From: Subject: krosner-101107 Date: Fri, 12 Oct 2007 12:34:23 -0400 MIME-Version: 1.0 Content-Type: text/html; charset="iso-8859-1" Content-Transfer-Encoding: quoted-printable Content-Location: http://us.gallerywatch.com/pipefile.asp?type=pdf&sid=AGDOC:27273:docs%2Fnews%2FUS%2Fagdocs%2F27273%5Frosner%2D101107%2Ehtm X-MimeOLE: Produced By Microsoft MimeOLE V6.00.2900.3198 krosner-101107 Governor Randall S. Kroszner
At the National Bankers = Association 80th=20 Annual Convention, Durham, North Carolina
October 11, 2007=20

Markets, Financial Institutions, and Consumers: The Roles of the = Federal=20 Reserve

It is a pleasure to take part in this event. I commend our hosts for = bringing=20 together such a broad range of participants and for developing an agenda = that=20 addresses issues of great significance to the banking community. My goal = today=20 is to offer a broad perspective of the Federal Reserve's various=20 responsibilities and complementary roles.

The roles of the Federal Reserve may seem somewhat obscure and, to = many, even=20 disconnected. I would venture a guess that as bankers, you think first = of=20 examiners when you hear "Federal Reserve"--and perhaps do so with a = groan. But=20 as you know, bank supervision is only one of the Federal Reserve's = functions. In=20 my remarks today, I will speak about some of the Federal Reserve's=20 responsibilities and discuss how they relate to markets, financial = institutions,=20 and consumers.

The Central Bank and Monetary Policy
As the nation's central bank, = the=20 Federal Reserve has the unique power in the U.S. financial system to = create=20 money, giving it the ability to conduct monetary policy for the U.S. = economy.=20 That power also enables the Federal Reserve to provide liquidity--a = capability=20 that is particularly important when the financial system is under = stress.=20 Indeed, the Federal Reserve was established in 1913 as a means of = addressing the=20 periodic financial panics and accompanying economic downturns that had = afflicted=20 the nation at various times.

The Congress has given the Federal Reserve specific objectives for = the=20 conduct of monetary policy--in particular, to conduct monetary policy in = a way=20 that promotes the long-run objectives of maximum sustainable employment = and=20 stable prices. Monetary policy is implemented primarily through open = market=20 operations--that is, the purchase and sale of securities in the open=20 market--which gives the Federal Reserve the ability to control = short-term=20 interest rates. The Federal Open Market Committee (FOMC) oversees the = conduct of=20 open market operations and formulates monetary policy by setting an = operating=20 target for the federal funds rate that is judged to be consistent with = fostering=20 the Federal Reserve's long-run objectives.

As part and parcel of its pursuit of maximum sustainable employment = and=20 stable prices, the Federal Reserve has a broad responsibility to foster=20 financial stability. I should hasten to add that financial stability = does not=20 imply that asset prices will be stable at all times or that investors = will be=20 protected from significant losses. Rather, financial stability is = fundamentally=20 about the efficient functioning of financial markets in channeling = credit and=20 financial resources to the most productive ends and allowing investors = to=20 effectively manage risks.

During periods of financial distress, the Federal Reserve can promote = financial stability by providing liquidity through both open market = operations=20 and the discount window. It can provide liquidity through open market = operations=20 by purchasing assets in the open market in exchange for newly created = reserves.=20 It can also address the liquidity needs of solvent but temporarily = illiquid=20 banks by lending to them through the discount window. Such lending can = allow=20 banks to meet payment obligations; to avoid "fire sales" of assets, = which can=20 disrupt financial markets; and to continue to lend to customers without=20 tightening terms or credit standards, which can limit economic growth. = It is=20 important to note that the ability and willingness of the central bank = to=20 provide liquidity may be useful in reducing market uncertainty and = bolstering=20 investor confidence, even if the actual amount of liquidity provided = turns out=20 to be rather modest. For these reasons, the ability to provide liquidity = is a=20 critical tool of a central bank.

