also facing challenges. Commodity price w eakness, coupled w ith changes in the federal price support programs, has placed pressures on the ability o f farmers to service their debt. This in turn has led to a rise in noncurrent farm loans. Banks are continuing to identify ways to work with their borrowers to navigate through this difficult period. Funding For banks to remain in sound condition, they must not only pay attention to the quality o f their assets, but also to the nature and quality o f their funding. In recent years, large and sm all banks alike have com e to rely increasingly on large w holesale deposits and nontraditional sources o f funds. They have done so in part as the demand for loans and their own growth objectives have outstripped the growth in insured core deposits. It is true that retail core deposit growth has been quite m eager over the past decade with higher returns in mutual funds and the stock market luring custom ers away from banking deposits. On the other hand, banks have also m ade the calculated decision to pay relatively low interest rates on som e types o f retail accounts and rely on higher-priced jum bo deposits or w holesale borrowing to fund increm ental asset growth. D espite com petition for household funds, com m unity banks have been relatively successful at m aintaining their core deposit bases. For exam ple, a decade ago banks w ith less than $50 m illion in assets funded around 80 percent o f their assets w ith core deposits. Over the course o f the past decade, that figure eroded by 7 percentage points, but remains -10- a fairly strong 73 percent o f assets. That com pares to core deposit holdings o f on ly 39 percent for banks w ith m ore than $10 billion in assets. W hile com m unity banks have experienced moderate erosion in the share o f core deposits funding assets, w hen that trend is coupled w ith rapid loan growth, pressures on bank liquidity have intensified. To replace core deposits, com m unity banks have been fairly successful at attracting jum bo deposits and have made use o f Federal H om e Loan Bank advances. Com m unity banks have also funded the gap betw een loan and deposit growth by liquidating securities holdings and accordingly raising the quantity o f loans relative to assets. The com bined deposit and loan trends have pushed liquidity benchmark ratios such as loans-to-deposits to historic peaks. On the other hand, there are som e signs o f r elief for bank liquidity. For one, the demand for loans by businesses and consumers appears to be moderating, and there are som e early indications that consum ers are returning to bank retail deposits in the w ake o f disappointing stock and mutual fund results. S till, m any o f these liquidity pressures are lik ely to remain in one form or another, and banks are lik ely to continue to explore non-deposit alternatives for m anaging their balance sheets. W hile the use o f non-deposit liab ilities to fund growth is not new to banks, the grow ing volum e, variety and com plexity o f these funds creates new issues. To m eet this challenge, banks must strive to fu lly understand the im plication o f relying on these types o f funds both from a liquidity and earnings perspective. The Federal R eserve recently issued guidance on the use o f com plex w holesale borrowings and d ie banking agencies recently issued guidance on rate sen sitive deposits to highlight the im portance o f adequate m anagem ent techniques for ensuring stable and consistent funding. -11- C ap ital and S u pervisory In itiatives The m ost stable funding source for bank balance sheets is shareholder equity. M ore significantly, shareholder equity’s key feature is its ability to absorb losses. The need for banks to hold capital commensurate with the risk they undertake is highlighted by recent w eaknesses in bank asset quality and the uncertain econom ic environment. Today, by virtue o f market pressures follow ing the difficulties o f the late 1980s, m inim um regulatory capital requirements and the ability o f many banking organizations to m easure and recognize their ow n needs for a cushion against m ore difficult tim es, the industry capital base appears adequate to m eet emerging challenges. From a regulatory capital perspective, the vast majority o f all banks m eet the definition for w ell capitalized. The original B asel Accord that w as adopted in 1988 has served supervisors and the industry fairly w ell over the past decade as one o f the primary tools for m aintaining a sound banking system . More recently, the nature and com plexity o f risk undertaken by m any larger organizations have m ade the blunt traditional measures o f capital adequacy, whether equity-to-assets, leverage, or current risk-based capital ratios, less m eaningful. In considering the lik ely continuation o f innovations over the next decade, supervisors must develop w ays to im prove their tools w hile reinforcing incentives for sound risk management. The new B asel risk-based proposal seeks to achieve the tw in objectives o f a more m eaningful capital adequacy measure and promoting sound risk management practices. The proposal b y the B asel Com m ittee that w as announced in January o f this year calls for an international capital accord that is based on three pillars: a minimum capital requirement that is more sensitive to risk, a supervisory review process, and market -12- discipline. It is important to note that the B asel Com m ittee is in the process o f review ing the public’s com m ents on the proposal and there are still a myriad o f important issues and details to address and work out before it can be im plem ented. The proposal offers a menu o f alternative frameworks for establishing m inim um capital requirements so that institutions can be matched w ith the approach that fits their particular degree o f sophistication, risk profile and risk m anagem ent capabilities. On one end o f the spectrum, the proposed advanced approach, designed for the m ost sophisticated and com plex entities, relies on a bank’s internal risk rating and loss estim ates in the establishm ent o f the m inim um requirements for credit exposures. A t the other end o f the spectrum, the proposed standardized approach m odifies the current framework to be som ewhat more risk sensitive but retains m any o f the sim ple features o f the current accord. The second pillar, the supervisory review process, requires supervisors to ensure that each bank has sound risk m anagem ent processes in place. The em phasis in that review is both on the integrity o f the process that produces the m etrics used in calculating the supervisory minimum, as w ell as the adequacy o f a bank’s ow n analysis o f its capital needs. The second pillar fits very w ell w ith the Federal R eserve’s efforts in recent years to encourage larger, more com plex banks to im prove their internal risk rating system s w hile placing more em phasis on their ow n internal analysis o f capital adequacy. The new accord is much more than an effort to im prove the m