2008 Annual Report

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Throughout 2008, the economy and financial system experienced extraordinary turbulence. The slumping U.S. housing market and rising delinquencies on subprime mortgages triggered a financial crisis that quickly spread to a wide range of asset classes, markets, and global financial institutions. In September, the crisis hit its boiling point. Lehman Brothers filed for bankruptcy, Merrill Lynch and Washington Mutual were acquired by other financial institutions, Goldman Sachs and Morgan Stanley reorganized as bank holding companies, and the Federal Reserve provided loans to AIG.

In the days following these events, financial regulators from around the world gathered at the Federal Reserve Bank of Chicago to discuss how banking rules would need to change. The timing of this conference brought an exceptional relevance to the proceedings. A group of financial reporters closely covered the conference's discussions and speeches. Participants filled the halls discussing recent events with counterparts from other countries. They frequently phoned colleagues at home to discuss the latest developments. The conference participants were at the forefront of discussions of how to find the right balance between bank-based and market-based financial intermediation.

The meeting was the Chicago Fed's annual International Banking Conference, co-sponsored by the European Central Bank. It is one of many examples of how the Chicago Fed fosters an informed public policy debate on important economic and financial issues. We frequently leverage our ability to convene experts in diverse fields to address major public policy questions. These conferences inform our own efforts to promote sustainable economic growth and price stability and help us develop and disseminate high-quality research. They also create and advance the intellectual framework needed for future policy discussions and support our bank supervision efforts.

In this essay, we highlight some of our conference discussions with experts from the public and private sectors during 2008. The questions addressed at these meetings related to a broad range of issues, including the global regulatory environment and how to make regulation more effective, the impact of the recession on community banks, improving banks' risk management practices, preventing home foreclosures and educating the public about available resources, improving household budget management, how private equity is adapting to the credit crunch, and the outlook for the auto industry.

What Regulatory Changes Are Needed?

Participants at the International Banking Conference in September identified several factors contributing to the asset-price bubble and ensuing credit market turmoil and proposed a range of regulatory changes that might prevent future crises. Conference participants debated the factors contributing to the asset-price bubble, with many blaming a combination of accommodative monetary policy, financial engineering, asset complexity, lack of adequate transparency, and questionable information provided by rating agencies. Looking forward, the conference participants proposed adjustments to regulatory policy ranging from minor tweaks to a major overhaul of existing capital requirements and regulatory structures. There was also significant debate about the future role of market discipline in influencing the behavior of both consumers and private companies.

Ideas for possible regulatory changes also surfaced frequently at a November conference titled, "The Capital Markets: After the Bubble." This event featured banking and securities regulators and risk management experts from the U.S. and abroad, including representatives of international and U.S. banking regulatory agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The presenters agreed significant changes are needed in various parts of international capital markets, deal structures, incentives, and governance. This conference also addressed new proposals on covered bonds and re-consolidation issues for structured investment vehicles and asset-backed commercial paper. Participants generally agreed that while these markets and products played a critical role in causing the global financial crisis, they are also critical to economic stability and recovery.

Many of those in attendance at the capital markets conference focused on securitizations and the ratings, governance, and transparency associated with those transactions. Since the breakdown of this market is a major cause of the financial crisis, its future structure is a key to recovery. And some of the smaller markets that have collapsed during this crisis, such as the one for auction rate securities, are unlikely to return in their previous form.

How Have Community Banks Been Affected by the Tumultuous Economic Environment?

The Chicago Fed hosted the Community Bankers Symposium in November, an event that attracted officers and directors from community banks and bank holding companies throughout the Midwest, as well as state and federal bank regulators. Panelists agreed that the current environment offers both challenges and opportunities. Bankers and regulators face the challenges of how best to assess risk management processes and how to value certain underlying assets, which serve as collateral for community bank loans. As for opportunities, some community banks are seeing increased loan demand as larger banks de-lever and shrink their balance sheets. From a deposit perspective, banks are seeing opportunities to raise funds through the Internet and because of a general flight to safety, with banks large and small benefiting from changes to the deposit insurance program.

Conference participants said that many community banks are going back to the basics, by creating underwriting standards with a focus on repayment capacity, establishing strong controls to ensure adherence to established policies, and ensuring that incentives are aligned with risk.

Finally, this conference emphasized the importance of community banking in providing fair and equal access to credit for consumers and small business proprietors.

What Has the Credit Crisis Revealed About Risk Management?