This brief overview of the role of the Federal Reserve in fostering = financial=20 stability is instructive in considering the policy actions undertaken in = response to recent disruptions and strains in financial markets. The = Federal=20 Reserve used a range of policy tools--including adjustments in = short-term=20 interest rates and the provision of liquidity--during this time of = market unrest=20 to counter the potential ill effects on the economy. On August 10, the = Federal=20 Reserve issued a statement announcing that it was providing liquidity to = facilitate the orderly functioning of financial markets and would = provide=20 reserves as necessary to promote trading in the federal funds market at = rates=20 close to the target rate of 5-1/4 percent. The announcement also noted = that the=20 discount window was available as a source of funding.

On August 17, the FOMC issued a statement noting that financial = market=20 conditions had deteriorated and that tighter credit conditions and = increased=20 uncertainty had the potential to dampen economic growth. The FOMC said = that it=20 judged the downside risks to growth to have increased appreciably and = stated=20 that it was prepared to act as needed to mitigate adverse effects on the = economy=20 arising from the disruptions in financial markets. At the same time, the = Board=20 of Governors announced that it had approved a 50 basis point reduction = in the=20 primary credit rate at the discount window, to 5-3/4 percent, to promote = the=20 restoration of orderly conditions in financial markets. Given the = turbulence in=20 the short-term funding market, the Board also approved a change in the=20 administration of the discount window that would allow the provision of = term=20 financing for as long as thirty days, renewable by the borrower. And on = August=20 21, the Federal Reserve Bank of New York announced some temporary = changes to the=20 terms and conditions of the System Open Market Account securities = lending=20 program, including a reduction in the minimum fee, in an effort to = facilitate=20 lending of securities by the Fed to address heightened safe-haven = demands for=20 Treasury securities.

These actions appeared helpful in mitigating some of the strains in = financial=20 markets, but financial market functioning had not returned to normal by = the time=20 of the September FOMC meeting. At that time, we judged that a 50 basis = point=20 lowering of the target federal funds rate was appropriate to offset the = effects=20 of tighter financial conditions on the economic outlook and reduce the = risks=20 that a further tightening in credit conditions could impact the housing = market=20 and lead to significant broader weakness in output and employment.

Bank Supervision
While the Federal Reserve's role in conducting = monetary=20 policy and providing liquidity garners a great deal of media attention, = its role=20 in bank supervision and regulation is no less important. The Federal = Reserve=20 shares responsibility for regulating and supervising the safety and = soundness of=20 the U.S. banking system with a number of federal and state government = agencies.=20 The Federal Reserve supervises state-chartered banks that are members of = the=20 Federal Reserve System, the U.S. operations of foreign banks, and, in = some=20 cases, the foreign operations of U.S. banks. In addition, it is the = umbrella=20 supervisor of all bank holding companies and financial holding = companies.=20 Although the banks and nonbank subsidiaries of these entities are often=20 supervised by other agencies, the Federal Reserve coordinates with the = primary=20 supervisors in assessing the overall financial condition of the = consolidated=20 organization.

The scope of the Federal Reserve's supervisory activities includes = regular=20 examinations of depository institutions and inspections of holding = companies to=20 assess the safety and soundness of these entities and to ensure that = they comply=20 with relevant banking laws and regulations.

In addition, the Federal Reserve contributes to the development of = policies=20 regarding banking supervision and regulation, collaborating with the = other=20 agencies to issue rules and guidance that help ensure that federally = supervised=20 banking entities are adhering to the high prudential standards that are=20 essential to maintain a stable banking system. The Federal Reserve plays = an=20 instrumental role in developing policies that affect both domestic and=20 international banking organizations. One visible example of such = collaboration=20 is the international effort known as Basel I and II that ultimately = resulted in=20 a framework that established minimum regulatory capital requirements, = increased=20 supervisory attention to banking institutions' capital adequacy and=20 risk-management techniques, and enhanced public disclosure of banking=20 organizations' risk exposures. These standards promote safety and = soundness and=20 reduce competitive inequi­ties among banking organizations operating = within=20 an increasingly global market.