eaningfulness o f minim um regulatory capital ratios, although that clearly is an important aspect o f the proposal. Em bodied in the proposal are som e important risk management principles and sound -13practices that supervisors would expect all o f the very largest and m ost com plex U .S. banks to be follow ing or aspiring to, even those not electing to use one o f the more advanced approaches. A s proposed, the capital standards should provide banking organizations in the United States and abroad with strong incentives to accelerate their developm ent and im plem entation o f improved risk management system s in order to qualify for a more risk-sensitive regulatory capital treatment. M oreover, the review necessary to ensure that bank risk m easures are sound m aintains the focus o f supervisors on the key elem ents o f control and risk management that govern safe and sound banking. The third pillar com plem ents the first tw o by bolstering market discipline through enhanced disclosures by banks. B y their very nature, many banking risks are opaque. H owever, innovations in recent years that have helped im prove the management o f risk have also led to the developm ent o f various summary statistics to m eaningfully describe risks that w ere qualitatively described in the past. W hile challenges remain in m aking such measures comparable or differences across institutions w ell understood, such disclosures are a necessary com plem ent to the other two pillars for the overall approach to retain the necessary lev el o f rigor and integrity. D isclosure o f inform ation that helps stakeholders determine risk profiles is designed, o f course, to increase, w hen necessary, the market pressure and costs on bank lenders that they w ould otherw ise receive as a matter o f course if they w ere not beneficiaries o f the safety net. Market discipline can also provide useful signals to supervisors. Significantly, the opportunity for enhanced market discipline through disclosure is substantial given that larger organizations fund about two thirds o f their assets w ith uninsured funds. H owever, supplem ental information w ill b e irrelevant unless uninsured -14- creditors b elieve that they are, in fact, at risk. Uninsured creditors have little reason to engage in risk analysis, let alone act on such analysis, i f they b elieve that they w ill alw ays be made w hole under a de facto too-big-to-fail policy. R ecognizing that dilem m a, in 1991 the Congress placed in the Federal D eposit Insurance Corporation Improvement A ct a requirement for a least-cost resolution o f financial institutions. Although an exception clause exists, it does not require that all uninsured creditors be made w hole. Conceptually, there are rare situations where events m ay require that the FDIC and other governmental resources be used tem porarily to sustain a failing institution pending its managed liquidation. But indefinitely propping up insolvent intermediaries is the road to stagnation and substantial resource m isallocation, as recent history attests. Indeed, i f the governm ent protects all creditors, or is generally believed to protect all creditors, the other efforts to reduce the costs o f the safety net w ill be o f little benefit. The im plications are sim ilar i f the public does not, or cannot, distinguish a bank from its affiliates. A s financial consolidation continues, and as banking organizations take advantage o f a w ider range o f activities, the perception that all creditors o f large banks, let alone o f their affiliates, are protected b y the safety net is a recipe for a vast m isallocation o f resources and increasingly intrusive supervision. Financial Holding Companies and Umbrella Supervision M indful o f the potential for the federal safety net to extend beyond what Congress intended in its enactm ent o f the G ram m -Leach-Bliley A ct (“GLB A ct”), the Federal R eserve has been careful to distinguish betw een insured depositories and uninsured holding com pany affiliates and parent organizations in the supervision o f financial holding com panies (“FHCs”). C onsequently, the Federal R eserve’s focus in FHC -15- supervision has been to identify and evaluate, on a consolidated group-wide basis, the significant risks that exist in a diversified holding com pany with a view to evaluating how such risks m ight affect the safety and soundness o f insured depository institution subsidiaries. Such supervision is not intended to im pose bank-like supervision on FHCs, nor is it intended to duplicate or replace supervision by the primary bank, thrift, or functional regulators o f FHC subsidiaries. Rather, it seeks, on the one hand, to balance the objective o f protecting the depository institution subsidiaries o f increasingly com plex organizations w ith significant inter-related activities and risks, against, on the other, the objective o f not im posing an unduly duplicative or onerous burden on the subsidiaries o f the organization. To accom plish that objective w e have relied on our long-standing relationships with primary bank, thrift, securities and foreign supervisors w hile forging new relationships w ith the functional regulators that oversee activities that are new ly permitted under the A ct. These relationships respect the individual statutory authorities and responsibilities o f the respective supervisors, but at the sam e tim e, allow for enhanced inform ation flow s and coordination so that individual responsibilities can be carried out effectively without creating duplication or excessive burden. The Federal Reserve places substantial reliance on internal m anagem ent information maintained by FHCs and on reports filed with, or prepared b y, bank, thrift, and functional regulators, as w ell as on publicly available information for both regulated and non-regulated subsidiaries. Since enactment o f the GLB A ct, over 500 FHCs have been formed. The vast majority o f those are sm all com m unity holding com panies that converted largely in an -16- effort to take advantage o f the insurance agency provisions o f the GLB A ct or to be w ell positioned should opportunities for exercising new powers present them selves. M ost o f the larger holding com panies have also converted to FHCs, and appear to be taking advantage o f the securities, merchant banking, and to a lesser extent, the insurance provisions o f the A ct. In addition to the conversion o f existing bank holding com panies, there have been a few nonbank financial service com panies that have applied for and received FHC status in connection w ith their acquisition o f banking organizations. In general, banking organizations appear to be taking a cautious and incremental approach to exercising new powers trader the GLB Act. In addition, the number o f new , truly diversified financial holding com panies across securities, insurance and banking has been few enough to let organizations and supervisors gradually gain experience and com fort in their operations.
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