[Senate Hearing 111-414]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-414

 
                       EXAMINING THE STATE OF THE
                            BANKING INDUSTRY

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                         FINANCIAL INSTITUTIONS

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

        THE CURRENT CONDITIONS OF KEY FINANCIAL INSTITUTIONS AND
      EXAMINING THE CONTINUING CHALLENGES THESE INSTITUTIONS FACE

                               __________

                            OCTOBER 14, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html




                  U.S. GOVERNMENT PRINTING OFFICE
56-415                    WASHINGTON : 2010
-----------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                     Dean Shahinian, Senior Counsel

                   Julie Chon, Senior Policy Adviser

                Mark Oesterle, Republican Chief Counsel

                Hester Peirce, Republican Senior Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

                 Subcommittee on Financial Institutions

                  TIM JOHNSON, South Dakota,  Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         MIKE JOHANNS, Nebraska
EVAN BAYH, Indiana                   KAY BAILEY HUTCHISON, Texas
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
JON TESTER, Montana                  JUDD GREGG, New Hampshire
HERB KOHL, Wisconsin
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                     Laura Swanson, Staff Director

                Gregg Richard, Republican Staff Director

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, OCTOBER 14, 2009

                                                                   Page

Opening statement of Chairman Johnson............................     1
        Prepared statement.......................................    39
Opening statements, comments, or prepared statement of:
    Senator Crapo................................................     1
        Prepared statement.......................................    39
    Senator Merkley..............................................     2
    Senator Bunning..............................................     3
    Senator Warner...............................................     3
    Senator Brown................................................     3

                               WITNESSES

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation..     4
    Prepared statement...........................................    39
    Responses to written questions of:
        Senator Crapo............................................   158
John C. Dugan, Comptroller of the Currency, Office of the 
  Comptroller of the Currency....................................     6
    Prepared statement...........................................    47
    Responses to written questions of:
        Senator Crapo............................................   159
Daniel K. Tarullo, Member, Board of Governors of the Federal 
  Reserve
  System.........................................................     7
    Prepared statement...........................................    61
    Responses to written questions of:
        Senator Crapo............................................   164
        Senator Vitter...........................................   166
Deborah Matz, Chairman, National Credit Union Administration.....     9
    Prepared statement...........................................    68
    Responses to written questions of:
        Senator Crapo............................................   169
Timothy T. Ward, Deputy Director, Examinations, Supervision, and 
  Consumer Protection, Office of Thrift Supervision..............    10
    Prepared statement...........................................   107
    Responses to written questions of:
        Senator Crapo............................................   171
Joseph A. Smith, Jr., North Carolina Commissioner of Banks, on 
  behalf of the Conference of State Bank Supervisors.............    11
        Prepared statement.......................................   147
    Responses to written questions of:
        Senator Crapo............................................   176
Thomas J. Candon, Deputy Commissioner, Vermont Department of 
  Banking, Insurance, Securities, and Health Care Administration, 
  on behalf of the National Association of State Credit Union 
  Supervisors....................................................    12
    Prepared statement...........................................   154
    Responses to written questions of:
        Senator Crapo............................................   176

                                 (iii)


                       EXAMINING THE STATE OF THE
                            BANKING INDUSTRY

                              ----------                              


                      WEDNESDAY, OCTOBER 14, 2009

                                       U.S. Senate,
                    Subcommittee on Financial Institutions,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met in room SD-538, Dirksen Senate Office 
Building, Senator Tim Johnson, Chairman of the Subcommittee, 
presiding.

            OPENING STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. As Congress and this Committee continue 
its work to stabilize financial institutions and promote our 
Nation's economic recovery, I have called this hearing today 
for regulators to give us an update on the current conditions 
of the financial institutions in our country. It is vital that 
we know what continuing challenges and concerns our Nation's 
institutions face. Specifically, I continue to be concerned 
about the lending environment for small businesses, the capital 
needs of institutions, and the impact of commercial real estate 
and other loan portfolios on balance sheets. In addition, while 
many of the large banks in our country have stabilized, the 
FDIC's list of troubled banks, many of them small community 
banks, is growing.
    While restructuring our Nation's regulatory system is this 
Committee's top priority, I do not think we can do that without 
a clear understanding of what is happening within the sector. 
Concerns and problems within individual financial institutions 
will still exist even with a new regulatory structure. 
Continuing to ensure the safety and soundness of viable 
institutions and the overall financial stability of our 
Nation's economy is vital to protecting all Americans' 
pocketbooks, savings, and retirement.
    I want to thank the witnesses for being here today, and I 
look forward to hearing from each of you regarding any 
developing trends or concerns within the banking industry or 
throughout the economy, and to hear of the regulatory or 
supervisory steps your agencies are taking to respond to these 
challenges.
    I will now turn to Senator Crapo for his opening statement.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman, for 
holding this hearing to examine the current status of the 
banking and credit union industry. Failures of small banks 
continue to grow, and the key trouble spots are looming, such 
as commercial real estate loans.
    According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium-sized banks. I am interested in learning to 
what extent the TALF, or Term Asset-backed Securities Loan 
Facility, encouraged capital to enter the commercial real 
estate market and what other steps regulators can and should 
take to address this problem.
    Many community banks and credit unions have tried to fill 
the lending gap created by the credit crisis. Even with these 
efforts, it is apparent that many consumers and small 
businesses are not receiving the lending they need to refinance 
their home loan, to extend or keep their current business line 
of credit, or to receive capital for new business 
opportunities.
    Regulators need to be mindful that they strike the 
appropriate balance to bolster capital and meet the credit 
needs of our economy, and FASB's new rules on off-balance 
sheets will create challenges on this point.
    As we begin to explore options to modernize our financial 
regulatory structure, it is important that our new structure 
allows financial institutions to play an essential role in the 
U.S. economy by providing a means for consumers and businesses 
to save for the future, protect and hedge against risk, and 
promote lending opportunities.
    Again, Mr. Chairman, I thank you for holding this hearing. 
I look forward to working with you and others on these issues.
    Senator Johnson. Senator Merkley. And I encourage members 
to be brief since there are seven panelists and many questions 
to be asked.

               STATEMENT OF SENATOR JEFF MERKLEY

    Senator Merkley. Thank you very much, Mr. Chair, for 
holding this hearing on the state of the banking industry. I 
want to be very clear that I am concerned about the effect of 
this crisis on our community banks. Our national economic 
crisis was sparked by the preemption of State predatory lending 
laws, the sale of mortgages, and certainly the securitization 
of these mortgages by Wall Street.
    But it is our community banks who have been hit with 
repeated FDIC assessments, who have seen asset values fall, and 
who have seen their regulators tighten the noose. Unlike 
institutions that were deemed ``too big to fail,'' our 
community banks apparently are deemed ``small enough to fail.''
    Despite the fact that community banks had little to do with 
causing our crisis, our community banks have been unable to 
lend. They are stuck with a Catch-22 situation where private 
sector investors are unwilling to deploy money unless the banks 
have TARP money in them, and TARP will not go into small banks 
out of concern for capitalization. Instead, the small banks are 
told to raise more money.
    I was very skeptical of TARP when first authorized because 
I felt it was focused too much on our Nation's largest banks. 
Now, given the crisis we are facing in Oregon and across the 
Nation, it is apparent that we need to speed credit access to 
the economy, and I believe that we need to support the 
recapitalization of our community banks as one of the best ways 
to get capital flowing to Main Street and get job growth 
started in our economy.
    Mr. Chair, over the next days and weeks, I will look 
forward to working with you and members of the Subcommittee and 
full Committee to figure out ways to break this gridlock and 
get capital flowing back to our community banks.
    Senator Johnson. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. I have no opening statement. I want to get 
to questions. Thank you.
    Senator Johnson. Thank you.
    Senator Warner.

                STATEMENT OF SENATOR MARK WARNER

    Senator Warner. I know we have got a lot of panelists. I 
will wait for my questions as well.
    Senator Johnson. Senator Brown.

               STATEMENT OF SENATOR SHERROD BROWN

    Senator Brown. Thank you, Mr. Chairman, and I will be 
brief.
    Yesterday, I had a roundtable of 15, 16, 17 small 
manufacturers in my boyhood home town of Mansfield, Ohio, a 
community of 50,000 that has lost a lot of manufacturing jobs, 
as much of the Midwest and much of the country have. Over and 
over, the discussion turned to they cannot get credit. You know 
that. Small business generally cannot get credit. Manufacturers 
have even more trouble getting credit than other small 
businesses, and auto chain manufacturers, auto supply chain 
manufacturers have even more trouble getting credit than other 
manufacturers.
    They typically went around the table and blamed--they did 
not blame the banks. They mostly blamed regulators, of course. 
I hope that we learn in this hearing what we can do as 
policymakers to increase the flow of credit, especially to 
manufacturers. It sort of goes without saying that pulling us 
out of this recession--at least in historical terms, what pulls 
us out of recessions are housing and manufacturing, especially 
auto manufacturing, understanding more in my State than some 
others. But it is particularly important that manufacturing get 
the credit it needs. They have people to sell to more and more. 
They have people that are working 30 hours that want to work 
40, and then they want to hire more people. But they cannot do 
any of that. They have got skilled workers, obviously, but they 
cannot do any of that unless credit is more liquid to them.
    So I ask your assistance in that. I said they blame the 
regulators. I do not necessarily. I think banks are fearful and 
cautious, for good reasons sometimes, and sometimes not so good 
reasons. But we are counting on you.
    Thanks.
    Senator Johnson. Senator Tester.
    [No response.]
    Senator Johnson. I would like to welcome our witnesses. I 
appreciate your taking the time out of your busy schedules to 
be here today.
    Today our panel of witnesses includes: Sheila Bair, 
Chairman of the Federal Deposit Insurance Corporation; John 
Dugan, Comptroller of the Office of the Comptroller of the 
Currency; and Governor Dan Tarullo, member of the Board of 
Governors of the Federal Reserve System. We are also welcoming 
Debbie Matz, Chairman of the National Credit Union 
Administration, to the panel for the first time since her 
confirmation over the summer.
    I would also like to welcome Timothy Ward, Deputy Director 
of Examinations, Supervision, and Consumer Protection at the 
Office of Thrift Supervision; Joseph Smith, the North Carolina 
Commissioner of Banks, on behalf of the Conference of State 
Bank Supervisors; and Thomas Candon, Deputy Commissioner of the 
Vermont Department of Banking, Insurance, Securities, and 
Health Care Administration, and Chairman of the National 
Association of State Credit Union Supervisors.
    While many of you have already been before the Committee 
many times this year on various topics, today we are continuing 
the important conversation of the state of the banking sector. 
I will ask that the witnesses please limit their testimony to 5 
minutes. Your full statements and any additional materials you 
may have will be entered into the record.
    Chairman Bair, please begin.

    STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Ms. Bair. Thank you. Chairman Johnson, Ranking Member 
Crapo, and members of the Committee, I appreciate the 
opportunity to testify on behalf of the FDIC regarding the 
condition of the banking industry and the measures being taken 
by the FDIC to address the challenges facing us in the current 
environment. We meet today just 1 year after the historic 
liquidity crisis in global financial markets that prompted an 
unprecedented response on the part of governments around the 
world.
    The financial landscape today is more stable than a year 
ago. Conditions appear to be moderating, and the liquidity of 
financial markets has improved. Even as we seek to end the 
extraordinary programs that were effective in addressing the 
liquidity crisis, we recognize that much more work needs to be 
done to meet the credit needs of households and small 
businesses.
    There is evidence that the U.S. economy is growing once 
again, but bank performance typically lags behind economic 
recovery, and this cycle is no exception. High levels of 
distressed assets have led to weak financial performance at 
many FDIC-insured institutions. These have been concentrated in 
three main areas: residential mortgage loans, construction 
loans, and credit cards. Continued high unemployment threatens 
to keep loss rates elevated for an extended period. As the 
economy improves, however, loss rates should moderate.
    Looking forward, the most prominent risk during the next 
several quarters is commercial real estate. Property cash-flows 
are falling due to declining rents and rising vacancies. Also, 
falling property prices will make it difficult for some 
borrowers to renew their financing.
    Given the substantial challenges faced by financial 
institutions, the FDIC maintains a balanced supervisory 
approach that focuses on strong oversight but remains sensitive 
to economic and real estate market conditions. We support 
banks' efforts to lend to creditworthy borrowers and to work 
constructively with existing borrowers to restructure loans 
where appropriate.
    I have heard reports that examiners are requiring banks to 
write down sound performing loans. I can assure you that that 
is not the policy of the FDIC. The Federal banking agencies are 
finalizing guidance on commercial real estate loan workouts 
that will make that clear.
    The FDIC has expressed support for making loans to 
creditworthy borrowers in numerous industry forums and in last 
November's interagency statement. In particular, banks should 
continue to provide credit to small businesses, an engine of 
growth that creates jobs.
    Poor credit quality and weak earnings have led to a surge 
in bank and thrift failures. So far this year, we have had 98 
failures. While we do not expect failures at the levels 
experienced in the late 1980s and early 1990s, our loss rates 
have been significant.
    To address adverse market conditions, the FDIC has employed 
additional resolution strategies that proved successful in the 
1990s: loss-sharing agreements and structured transactions. 
These arrangements allow the FDIC to quickly return assets to 
the private sector, obtain better pricing, and minimize 
disruption to borrowers and communities from a bank failure. 
They save money for the deposit insurance fund and streamline 
our resolution workload.
    As a result of increased bank failures, the deposit 
insurance fund is projected to need a new infusion of cash next 
year. To meet the fund's liquidity needs, we are seeking public 
comment on a proposal to collect $45 billion through a 
prepayment of deposit insurance assessments instead of a 
special assessment.
    In addition, we are implementing a restoration plan that 
should return the fund to a positive balance in 2012 and the 
reserve ratio to the minimum of 1.15 percent within the 
statutory 8-year timeframe.
    The FDIC will continue protecting insured depositors as we 
have for over 75 years. No depositor has ever lost a penny of 
insured deposits and never will.
    In closing, I would urge Congress to consider the impact of 
any new legislative initiatives on the structure of the banking 
industry as we emerge from this crisis. If reform measures 
perpetuate too big to fail, there will be a further trend 
toward consolidation into large and more complex institutions 
at the expense of smaller and more transparent competitors.
    I urge Congress to implement policies that will assure 
continuation of a robust community banking sector, and when 
institutions do fail, as some inevitably will, we need a strong 
resolution authority that will assure market discipline on all 
institutions, large and small.
    Thank you very much.
    Senator Johnson. Thank you.
    Mr. Dugan.

STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE 
               OF THE COMPTROLLER OF THE CURRENCY

    Mr. Dugan. Thank you, Chairman Johnson, Senator Crapo, and 
members of the Subcommittee. I am pleased to testify on the 
current condition of the national banking system, including 
trends in bank lending, asset quality, and problem banks. The 
OCC supervises over 1,600 national banks and Federal branches, 
which constitute approximately 18 percent of all federally 
insured banks and thrifts, holding just over 61 percent of all 
bank and thrift assets. As described in my written statement, 
the OCC has separate supervisory programs for large, mid-sized, 
and community banks that are tailored to the unique challenges 
faced by each.
    Today I would like to focus on three key points.
    First, despite early signs of the recession ending, credit 
quality is continuing to worsen across almost every class of 
asset in banks of almost every size. The strains on borrowers 
that first appeared in the housing sector have spread to other 
retail and commercial borrowers. For some credit portfolio 
segments, the rate of nonperforming loans is at or near 
historical highs. In many cases, this declining asset quality 
reflects risks that have been built up over time.
    While we are seeing some initial signs of improvement in 
some asset classes, as the economy begins to recover, it will 
take time for problem credits to work their way through the 
banking system because credit losses often lag behind the 
return to economic growth.
    Second, it is very important to keep in mind that the vast 
majority of national banks are strong and have the financial 
capacity to withstand declining asset quality. As I noted in 
testimony before the full Committee last year, we anticipated 
that credit quality would worsen and that banks would need to 
further strengthen their capital and loan loss reserves. Net 
capital levels in national banks have increased by more than 
$186 billion over the last 2 years, and net increases to loan 
loss reserves have exceeded $92 billion.
    While these increases have considerably strengthened 
national banks, we anticipate additional capital and reserves 
will be needed to absorb additional potential losses in banks' 
portfolios. In some cases, that may not be possible, however, 
and as a result, there will continue to be a number of smaller 
institutions that are not likely to survive their mounting 
credit problems.
    In these cases, we are working closely with the FDIC to 
ensure timely resolutions in a manner that is least disruptive 
to local communities.
    Third, during this stressful period, we are extremely 
mindful of the need to maintain a balanced approach in our 
supervision of national banks. We strive continually to ensure 
that our examiners are doing just that. We are encouraging 
banks to work constructively with borrowers who may be facing 
difficulties and to make new loans to creditworthy borrowers, 
although it is true that in today's weaker economic 
environment, credit demand among businesses and consumers has 
significantly declined. And we have repeatedly and strongly 
emphasized that examiners should not dictate loan terms or 
require banks to charge off loans simply due to declines in 
collateral values.
    Balanced supervision, however, does not mean turning a 
blind eye to credit and market conditions or simply allowing 
banks to forestall recognizing problems on the hope that 
markets or borrowers may turn around. As we have learned in our 
dealings with problem banks, a key factor in restoring a bank 
to health is ensuring that bank management realistically 
recognizes and addresses problems as they emerge, even as they 
work with struggling borrowers.
    One area where national banks are stepping up efforts to 
work with distressed borrowers is in foreclosure prevention. 
Our most recent quarterly report on mortgage metrics shows that 
actions by national bank servicers to keep Americans in their 
homes rose by almost 22 percent in the second quarter. Notably, 
the percentage of modifications that reduced monthly principal 
and interest payments increased to more than 78 percent of all 
new modifications, up from about 54 percent the previous 
quarter. We view this as a positive development since 
modifications that result in lower monthly payments are less 
likely to redefault.
    While many challenges lie ahead, especially with regard to 
the significant decline in credit quality, I firmly believe 
that the collective measures that Government officials, bank 
regulators, and many bankers have taken in recent months have 
put our financial system on a much more sound footing. The OCC 
is firmly committed to a balanced approach that encourages 
bankers to lend and to work with borrowers in a safe and sound 
manner while recognizing and addressing problems on a timely 
basis.
    Thank you.
    Senator Johnson. Thank you, Mr. Dugan.
    Mr. Tarullo.

 STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF 
                   THE FEDERAL RESERVE SYSTEM

    Mr. Tarullo. Thank you, Mr. Chairman, Senator Crapo, 
members of the Subcommittee. Let me begin by echoing a few 
points that my colleagues made in either their written or oral 
statements.
    First, compared to the situation of 8 to 12 months ago, the 
financial system has been significantly stabilized. The largest 
banking institutions, each of whose financial conditions was 
evaluated in our stress tests and then announced to markets and 
the public, have raised $60 billion in capital since last 
spring. We continue to see a narrowing of spreads in some parts 
of the market, such as corporate bonds, and in short-term 
funding markets.
    Second, however, important segments of our credit system 
are still not functioning effectively. Many securitization 
markets have had trouble restarting without Government 
involvement. Lending by commercial banks has declined through 
much of 2009. This decline reflects both weaker demand and 
tighter supply conditions, with particularly severe 
consequences for small and medium-sized businesses, which are 
much more dependent on banks than on the public capital markets 
that can be accessed by larger corporations.
    Banks will continue to suffer significant losses in coming 
quarters as residential mortgage markets continue to adjust. 
Losses on CRE loans, which represent a disproportionate share 
of the assets of some small and medium-sized banks, are likely 
to climb. The strains on these banks, when added to the more 
cautious underwriting typical of recessions, compound the 
problems of small businesses that rely on community banks for 
their borrowing.
    Third, it is important that bank supervisors take an even-
handed approach in examining banks during these stressful 
times. We certainly do not want examiners to exacerbate the 
problems of declining CRE prices and restricted availability of 
credit by reflexively criticizing loans solely because, for 
example, the underlying collateral has declined in value. At 
the same time, we do not want supervisory forbearance that will 
put off inevitable losses, which may well increase over time, 
with attendant implications for the Federal Deposit Insurance 
Fund.
    So it is relatively easy to summarize the situation and 
state the problem. The question on everyone's mind is when and 
how it can be ameliorated. There are no easy answers, but let 
me offer a few observations.
    We as banking regulators should certainly redouble our 
efforts to ensure that the even-handed guidance we are issuing 
in Washington will be implemented faithfully by our examiners 
throughout the country. But we should not fool ourselves that 
even the best implementation of this policy will come close to 
solving the problems caused by significantly reduced demand for 
commercial properties that were in many cases highly leveraged 
on the assumption of rising asset prices.
    The problems lie deeper. In a weak economy that has, in 
turn, weakened many of our banks, supervisory guidance is 
neither appropriate for, nor effective as, an economic stimulus 
measure. At the most basic level, the strengthening of CRE 
markets and a return to a fully healthy banking system depend 
on growth in the economy as a whole, and particularly on a 
reduction in unemployment.
    I believe that the most important Federal Reserve action to 
promote CRE recovery is through our monetary policy. Our 
actions to date have helped return the Nation to growth sooner 
than many have expected. Nonetheless, because economic 
performance remains relatively weak, the Federal Open Market 
Committee indicated after our last meeting that conditions are 
likely to warrant exceptionally low levels of the Federal funds 
rate for an extended period.
    The Federal Reserve has also taken a series of steps to 
increase liquidity for financing capital of interest to 
consumers and small businesses, including the TALF program, 
which we recently extended through March, with a longer 
extension for commercial mortgage-backed securities.
    I suspect, though, that more direct efforts may be needed 
to make credit available to some creditworthy small businesses. 
Congress and the Administration may wish to consider temporary 
targeted programs while conditions in the banking industry 
normalize.
    Thank you very much, Mr. Chairman.
    Senator Johnson. Thank you.
    Ms. Matz.

  STATEMENT OF DEBORAH MATZ, CHAIRMAN, NATIONAL CREDIT UNION 
                         ADMINISTRATION

    Ms. Matz. Thank you, Chairman Johnson, Senator Crapo, and 
members of the Subcommittee. I am pleased to provide NCUA's 
views on the state of the industry.
    As you have heard from my counterparts, the stress on the 
entire financial sector has translated into a challenging time 
for financial institutions, including credit unions. 
Nonetheless, I am confident that credit unions can and will 
weather the storm.
    Corporate credit unions pose the most serious challenges to 
the credit union industry. Corporate credit unions are 
wholesale credit unions created by retail credit unions to 
provide investment services, liquidity, and payment systems. 
For four decades, this system worked well. However, in 2008, 
corporate exposure to mortgage-backed securities created 
tangible liquidity difficulties. In response to a growing 
crisis, NCUA asked Congress to increase the borrowing ceiling 
on our back-up liquidity source--the Central Liquidity 
Facility. Congress granted NCUA's request, and it is clear to 
me that if you had not acted in such a swift and decisive 
manner, the entire credit union system, not just the corporate 
network, would have been in serious jeopardy.
    Despite this successful intervention, problems continued. 
In March, the two largest corporates were placed into 
conservatorship by NCUA due to the deterioration in their 
portfolios. Losses flowed through the system and resulted in 
writedowns of capital not only by other corporates but by 
retail credit unions that invested in these institutions. Given 
the tenuous real estate market, NCUA expects additional losses 
to materialize.
    These conservatorships permit the corporate system to 
continue to function and to serve retail credit unions and, 
most importantly, their 90 million members. Again, a mechanism 
was developed, the Corporate Credit Union Stabilization Fund, 
which permitted replenishment by the industry over a 7-year 
period. This spreading out of costs was critical as credit 
union earnings were already experiencing pressures. The 
Corporate Stabilization Fund has permitted NCUA to maintain its 
mandated equity ratio in the Share Insurance Fund. At no point 
during this crisis has the equity ratio fallen below the 1.2 
percent established by Congress, and today it stands at 1.3 
percent, assuring consumers that their insured deposits are 
safe.
    Retail credit unions have their own challenges independent 
of the corporates. The good news is that, despite the troubled 
economy, credit union lending has increased by almost 8 percent 
since 2007. However, delinquencies and loan losses have also 
increased, particularly in real estate lending. In 2007, about 
0.3 percent of such loans were delinquent. The figure now 
stands at 1.62 percent.
    Industry-wide capital, while still strong, has declined 
from 11.8 percent in 2007 to 10 percent. On the one hand, I am 
encouraged by the fact that 98 percent of the 7,700 federally 
insured credit unions are at least adequately capitalized. On 
the other hand, 21 credit unions have failed so far this year 
compared to 18 in all of 2008. That number could well rise in 
2010. Most troubling is the increase in credit unions which 
have been downgraded to CAMEL 4 and 5. Between December 2008 
and August 2009, the assets of credit unions in these 
categories have almost doubled.
    Clearly, credit unions have not been spared from the harsh 
effects of the economic downturn. In tandem with the assessment 
of corporate losses described above, this presents a difficult 
road for credit unions to travel in 2010 and beyond.
    NCUA has been proactive in our efforts to mitigate the 
situation. NCUA examiners work with credit unions to avoid the 
riskiest types of mortgage lending, and this oversight was 
complemented by the fact that, as member-owned cooperatives, 
credit unions try to put their members into lending products 
they can afford. As a result, the industry largely steers clear 
of exotic mortgage lending. Only 2.3 percent of all credit 
union mortgage loans are exotic.
    Additionally, NCUA has enhanced our supervision. We 
shortened our examination cycle. We added 50 examiners in 2009 
and anticipate adding 57 more in 2010, and we upgraded our risk 
management system to identify and resolve problems more 
quickly.
    NCUA has an obligation to consumers. As a safety and 
soundness regulator, we will be successful if we preserve 
strong credit unions capable of meeting the financial needs of 
their members. Credit union members rightfully expect a 
reliable and well-capitalized deposit insurance regime. While 
the year ahead will be challenging, I am confident that we and 
the credit union industry we regulate will be stronger in the 
end.
    I welcome the opportunity to answer your questions.
    Senator Johnson. Thank you, Ms. Matz.
    Mr. Ward.

 STATEMENT OF TIMOTHY T. WARD, DEPUTY DIRECTOR, EXAMINATIONS, 
    SUPERVISION, AND CONSUMER PROTECTION, OFFICE OF THRIFT 
                          SUPERVISION

    Mr. Ward. Good afternoon, Chairman Johnson, Ranking Member 
Crapo, and members of the Subcommittee. Thank you for the 
opportunity to testify today on the financial condition and 
performance of the thrift industry.
    As of June 30, 2009, OTS regulated 794 thrift institutions 
with combined assets of $1.1 trillion. We also regulated 459 
savings and loan holding companies with aggregated consolidated 
assets of approximately $5.5 trillion. Most OTS regulated 
thrifts are smaller, community-based institutions. At the end 
of the second quarter, 86 percent of the thrifts had assets 
less than $1 billion. Three percent, or 25 thrifts, had assets 
greater than $10 billion, and those 25 large thrifts held 66 
percent of total industry assets.
    Thrifts in general are weathering the recession fairly 
well. Capital overall is strong. The industry's second quarter 
earnings improved to break even. And loan loss reserves have 
been substantially bolstered to near record levels. Because 
additions to loan loss reserves are direct charges to income, 
the industry's earnings remain weak by historical standards. 
Loss provisioning is expected to continue at elevated levels 
until inventories of unsold homes decline, home prices 
stabilize, and the employment picture brightens.
    Problem assets are continuing to increase, rising to 3.52 
percent of total assets in the second quarter, up from 2.68 
percent 1 year earlier. This compares unfavorably to an average 
level of 0.78 percent from 2000 to 2007.
    These stresses have caused an increase in problem thrifts 
and a general decline in safety and soundness ratings across 
the industry. As of September 30, 2009, there were 42 problem 
thrifts representing 5.4 percent of all OTS-regulated thrifts. 
A year ago, there were 16 problem thrifts, or 2 percent of the 
total. Twelve thrifts have failed this year, compared with five 
last year. The OTS is working closely with problem institutions 
to prevent failures, but more thrifts are expected to fail 
before the economy fully recovers.
    Foreclosures continue to be a concern. Although sustainable 
loan modifications and payment plans to avoid foreclosures are 
increasing, the number of seriously delinquent mortgages and 
foreclosures in process are continuing to rise. Progress is 
being made on this front, but when so many American families 
are losing their homes, the progress certainly does not seem to 
be fast enough.
    In summary, Mr. Chairman, it is too early for us to say we 
have hit bottom and the worst is over. We believe significant 
challenges lie ahead as unemployment continues to rise and the 
housing market continues to work its way through a significant 
down cycle. Despite these challenges, the overall condition of 
the thrift industry is sound, with strong capital and 
substantially bolstered loss reserves. Recent earnings have 
shown signs of improvement, reflecting what we hope are 
indications that the nation's economy is beginning to turn 
around.
    Thank you again for having me here today. I look forward to 
responding to your questions.
    Senator Johnson. Thank you, Mr. Ward.
    Mr. Smith.

STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA COMMISSIONER 
OF BANKS, ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS

    Mr. Smith. Chairman Johnson and Ranking Member Crapo, 
members of the Subcommittee, I am Joseph A. Smith, Jr. I am 
North Carolina Commissioner of Banks and Chairman of the 
Conference of State Bank Supervisors, on whose behalf I am 
testifying. Thank you very much, as always, for the 
opportunity.
    The members of CSBS and our Federal partners, the FDIC and 
the Federal Reserve, supervise 73 percent of the banks in the 
United States, accounting for approximately 30 percent of total 
banking assets. Our banks are not, as a rule, systemically 
significant. However, they are locally significant in the 
markets they serve, which includes virtually all of the United 
States. State chartered banks provide healthy competition in 
urban markets and are often the only banks in rural and exurban 
markets.
    While there are pockets of strength in some parts of the 
country, the majority of my colleagues have characterized 
banking conditions in their States as, and I quote, ``gradually 
declining.'' This should be no surprise, given that traditional 
banks are a reflection of the overall health of the economy.
    What cannot be ignored is that the return to health of our 
largest banks is the direct result of unprecedented, 
extraordinary efforts by Congress and Federal regulators to 
ensure their success. The majority of banks, however, have not 
been the beneficiaries of this assistance and are experiencing 
a harshly, harshly procyclical regulatory environment, as 
required by Federal law. This explains the tale of two 
industries you are likely hearing from banks in your State 
versus the news you hear from Wall Street.
    What can or should be done about this? My colleagues and I 
submit that the place to start is with a vision of what we, the 
industry, policymakers, regulators, and other stakeholders, 
want the U.S. banking market to look like after the current 
troubles have subsided. In our view, the desirable outcome is a 
banking industry that continues to be competitive, with 
thousands of banks, rather than hundreds or tens, diverse, of 
banks of various sizes, operating strategies, and customer 
focuses, and strong, with capital, liquidity, and risk 
management sufficient to meet the challenges of the 
marketplace.
    This is not an argument for the status quo. In fact, my 
colleagues and I are in general agreement with our Federal 
colleagues that our banks have been too concentrated in 
commercial real estate and too dependent on non-core deposits. 
Where we sometimes disagree with them is on the severity with 
which we judge banks in a down market, the result of which is, 
in our view, to make bad situations worse. I would hasten to 
add that our disagreements are of degree, not kind. We 
generally agree with the diagnosis. The treatment is sometimes 
debatable.
    To address the current stress of our banks, CSBS 
respectfully suggests, one, that on-the-ground supervisors be 
given greater latitude to assess the condition of banks based 
on reasonable economic assumptions rather than assumptions of 
the end of the world.
    Two, that clear rules of the road be established for 
private equity investments and that supervisory applications by 
strategic investors be expedited once clearly established 
thresholds have been met.
    Three, that the acquisition of distressed banks by healthy 
banks be expedited and at least considered for capital purchase 
investments under the TARP program.
    Fourth, that troubled banks be allowed to reduce their 
dependence on brokered deposits in a gradual and orderly way.
    And fifth, that Congress seriously consider revisions to 
the Prompt Corrective Action and Least Cost Resolution 
provisions of FDICIA, which have limited regulatory discretion 
in the handling of distressed institutions.
    While we don't think that our suggestions will solve all 
the problems of the banking industry, we do think they can 
reduce the number of failures and the attendant cost to the 
Deposit Insurance Fund, which is, let it be remembered, funded 
by healthy banks. We believe our approach can reduce at least 
the pace of decline in the commercial real estate market with 
potential positive effects on the economy and the recovery. 
Importantly, it can help preserve the diversity of our 
financial system that is critical to the future health and even 
viability of our State and local economies.
    Once again, thank you for this opportunity to appear before 
you. I would be happy to answer any questions you may have. 
Thank you, sir.
    Senator Johnson. Thank you, Mr. Smith.
    Mr. Candon.

  STATEMENT OF THOMAS J. CANDON, DEPUTY COMMISSIONER, VERMONT 
 DEPARTMENT OF BANKING, INSURANCE, SECURITIES, AND HEALTH CARE 
ADMINISTRATION, ON BEHALF OF THE NATIONAL ASSOCIATION OF STATE 
                    CREDIT UNION SUPERVISORS