The full range of its supervisory activities gives the Federal = Reserve=20 ongoing access to critical information about the banking system that is=20 pertinent to our assessment of the state of the overall economy and has = proved=20 highly valuable during the most recent market stress. With data on = financial=20 institutions' managerial, operational, and risk-management systems, the = Federal=20 Reserve has information about the overall condition of the banking = institutions=20 it supervises as well as insight into developments in the broader = financial=20 markets. Such knowledge allows for a broad and deep understanding of=20 developments in financial markets and financial institutions. These = supervisory=20 activities provide the Federal Reserve with access to real-time = information that=20 facilitates the formulation of policy responses during periods of = financial=20 stress.

For example, we are all well aware that the subprime mortgage market = has=20 presented supervisory concerns. The Federal Reserve has collaborated = with=20 various agencies to address these concerns, working to overcome = challenges=20 presented by the rapid pace of financial innovation and the complex = regulatory=20 scheme of the mortgage market. The federal supervisory agencies first = issued=20 guidance on subprime lending in 1999 and expanded it in 2001 to = emphasize that=20 lending standards should include well-defined underwriting parameters, = such as=20 acceptable loan-to-value and debt-to-income ratios and minimum = acceptable credit=20 scores. Further, it advises institutions actively involved in the = securitization=20 and sale of subprime loans to develop contingency plans that include = alternate=20 funding sources and measures for raising additional capital if = necessary.

As the mortgage industry continued to expand its product offerings, = the=20 Federal Reserve and the other federal agencies observed in 2005 that = lenders=20 were increasingly offering nontraditional, or "exotic," mortgage loans, = which=20 defer the repayment of principal and, sometimes, interest. Of particular = concern=20 with these types of loans were the lack of principal amortization and = the=20 potential for negative amortization. Moreover, the easing of = underwriting=20 standards and the marketing of these products to a wider spectrum of = borrowers=20 held the potential to create larger risks. In 2006, the Federal Reserve = and the=20 other banking agencies issued guidance on nontraditional mortgage = products to=20 address these concerns. This guidance underscores the sound underwriting = procedures, portfolio-risk management strategies, and consumer = protection=20 practices that institutions should follow to prudently originate and = manage=20 nontraditional mortgage loans. A major aspect of this guidance is the=20 recommendation that a lender's analysis of repayment capacity include an = evaluation of the borrower's ability to repay the debt by final maturity = at the=20 fully indexed rate, assuming a fully amortizing repayment schedule.

Continuing concerns about the subprime market led the federal = regulators to=20 issue further guidance this year regarding adjustable-rate mortgages = (ARMs). Of=20 particular concern were those ARM products that allow for low initial = payments=20 based on a fixed introductory rate that expires after a short period and = then=20 adjust to a variable rate, plus a margin, for the remaining term of the = loan.=20 These products may result in payment shock to some borrowers, = heightening risks=20 to both lenders and borrowers.

Consumer Protection in Financial Services
As you can see, the = scrutiny of=20 safety and soundness issues in the subprime mortgage market also raised = concerns=20 relating to consumer protection--another area of significant = responsibility for=20 the Federal Reserve. Toward this end, the Federal Reserve has primary=20 rule-writing authority for many consumer protection laws. It takes two=20 fundamental approaches to consumer protection: one focuses on the = provision of=20 information, and the other involves the development and enforcement of = rules=20 against abusive and unfair practices.