With risk management in banking becoming more complex and sophisticated, the Chicago Fed's Supervision and Regulation Department partnered with DePaul University's Center for Financial Services in April of 2008 to sponsor a conference on the issue. It brought together bankers, supervisors and academics to focus on comprehensive risk management, also known as enterprise risk management (ERM).

One panel discussed how the blurring of credit and capital markets has complicated risk management. In recent years, more banks have adopted the "originate-to-distribute" model, under which they originate loans for the sole purpose of selling them to others. Now loans that were traditionally credit assets are common in trading books, and the difference between credit risk and market risk has become increasingly less distinct. Jeff Phillips of BMO Capital Markets Group discussed how this had contributed to recent financial turmoil. Kathryn Dick from the Office of the Comptroller of the Currency and Coryann Stefannson from the Federal Reserve Board examined how the market blurring has affected bank supervision. The panel discussion following these presentations centered on the use of credit ratings by investors and regulators and how these ratings might be improved.

Finally, the conference included keynote addresses from Eric S. Rosengren, president of the Federal Reserve Bank of Boston, and Craig S. Donohue, chief executive officer of the CME Group. In light of recent difficulties in pricing complex financial instruments, Rosengren questioned whether some instruments should be more standardized or possibly moved from dealer markets to exchange-traded instruments. Similarly, Donohue advocated a more centralized and transparent execution system for these products.

Federal Reserve Chairman Ben Bernanke also spoke about risk management at the Chicago Fed's annual Bank Structure Conference in May of 2008. This gathering is the Chicago Fed's longest-running conference and traditionally draws top leaders in the nation's financial industry. Past speakers include FDIC Chairman Sheila Bair, SEC Chairman Christopher Cox, and Treasury Secretary John Snow. Joining Chairman Bernanke last year was James Lockhart, director of the Office of Federal Housing Enterprise Oversight, and James Rohr, chairman and CEO of the PNC Financial Services Group.

Chairman Bernanke focused his remarks on risk management lessons from the credit market turmoil, explaining that, "The turmoil in credit markets underscores some important principles for bank risk management, including the value of proper risk identification and measurement, the need for robust and objective valuation methods, the importance of preparing for liquidity disruptions, and the critical role of strong oversight by senior managers." He also noted that the role of the Fed and other supervisors is no less critical. "[It] is clear that supervisors must redouble their efforts to help organizations improve their risk-management practices," Bernanke said. "Accordingly, we have increased supervisory attention to this issue. ... We are also considering the need for additional or revised supervisory guidance regarding various aspects of risk management, including further emphasis on the need for an enterprise-wide perspective when assessing risk. ... We are also seeking to promote better disclosures by banking institutions with the goal of increasing transparency, thereby strengthening market discipline."

What Can Banks, Regulators, and Community Organizations Do to Prevent Home Foreclosures?

The Bank convened the Regional Home Ownership Preservation Initiative (RHOPI) with the Chicago Community Trust and NHS of Chicago. Individuals representing almost 100 organizations worked to reach recommendations and action steps late in 2008 to address the high rates of foreclosure and resulting vacant property in the metropolitan area. Other key topics included homeowner counseling, legal assistance, refinancing, and loss mitigation issues. Many of these organizations are now implementing recommendations from this forum. Participants agreed that preventing further foreclosures was an important goal, because a large proportion of loans already modified to prevent or remedy default have also defaulted. An even more difficult issue is the many vacant properties resulting from foreclosures in our region. A group of RHOPI participants is working to channel federal and other relief to the hardest hit areas of the Chicago metro area.

During the past year, the Chicago Fed also sponsored numerous other discussions about the foreclosure crisis and the resources available to local communities to deal with housing issues. Among these forums were a symposium co-sponsored by the Iowa and Davenport Civil Rights Commissions on "Fair Lending/ Fair Housing in the Foreclosure Crisis," conferences co-sponsored by the University of Wisconsin Extension and the Wisconsin Housing and Economic Development Authority to address the problems wrought by foreclosures in that state, and a conference at the Chicago Fed's Detroit Branch on "Saving the American Dream: Preventing Foreclosure & Preserving Homeownership." At the meeting in Detroit, discussion focused on both mortgage foreclosures and tax foreclosures. With many Michigan residents facing tax foreclosures, participants agreed more communication is needed with the public about the problem. Toward that end, they formed a task force to inform consumers about resources available to those facing a tax foreclosure.

In addition, at the Bank Structure Conference in May, financial regulators discussed their efforts to provide delinquent homeowners with information to work with mortgage holders and evaluate their options. A representative from the Hope Now Alliance also described its work with counselors, mortgage companies, investors, and financially constrained homeowners, all designed to enable residents to stay in their homes.

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