    Mr. Candon. Honorable Chairman Johnson, Ranking Member 
Crapo, and members of the Subcommittee, thank you for the 
opportunity to testify. I am the Deputy Commissioner of Banking 
and Securities for the Vermont Department of Banking, 
Insurance, Securities, and Health Care Administration. I appear 
on behalf of the State Credit Union Regulators as Chairman of 
NASCUS. Today, I will share information on the conditions of 
State credit unions and areas for reform.
    Like all financial institutions, State credit unions have 
been adversely affected by the current economy. However, at 
this point, State natural person credit unions remain generally 
healthy and continue to serve the needs of their members and 
their communities. For the most part, natural person credit 
unions did not engage in many of the practices that 
precipitated the current market downturn. However, we have 
several issues to bring to your attention about the impact of 
the economy and the need for capital options for credit unions.
    State regulators remain concerned about unemployment and 
its effects on credit union members' ability to meet their 
obligations. We also see increases in delinquencies and charge-
offs as well as pressure on earnings, especially in smaller 
State credit unions. Although loan delinquency and net charge-
offs have increased, State regulators indicate that the levels 
remain manageable.
    In response to this trend, regulators are increasing their 
oversight of consumer credit products, including auto loans, 
credit cards, real estate and home equity loans. State 
regulators are also closely monitoring member business lending 
in credit unions. Some States, including my home State of 
Vermont, have not experienced the fallout from commercial real 
estate or subprime lending because State credit unions do not 
engage in those activities. State regulators continue to 
encourage credit unions to exercise sound underwriting 
practices, proper risk management, and due diligence, as these 
are the practices that have kept credit unions healthier 
through the economic downturn.
    In anticipation of prolonged economic problems, State 
regulators will closely monitor both lending and investment 
activities. State regulators also emphasize strong governance 
standards at the credit union board level. We will continue 
close supervision through offsite monitoring and onsite 
examinations and visitations. The growing trend toward 
consolidation is on the minds of State regulators as credit 
union mergers continue to occur, both voluntarily and for 
regulatory purposes. As economic pressures continue, finding 
suitable merger partners may become more difficult.
    In response to your question about capital needs, access to 
capital for credit unions is critical. Unlike other financial 
institutions, credit union access to capital is limited to 
reserves and retained earnings. State regulators recommend 
capital raising options for all credit unions. Access to 
supplemental capital will enable credit unions to respond 
proactively to changing market conditions, thereby 
strengthening safety and soundness and providing a buffer for 
the Credit Union's Share Insurance Fund.
    It is NASCUS's studied belief that a change to the Federal 
law could provide this valuable tool to credit unions without 
altering their nonprofit and cooperative structure. 
Supplemental capital will not be appropriate for every credit 
union nor would every credit union need access to supplemental 
capital. However, the option should be available.
    State regulators are also concerned about the impact of 
corporate credit union losses on natural person credit unions. 
Given the severity of the losses, it is clear that enhanced 
regulatory standards for capital, governance, and risk 
management are necessary. State regulators are working with the 
NCUA to ensure the safety and soundness of corporate credit 
unions and to mitigate future risk.
    Last, I would like to emphasize the value of the dual 
regulatory system. State regulators have demonstrated the 
importance of local supervision of State-chartered institutions 
and the value of the dual regulatory system. State regulators 
have always emphasized consumer protection along with safety 
and soundness as an important part of their mission and 
accountability to Governors and State legislatures. Further, 
State regulators have the expertise to identify areas of risk 
and take enforcement actions where necessary. As regulatory 
modernization efforts are considered by the Senate Banking 
Committee, we encourage you to retain State supervision and 
reaffirm State authority.
    NASCUS and State regulators appreciate the opportunity to 
testify today. I will be pleased to respond to any questions 
that you have. Thank you, Mr. Chairman.
    Senator Johnson. Thank you, Mr. Candon.
    Let us put 7 minutes on the clock for each member to ask 
questions of our witnesses.
    Ms. Bair, so far, 98 institutions have failed this year and 
the FDIC's watch list has grown to 416 institutions. How many 
more of the troubled institutions do you anticipate will fail? 
Is the FDIC staffed up to deal with an increase in failures?
    Ms. Bair. Mr. Chairman, thank you for asking that question. 
There will be more failures. We do not make our failure 
projections public, but failures will continue at a pretty good 
pace this year and next. We think we will have about $100 
billion in losses over a 5-year period starting at the 
beginning of 2009. Twenty-five billion of that has already been 
realized from failures this year, and we have already reserved 
for another $32 billion as of the end of the second quarter.
    We are ready for this, though. We have been prepared for 
some time. We started staffing up in 2007, especially in our 
receivership and resolution staff, but also beefing up our 
examination staff. We have 6,300 staff on board now. That 
number will likely go to 7,000. We also have a significant 
roster of consultants that we use to help with bank closings as 
well as asset valuations, asset management, and asset 
marketing. The FDIC really is designed for this type of 
activity. We can expand very quickly and then contract very 
quickly. A lot of our hires are temporary 2-year hires.
    Overall, we have got a very good track record. These 
closings have been seamless. Through using loss share, we have 
been able to, more often than not, do a whole bank transaction. 
So another bank that serves that same community acquires both 
the deposits and the assets, which is good for bank customers. 
Frequently, the depositors are also the borrowers at the bank.
    Overall, it has been handled well. I think the staff have 
made a tremendous effort. We are well staffed and very much 
prepared for this.
    Senator Johnson. Governor Tarullo, there has been much 
concern raised that commercial real estate is the next problem 
area for financial institutions. What are the differences 
between the concerns over commercial real estate and the 
problems we experienced last year with mortgages?
    Mr. Tarullo. Senator, other than the fact that each 
presents a significant and troubled portfolio of assets for 
financial institutions, I think there are some salient 
differences.
    First, and I think of particular interest to many Members 
of this Committee, the places in which the mortgages are 
relatively concentrated do vary. As I noted in my opening 
statement, although large financial institutions certainly do 
have CRA exposures on their books, proportionately speaking the 
exposures are to a much more significant extent on the books of 
smaller and regional institutions, and oftentimes--not always, 
but oftentimes, those exposures are geographically 
concentrated. You have a small bank that tends to lend in a 
fairly small area. If the commercial real estate market there 
goes bad, then there is a problem. So, that is number one.
    Number two, in commercial real estate, generally speaking 
you don't have a 30-year fixed mortgage, as you do with 
residential mortgages. Instead, you have loans that need to be 
rolled over as a project proceeds or as a completed project is 
paid down, and that means you have a refinancing problem. So 
this year and next, we have got about $500 billion each year 
that is going to need to be refinanced and that creates a set 
of challenges that are perhaps no more serious than, but 
different from, the case with residential mortgages.
    Third, I would say that while there is some similarity, 
there are some different ways in which the situation plays out. 
We had subprime mortgages. We had Alt-A mortgages, we had prime 
mortgages, which as you know, Senator, presented ultimately the 
same set of problems, but at different times. In the commercial 
real estate arena, we have got very different kinds of lending, 
and there is an important distinction between construction and 
development loans, where essentially the builder is just 
starting to put something on the property, on the one hand, and 
so-called income-producing properties, a completed hotel or a 
multi-unit residential structure, where there is an income 
stream.
    The most serious problems are going to be in the former 
category, with the construction and development loans, which 
have no income stream. You are going to have problems in the 
second category, but that is something you can at least try to 
work with in some cases.
    Senator Johnson. Ms. Matz, I know that the NCUA is 
currently in the process of finalizing new rules for its 
corporate credit unions. Are you considering changes regarding 
the concentration of risks that corporate credit unions can 
have?
    Ms. Matz. Thank you for asking that question. As I think 
you are aware, when I was on the NCUA Board in 2002, I was the 
lone member who voted against the corporate rule at that time 
because I felt it didn't provide adequate parameters on 
investment authority and concentration of risk. So, we won't 
make that mistake again.
    At our Board meeting in November, we will take up the 
proposed corporate rule and we will address the riskiest area, 
which we consider the investment authority. We will set limits 
on the types of securities and the concentration of securities 
that corporates can invest in. We will address capital. We will 
have stringent requirements for capital retention that will be 
comparable to Basel I. We will set requirements for asset 
liability management so that asset cash-flow and liability 
cash-flows match. And we will have new governance rules, which 
are not included in the current regulation. So, I believe we 
will address the issues that led to the problems we are having 
today.
    Senator Johnson. Ms. Bair, do you have any concerns about 
smaller institutions having risk concentrated in one product 
area or one geographic area?
    Ms. Bair. Getting back to some of the regulatory reform 
issues that this Committee will be looking at, I think the 
community banking sector is very important to our economy and 
very important to our country. I do worry that because of 
competitive pressures and uneven playing fields, that they have 
become highly concentrated in commercial real estate loans and 
small business lending. Those are their niche areas where they 
have been able to hold ground against the larger banks as well 
as the shadow sector. I would like to see them be able to 
diversify their balance sheet, especially in consumer retail, 
and get back into providing those financial services. So, I do 
think that this is important.
    But in the near term, clearly, there is a lot of commercial 
real estate on the books of smaller banks. For the most part, 
they have managed those exposures well. Some, though, are more 
distressed than others, and clearly, commercial real estate 
will be a bigger driver of bank failures going forward.
    Senator Johnson. Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    There are a lot of issues that I would like to explore with 
this panel, but in my first round, at least here, I want to 
focus on one, and that is, as I think everybody knows, amidst 
all the issues that we are dealing with here in Congress, one 
of them, one of the big ones that I expect we will be dealing 
with more aggressively soon is the overall financial regulatory 
restructuring that is being proposed.
    I would like to get the opinion of the members of the panel 
with regard to their thoughts on one aspect of that, and that 
is the proposal that we consolidate all of the banking 
regulators into one single Federal banking regulatory agency. I 
don't know that in my 7 minutes I can get through the whole 
panel, but let us start with you, Ms. Bair.
    Ms. Bair. Thank you, Senator. My position is out there 
already. We have not liked this idea. The proposal was pushed 
in 2006 as an FSA-type model, although I know some of the ideas 
kicked around were a little different from FSA. We fear 
regulatory consolidation regardless of where it might be 
located. Clearly there may be some room for streamlining of 
bank regulation, but concentrating all the power with a single 
entity is a tremendous bet. If they do the right thing, then 
maybe we are OK. But if they do the wrong thing, we are really 
in the soup.
    In particular, taking the FDIC out of the supervisory 
process and the process of setting the capital standards and 
the underwriting standards, et cetera, would go in a different 
direction from where this Committee would like to go. We are 
not perfect by any means, but we are a conservative voice. 
Since we have a tremendous exposure as deposit insurer, our 
record shows that we are conservative when it comes to 
supervisory measures.
    Being an examiner also gives us a constant stream of 
information about banking trends, which helps us a lot in 
setting insurance premiums as well as helping our examiners 
prepare for working with the State regulators or the Federal 
chartering regulators when banks get into trouble and have to 
be wound down and put into resolution.
    So, we are very concerned about it. We fear it would weaken 
the FDIC. It could overall weaken banking regulation.
    Senator Crapo. Thank you.
    Mr. Dugan, do you have an opinion on this?
    Mr. Dugan. I do. As we testified here on this very subject 
about a month ago, I can't sit here and defend four separate 
Federal banking regulators and a separate holding company 
regulator. We don't have four food and drug agencies and the 
like. But I do think, on the other hand, if you moved all the 
way to one single regulator, you get some benefits in 
efficiency, but you also get some tradeoffs of the kind that 
Chairman Bair just described, that if you take certain 
regulators out of their current supervision, they don't keep 
their hand in it to the extent that they otherwise would.
    And so if you asked me, do I think that we can have more 
consolidation in the industry, I would say yes. But I would say 
to be careful. Each step along way, the trade-offs become more 
pronounced.
    Senator Crapo. Thank you.
    Mr. Tarullo, I want to hold off on you yet, because I want 
to get the perspective of the State Bank Supervisors from Mr. 
Smith before my time runs out, and then we will come back if we 
can.
    Mr. Smith. We oppose it from the tops of our heads to the 
bottoms of our feet----
    [Laughter.]
    Mr. Smith.----for the reasons that Chairman Bair has 
stated, and we believe honestly and truly that a single 
regulator would weaken or destroy the dual banking system and 
think that would be a bad thing for America.
    Senator Crapo. All right. Thank you.
    Mr. Tarullo.
    Mr. Tarullo. Thank you, Senator. So, let me echo the 
approach that Comptroller Dugan took, which is to say in any 
proposal, you are going to have some benefits and you are going 
to have some costs. I think on this one, I would just add two 
points, or reiterate one point and make an additional point. 
The reiteration is the point that Chairman Bair made, which is 
you lose something, and part of what you lose here is the 
insight that the Federal Deposit insurer or the monetary policy 
authority gets into the functioning of the banking system by 
being an examiner, and that is something that does require 
experience. It does require actually being involved in the guts 
of examination and supervision.
    Second, in terms of priorities, again, it is certainly 
debatable what model you want to have, and a lot of countries 
around the world have debated it, but I don't think that the 
existence of multiple banking regulators at the Federal level 
played a particularly important role in the genesis of this 
crisis. There are a lot of problems. There was a lot of blame 
to go around for a lot of reasons. But I don't think it was the 
coexistence of the FDIC and the Comptroller that was a 
particular problem here.
    Senator Crapo. Thank you.
    Ms. Matz.
    Ms. Matz. The Administration proposal kept NCUA as an 
independent regulator, and we support that.
    Senator Crapo. So you are willing to stick with that?
    Ms. Matz. Yes.
    Senator Crapo. All right.
    Mr. Ward.
    Mr. Ward. We think multiple viewpoints among the regulators 
fosters better decisionmaking and is a very healthy thing. We 
have a tremendous working relationship with the FDIC. We don't 
always see eye-to-eye on our institutions, but that is a very 
healthy pressure among our examiners.
    Senator Crapo. All right.
    Mr. Candon.
    Mr. Candon. Thank you, Senator. I would second what 
Chairman Matz responded to your question. The President had 
recommended the NCUA be left out of the consolidation. Thank 
you.
    Senator Crapo. All right. Thank you.
    Let me go back to you, Mr. Smith. As you indicated, you are 
very opposed to the consolidation. Mr. Dugan indicated that 
although one single regulator wouldn't necessarily be the way 
you--if I am correctly representing you--would go, that we 
don't really need four or five. What are your thoughts about 
that? Is there room for some consolidation?
    Mr. Smith. Well, far be it from we poor State regulators to 
tell the Federal folks what to do with your territory. I think 
there could be consolidation, I guess, among the Federal 
agencies, but I will say we believe, and I agree with Governor 
Tarullo and Chairman Bair, that our relationships that we have 
with the Fed and the FDIC work very well, and we also agree 
with the Obama administration's proposal to leave that alone 
and unimpaired.
    Senator Crapo. All right. Thank you.
    I am going to shift gears and come back to you, Ms. Bair, 
and this really is a question on the resolution authority and 
the process of resolution when a bank is seized or declared a 
failed bank. I recently have had a couple of those experiences 
in Idaho and I have had those who have been borrowers from the 
bank contact me to indicate that they really are not happy with 
the resolution authority.
    Just to give you an example, there are some who have 
contacted me who have indicated that they were in a position to 
repay much more than their particular loan ended up being 
auctioned for by the FDIC and that in that process, what 
happened was they were put in a bad situation because the loan 
was auctioned. The person or entity that purchased the loan 
immediately called it due. They were then put in a bind. The 
FDIC got 30 or 40 cents on the dollar. The one who really 
gained was the person who bought it at auction. The taxpayer 
didn't win. The FDIC didn't win. The borrower didn't win. And 
the bank didn't win.
    What is your reaction to that kind of an inquiry?
    Ms. Bair. I do hear this a lot and I look into it when I 
hear it. I don't know what the specific situation is you 
referred to, but I have found that, frequently, what has 
happened is a borrower may be wanting to get a bit of a deal. 
We are subject to least cost resolution, and although some 
reasonable price could perhaps be considered that would be 
better than what we would get if we auctioned the pool of loans 
off, other times, we have been approached by borrowers who just 
want a really low price for themselves--50 or 60 cents on the 
dollar or lower. That is not something that we can justify 
under least cost.
    Also, sometimes they will say they want to buy their loan 
out, but they don't have the cash resources to do it. So, when 
we ask for verification of their financial resources or who 
their new lender will be, they are not able to provide that. 
Sometimes the truth here is a bit more difficult than it may 
appear initially.
    Our policy is to offer borrowers the ability to buy back 
their loan if they offer a reasonable price and have the 
financial capability to do that. At my request, our ombudsman 
put together a Borrower Bill of Rights, which is on our 
website, and I would be happy to share with you and your staff, 
so that borrowers understand our process and what they can do.
    If the prices go too low, there is a question about least 
cost to our Fund, also. It is very difficult, given the volume 
that we have to do, to individually sell each of these loans, 
and at some point, you just have to market them in bulk. But, 
if a borrower is offering a reasonable price, has the financial 
capability and can show they can buy the loan back, we will sit 
down and accommodate them.
    Senator Crapo. Thank you very much.
    Senator Johnson. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    Chairman Bair, I wanted to go back to your testimony. You 
mentioned that you do not share your forecasts on the number of 
banks that might fail, and I can certainly understand that. Are 
you able to give us an order of magnitude? For example, in 2008 
we had 25 banks failing; in 2009, it is up to just shy of 100. 
Do we expect the next year to look more like 2008 or more like 
2009?
    Ms. Bair. It will look more like 2009.
    Senator Merkley. More like 2009. Thank you.
    Chairman, community banks hold 11 percent of the industry 
assets, but 38 percent of small business and small farm loans. 
Since small business is a key driver of the economic recovery, 
would it be fair to say that recapitalizing community banks 
would be a smart way to get lending flowing back to Main 
Street?
    Ms. Bair. We have been in discussions with Treasury for 
some time about making the TARP program work better for 
community banks. The 25 largest domestic institutions that 
qualified 100 percent participation in the TARP program. For 
the smaller institutions, it is about 9 percent. So, clearly, 
we think the program could be working better for the smaller 
institutions.
    In preparation for this testimony, I went back to look at 
small loan balances of larger and smaller institutions. Even 
though year over year, as of June 30th, small loan balances 
were down 1.9 percent overall, for the community banks, those 
less than $1 billion in assets, loan balances were up slightly 
over 2 percent. So community banks look like they are still in 
there trying to make these loans, but some additional capital 
support would be really helpful.
    Senator Merkley. Could you give us some sense of what that 
might look like?
    Ms. Bair. While this is Treasury's program, an idea that 
has been discussed is a dollar-for-dollar matching program. 
Right now the viability standard puts a lot of pressure on our 
examiners to try to identify the institutions that are, without 
the additional money, viable. Frankly, the ones that are 
clearly viable without the money do not want it. It is really 
the institutions where the decision is less clear that will 
come to us. But many times they are worthy, we think, and can 
raise significant private capital. So we have suggested a 
dollar-for-dollar matching program. This would provide an 
additional validation of viability from the market. The market 
may be willing to put additional capital in, help provide some 
additional protection to Treasury, and perhaps make the terms a 
little less onerous. This could perhaps be tied to increasing 
small business loans.
    So I think there are--and I know Senator Warner has had 
some thoughts on this--ways to approach this that would make 
the program work better for the smaller banks.
    Senator Merkley. Thank you. And would this have--did I see 
a hand raised there? Oh, no. Just scratching. OK.
    [Laughter.]
    Senator Merkley. At hearings and auctions, you have to be 
very careful how you are moving.
    In terms of the impact upon our commercial real estate, 
what are things that we can do to assist our community banks 
and, therefore, our small commercial real estate markets as we 
face a lot of balloon loans that will be coming due in the 
couple years ahead?
    Ms. Bair. I think it is a problem. We are encouraging banks 
to work to restructure these loans. If they have a creditworthy 
borrower, a restructured loan with a lower payment, can make 
that a performing loan. We want them to do that. That preserves 
value, just the way it does with home mortgages. It is the same 
principle with commercial real estate. And we are in the 
process of finalizing guidance right now that makes that very 
clear and provides examples to our examiners of what we 
consider prudent workouts. This should be encouraged, not 
criticized.
    In the near term that is the best we can do. Of course, 
bringing back the securitization market for commercial 
mortgages is going to be much more difficult. I know the 
Federal Reserve Board has been working on that, as has 
Treasury. But that is going to be a longer haul.
    Senator Merkley. One of the things I keep hearing back home 
in Oregon is from owners who have fully performed on their 
loans, but as their loans come up to be rolled over, the 
estimate of the value of their property has dropped enough that 
the bank is very nervous about reissuing it.
    Is there any form of guarantee that the Federal Government 
could do for, if you will, the difference in the drop in equity 
on loans that have been performing for the entire period to 
enable those banks to be able to meet the regulators' 
requirements and at the same time be able to reissue those 
loans so we do not freeze up or seize up in those commercial 
markets?
    Ms. Bair. I am unaware of any current programs that would 
do that. That is a new idea. I would just like to think about 
it. Others might want to have a comment.
    Senator Merkley. All right. Thank you very much.
    Senator Johnson. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    This is for the primary regulators, though others may want 