I will speak first about the importance of providing consumers with = pertinent=20 and accurate information. Clearly, information is critical to the = effective=20 functioning of markets. A core principle of economics is that markets = are more=20 competitive, and therefore more efficient, when accurate information is=20 available to both consumers and suppliers. When information on = alternatives is=20 readily available, product offerings must meet customers' demands and = offering=20 prices must reflect those of market competitors. If consumers are well = informed,=20 they are in a better position to make decisions that are in their best = interest.=20 Information helps and empowers individual consumers by improving their = ability=20 to compare products and choose those that will help them meet their = personal=20 goals, and this informed comparison shopping enhances competition. As a = result,=20 a significant component of the rule-writing process involves crafting = disclosure=20 requirements that provide consumers with consistent and relevant = information=20 about the terms and fees of financial products.

The Federal Reserve is keenly aware, however, that information alone = may not=20 always be sufficient to combat abusive practices--which brings me to the = importance of rules and the enforcement of consumer protection measures. = Indeed,=20 the consumer financial services laws implemented by the Federal Reserve = contain=20 a number of substantive protections, reflecting carefully considered = legislative=20 judgments that certain practices should be restricted or prohibited. = Enforcement=20 of these rules is carried out through the Federal Reserve's supervisory=20 oversight for compliance with consumer protection laws and = regulations.

As consumer protection issues have emerged in relation to subprime = mortgage=20 lending, the Federal Reserve has sought to address concerns by using its = various=20 supervisory and rule-writing tools. In doing so, it is extremely = important to=20 strike the right balance by seeking to protect consumers from abusive = lending=20 practices without restricting credit from responsible lenders to = borrowers with=20 shorter or lower-rated credit histories. The guidance pieces on subprime = and=20 nontraditional mortgages that I mentioned earlier address many issues = relating=20 to consumer protection, in addition to safety and soundness. We are also = undertaking other actions to address concerns related to the flow of = information=20 to consumers and enforcement of consumer protections.

One concern is the need to improve the mortgage information that = consumers=20 receive. As I mentioned earlier, effective disclosure empowers consumers = and=20 enhances competition. But to be effective, disclosures must give = consumers=20 information that they can readily understand at a time when the = information is=20 relevant. I anticipate that to that end, the Federal Reserve will = propose=20 improvements to the rules governing the disclosure of mortgage loan = terms and=20 conditions and the timing of those disclosures. We will soon begin an = extensive=20 consumer testing process in order to ensure that the new draft = disclosures we=20 propose will be comprehensible and useful to borrowers. To further = improve=20 consumers' access to meaningful information, the Federal Reserve also = plans to=20 propose rule changes to address misleading practices in mortgage loan=20 advertisements and solicitations.

In addition to providing consumers with better information, the = Federal=20 Reserve plans to exercise its rule-making authority under the Home = Ownership and=20 Equity Protection Act (HOEPA) to address unfair or deceptive mortgage = lending=20 practices. We plan to propose rules by the end of this year that would = apply to=20 subprime loans offered by all mortgage lenders. The practices that may = be=20 addressed involve prepayment penalties, stated-income lending, failure = to=20 require escrows for taxes and insurance, and making loans without regard = to the=20 borrower's ability to repay. In the many Federal Reserve efforts to = gather input=20 from a variety of stakeholders, including a full-day hearing I chaired = in June=20 that yielded valuable insight from both the industry and consumer = groups, these=20 areas have been highlighted as practices for which there is a potential = for=20 abuse.

With respect to supervision of consumer protection in subprime = lending, I=20 would like to highlight an important collaboration with other federal = and state=20 agencies to expand consumer compliance reviews to include selected=20 non-depository mortgage lenders. As I mentioned earlier, the regulatory = scheme=20 for the mortgage industry has become extremely complex as the breadth = and depth=20 of this market has grown over the past decade and the role of nonbank = mortgage=20 lenders, particularly in the subprime market, has increased. In fact, = data=20 collected under the Home Mortgage Disclosure Act show that independent = mortgage=20 companies--those that are not depository institutions, subsidiaries of=20 depository institutions, or holding company affiliates--made about 46 = percent of=20 higher-priced first-lien mortgages in 2006.1 In addition, there has been = an=20 increased presence of mortgage brokers, often independent entities who = take loan=20 applications and shop them to depository institutions or other lenders. = The=20 increased fragmentation of the mortgage process, from marketing of = products to=20 servicing of loans after origination, has created a number of challenges = in=20 monitoring practices of various nonbank market players. These market=20 developments have resulted in the oversight of mortgage lending = extending beyond=20 the federal banking agencies, and this underscores the importance of=20 collaborating with the state banking agencies and other organizations to = address=20 concerns in the subprime mortgage market.

Various outreach and research efforts have revealed the value of = increasing=20 the scrutiny of these lenders, to deepen our understanding of their = policies and=20 practices. To this end--and to take advantage of the dual-supervisory = roles of=20 federal and state agencies--we have launched a cooperative pilot project = to=20 conduct reviews of non-depository lenders with significant subprime = mortgage=20 operations. The reviews will evaluate the companies' underwriting = standards and=20 senior-management oversight of risk-management strategies for ensuring=20 compliance with consumer protection laws and regulations. Our partners = in this=20 initiative are the Office of Thrift Supervision, the Federal Trade = Commission,=20 and state agencies represented by the Conference of State Banking = Supervisors=20 (CSBS) and the American Association of Residential Mortgage = Regulators.

As part of this project, the Federal Reserve will review nonbank = subsidiaries=20 of bank holding companies for compliance with a number of regulations, = including=20 TILA, HOEPA, the Equal Credit Opportunity Act, the Real Estate = Settlement=20 Procedures Act, and the Home Mortgage Disclosure Act. The other partners = in the=20 project will conduct similar reviews of non-depository subsidiaries of = thrift=20 holding companies, independent mortgage lending companies, and mortgage = brokers=20 doing business with these entities. The partner agencies intend to share = information about their findings with each other, review the lessons = learned,=20 and seek additional ways to cooperate to ensure effective and consistent = supervision of these entities. At the conclusion of the reviews, the = agencies=20 will analyze the results and determine whether to continue the project = and, if=20 so, how to focus future reviews.

Finally, I would like to say a few words about what the Federal = Reserve is=20 doing to help borrowers who may be facing difficulty paying their = mortgages.=20 Undoubtedly, foreclosures can have a devastating impact on borrowers, = lenders,=20 families, and communities. To the extent possible, efforts should be = made to=20 avoid foreclosure. Toward that end, the Federal Reserve along with the = other=20 agencies have encouraged lenders and servicers to identify opportunities = to work=20 with borrowers confronting mortgage delinquency or foreclosure. For = example,=20 lenders and servicers may be able to assist troubled borrowers by = modifying the=20 loan, deferring payments, extending the loan maturities, converting an=20 adjustable-rate mortgage to a fixed-rate or fully-indexed loan, or = capitalizing=20 delinquent amounts. The best outcome is a loss mitigation strategy that = results=20 in a mortgage obligation that the borrower can meet in a sustained = manner. The=20 use of these and other loss mitigation techniques is consistent with = guidance=20 that emphasizes the importance of prudent underwriting practices to help = ensure=20 that borrowers can meet the terms of their mortgage obligation and = maintain=20 homeownership.

Conclusion
In closing, I would like to reiterate that the Federal = Reserve=20 is committed to using its broad range of policy and supervisory tools to = support=20 efficient and fair markets. I have touched on the ways the Federal = Reserve has=20 used some of its tools and described the various efforts we have under = way. I=20 assure you that the Federal Reserve will continue to use these tools, as = well as=20 to examine various other authorities, to respond in a deliberative and = balanced=20 manner that is in the interests of markets, financial institutions, and=20 consumers.

Footnotes

1. Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, "The = 2006 HMDA=20 Data (1.31 MB PDF)," The Federal Reserve Bulletin, September 2007,=20 http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06draft.pdf. = Return to=20 text