to answer this question also. Do you have enough power to 
restrict the activities and risk taking of banks and holding 
companies? Do not be bashful.
    [Laughter.]
    Senator Bunning. Usually you are not.
    Ms. Bair. Well, for holding companies, no. I would defer to 
the holding company regulators down the aisle here. We have no 
authority over holding companies.
    Senator Bunning. Well, you do have a lot of banks, though.
    Ms. Bair. That we do.
    Mr. Dugan. For the banks themselves, I think we do have 
adequate powers to restrict activities that we think are unsafe 
and unsound, but not the holding companies. Just the bank and 
the direct subsidiaries of the banks.
    Senator Bunning. Fed?
    Mr. Tarullo. Senator, with respect to banks, I think on an 
ongoing basis, the answer is yes, although when it comes to 
closing an institution, we do not have the breadth of authority 
that the OCC or the FDIC has for the banks for which they are 
the primary Federal regulators.
    With respect to holding companies, there is, as you know, 
some lingering ambiguity from the Gramm-Leach-Bliley Act as to 
the reach of Federal Reserve authority over regulated 
subsidiaries.
    Senator Bunning. On in the Fed's mind.
    Mr. Tarullo. Well, Senator, I think it is in a number of 
people's minds, and as we have said before, we would welcome 
clarification of that in any legislation that----
    Senator Bunning. We clarified that in 1994, but that has 
not been interpreted by the Fed.
    Mr. Tarullo. If you look at the statute and the legislative 
history, there was some sense that there was supposed to be 
deference to functional regulators of subsidiaries.
    Senator Bunning. Correct. And you were powered to write the 
regs and did not.
    Mr. Tarullo. Well, Senator, as you know, I cannot----
    Senator Bunning. I am not going to get into that dispute 
with you.
    Mr. Tarullo. OK. So let me just leave it there, though, 
with--I think with respect to the bank----
    Senator Bunning. Ms. Bair, would you like to comment about 
your ability to regulate the banks with the power that you now 
have?
    Ms. Bair. There may be certain detailed areas, for 
instance, back-up authority, where through our good working 
relationships, we are able to effectively use it. Although, if 
we ever needed to bring an enforcement action with back-up 
authority, it is a fairly protracted process.
    Going forward as part of reform, we would like to see 
greater consistency in standards, particularly capital 
standards, between bank holding companies and banks. We think 
bank holding companies should be a source of strength for banks 
and should at least have as strong a capital level and quality 
of capital as the banks. There are a few areas where we would 
like to see some improvements, and that is not a secret. My 
fellow regulators know of our views on that.
    But, overall, I think the powers for both banks and bank 
holding companies have been pretty adequate, and perhaps there 
are areas where we could have used them better. Again, in terms 
of reform, looking at the disparities between the bank and the 
non-bank sector cannot be emphasized enough. As we try to 
improve the robust nature and quality of bank and bank holding 
company regulation, if there is still a giant shadow sector out 
there that is basically beyond the reach of meaningful 
prudential oversight, you are going to have the same problem 
that drove this crisis. Higher-risk activity will go into that 
shadow sector.
    Senator Bunning. That is basically what I am asking. In 
other words, if there is a bank either that you are in charge 
of or the OCC or the holding companies, and they are doing 
things that you know that get them in trouble, can you stop it?
    Ms. Bair. Yes.
    Mr. Dugan. Yes.
    Senator Bunning. You have enough power to stop it.
    Mr. Dugan. Yes.
    Ms. Bair. Yes.
    Senator Bunning. The Fed also.
    Mr. Tarullo. Ultimately, yes.
    Senator Bunning. Ultimately. OK.
    Why should firms that are supported by taxpayers' 
guarantees and insured deposits and access to Fed windows be 
allowed to make huge profits on their own trading? What 
restrictions have you put on these activities?
    Mr. Tarullo. Well, Senator, the restrictions that would 
apply to the activities of subsidiaries of financial holding 
companies or bank holding companies would be the capital 
liquidity and risk management restraints that would apply to 
any holding company, which is to say there is substantially 
less leverage permitted for such a company today than may have 
been the case before it became a bank holding company. And so 
that puts non-trivial constraints on what they can do.
    But under the structure of Gramm-Leach-Bliley, they are 
permitted to have subsidiaries that do engage in these trading 
activities so long as they conform to the capital and liquidity 
requirements.
    Senator Bunning. If I have heard it once, I have heard it 
ten times, from not only the Secretary of the Treasury but the 
head of the Federal Reserve, that there are institutions in 
this country that are too big to fail. Too big to fail.
    Now, it is up to the people sitting at this desk or these 
all gathered here to stop that. I need suggestions.
    Mr. Tarullo. Well, I think Chairman Bair alluded earlier to 
something with which I certainly agree, that we need to have 
capital and other requirements that take full account of the 
additional risk that may be created by very large institutions.
    Senator Bunning. The AIGs of the world.
    Mr. Tarullo. The AIGs of the world for certain, Senator.
    Senator Bunning. OK.
    Ms. Bair. Well, and as we have said before, we do think----
    Senator Bunning. I wanted to ask you one more question 
before you get away since I only have 25 seconds. Right now the 
FDIC is considering forcing banks to prepay their assessments 
for the next 3 years. I have two questions about this.
    First, earlier this year you asked Congress for a higher 
credit line at Treasury, and we gave it to you. Why didn't you 
use that credit line? Is it really because Treasury has no room 
under the debt ceiling?
    Ms. Bair. No, that is not the reason. We view the credit 
line as being there for emergencies for unexpected loss. 
Particularly, earlier this year, we thought it was very urgent 
to make sure we had plenty of breathing room there.
    But what we are talking about with the prepaid assessments 
for losses is different.
    Senator Bunning. There is only one problem with that. The 
banks that have not put you in the problem are the very banks 
that are going to get assessed.
    Ms. Bair. Well, the prepaid assessment is different from 
the special assessment.
    Senator Bunning. I understand that, but they are the same 
banks.
    Ms. Bair. They are the same banks, and at the end of the 
day, that is how insurance works. The lower risk banks end up 
generally to some level subsidizing the higher risk banks.
    Senator Bunning. Let me finish this. Second, will that 
prepaid payment be enough to cover all the losses? Or will you 
have to raise more money again in the future?
    Ms. Bair. Based on our current projections, that will be 
more than ample. But, again, a lot of this depends on the 
economy. So if the economy has unforeseen troubles, that could 
be different. But based on current projections this year, yes.
    Senator Bunning. I am only an economist, so I would tell 
you you've got a problem.
    Ms. Bair. OK.
    Senator Johnson. Senator Tester.
    Senator Tester. Thank you, Mr. Chairman.
    I want to step back a little bit, Chairwoman Bair, to what 
Senator Crapo was--just very quickly. You said that when it 
came to buying back loans per se, the borrowers were often 
given a chance to buy those loans back. How is the value of 
those determined?
    Ms. Bair. It is difficult. Certainly if they just want to 
buy their loan back at what they owe----
    Senator Tester. At 100 percent----
    Ms. Bair. Right. Then that would be great. We would welcome 
that. Again, they need to demonstrate they actually have the 
ability to do that.
    If they want to have a discount, a couple of issues arise. 
If they have the capability to keep paying on the loans, if the 
loan is performing, the question becomes whether we should 
negotiate a deal for a borrower that is otherwise fully capable 
of making repayment on the loan.
    Even then, we do provide some flexibility, but we are 
required to pursue least-cost resolution, which means we need 
to get the best price for all the loans that we inherit in a 
receivership. Frequently just trying to do them one by one is 
not administratively practical and would get generally lower 
prices than if you market them all in bulk.
    Senator Tester. Right. So seldom do you peel one loan out 
and sell it.
    Ms. Bair. I can get you numbers of how often it happens. 
But, again, if they want to pay it off completely, we welcome 
that. Even below that, we will work with them. But frequently 
they are not able to. They say they want to, but they are not 
able to.
    Senator Tester. OK. The deposit insurance fund, we have 
about what you are going to do in the short term. The Senator 
from Kentucky talked a little bit about the long term. Do you 
plan on permanently raising the rates on the long term, over 
the long term, to handle solvency in that fund?
    Ms. Bair. Right. Well, we would bump up the rates by three 
basis points beginning in 2011. That would bring the base rate 
up to 15 to 19 basis points for most banks. That is still well 
below the 23 basis points that was assessed on the industry 
during the S&L days. So as the economy recovers, as the banking 
sector heals, as our losses go down, we will constantly 
reassess that. We will stay within the range that Congress has 
prescribed, though I think perhaps Congress may want to think 
about giving us additional flexibility to build the fund up in 
good times. It is something that will be continuously 
monitored, but as of our projections now, we believe with the 
three-basis-point bump-up in 2011, we will be able to 
reestablish the fund and get it back to 1.15 within 8 years, 
which is what Congress has asked us to do.
    Senator Tester. OK. Is there a point in time in which you 
permanently raise their rates?
    Ms. Bair. No, I do not think so. When the FDIC Board sets 
risk-based assessments, consideration is given to the risks in 
the banking system and the needs of the DIF to cover projected 
losses.
    Senator Tester. This can be for Mr. Tarullo or Mr. Dugan. 
Actually, you can answer it, too, Ms. Bair. But there has been 
a lot of discussion about the make-up of systemic risk 
regulators and the powers entrusted to that body. I guess the 
question is--and, Mr. Smith, you may want to jump in on this, 
too. Do you believe there is a value in allowing 
representatives from State regulators to participate in the 
systemic risk regulator?
    Mr. Tarullo. Senator, I think it depends, as it often does, 
on how one conceives of what a systemic risk regulator is 
doing. I think there have been discrete functions which 
sometimes get lumped under that umbrella.
    What we have thought of in terms of the Federal Reserve's 
role is consolidated supervision of systemically important 
institutions, and so it is very much a supervisory function, 
making sure that you are covering everybody who could pose a 
risk to the system. And in that context, of course, if there is 
a State bank, the State banking supervisor absolutely should be 
participating.
    A second context is thinking in terms of collective efforts 
to identify emerging risks and figure out what can be done, and 
there I think it is profitable to have people who see things 
from different parts of the financial system participating.
    Senator Tester. OK. If there is a council of regulators, 
should the State regulators be represented?
    Mr. Tarullo. It depends, I think, Senator, on the functions 
of that council. If it is a matter of analysis and scrutiny and 
trying to coordinate, then I think there is a good case to be 
made for it. If it is a matter of actually making some binding 
Federal law decisions, then it probably is not.
    Senator Tester. OK. Sheila, I have heard from banks that 
the FDIC is becoming more and more concerned about AG loans. Is 
that true? And I guess the question is why, even though the 
markets are in the tank. That probably answers it.
    Ms. Bair. Not that I am aware of, Senator. We have been 
monitoring it for some time, but this is the second time in a 
week that somebody has asked for that so maybe I will probe a 
little more.
    [Laughter.]
    Ms. Bair. But not that I am aware of, no. We are monitoring 
this.
    Senator Tester. I appreciate that.
    Ms. Bair. Senator, could I just go back to the borrower 
question?
    Senator Tester. Go ahead. Sure.
    Ms. Bair. One of the reasons we do whole bank transactions 
with loss share is if we can sell the whole bank, we do not run 
into this problem. A new bank gets those loans, services those 
loans, and it preserves the relationship with the borrower. It 
is only where we cannot do the whole bank transaction that we 
get into this problem.
    Senator Tester. OK. Well, I understand. You are kind of 
between a rock and a hard place, quite honestly, because it 
does not seem quite fair to let somebody else make a bunch of 
dough on it when you could cut that--anyway, I do not want to 
go there.
    Mr. Tarullo, there was a front-page story in the Wall 
Street Journal--we are going down a little different avenue 
here now--that talked about workers at the top 23 investment 
banks, hedge funds, asset managers, stock and commodity 
exchanges can expect to earn even more this year than they did 
in 2007, which was the peak year. I guess the question is, 
getting right to it: Are we returning to the attitude of greed 
that really occurred before the economic downturn--and that is 
being kind--in 2008?
    Mr. Tarullo. I do not know, Senator, that I can comment on 
what everybody else out there is thinking. I guess here is what 
I would say:
    First, I do have concerns sometimes in a variety of 
contexts that people in general, including in financial 
institutions, have not come to grips with the fact that things 
have changed. Things have changed in a basic way, and I think 
the presence of many of us at this table today promises that 
things are going to change more. That means business models. 
That means the way of assessing risk. That means how you run 
your institution.
    Second, with respect to the story itself, I do think that 
is a bit speculative, it is a bit projecting what is about to 
happen, and I think we should watch and see what, in fact, does 
happen and what, in fact, these firms are doing with their 
capital standards, which is ultimately of great importance to 
us.
    Senator Tester. OK. If I might, Mr. Chairman, you know what 
the unemployment numbers.
    Mr. Tarullo. I do.
    Senator Tester. And there are folks in many of these 
companies that are up here right now lobbying to make sure t 
there is no or very, very little regulation on a lot of the 
incidences that created the economic collapse.
    Do you find that some--because they are making a ton of 
dough. Do you find that somewhat ironic, troublesome?
    Mr. Tarullo. What I hope is that this Committee and the 
Congress as a whole will pass a strong set of reforms, no 
matter what other people out there are saying.
    Senator Tester. OK. Thank you very much.
    Thank you, Mr. Chairman.
    Senator Johnson. Senator Gregg.
    Senator Gregg. Thank you, Mr. Chairman, and I want to thank 
the panel for their excellent testimony. It has been most 
interesting.
    First off, I want to congratulate the FDIC for deciding to 
forward-fund the fees. I think that is the right approach. You 
do a lot of things right. You have done a lot of things right 
during this problem.
    You did a lot of things right when I was Governor in 1989 
in New Hampshire and five of our seven largest banks closed. 
Mr. Seidman came in and basically was our white knight.
    But you did say something that really concerns me, and that 
is, how you interpret the TARP, this idea that the TARP should 
be now used as a capital source for a lot of smaller banks that 
are having problems raising capital. I think all of you 
basically in your testimony have said we are past the massive 
systemic risk of a financial meltdown that would have caused a 
cataclysmic event.
    TARP came about because of that massive potential 
cataclysmic event, and its purpose was to basically stabilize 
the financial markets and be used in that manner in order to 
accomplish that. As one of the authors, along with Senator 
Dodd--we sat through the negotiations of that--I think I am 
fairly familiar with that purpose. That was the goal. It should 
not now be used as a piggy bank for housing. It should not be 
used as a piggy bank for whatever the interest of the day is 
that can be somehow--it should not have been used for the 
automobile industry, and it really should not be used in order 
to have a continuum of capital available to smaller banks who 
have problems, in my opinion, because then you are just going 
to set up a new national program which will essentially 
undermine the forces of the market, and that would be a 
mistake.
    I did hear you say, Madam Chairman, that you expect $100 
billion in losses. Is that a net number? Or do you expect to 
recoup some percentage of that?
    Ms. Bair. No, that is what we project our losses to be over 
the next 5 years.
    Senator Gregg. So that is a net number after recoupment?
    Ms. Bair. Yes.
    Senator Gregg. Well, is it--do you expect of that $100 
billion in bad loans to be getting back 30 percent of----
    Ms. Bair. The $100 billion would be our losses. So let us 
say we had a 25-percent loss rate on our bank failures so far, 
so you would be talking about $400 billion in failed bank 
assets.
    Senator Gregg. Well, OK, so it----
    Ms. Bair. That is since the beginning of 2009, though. And, 
again, a lot of that has already been realized and reserved 
for.
    Senator Gregg. And you have got $64 billion, you said, or 
something, that has been realized and reserved against, so you 
have got about----
    Ms. Bair. That is right, yes.
    Senator Gregg.----$36 billion to go. OK.
    I have got a philosophical question here. If we look at 
this problem--granted, commercial real estate is now the 
problem, but commercial real estate, as I understand it from 
your testimony, is not--it is a serious problem. It is just not 
a systemic event. It is not going to cause a meltdown of our 
industries--of our financial industry. It may impact rather 
significantly especially the middle-sized regional banks and 
some of the smaller banks, but it is not systemic.
    The systemic event was caused in large part in the banking 
industry by the primary residence lending activity--subprime, 
Alt-A, and regular loans. And all I heard about as the 
proposals for getting at this is regulatory upon regulatory 
layers to try to figure out a way to basically protect 
ourselves from having that type of excess in this arena occur 
again.
    But when you get down to it, it is all about underwriting. 
I mean, the bottom line is this is about underwriting. It is 
about somebody lent to somebody who either did not have the 
wherewithal to pay it back or who had an asset which was not 
worth what they lent on that asset. And probably the person who 
lent it did not really care because they were just getting the 
fee and they were going to sell it into the securitized market 
anyway.
    So if you really want to get at this issue, wouldn't it be 
more logical and simpler and--it is not the whole solution. 
Clearly, there has to be regulatory reform. But shouldn't we 
look at the issue of having different underwriting standards, 
both of which the OCC and the FDIC have the authority over, in 
the area of what percentage to asset can you lend? You know, do 
you have to have 90 percent, 80 percent? Shouldn't we have an 
underwriting standard that says you either get--that there is 
recourse? Shouldn't we have underwriting standards that gives 
you the opportunity to either have an 80-percent or 90-percent 
choice or a covered loan, something like that? Isn't that 
really a simpler way from a standpoint of not having--granted, 
it would chill the ability to get a house because people who 
could not afford to buy the house and could not afford to pay 
the loan back probably would not be able to get the loan. But 
isn't that where we should really start this exercise, with 
recourse and 80 percent or 90 percent equity--10, 20 percent 
equity value and/or, alternatively, covered funds? I would ask 
everybody who actually is on the front lines of lending today.
    Ms. Bair. Certainly underwriting is key, but poor 
underwriting is not necessarily the driver of future losses 
now. We are seeing loans go bad now that were good when they 
were made. But because of the economy--because people are 
losing their jobs, or retailers are having to close, or hotels 
cannot fill up--those loans are going bad.
    The economic dynamic is kicking in in terms of the credit 
distress that we are increasingly seeing on bank balance 
sheets.
    You are right, the subprime mortgage mess got started with 
very weak underwriting. It started in the non-bank sector. It 
spilled back into the banking sector. I think all of us wish we 
had acted sooner, but we did move to tighten underwriting 
standards, and strongly encouraged the Federal Reserve Board to 
impose rules across the board for both banks and non-banks. 
This, again, is the reason why you need to make sure that the 
stronger underwriting standards going forward apply to both 
banks and non-banks.
    Senator Gregg. Well, what should those underwriting 
standards be?
    Ms. Bair. You should have to document income. You should do 
teaser-rate underwriting. The Federal Reserve Board has put a 
lot of these in effect now under the HOEPA rules. You have to 
document income. You cannot do payment shock loans. You have 
got to make sure the borrower can repay the loan if it is an 
adjustable rate mortgage that resets. These are just common-
sense underwriting principles that have applied to banks for a 
long time.
    Senator Gregg. Or should there be recourse?
    Ms. Bair. That has been a prerogative of the States. Some 
mortgage lending is recourse, some is non-recourse, depending 
on the State.
    Senator Gregg. Should there be a requirement that you 
cannot lend to 100 percent of value?
    Ms. Bair. I think there is a strong correlation with loan-
to-value ratios (LTVs). We actually recognize that in our 
capital standards that we are working on now. We would require 
a much higher risk weighting of loans which have high LTVs. So 
through capital charges, we are recognizing and trying to 
incent lower LTVs.
    Senator Gregg. I am running out of time unfortunately.
    Mr. Dugan. Senator, I think that you are onto a very 
important point that I do not think has gotten the same kind of 
attention that it deserved and what got us here in the mortgage 
market, not just in subprime. I think we lost our way as a 
country in terms of some of our basic underwriting standards on 
loan-to-value and on stated income, and I think it is worth 
exploring having a more common set of minimum underwriting 
standards that apply across the board with more specificity 
than what we have today, which I think is what you are 
suggesting.
    Mr. Tarullo. Senator, I think leverage on the expectation 
of rising asset prices was at the heart of the subprime 
problem, and indeed, it is at the heart of some of the other 
problems that we see, to some degree, in commercial real 
estate, as well. So, I would try to reinforce any instinct you 
have to push people toward better underwriting standards, and 
we, as the Chairman noted, are trying to do that ourselves.
    Mr. Smith. I would only add, Senator, that in the most 
successful period I know of in home lending in the United 
States, there were mainly two, maybe three varieties of loans 
generally in the underwriting standards world, as you say. 
There was a requirement of a downpayment, for standard 
documentation, and the people that made the loans kept them. 
And on the basis of that lending experience, we projected--the 
magicians on Wall Street did projections about the loans that 
weren't like that.
    So, I think there is--as you point out, the issue there is 
the issue of access to housing, and that is what it is. There 
is no free lunch and no easy answer.
    Senator Gregg. Thank you. Thank you very much for your 
testimony.
    Senator Johnson. Senator Bennet.
    Senator Bennet. Thank you, Mr. Chairman, and I would also 
like to thank the panel for your excellent testimony.
    Every weekend when I go home to Colorado, what I hear from 
small businesses is they have no access to capital, no access 
to credit, and we are in this, as the panel has talked about, 
in this remarkably difficult period where, on the one hand, the 
securitized market that blew up or imploded is now gone and has 
not been replaced, which is probably a good thing from a 
leverage point of view, but it hasn't been replaced.
    On the other hand, we have got this looming commercial real 
estate issue that is still out there. And sort of caught in 
between all that are our small businesses who need access to 
capital in order to grow and in order to deal with the 
unemployment rate that Senator Tester talked about and sort of 
this folding back on top of itself.
    And I wondered, Mr. Tarullo, you mentioned in your 
testimony at the beginning your view that maybe some more 
direct efforts--I think you described it as temporary targeted 
programs--might be necessary to get our small businesses access 
to the credit that they need, and I wonder if you could 
elaborate a little bit more on that, because I suspect you are 
right. And in addition to that, I would ask to what extent we 
think the current accounting regimes are ones that are either 
helping banks extend credit to small businesses or are 
intruding on their ability to do that.
    Mr. Tarullo. So, Senator, I don't want to step on the 
prerogatives of the Congress, the Administration, various 
agencies that may have----
    Senator Bennet. You can step on my prerogatives. I----
    Mr. Tarullo.----but here is what I think. So what did we as 
a government, as a country, try to do with residential 
mortgages--not yet as successfully as I think many people would 
have wanted? We tried to do something about people losing their 
homes and to provide some mechanisms, some special mechanisms 
that would address those issues specifically, even as we all 
tried to put a foundation under the economy and get it growing 
again.
    And my thought was that something similar probably needs to 
be done in the small business arena, because I don't think I 
hear as many of the stories as you do, but I hear enough of 
them, because I do try to get out and talk to borrowers as well 
as lenders. So, whether that is trying to streamline SBA 
lending and make the direct lending possibilities more real, or 
whether it is a new program which tries to provide guarantees, 
I don't have a strong view on that and the Federal Reserve 
certainly has no view on it. But I do think that something 
targeted is going to be an important complement to the macro, 
bank regulatory, and TALF efforts that we have.
    Senator Bennet. Does anyone else have a view on that? Mr. 
Smith?
    Mr. Smith. I would say in the absence of the type of a 
program of the type Governor Tarullo is talking about, it seems 
to me what clearly is needed is for small and medium-sized 
banks to clear up their balance sheet problems they have right 
now. I mean, the problems small businesses have in part are 
based on the fact that balance sheets have impaired real estate 
on them that has to be dealt with some way and that they have 
insufficient capital to make additional loans until that is 
cleared up. So until we work through--I mean, with all due 
respect to Senator Gregg, until the real estate, the follow-on 
problem of the commercial real estate problem for many of our 
banks is that it clogs up the balance sheets or impairs them in 
a way they can't make loans.
    Senator Bennet. I guess I would ask, Chairman Bair, maybe 
you or Mr. Smith, to what extent--I mean, I am told that in the 
early 1980s when we ran into trouble on agriculture, we did 
some things like stretch out the period of time that assets had 
to be marked down. And I don't want to tread into this too 
much, but I wonder whether, given how serious the commercial 
real estate problem is, whether we are in a position to unclog 
the assets in a way that puts banks again in a position to be 
able to lend to small businesses.
    Ms. Bair. You need to be careful, obviously. You want to 
provide flexibility to try to restructure the loans and 
accommodate borrowers in a way that preserves value but is 
fully disclosed. You don't want to defer losses. If the losses 
are there, they need to be realized. There is this difficult 
balance. You would not want to go over to the regulatory 
forbearance situation, which I think did get us in trouble 
during the S&L days. So, like anything, it is an important 
balance.
    I wish Senator Gregg was still here, because regarding the 
capital support for the smaller banks, the smaller banks are 
disproportionately a source of lending, particularly for small 
business. That is what they do. They do small business lending. 
They do commercial real estate. I am not normally an advocate 
for government support programs, but I do think the tremendous 
disparities in TARP between the 25 largest banks, with 100 
percent participation, and for the smaller banks, less than 9 
percent participation has created competitive disparities 
between large and small institutions--between the too-big-to-
fail institutions where funding costs are going down, and the 
smaller institutions where funding costs are going up.
    Again, with a matching program that provides market 
validation that an institution is viable, markets are more 
willing to put more capital in. Additional capital could help 
balance-sheet capacity to enable more of this type of lending 
by the smaller banks.
    Ms. Matz. Senator, I just wanted to make the point that 
credit unions make loans to small businesses, or club member 
business lending, and the average loan is only about $170,000. 
So they really are targeted to small businesses. In the current 
year, the lending is up almost $2 billion. Last year, it was up 
$5 billion. So, more and more, credit unions are making more 
and more loans to small businesses.
    Senator Bennet. Thank you, Mr. Chairman.
    Senator Johnson. Senator Corker.
    Senator Corker. Mr. Chairman, thank you, and as always, I 
thank each of you for your testimony. I always learn something 
when you are here.
    I also wish Senator Gregg was here. I think we share some 
of the same intuitions and concerns, and while you know I 
respect the FDIC and your leadership very much, I tend to hear 
regulators talking about them wanting assistance to the banks 
that they have liabilities to. I know Chairman Dugan, who I 
also respect greatly, very much appreciated the TARP assistance 
to the banks that he regulated so they wouldn't fail, and now 
you very much would like TARP assistance to the banks that you 
have depositor worries with. I just hate to hear us move into 
that mode, and again, I respect you both very, very much and 
have worked with you on lots of legislation. I do hate hearing 
that kind of thing.
    Chairman Bair, I know you mentioned the underwriting wasn't 
really the issue because loans were underwritten well in the 
past today are problems. But again, I think that was driven by 
the fact that we had poor underwriting in the beginning and it 
created a financial system issue that has really put us into 
this situation. So, I do think those are very much tied 
together.
    I will have to say that as we have looked at the regulatory 
reforms, it seems like we are just sort of rearranging the deck 
chairs. I mean, the issue has been always real estate in modern 
times. As we have had financial crises, it has always been real 
estate. I haven't heard anything in the regulatory reform--I 
know we talk about capital requirements, but the kinds of 
losses we have had, we would have blown through those capital 
requirements you all are talking about very, very quickly. We 
still would have needed a systemic bailout or some kind of 
mechanism. So, to me, that is not it.
    I know that we talked a little bit gratuitously about maybe 
we ought to put that in regulation--I mean, in laws. I can't 
imagine us writing laws up here that talk about what the equity 
ought to be in homes and those kind of things. You all don't 
really want us to do that, do you?
    So, it seems to me that actually the Fed is supposed to put 
out that type of guidance, is that correct?
    Mr. Tarullo. That is correct, Senator, and we have now, 
yes.
    Senator Corker. So you are sending out guidance----
    Mr. Tarullo. Well, there is----
    Senator Corker.----that says that loans, you have to have 
20 percent down payment----
    Mr. Tarullo. This is on the consumer protection side. One 
of the needs to underwrite is to make sure that you are going 
to make an assessment based on the ability of the borrower to 
pay, not just on the rising value of the real estate, for 
example.
    Mr. Dugan. But, Senator, more generally, it is not just the 
Fed. All of us----
    Mr. Tarullo. Right. When it comes to safety and soundness, 
every regulator----
    Senator Corker. I mean, I think it would be wonderful. Let 
us face it. In the desire for policymakers to make sure people 
at every income level led the life of middle-class citizens, we 
promoted loan making that helped destroy our system. That 
wasn't the whole picture, but that certainly was a part of it. 
Are each of you as regulators saying that you are going to put 
out strong standards that really counter policymakers' desire 
to make sure that everybody in America has a home and a ham in 
their pot? Is that basically what you are saying you are going 
to do, because I think that is the only way, by the way, we are 
going to keep this from happening again, is it not?
    Mr. Tarullo. I think, as Chairman Bair said a little while 
ago--she didn't say it quite in these words, but what I heard 
her say was, we have got to worry about problems in the future 
as well as problems in the past. I do think that the problems 
with underwriting played a very central, though not the only 
role, in the financial crisis. I do think we need underwriting 
standards for residential mortgages and in other areas----
    Senator Corker. And each of you can write those, is that 
correct?
    Mr. Dugan. Yes.
    Senator Corker. And are each of you going to write 
standards that are dramatically different from those that got 
us into the situation? I mean, each of you agreed with Senator 
Gregg's questions, but I wonder if we are actually going to 
take action to make that occur.
    Ms. Bair. First of all, I want to clarify, there is plenty 
of bad underwriting. I want to emphasize that, the kinds of new 
credit problems we are seeing now are more economically driven. 
There was plenty of bad underwriting in both mortgage lending 
as well as commercial real estate.
    We have tightened the standards tremendously. I think we 
are being criticized in other quarters. Please note that we 
issued commercial real estate guidance in 2006.
    Senator Corker. Well, I----
    Ms. Bair. The Federal Reserve Board has issued rules that 
apply to both banks and non-banks for mortgage lending that 
significantly tighten the standards. That already has taken 
place. Also, we are working on capital rules that will require 
greater capital charges against higher-risk loans, such as 
those with high LTVs. The bank regulators are doing all that, 
and have for some time.
    You still have a fairly significant non-bank sector, one 
that can come back as the capital markets heal. That is why I 
hope that, going forward, in terms of whatever reforms you come 
up with, that those reforms will reflect the fact that there 
are two different sectors, two different providers of credit in 
this country. We can keep tamping down on the banks as we have 
been. But if the non-bank sector is left, by and large, 
unregulated, that is not going to fix the problem.
    Mr. Dugan. And Senator, if I could just add, if you look at 
the experience of Canada where they are our neighbors and have 
a much more conservative standard for underwriting, where they 
verify income and have loan-to-value ratios that are higher, 
you can't get a 30-year fixed-rate mortgage, but they have very 
high levels of home ownership and they didn't have any of these 
problems. So, they have more of a system that has a basic 
minimum that cuts across the board. It may not be the right 
ones for us, but I definitely think it is worth exploring.
    Senator Corker. And I would really like--I know that I am 
going to run out of time here and we are not going to be able 
to--but we talk often, I know, all of us--I would really like 
to see what it is we need to do on our end. I don't think we as 
a country have the political will to do the things we need to 
do to make sure that this doesn't happen again. I absolutely do 
not see it. I mean, this regulatory reform, again, is just 
moving chairs around. It is not changing anything about the way 
that we go about doing this business. And I hope that as we 
move along, you all will help with that.
    Mr. Tarullo, again, I thank you for your testimony, also, 
as always. I am wondering, on 13(3), as we move into 
regulation, should we--I mean, in essence, we are going to be 
talking about TARP and resolution and all of those kind of 
things down the road, but on the 13(3) issue, exigent 
circumstances, should we move to narrow the Fed's ability to 
use 13(3) for specific institutions, move away from that so 
that your assistance is at the system level, but where you are 
not specifically--I mean, in essence, you can get around--I 
know that some people here support the Administration's 
proposal to sort of codify TARP. I don't. I think we should end 
TARP at the end of the year. But it seems to me that under 
13(3), the way you now have it, you all can work around that at 
the Fed and, in essence, do the same thing at specific 
institutions, and I am wondering if you feel we ought to limit 
that.
    Mr. Tarullo. So, I would say, Senator, that I think most 
people at the Federal Reserve would be happy if they were not 
in the position where people came to us when there was a need 
for resolving or dealing with a specific financial institution, 
but I do think one needs to have a mechanism, a mechanism in 
law by which some part of the government can deal with the 
large financial institution that may be in distress.
    And that is why I think all three of us, certainly, have 
supported moving forward with a resolution mechanism that would 
cover the large financial institutions. I do think within the 
context of that, you have to address the question of potential 
funding streams for short-term liabilities or the sort. So, I 
think it needs to be addressed somewhere. It doesn't need to be 
in 13(3).
    Senator Corker. If I am hearing you properly, if we had a 
resolution mechanism in place, which we did not have for 
complex bank holding companies and others, like AIG, which is 
not one of those--if we had a resolution mechanism that was 
defined and we had the ability to fund the short term, while 
you are resolving that, hopefully not in conservatorship but in 
receivership, where you are putting them out of business, in 
essence, we could narrow the abilities of the Fed and also not 
support the Administration's proposal for Treasury to hold unto 
itself the ability to put taxpayer money into various entities 
they feel might pose systemic risk. We could do away with that 
if we had an appropriate resolution mechanism.
    Mr. Tarullo. Well, I think you do need a mechanism that can 
provide, in appropriate circumstances, for the sort of 
assistance that might be needed, and if you have that, it 
doesn't need to be done through 13(3), and as I said, I think 
the Federal Reserve would prefer that it not be done through 
13(3).
    Senator Corker. And you are perfectly satisfied we are 
resolving them out of existence? You are not talking about that 
assistance to conserve an institution?
    Mr. Tarullo. Well, I think--so, Senator, that is probably 
one of the open questions, and exactly what do we mean, I think 
there is--I think what is important is that there be real 
prospects of losses for shareholders and creditors when their 
large institution gets in that circumstance.
    Senator Corker. Mr. Chairman, I thank you, and I am sorry 
we didn't get to each of you. I do hope that what we are doing 
with the smaller banks, that some assistance was being sought 
through TARP here earlier, I hope that we are encouraging them, 
while they can, those who can, to raise capital. I have seen 
this taking place now and shareholders are being deluded and we 
are going ahead and raising the capital necessary to weather 
this storm.
    I thank each of you and I look forward to seeing you again 
soon.
    Senator Johnson. Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. I want to thank 
you for holding this hearing. I thank the witnesses.
    I would like to talk a little bit about fees and consumer 
protection, Consumer Protection Agency. Many of the banks we 
know have reacted to lost profits from their mortgage problems 
by raising fees on consumers, one of which is overdraft fees. 
There is no transparency. They don't give consumers a real 
chance to decide if they want--even want this kind of 
protection.
    Banks raked in about $24 billion in overdraft fees last 
year. That was up 35 percent from the year before. That ought 
to stick out. Even accounting for higher debit card use, a 
worsening credit environment due to the economy, that is a 
massive increase. It indicates to me that consumers are bearing 
a disproportionate burden in maintaining the health of many 
banks' balance sheets.
    They are also raising ATM fees, as you know. Bank of 
America recent raised its fee for other bank customers to $3. 
That would have been unheard of a few years ago. Maybe one of 
these fly by-night machines would have done that, but not a 
major bank. And the average cost of an ATM transaction is also 
now over $3.
    Even if you withdraw $100, that is a high fee in percentage 
terms, and, of course, the overdraft fees, you buy a $2 cup of 
coffee and they charge you $35 without even telling you. It 
makes your blood boil.
    So, my question is this. This is to really to Comptroller 
Dugan, Mr. Ward. As regulators, you are responsible for not 
only safety and soundness, but consumer protections. Maybe Mr. 
Tarullo also has a role here. What are you doing to ensure that 
consumers don't bear the brunt of banks' efforts to repair 
balance sheets, particularly in these two instances?
    Mr. Dugan. On the area of overdraft fees, we actually don't 
have the rulemaking authority in that area. The Federal Reserve 
has that authority. They currently have a proposal that is out. 
We also don't have authority to write rules for unfair and 
deceptive practices. We have done, as regulators----
    Senator Schumer. Don't you have general authority on 
consumer-type issues? Not at all?
    Mr. Dugan. Not on general fee regulation. Either it is 
mostly disclosure-based that is set by rules promulgated by 
others, or if it gets to a point where it is unfair and 
deceptive, yes. And in answer----
    Senator Schumer. Don't you think these are unfair and 
deceptive----
    Mr. Dugan. I think that it is absolutely the case that 
consumers should be given the right to opt in--to have a choice 
about whether to participate in these programs or not.
    Senator Schumer. But, Mr. Dugan, if you decided that these 
were unfair and deceptive, which I think average people hearing 
about these, they are deceptive because you don't know, they 
are unfair because they are so high, you could do something.
    Mr. Dugan. And I think that the proposal that the Federal 
Reserve has put out that has not yet been adopted does address 
the question of consent to these programs, which is critically 
important.
    Senator Schumer. OK, the Fed, tell us what you are doing.
    Mr. Tarullo. That is correct, Senator. We have a proposal 
that we are working on right now which would go right to the 
heart of the issue of opt in/opt out. And although I can't 
obviously prejudge what the Board will do, I expect that within 
the next month, that is going to come up for consideration----
    Senator Schumer. Has that been made public, that proposal?
    Mr. Tarullo. Yes. That has been made public.
    Senator Schumer. OK. And what does it do, specifically?
    Mr. Tarullo. This would provide for the ability of a 
consumer to know that he or she was opting into a program like 
this and to understand the terms under which----
    Senator Schumer. It would let the consumer know at the 
time----
    Mr. Tarullo. Yes.
    Senator Schumer.----that they are in overdraft status and--
--
    Mr. Tarullo. That is actually more difficult technically, 
and that is some of what is out for comment right now.
    Senator Schumer. Well, they used to do that all the time.
    Mr. Tarullo. But that is----
    Senator Schumer. It would not honor the request because you 
didn't have the money.
    Mr. Tarullo. Right, and with the advent of technologies 
like debit cards, for example, it becomes more complicated than 
it was before. But that is one of the things that is out for 
comment and consideration right now, is how this might be done.
    Senator Schumer. OK. When did you start working on this 
proposal?
    Mr. Tarullo. Let me see. I actually don't----
    Senator Schumer. Not only you, but----
    Mr. Tarullo. I don't know when the staff started working on 
it, Senator, and I will have to get back to you on that. I 
first became aware of it a couple of months ago.
    Senator Schumer. Right. OK. And what about on the other 
issue that I mentioned?
    Mr. Tarullo. On the fees issue?
    Senator Schumer. Yes.
    Mr. Tarullo. So, I don't think we have a current rulemaking 
on ATM fees. That has been an issue in the past, so I would 
have to----
    Senator Schumer. Do you think $3 is excessive?
    Mr. Tarullo. Well, I think--again, there----
    Senator Schumer. Well, let me ask you another question. Has 
the cost from 2 years ago to now gone up so that it would merit 
a large increase in the fee?
    Mr. Tarullo. Well, I doubt that the cost has gone up very 
much, and so the question, as with all fees, becomes the degree 
to which an institution ought to be able to make that judgment 
if it is fully disclosed or not.
    Senator Schumer. OK. As you know, I think the Fed does a 
good job in many areas, but in consumer protection, I don't 
think the regulatory agencies have done a good job, and here 
is--I mean, maybe this is a little rhetorical. It is to me, but 
I am going to let you guys answer it. I mean, isn't what we 
have just heard a good reason that we need a strong, 
independent agency to protect the interests of consumers, 
separate and apart from safety and soundness regulators?
    Mr. Tarullo. Umm----
    Senator Schumer. I mean, I have found that in the consumer 
area, the Fed and the OCC doesn't do much, although I think 
they have the power to do some things. It is slow. Still in the 
back of their mind is the idea of safety and soundness and bank 
balance sheets. And the consumer doesn't get all the protection 
he or she deserves. It is one of the reasons I believe the 
agency that Senator Dodd is proposing, and original Senator 
Durbin and I proposed, a Consumer Financial-Consumer Product 
Safety Commission, is so needed. Also, they are able to deal 
with new issues as they come up. They don't--I suppose Mr. 
Dugan would have to go into rulemaking and say what is unfair, 
what is deceptive, and they would figure out a way around that.
    Why wouldn't it be better to have these myriad of issues--
and our financial institutions are getting better and better at 
coming up with new ways to make fees--why isn't it better to 
have an agency exclusively devoted to that doing the job as 
opposed to a regulator which has many other important jobs to 
do to deal with? I would ask both Mr. Tarullo and Mr. Dugan, 
and then anyone else who would want to comment.
    Mr. Dugan. Sure.
    Mr. Tarullo. Senator, as I think you know, the Federal 
Reserve, as a Board, has no position one way or the other on 
creation of the CFPA, but I would make the following 
observations. First, I think there are undoubted merits to 
having a single Consumer Protection Agency whose sole focus is 
on that function.
    Second, though, you will lose something if you do it. You 
will lose some of the combination of understanding of safety 
and soundness and consumer protection. I think there is a risk. 
This has not necessarily happened, but there is a risk that 
sometimes the impact on credit availability won't be fully 
understood. These are things that can be addressed, but I think 
that there would be costs.
    A third point is, as you probably also know, prior to my 
joining the Federal Reserve Board in January, I was quite 
critical of the failure of the bank regulatory agencies 
generally to engage in enough consumer protection on subprime, 
on credit cards, and many other things. I will say, though, 
that I think in the last few years, Chairman Bernanke has set a 
tone at the Fed which has been one of looking for vigorous 
consumer protection and that the rules on credit cards and the 
rules on home mortgages are evidence of that. It may not be 
everything you think that needs to be done, but I think it has 
been done.
    Senator Schumer. Chairman Dugan?
    Mr. Dugan. Senator, I think there are two very powerful----
    Senator Schumer. Comptroller Dugan.
    Mr. Dugan. Comptroller. That is OK. There are two very good 
and powerful ideas connected with the CFPA. One is to have 
common rules that apply to everybody, whether you are a bank or 
a non-bank, and to have strong authority to do that. So I think 
that is important.
    Second, I think the part of the system that had the least 
attention paid to it were the non-banks in terms of how rules 
are implemented. You don't have the comprehensive regime today. 
So that part, I think, can be a very good and powerful idea.
    The part that I have had concerns about is implementing 
those rules on banks and carrying them out through supervision, 
examination, and enforcement. I think that should stay with the 
bank regulators. I think that you do get a benefit from things 
that are interwoven together between consumer protection and 
safety and soundness, like underwriting standards in subprime 
mortgages, which are related to consumer protection issues. We 
see examples of it all the time, which I provided to the 
Committee in our last testimony. That is the part I would worry 
about.
    And then, second, the notion that the new agency should 
focus its implementation responsibilities on the non-banks, 
again, very powerful idea.
    Senator Schumer. Would you just--I know my time has 
expired, Mr. Chairman--in retrospect, do you think the 
regulatory agencies, not yours in particular, but including 
yours--have done as vigorous a job on consumer protection as 
they should have?
    Mr. Dugan. I----
    Senator Schumer. In the areas that you have jurisdiction 
over, not the non-banks.
    Mr. Dugan. Well, again, you have to sort of go area by 
area, but in some places, no. Other places, yes, which I think 
are not recognized. And I do think there has been the systemic 
problem that we only have a part of the pie and there is a big 
chunk of it that no one is looking at.
    Senator Schumer. No, that is true. That is one argument for 
it.
    Do you agree? Mr. Tarullo, how about you? Do you think your 
agency and all of the agencies have done as good a job as they 
should have on consumer protection?
    Mr. Tarullo. Senator, I am on record saying it, so I will 
say it again. I don't think the agencies, including the Federal 
Reserve, did a good enough job.
    Senator Schumer. Thank you. Thanks, Mr. Chairman.
    Senator Johnson. I want to thank the witnesses once again 
for being here today. I look forward to working with the 
members of the Banking Committee as we continue to consider 
measures to stabilize the banking sector and our economy as a 
whole.
    This hearing is adjourned.
    [Whereupon, at 4:29 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
follow:]

               PREPARED STATEMENT OF SENATOR TIM JOHNSON

    As Congress and this Committee continue its work to stabilize 
financial institutions and promote our nation's economic recovery, I 
have called this hearing today for regulators to give us an update on 
the current conditions of the financial institutions in our country. It 
is vital that we know what continuing challenges and concerns our 
nation's institutions face. Specifically, I continue to be concerned 
about the lending environment, particularly for small businesses, the 
capital needs of institutions, and the impact of commercial real estate 
and other loan portfolios on institutions' balance sheets. In addition, 
while many of the large banks in our country have stabilized, the 
FDIC's list of troubled banks, many of them small community banks, is 
growing.
     While restructuring our nation's regulatory system is this 
Committee's top priority, I don't think we can do that without a clear 
understanding of what is happening within the sector. Concerns and 
problems within individual financial institutions will still exist even 
with a new regulatory structure unless they are addressed as well. 
Continuing to ensure the safety and soundness of viable institutions 
and the overall financial stability of our nation's economy is vital to 
protecting all Americans' pocketbooks, savings and retirement.
    I want to thank the witnesses for being here today, and I look 
forward to hearing from each of you regarding any developing trends or 
concerns within the banking industry or throughout the economy, and to 
hear of the regulatory or supervisory steps your agencies are taking to 
respond to these challenges.
                                 ______
                                 
                PREPARED STATEMENT OF SENATOR MIKE CRAPO

    Thank you, Mr. Chairman, for holding this hearing to examine the 
state of the banking and credit union industry.
    Failures of small banks continue to grow and key trouble spots are 
looming, such as commercial real estate loans. According to a recent 
New York Times article, about $870 billion, or roughly half of the 
industry's $1.8 trillion of commercial real estate loans, now sit on 
the balance sheet of small and medium sized banks. I am interested in 
learning to what extent has the Term Asset-Backed Securities Loan 
Facility (TALF) encouraged capital to enter the commercial real estate 
market and what other steps should regulators take to address this 
problem.
    Many community banks and credit unions have tried to fill the 
lending gap caused by the credit crisis. Even with these efforts, it is 
apparent that many consumers and small businesses are not receiving the 
lending they need to refinance their home loan, extend their business 
line of credit, or receive capital for new business opportunities. 
Regulators need to be mindful that they strike the appropriate balance 
to bolster capital and meet the credit needs of our economy. FASB's new 
rules on off-balance sheets will create challenges on this point.
    As we began to explore options to modernize our financial 
regulatory structure, it is important that our new structure allows 
financial institutions to play an essential role in the U.S. economy by 
providing a means for consumers and businesses to save for the future, 
to protect and hedge against risk, and promote lending opportunities.
    Again, I thank the Chairman for holding this hearing and I look 
forward to working with him and other Senators on these and other 
issues.
                                 ______
                                 
                  PREPARED STATEMENT OF SHEILA C. BAIR
            Chairman, Federal Deposit Insurance Corporation
                            October 14, 2009

    Chairman Johnson, Ranking Member Crapo and members of the 
Subcommittee, I appreciate the opportunity to testify on behalf of the 
Federal Deposit Insurance Corporation (FDIC) regarding the condition of 
FDIC-insured institutions and the deposit insurance fund (DIF). While 
challenges remain, evidence is building that financial markets are 
stabilizing and the American economy is starting to grow again. As 
promising as these developments are, the fact is that bank performance 
typically lags behind economic recovery and this cycle is no exception. 
Regardless of whatever challenges still lie ahead, the FDIC will 
continue protecting insured depositors as we have for over 75 years.
    The FDIC released its comprehensive summary of second quarter 2009 
financial results for all FDIC-insured institutions on August 27. The 
FDIC's Quarterly Banking Profile provided evidence that the difficult 
and necessary process of recognizing loan losses and cleaning up 
balance sheets continues to be reflected in the industry's bottom line. 
As a result, the number of problem institutions increased significantly 
during the quarter. We expect the numbers of problem institutions to 
increase and bank failures to remain high for the next several 
quarters.
    My testimony today will review the financial performance of FDIC-
insured institutions and highlight some of the most significant risks 
that the industry faces. In addition, I will discuss the steps that we 
are taking through supervisory and resolutions processes to address 
risks and to reduce costs from failures. Finally, I will summarize the 
condition of the DIF and the recent steps that we have taken to 
strengthen the FDIC's cash position.
Economy
    In the wake of the financial crisis of last Fall and the longest 
and deepest recession since the 1930s, the U.S. economy appears to be 
growing once again. Through August, the index of leading economic 
indicators had risen for five consecutive months. Consensus forecasts 
call for the economy to grow at a rate of 2.4 percent or higher in both 
the third and fourth quarters. While this relative improvement in 
economic conditions appears to represent a turning point in the 
business cycle, the road to full recovery will be a long one that poses 
additional challenges for FDIC-insured institutions.
    While we are encouraged by recent indications of the beginnings of 
an economic recovery, growth may still lag behind historical norms. 
There are several reasons why the recovery may be less robust than was 
the case in the past. Most important are the dislocations that have 
occurred in the balance sheets of the household sector and the 
financial sector, which will take time to repair.
    Households have experienced a net loss of over $12 trillion in net 
worth during the past 7 quarters, which amounts to almost 19 percent of 
their net worth at the beginning of the period. Not only is the size of 
this wealth loss unprecedented in our modern history, but it also has 
been spread widely among households to the extent that it involves 
declines in home values. By some measures, the average price of a U.S. 
home has declined by more than 30 percent since mid-2006. Home price 
declines have left an estimated 16 million mortgage borrowers 
``underwater'' and have contributed to an historic rise in the number 
of foreclosures, which reached almost 1.5 million in just the first 
half of 2009.\1\
---------------------------------------------------------------------------
    \1\ Sources: Moody's Economy.com (borrowers ``underwater'') and 
FDIC estimate based upon Mortgage Bankers Association, National 
Delinquency Survey, second quarter 2009 (number of foreclosures).
---------------------------------------------------------------------------
    Household financial distress has been exacerbated by high 
unemployment. Employers have cut some 7.2 million jobs since the start 
of the recession, leaving over 15 million people unemployed and pushing 
even more people out of the official labor force. The unemployment rate 
now stands at a 26-year high of 9.8 percent, and may go higher, even in 
an expanding economy, while discouraged workers re-enter the labor 
force.
    In response to these disruptions to wealth and income, U.S. 
households have begun to save more out of current income. The personal 
savings rate, which had dipped to as low as 1.2 percent in the third 
quarter of 2005, rose to 4.9 percent as of second quarter 2009 and 
could go even higher over the next few years as households continue to 
repair their balance sheets. Other things being equal, this trend is 
likely to restrain growth in consumer spending, which currently makes 
up more than 70 percent of net GDP.
    Financial sector balance sheets also have undergone historic 
distress in the recent financial crisis and recession. Most notably, we 
have seen extraordinary government interventions necessary to stabilize 
several large financial institutions, and now as the credit crisis 
takes its toll on the real economy, a marked increase in the failure 
rate of smaller FDIC-insured institutions. Following a 5-year period 
during which only ten FDIC-insured institutions failed, there were 25 
failures in 2008 and another 98 failures so far in 2009.
    In all, FDIC-insured institutions have set aside just over $338 
billion in provisions for loan losses during the past six quarters, an 
amount that is about four times larger than their provisions during the 
prior six quarter period. While banks and thrifts are now well along in 
the process of loss recognition and balance sheet repair, the process 
will continue well into next year, especially for commercial real 
estate (CRE).
    Recent evidence points toward a gradual normalization of credit 
market conditions amid still-elevated levels of problem loans. We meet 
today just 1 year after the historic liquidity crisis in global 
financial markets that prompted an unprecedented response on the part 
of governments around the world. In part as a result of the Treasury's 
Troubled Asset Relief Program (TARP), the Federal Reserve's extensive 
lending programs, and the FDIC's Temporary Liquidity Guarantee Program 
(TLGP), financial market interest rate spreads have retreated from 
highs established at the height of the crisis last Fall and activity in 
interbank lending and corporate bond markets has increased.
    However, while these programs have played an important role in 
mitigating the liquidity crisis that emerged at that time, it is 
important that they be rolled back in a timely manner once financial 
market activity returns to normal. The FDIC Board recently proposed a 
plan to phaseout the debt guarantee component of the Temporary 
Liquidity Guarantee Program (TLGP) on October 31st. This will represent 
an important step toward putting our financial markets and institutions 
back on a self-sustaining basis. And even while we seek to end the 
various programs that were effective in addressing the liquidity 
crisis, we also recognize that we may need to redirect our efforts to 
help meet the credit needs of household and small business borrowers.
    For now, securitization markets for government-guaranteed debt are 
functioning normally, but private securitization markets remain largely 
shut down. During the first 7 months of 2009, $1.2 trillion in agency 
mortgage-backed securities were issued in comparison to just $9 billion 
in private mortgage-backed securities. Issuance of other types of 
private asset-backed securities (ABS) also remains weak. ABS issuance 
totaled only $118 billion during the first 9 months of 2009 in 
comparison to $136 billion during the first 9 months of 2008 and peak 
annual issuance of $754 billion in 2006.
    Significant credit distress persists in the wake of the recession, 
and has now spread well beyond nonprime mortgages. U.S. mortgage 
delinquency and foreclosure rates also reached new historic highs in 
second quarter of 2009 when almost 8 percent of all mortgages were 
seriously delinquent. In addition, during the same period, foreclosure 
actions were started on over 1 percent of loans outstanding.\2\ 
Consumer loan defaults continue to rise, both in number and as a 
percent of outstanding loans, although the number of new delinquencies 
now appears to be tapering off. Commercial loan portfolios are also 
experiencing elevated levels of problem loans which industry analysts 
suggest will peak in late 2009 or early 2010.
---------------------------------------------------------------------------
    \2\ Source: Mortgage Bankers Association, National Delinquency 
Survey, Second Quarter 2009.
---------------------------------------------------------------------------
Recent Financial Performance of FDIC-Insured Institutions
    The high level of distressed assets is reflected in the weak 
financial performance of FDIC-insured institutions. FDIC-insured 
institutions reported an aggregate net loss of $3.7 billion in second 
quarter 2009. The loss was primarily due to increased expenses for bad 
loans, higher noninterest expenses and a one-time loss related to 
revaluation of assets that were previously reported off-balance sheet. 
Commercial banks and savings institutions added $67 billion to their 
reserves against loan losses during the quarter. As the industry has 
taken loss provisions at a rapid pace, the industry's allowance for 
loan and lease losses has risen to 2.77 percent of total loans and 
leases, the highest level for this ratio since at least 1984. However, 
noncurrent loans have been growing at a faster rate than loan loss 
reserves, and the industry's coverage ratio (the allowance for loan and 
lease losses divided by total noncurrent loans) has fallen to its 
lowest level since the third quarter of 1991.\3\
---------------------------------------------------------------------------
    \3\ Noncurrent loans are loans 90 or more days past due or in 
nonaccrual status.
---------------------------------------------------------------------------
    Insured institutions saw some improvement in net interest margins 
in the quarter. Funding costs fell more rapidly than asset yields in 
the current low interest rate environment, and margins improved in the 
quarter for all size groups. Nevertheless, second quarter interest 
income was 2.3 percent lower than in the first quarter and 15.9 percent 
lower than a year ago, as the volume of earning assets fell for the 
second consecutive quarter. Industry noninterest income fell by 1.8 
percent compared to the first quarter.
    Credit quality worsened in the second quarter by almost all 
measures. The share of loans and leases that were noncurrent rose to 
4.35 percent, the highest it has been since the data were first 
reported. Increases in noncurrent loans were led by 1-to-4 family 
residential mortgages, real estate construction and development loans, 
and loans secured by nonfarm nonresidential real estate loans. However, 
the rate of increase in noncurrent loans may be slowing, as the second-
quarter increase in noncurrent loans was about one-third smaller than 
the volume of noncurrent loans added in first quarter. The amount of 
loans past-due 30-89 days was also smaller at the end of the second 
quarter than in the first quarter. Net charge-off rates rose to record 
highs in the second quarter, as FDIC-insured institutions continued to 
recognize losses in the loan portfolios. Other real estate owned (ORE) 
increased 79.7 percent from a year ago.
    Many insured institutions have responded to stresses in the economy 
by raising and conserving capital, some as a result of regulatory 
reviews. Equity capital increased by $32.5 billion (2.4 percent) in the 
quarter. Treasury invested a total of $4.4 billion in 117 independent 
banks and bank and thrift holding companies during the second quarter, 
and nearly all of these were community banks. This compares to a total 
of more than $200 billion invested since the program began. Average 
regulatory capital ratios increased in the quarter as well. The 
leverage capital ratio increased to 8.25 percent, while the average 
total risk-based capital ratio rose to 13.76 percent. However, while 
the average ratios increased, fewer than half of all institutions 
reported increases in their regulatory capital ratios.
    The nation's nearly 7,500 community banks--those with less than $1 
billion in total assets--hold approximately 11 percent of total 
industry assets. They posted an average return on assets of negative 
0.06 percent, which was slightly better than the industry as a whole. 
As larger banks often have more diverse sources of noninterest income, 
community banks typically get a much greater share of their operating 
income from net interest income. In general, community banks have 
higher capital ratios than their larger competitors and are much more 
reliant on deposits as a source of funding.
    Average ratios of noncurrent loans and charge-offs are lower for 
community banks than the industry averages. In part, this illustrates 
the differing loan mix between the two groups. The larger banks' loan 
performance reflects record high loss rates on credit card loans and 
record delinquencies on mortgage loans. Community banks are important 
sources of credit for the nation's small businesses and small farmers. 
As of June 30, community banks held 38 percent of the industry's small 
business and small farm loans.\4\ However, the greatest exposures faced 
by community banks may relate to construction loans and other CRE 
loans. These loans made up over 43 percent of community bank 
portfolios, and the average ratio of CRE loans to total capital was 
above 280 percent.
---------------------------------------------------------------------------
    \4\ Defined as commercial and industrial loans or commercial real 
estate loans under $1 million or farm loans less than $500,000.
---------------------------------------------------------------------------
     As insured institutions work through their troubled assets, the 
list of ``problem institutions''--those rated CAMELS 4 or 5--will grow. 
Over a hundred institutions were added to the FDIC's ``problem list'' 
in the second quarter. The combined assets of the 416 banks and thrifts 
on the problem list now total almost $300 billion. However, the number 
of problem institutions is still well below the more than 1,400 
identified in 1991, during the last banking crisis on both a nominal 
and a percentage basis. Institutions on the problem list are monitored 
closely, and most do not fail. Still, the rising number of problem 
institutions and the high number of failures reflect the challenges 
that FDIC-insured institutions continue to face.
Risks to FDIC-Insured Institutions
    Troubled loans at FDIC-insured institutions have been concentrated 
thus far in three main areas--residential mortgage loans, construction 
loans, and credit cards. The credit quality problems in 1-to-4 family 
mortgage loans and the coincident declines in U.S. home prices are well 
known to this Committee. Net chargeoffs of 1- to 4-famly mortgages and 
home equity lines of credit by FDIC-insured institutions over the past 
2 years have totaled more than $65 billion. Declining home prices have 
also impacted construction loan portfolios, on which many small and 
mid-sized banks heavily depend. There has been a tenfold increase in 
the ratio of noncurrent construction loans since mid-year 2007, and 
this ratio now stands at a near-record 13.5 percent. Net charge-offs 
for construction loans over the past 2 years have totaled about $32 
billion, and almost 40 percent of these were for one-to-four family 
construction.
    With the longest and deepest recession since the 1930s has come a 
new round of credit problems in consumer and commercial loans. The net 
charge-off rate for credit card loans on bank portfolios rose to 
record-high 9.95 percent in the second quarter. While stronger 
underwriting standards and deleveraging by households should eventually 
help bring loss rates down, ongoing labor market distress threatens to 
keep loss rates elevated for an extended period. By contrast, loans to 
businesses, i.e., commercial and industrial (C&I) loans, have performed 
reasonably well given the severity of the recession in part because 
corporate balance sheets were comparatively strong coming into the 
recession. The noncurrent loan ratio of 2.79 percent for C&I loans 
stands more than four times higher than the record low seen in 2007, 
but remains still well below the record high of 5.14 percent in 1987.
    The most prominent area of risk for rising credit losses at FDIC-
insured institutions during the next several quarters is in CRE 
lending. While financing vehicles such as commercial mortgage-backed 
securities (CMBS) have emerged as significant CRE funding sources in 
recent years, FDIC-insured institutions still hold the largest share of 
commercial mortgage debt outstanding, and their exposure to CRE loans 
stands at an historic high. As of June, CRE loans backed by nonfarm, 
nonresidential properties totaled almost $1.1 trillion, or 14.2 percent 
of total loans and leases.
    The deep recession, in combination with ongoing credit market 
disruptions for market-based CRE financing, has made this a 
particularly challenging environment for commercial real estate. The 
loss of more than 7 million jobs since the onset of the recession has 
reduced demand for office space and other CRE property types, leading 
to deterioration in fundamental factors such as rental rates and 
vacancy rates. Amid weak fundamentals, investors have been re-
evaluating their required rate of return on commercial properties, 
leading to a sharp rise in ``cap rates'' and lower market valuations 
for commercial properties. Finally, the virtual shutdown of CMBS 
issuance in the wake of last year's financial crisis has made financing 
harder to obtain. Large volumes of CRE loans are scheduled to roll over 
in coming quarters, and falling property prices will make it more 
difficult for some borrowers to renew their financing.
    Outside of construction portfolios, losses on loans backed by CRE 
properties have been modest to this point. Net charge-offs on loans 
backed by nonfarm, nonresidential properties have been just $6.2 
billion over the past 2 years. Over this period, however, the 
noncurrent loan ratio in this category has quadrupled, and we expect it 
to rise further as more CRE loans come due over the next few years. The 
ultimate scale of losses in the CRE loan portfolio will very much 
depend on the pace of recovery in the U.S. economy and financial 
markets during that time.
FDIC Response to Industry Risks and Challenges
Supervisory Response to Problems in Banking Industry
    The FDIC has maintained a balanced supervisory approach that 
focuses on vigilant oversight but remains sensitive to the economic and 
real estate market conditions. Deteriorating credit quality has caused 
a reduction in earnings and capital at a number of institutions we 
supervise which has resulted in a rise in problem banks and the 
increased issuance of corrective programs. We have been strongly 
advocating increased capital and loan loss allowance levels to cushion 
the impact of rising non-performing assets. Appropriate allowance 
levels are a fundamental tenet of sound banking, and we expect that 
banks will add to their loss reserves as credit conditions warrant--and 
in accordance with generally accepted accounting principles.
    We have also been emphasizing the importance of a strong workout 
infrastructure in the current environment. Given the rising level of 
non-performing assets, and difficulties in refinancing loans coming due 
because of decreased collateral values and lack of a securitization 
market, banks need to have the right resources in place to restructure 
weakened credit relationships and dispose of other real estate holdings 
in a timely, orderly fashion.
    We have been using a combination of offsite monitoring and onsite 
examination work to keep abreast of emerging issues at FDIC-supervised 
institutions and are accelerating full-scope examinations when 
necessary. Bankers understand that FDIC examiners will perform a 
thorough, yet balanced asset review during our examinations, with a 
particular focus on concentrations of credit risk. Over the past 
several years, we have emphasized the risks in real estate lending 
through examination and industry guidance, training, and targeted 
analysis and supervisory activities. Our efforts have focused on 
underwriting, loan administration, concentrations, portfolio management 
and stress testing, proper accounting, and the use of interest 
reserves.
    CRE loans and construction and development loans are a significant 
examination focus right now and have been for some time. Our examiners 
in the field have been sampling banks' CRE loan exposures during 
regular exams as well as special visitations and ensuring that credit 
grading systems, loan policies, and risk management processes have kept 
pace with market conditions. We have been scrutinizing for some time 
construction and development lending relationships that are supported 
by interest reserves to ensure that they are prudently administrated 
and accurately portray the borrower's repayment capacity. In 2008, we 
issued guidance and produced a journal article on the use of interest 
reserves,\5\ as well as internal review procedures for examiners.
---------------------------------------------------------------------------
    \5\ FDIC, Supervisory Insights, http://www.fdic.gov/regulations/
examinations/supervisory/insights/sisum08/article01_Primer.html.
---------------------------------------------------------------------------
    We strive to learn from those instances where the bank's failure 
led to a material loss to the DIF, and we have made revisions to our 
examination procedures when warranted. This self-assessment process is 
intended to make our procedures more forward-looking, timely and risk-
focused. In addition, due to increased demands on examination staff, we 
have been working diligently to hire additional examiners since 2007. 
During 2009, we hired 440 mid career employees with financial services 
skills as examiners and almost another 200 examiner trainees. We are 
also conducting training to reinforce important skills that are 
relevant in today's rapidly changing environment. The FDIC continues to 
have a well-trained and capable supervisory workforce that provides 
vigilant oversight of state nonmember institutions.
Measures to Ensure Examination Programs Don't Interfere with Credit 
        Availability
    Large and small businesses are contending with extremely 
challenging economic conditions which have been exacerbated by turmoil 
in the credit markets over the past 18 months. These conditions, 
coupled with a more risk-averse posture by lenders, have diminished the 
availability of credit.
    We have heard concerns expressed by Members of Congress and 
industry representatives that banking regulators are somehow 
instructing banks to curtail lending, making it more difficult for 
consumers and businesses to obtain credit or roll over otherwise 
performing loans. This is not the case. The FDIC provides banks with 
considerable flexibility in dealing with customer relationships and 
managing loan portfolios. I can assure you that we do not instruct 
banks to curtail prudently managed lending activities, restrict lines 
of credit to strong borrowers, or require appraisals on performing 
loans unless an advance of new funds is being contemplated.
    It has also been suggested that regulators are expecting banks to 
shut off lines of credit or not roll-over maturing loans because of 
depreciating collateral values. To be clear, the FDIC focuses on 
borrowers' repayment sources, particularly their cash-flow, as a means 
of paying off loans. Collateral is a secondary source of repayment and 
should not be the primary determinant in extending or refinancing 
loans. Accordingly, we have not encouraged banks to close down credit 
lines or deny a refinance request solely because of weakened collateral 
value.
    The FDIC has been vocal in its support of bank lending to small 
businesses in a variety of industry forums and in the interagency 
statement on making loans to creditworthy borrowers that was issued 
last November. I would like to emphasize that the FDIC wants banks to 
make prudent small business loans as they are an engine of growth in 
our economy and can help to create jobs at this critical juncture.
    In addition, the Federal banking agencies will soon issue guidance 
on CRE loan workouts. The agencies recognize that lenders and borrowers 
face challenging credit conditions due to the economic downturn, and 
are frequently dealing with diminished cash-flows and depreciating 
collateral values. Prudent loan workouts are often in the best interest 
of financial institutions and borrowers, particularly during difficult 
economic circumstances and constrained credit availability. This 
guidance reflects that reality, and supports prudent and pragmatic 
credit and business decisionmaking within the framework of financial 
accuracy, transparency, and timely loss recognition.
Innovative resolution structures
    The FDIC has made several changes to its resolution strategies in 
response to this crisis, and we will continue to re-evaluate our 
methods going forward. The most important change is an increased 
emphasis on partnership arrangements. The FDIC and RTC used partnership 
arrangements in the past--specifically loss sharing and structured 
transactions. In the early 1990s, the FDIC introduced and used loss 
sharing. During the same time period, the RTC introduced and used 
structured transactions as a significant part of their asset sales 
strategy. As in the past, the FDIC has begun using these types of 
structures in order to lower resolution costs and simplify the FDIC's 
resolution workload. Also, the loss share agreements reduce the FDIC's 
liquidity needs, further enhancing the FDIC's ability to meet the 
statutory least cost test requirement.
    The loss share agreements enable banks to acquire an entire failed 
bank franchise without taking on too much risk, while the structured 
transactions allow the FDIC to market and sell assets to both banks and 
non-banks without undertaking the tasks and responsibilities of 
managing those assets. Both types of agreements are partnerships where 
the private sector partner manages the assets and the FDIC monitors the 
partner. An important characteristic of these agreements is the 
alignment of interests: both parties benefit financially when the value 
of the assets is maximized.
    For the most part, after the end of the savings and loan and 
banking crisis of the late 1980s and early 1990s, the FDIC shifted away 
from these types of agreements to more traditional methods since the 
affected asset markets became stronger and more liquid. The main reason 
why we now are returning to these methods is that in the past several 
months investor interest has been low and asset values have been 
uncertain. If we tried to sell the assets of failed banks into today's 
markets, the prices would likely be well below their intrinsic value--
that is, their value if they were held and actively managed until 
markets recover. The partnerships allow the FDIC to sell the assets 
today but still benefit from future market improvements. During 2009, 
the FDIC has used loss share for 58 out of 98 resolutions. We estimate 
that the cost savings have been substantial: the estimated loss rate 
for loss share failures averaged 25 percent; for all other 
transactions, it was 38 percent. Through September 30, 2009, the FDIC 
has entered into seven structured transactions, with about $8 billion 
in assets.
    To address the unique nature of today's crisis, we have made 
several changes to the earlier agreements. The earlier loss share 
agreements covered only commercial assets. We have updated the 
agreements to include single family assets and to require the 
application of a systematic loan modification program for troubled 
mortgage loans. We strongly encourage our loss share partners to adopt 
the Administration's Home Affordable Modification Program (HAMP) for 
managing single family assets. If they do not adopt the HAMP, we 
require them to use the FDIC loan modification program which was the 
model for the HAMP modification protocol. Both are designed to ensure 
that acquirers offer sustainable and affordable loan modifications to 
troubled homeowners whenever it is cost-effective. This serves to lower 
costs and minimize foreclosures. We have also encouraged our loss share 
partners to deploy forbearance programs when homeowners struggle with 
mortgage payments due to life events (unemployment, illness, divorce, 
etc.). We also invite our loss share partners to propose other 
innovative strategies that will help keep homeowners in their homes and 
reduce the FDIC's costs.
    In addition, the FDIC has explored funding changes to our 
structured transactions to make them more appealing in today's 
environment. To attract more bidders and hopefully higher pricing, the 
FDIC has offered various forms of leverage. In recent transactions 
where the leverage was provided to the investors, the highest bids with 
the leverage option substantially improved the overall economics of the 
transactions. The overall feedback on the structure from both investors 
and market participants was very positive.
The Condition of the Deposit Insurance Fund
Current Conditions and Projections
    As of June 30, 2009, the balance (or net worth) of the DIF (the 
fund) was approximately $10 billion. The fund reserve ratio--the fund 
balance divided by estimated insured deposits in the banking system--
was 0.22 percent. In contrast, on December 31, 2007, the fund balance 
was almost $52 billion and the reserve ratio was 1.22 percent. Losses 
from institution failures have caused much of the decline in the fund 
balance, but increases in the contingent loss reserve--the amount set 
aside for losses expected during the next 12 months--has contributed 
significantly to the decline. The contingent loss reserve on June 30 
was approximately $32 billion.
    The FDIC estimates that as of September 30, 2009, both the fund 
balance and the reserve ratio were negative after reserving for 
projected losses over the next 12 months, though our cash position 
remained positive. This is not the first time that a fund balance has 
been negative. The FDIC reported a negative fund balance during the 
last banking crisis in the late 1980s and early 1990s.\6\ Because the 
FDIC has many potential sources of cash, a negative fund balance does 
not affect the FDIC's ability to protect insured depositors or promptly 
resolve failed institutions.
---------------------------------------------------------------------------
    \6\ The FDIC reported a negative fund balance as of December 31, 
1991 of approximately -$7.0 billion due to setting aside a large ($16.3 
billion) reserve for future failures. The fund remained negative for 
five quarters, until March 31, 1993, when the fund balance was 
approximately $1.2 billion.
---------------------------------------------------------------------------
    The negative fund balance reflects, in part, an increase in 
provisioning for anticipated failures. The FDIC projects that, over the 
period 2009 through 2013, the fund could incur approximately $100 
billion in failure costs. The FDIC projects that most of these costs 
will occur in 2009 and 2010. In fact, well over half of this amount 
will already be reflected in the September 2009 fund balance. 
Assessment revenue is projected to be about $63 billion over this 5-
year period, which exceeds the remaining loss amount. The problem we 
are facing is one of timing. Losses are occurring in the near term and 
revenue is spread out into future years.
    At present, cash and marketable securities available to resolve 
failed institutions remain positive, although they have also declined. 
At the beginning of the current banking crisis, in June 2008, total 
assets held by the fund were approximately $55 billion, and consisted 
almost entirely of cash and marketable securities (i.e., liquid 
assets). As the crisis has unfolded, the liquid assets of the fund have 
been expended to protect depositors of failed institutions and have 
been exchanged for less liquid claims against the assets of failed 
institutions. As of June 30, 2009, while total assets of the fund had 
increased to almost $65 billion, cash and marketable securities had 
fallen to about $22 billion. The pace of resolutions continues to put 
downward pressure on cash balances. While the less liquid assets in the 
fund have value that will eventually be converted to cash when sold, 
the FDIC's immediate need is for more liquid assets to fund near-term 
failures.
    If the FDIC took no action under its existing authority to increase 
its liquidity, the FDIC projects that its liquidity needs would exceed 
its liquid assets next year.
The FDIC's Response
    The FDIC has taken several steps to ensure that the fund reserve 
ratio returns to its statutorily mandated minimum level of 1.15 percent 
within the time prescribed by Congress and that it has sufficient cash 
to promptly resolve failing institutions.
    For the first quarter of 2009, the FDIC raised rates by 7 basis 
points. The FDIC also imposed a special assessment as of June 30, 2009 
of 5 basis points of each institution's assets minus Tier 1 capital, 
with a cap of 10 basis points of an institution's regular assessment 
base. On September 22, the FDIC again took action to increase 
assessment rates--the board decided that effective January 1, 2011, 
rates will uniformly increase by 3 basis points. The FDIC projects that 
bank and thrift failures will peak in 2009 and 2010 and that industry 
earnings will have recovered sufficiently by 2011 to absorb a 3 basis 
point increase in deposit insurance assessments. We project that these 
steps should return the fund to a positive balance in 2012 and the 
reserve ratio to 1.15 percent by the first quarter of 2017.
    While the final rule imposing the special assessment in June 
permitted the FDIC to impose additional special assessments of the same 
size this year without further notice and comment rulemaking, the FDIC 
decided not to impose any additional special assessments this year. Any 
additional special assessment would impose a burden on an industry that 
is struggling to achieve positive earnings overall. In general, an 
assessment system that charges institutions less when credit is 
restricted and more when it is not is more conducive to economic 
stability and sustained growth than a system that does the opposite.
    To meet the FDIC's liquidity needs, on September 29 the FDIC 
authorized publication of a Notice of Proposed Rulemaking (NPR) to 
require insured depository institutions to prepay about 3 years of 
their estimated risk-based assessments. The FDIC estimates that 
prepayment would bring in approximately $45 billion in cash.
    Unlike a special assessment, prepaid assessments would not 
immediately affect the DIF balance or depository institutions' 
earnings. An institution would record the entire amount of its prepaid 
assessment as a prepaid expense (asset) as of December 30, 2009. As of 
December 31, 2009, and each quarter thereafter, the institution would 
record an expense (charge to earnings) for its regular quarterly 
assessment for the quarter and an offsetting credit to the prepaid 
assessment until the asset is exhausted. Once the asset is exhausted, 
the institution would record an expense and an accrued expense payable 
each quarter for its regular assessment, which would be paid in arrears 
to the FDIC at the end of the following quarter. On the FDIC side, 
prepaid assessments would have no effect on the DIF balance, but would 
provide us with the cash needed for future resolutions.
    The proposed rule would allow the FDIC to exercise its discretion 
as supervisor and insurer to exempt an institution from the prepayment 
requirement if the FDIC determines that the prepayment would adversely 
affect the safety and soundness of the institution.
    The FDIC believes that using prepaid assessments as a means of 
collecting enough cash to meet upcoming liquidity needs to fund future 
resolutions has significant advantages compared to imposing additional 
or higher special assessments. Additional or higher special assessments 
could severely reduce industry earnings and capital at a time when the 
industry is under stress. Prepayment would not materially impair the 
capital or earnings of insured institutions. In addition, the FDIC 
believes that most of the prepaid assessment would be drawn from 
available cash and excess reserves, which should not significantly 
affect depository institutions' current lending activities. As of June 
30, FDIC-insured institutions held more than $1.3 trillion in liquid 
balances, or 22 percent more than they did a year ago.\7\
---------------------------------------------------------------------------
    \7\ Liquid balances include balances due from Federal Reserve 
Banks, depository institutions and others, Federal funds sold, and 
securities purchased under agreements to resell.
---------------------------------------------------------------------------
    In the FDIC's view, requiring that institutions prepay assessments 
is also preferable to borrowing from the U.S. Treasury. Prepayment of 
assessments ensures that the deposit insurance system remains directly 
industry-funded and it preserves Treasury borrowing for emergency 
situations. Additionally, the FDIC believes that, unlike borrowing from 
the Treasury or the FFB, requiring prepaid assessments would not count 
toward the public debt limit. Finally, collecting prepaid assessments 
would be the least costly option to the fund for raising liquidity as 
there would be no interest cost. However, the FDIC is seeking comment 
on these and other options in the NPR.
    The FDIC's proposal requiring prepayment of assessments is really 
about how and when the industry fulfills its obligation to the 
insurance fund. It is not about whether insured deposits are safe or 
whether the FDIC will be able to promptly resolve failing institutions. 
Deposits remain safe; the FDIC has ample resources available to 
promptly resolve failing institutions. We thank the Congress for 
raising our borrowing limit, which was important from a public 
confidence standpoint and essential to assure that the FDIC is prepared 
for all contingencies in these difficult times.
Conclusion
    FDIC-insured banks and thrifts continue to face many challenges. 
However, there is no question that the FDIC will continue to ensure the 
safety and soundness of FDIC-insured financial institutions, and, when 
necessary, resolve failed financial institutions. Regarding the state 
of the DIF and the FDIC Board's recent proposal to have banks pay a 
prepaid assessment, the most important thing for everyone to remember 
is that the outcome of this proposal is a non-event for insured 
depositors. Their deposits are safe no matter what the Board decides to 
do in this matter. Everyone knows that the FDIC has immediate access to 
a $100 billion credit line at Treasury that can be expanded to $500 
billion with the concurrence of the Federal Reserve and the Treasury. 
We also have authority to borrow additional working capital up to 90 
percent of the value of assets we own. The FDIC's commitment to 
depositors is absolute, and we have more than enough resources at our 
disposal to make good on that commitment.
    I would be pleased to answer any questions from the members of the 
Subcommittee.
                                 ______
                                 
                 PREPARED STATEMENT OF JOHN C. DUGAN *
                      Comptroller of the Currency
               Office of the Comptroller of the Currency
                            October 14, 2009

---------------------------------------------------------------------------
    * Statement Required by 12 U.S.C. Sec.  250: The views expressed 
herein are those of the Office of the Comptroller of the Currency and 
do not necessarily represent the views of the President.
---------------------------------------------------------------------------
I. Introduction
    Chairman Johnson, Senator Crapo, and members of the Subcommittee, I 
am pleased to testify on the current condition of the national banking 
system, including trends in bank ending, asset quality, and problem 
banks. The OCC supervises over 1,600 national banks and Federal 
branches, which constitute approximately 18 percent of all federally 
insured banks and thrifts, holding just over 61 percent of all bank and 
thrift assets. These nationally chartered institutions include 15 of 
the very largest U.S. banks, with assets generally exceeding $100 
billion; 23 mid-sized banks, with assets generally ranging between $10 
billion and $100 billion; and over 1,500 community banks and trust 
banks, with assets between $1.5 million and $10 billion. The OCC has 
dedicated supervisory programs for these three groups of institutions 
that are tailored to the unique challenges faced by each.
    My testimony today makes three key points. First, credit quality is 
continuing to deteriorate across almost all classes of banking assets 
in nearly all sizes of banks. As the economy has weakened, the strains 
on borrowers that first appeared in the housing sector have spread to 
other retail and commercial borrowers. For some credit portfolio 
segments, the rate of nonperforming loans is at or near historical 
highs. In many cases, this declining asset quality reflects risks that 
built up over time, and while we may be seeing some initial signs of 
improvement in some asset classes as the economy begins to recover, it 
will generally take time for problem credits to work their way through 
the banking system.
    Second, the vast majority of national banks are strong and have the 
financial capacity to withstand the declining asset quality. As I noted 
in my testimony last year before the full Committee, we anticipated 
that credit quality would worsen and that banks would need to further 
strengthen their capital and loan loss reserves.\1\ Net capital levels 
in national banks have increased by over $186 billion over the last 2 
years, and net increases to loan loss reserves have exceeded $92 
billion. While these increases have considerably strengthened national 
banks, we anticipate additional capital and reserves will be needed to 
absorb the additional potential losses in banks' portfolios. In some 
cases that may not be feasible, however, and as a result, there will 
continue to be a number of smaller institutions that are not likely to 
survive their mounting credit problems. In these cases we are working 
closely with the FDIC to ensure timely resolutions in a manner that is 
least disruptive to local communities.
---------------------------------------------------------------------------
    \1\ Testimony of John C. Dugan before the Committee on Banking, 
Housing, and Urban Affairs, United States Senate, June 5, 2008, page 2.
---------------------------------------------------------------------------
    Third, during this stressful period we are extremely mindful of the 
need to take a balanced approach in our supervision of national banks, 
and we strive continually to ensure that our examiners are doing just 
that. We are encouraging banks to work constructively with borrowers 
who may be facing difficulties and to make new loans to creditworthy 
borrowers. And we have repeatedly and strongly emphasized that 
examiners should not dictate loan terms or require banks to charge off 
loans simply due to declines in collateral values.
    Balanced supervision, however, does not mean turning a blind eye to 
credit and market conditions, or simply allowing banks to forestall 
recognizing problems on the hope that markets or borrowers may turn 
around. As we have learned in our dealings with problem banks, a key 
factor in restoring a bank to health is ensuring that bank management 
realistically recognizes and addresses problems as they emerge, even as 
they work with struggling borrowers.
II. Condition of the National Banking System: Credit Quality Has 
        Replaced Liquidity as Major Concern
    Beginning in the fall of 2007 and extending through the first 
quarter of this year, bank regulators and the industry were confronted 
with unprecedented disruptions in the global financial markets. In the 
wake of severe problems with subprime mortgages, the value of various 
securitized assets and structured investment products declined 
precipitously. Key funding and short term credit markets froze, 
sparking a severe contraction in the liquidity that sustains much of 
our economy and banking system, including uninsured deposit funding. 
The combination of these events led to failures, government assistance, 
and government takeover of several major financial institutions. 
Through the collective efforts and programs resulting from actions 
taken by Congress, the Treasury Department, the Federal Reserve Board, 
the Federal Deposit Insurance Corporation, and governments around the 
world, there has been significant stabilization in credit and funding 
markets for all financial institutions, including banks of all sizes.
    As reflected in both the TED and Libor-OIS spreads,\2\ each of 
which has fallen to less than 20 basis points after peaking at well 
over 300 basis points during the crisis, the interbank funding market 
has vastly improved, with banks once again willing to extend credit to 
counterparties. There has also been a slight rebound in certain 
securitization markets. For example, non-mortgage asset-backed 
securities issuance for 2Q:2009 totaled $49 billion, up 121 percent 
from 1Q:2009. Similarly, syndicated market loan issuances increased to 
$156 billion in 2Q:2009, up 37 percent from 1Q:2009.
---------------------------------------------------------------------------
    \2\ The TED spread reflects the difference between the interest 
rates on interbank loans in the Eurodollar market and short-term U.S. 
Government Treasury bills. The OIS is the overnight indexed swap rate. 
Both spreads are a measure of how markets are viewing the risks of 
financial counterparties.
---------------------------------------------------------------------------
    The drag on national banks' balance sheets and earnings from the 
overhang of various structured securities products has been very 
significantly reduced due to the substantial write-downs that banks 
took on these assets in 4Q:2008 and 1Q:2009 and the overall recovery in 
credit markets. Losses sustained at our 10 largest banking companies 
for these securities reached $44 billion in 2008, but dropped to $8 
billion in 1Q:2009 and $1 billion in 2Q:2009. There are some banks that 
still face strains in their investment portfolios, largely due to their 
holding of certain private label mortgage-backed and trust preferred 
securities. While most banks will be able to absorb the losses that may 
arise from these holdings, there is a small population of banks that 
have significant concentrations in these products that we are closely 
monitoring. We expect these banks will continue to take incremental 
credit impairments through earnings until mortgage metrics improve.
    In my financial condition testimony before the full Committee last 
year, I observed that, as market conditions began to stabilize, the 
focus of supervisors and bankers would increasingly turn to the more 
traditional challenges of identifying and managing problem credits.\3\ 
That has indeed proven to be the case, as declining asset quality has 
become the central challenge facing banks and supervisors today. While 
there recently have been some signs of economic recovery, data through 
the second quarter of this year demonstrate that asset quality across 
the national bank population significantly deteriorated over the 
preceding twelve months, as both retail and commercial borrowers 
remained under stress from job losses and the overall contraction in 
the economy. The percentage of noncurrent loans (loans that are 90 days 
or more past due or on nonaccrual) increased dramatically and reached 
the highest level in at least twenty 5 years (see Chart 1).
---------------------------------------------------------------------------
    \3\ Testimony of John C. Dugan before the Committee on Banking, 
Housing, and Urban Affairs, United States Senate, June 5, 2008, page 9.


    In addition, the rate at which banks are charging off loans has 
also accelerated and, for some portfolio segments, now exceeds previous 
peaks experienced during the last credit cycle. Continued concerns 
about the economy are also affecting loan growth and demand as 
businesses, consumers, and bankers themselves retrench on the amount of 
leverage and borrowing they want to assume. As a result, loan growth 
through 2Q:2009 has slowed across the national bank population and in 
various portfolio segments. (See charts 2 and 3)




    A number of factors are evident for this decline in credit, 
including the following:

    Reduction in loan demand, as reductions in consumer 
        spending have caused businesses to cut back on inventory and 
        other investments;

    Reduction in the demand for credit from borrowers who may 
        have been able to afford or repay a loan when the economy was 
        expanding, but now face constrained income or cash-flow and 
        debt service capacity;

    Reductions in loan demand as households work to rebuild 
        their net worth, as reflected in the increased U.S. savings 
        rate;

    Actions taken by bankers to scale back their risk exposures 
        due to weaknesses in various market and economic sectors, and 
        to strengthen underwriting standards and loan terms that had 
        become, in retrospect, too relaxed. In addition, many banks 
        have increasingly shifted their focus and resources to loan 
        collections, workouts, and resolutions, and some troubled banks 
        have curtailed lending due to funding and capital constraints; 
        and

    Continued uncertainty on the part of borrowers and lenders 
        about the strength and speed of the economic recovery in many 
        regions of the country.

    As demonstrated in chart 4 below, businesses have significantly 
reduced their investments and inventories and, in an effort to 
strengthen their own balance sheets, many larger businesses have 
replaced short-term borrowing with longer-term corporate bond issues. 
Similarly, chart 5 shows that consumers are repairing their personal 
balance sheets with significant increases in their personal savings 
rates.




    This interplay of factors and their effects on lending are 
consistent with our recent annual underwriting survey and the Federal 
Reserve Board's most recent Senior Loan Officer Survey. OCC examiners 
report that the financial market disruption continues to affect 
bankers' appetite for risk and has resulted in a renewed focus on 
fundamental credit principles by bank lenders. Our survey indicates 
that primary factors contributing to stronger underwriting standards 
are bankers' concerns about unfavorable external conditions and product 
performance.\4\ In its July Senior Loan Officer Survey, the Federal 
Reserve reported that ``demand for loans continued to weaken across all 
major categories except for prime residential mortgages.''\5\
---------------------------------------------------------------------------
    \4\ OCC Survey of Underwriting Practices 2009, page 3.
    \5\ Board of Governors of the Federal Reserve System, ``The July 
2009 Senior Loan Officer Survey on Bank Lending Practices,'' page 1.
---------------------------------------------------------------------------
    Some have also suggested that unnecessary supervisory actions may 
have significantly contributed to the decline in credit availability. 
While I do not believe the evidence supports this suggestion, I do 
believe, as addressed in more detail at the end of this testimony, that 
it is critical for supervisors to stay focused on the type of balanced 
supervision that is required in the stressful credit conditions 
prevalent today.
    Finally, the combination of deteriorating credit quality, lower 
yields on earning assets, and slower loan growth is the primary factor 
currently affecting national banks' earnings. As shown in Chart 6, 
there has been a marked deterioration in the return on equity across 
the national banking population as modest increases in banks' net 
interest margins due to more favorable costs of funds have failed to 
offset credit quality problems and the continued need for banks to 
build loan loss reserves.




III. Trends in Key Credit Portfolios and Capital and Reserve Positions
    Against this backdrop, let me now describe trends in major credit 
segments and in capital and loan loss reserve levels.

A. Retail Credit
    Although retail loans--mortgages, home equity, credit cards, and 
other consumer loans--account for just over half of total loans in the 
national banking system, they currently account for two-thirds of total 
losses, delinquencies, and nonperforming credits. To a large extent, 
however, these problems are confined to the largest 15 national banks, 
which hold almost 91 percent of retail loans in the national banking 
system.

1. First and Second Mortgages
    The residential mortgage sector was the epicenter of the financial 
turmoil and continues to figure prominently in the current condition of 
the banking industry. As the economy has worsened, problems that 
started in the subprime market have spread to the so-called ``Alt A'' 
market, and increasingly, to the prime market. While over-leverage and 
falling housing prices were the initial drivers of delinquencies and 
loan losses, borrower strains resulting from rising unemployment and 
underemployment are an increasingly important factor. In the first 
mortgage market, the June 30, 2009 Mortgage Bankers Association's 
National Delinquency Survey shows continued growth in foreclosure 
inventory, but a relatively flat rate of new foreclosure starts overall 
between the first and second quarter of this year. The rate of prime 
foreclosures, however, continues to increase, with starts at about 1 
percent of the surveyed population as of the end of the second quarter. 
Although this percentage is still relatively small, the impact is 
significant given the much larger size of the prime market segment 
compared to the markets for subprime and Alt-A loans. While it is true 
that many first mortgages were sold to third party investors via the 
securitization market, and the loan quality of such mortgages retained 
by banks is generally higher than those sold to third parties, it 
nevertheless remains the case that a number of larger banks have 
significant on-balance sheet exposure to first mortgage losses from 
portfolios that continue to deteriorate.
    The same is true of second mortgages--home equity loans and lines 
of credit--except that the overwhelming majority of these loans reside 
on bank balance sheets. There were some positive signs in the second 
quarter showing home equity loan delinquency rates falling, and the 
pace of increase in second lien charge-off rates slowing. But the hard 
fact is that losses on these loans through the first half of this year 
nearly equaled total losses for all of 2008, and loss rates are 
expected to continue to climb--though at a slower rate--through at 
least the middle of 2010.
    In short, deterioration in the first and second residential 
mortgage markets continue to dominate the credit quality performance in 
national banks' retail portfolios, as it has since the second half of 
2008. Total delinquent and nonperforming residential real estate loans 
(mortgage and home equity) in national banks now hover around 9.4 
percent, with a loss rate of just over 2.5 percent--the highest level 
since we have been collecting this data.
    There have been some positive indicators in the housing market in 
recent months that could slow the pace of losses in residential 
mortgages, including increased home sales in June and July, and slight 
increases in the Case-Shiller composite index for certain metropolitan 
areas. While these signs are encouraging, it is too early to determine 
whether they signal a true turning point in this sector. For example, 
the increase in home sales this summer is consistent with seasonal 
trends and may not be sustainable. In addition, sales may be enjoying a 
temporary boost from the First-Time Homebuyer Tax Credit program which, 
unless extended, will end in November. Much will depend, of course, on 
the extent to which economic recovery takes hold and truly stabilizes 
the housing market.
    In terms of mortgage modifications, all of the major national bank 
mortgage servicers are actively participating in the Administration's 
Making Home Affordable Program. Servicers have been significantly 
expanding their staff levels in the loss mitigation/collection areas--
doubling and tripling customer contact personnel, and requiring night 
and weekend overtime work. Servicers have also been ramping up their 
training efforts, customer service scripts, and automated qualification 
and underwriting systems to improve the processing of loan modification 
requests. The OCC is closely monitoring these and other home 
modification efforts through onsite examinations and other ongoing 
supervisory initiatives, as well as through our Mortgage Metrics 
quarterly reporting program. And examiners continue to monitor 
modification programs for compliance with all applicable fair lending 
and consumer compliance laws.
    Our latest Mortgage Metrics report shows that actions to keep 
Americans in their homes grew by almost 22 percent during 2Q:2009.\6\ 
Notably, the percentage of modifications that reduced borrowers' 
monthly principal and interest payments continued to increase to more 
than 78 percent of all new modifications, up from about 54 percent in 
the previous quarter. We view this as a positive development, as 
modifications that reduce borrowers' monthly payments generally produce 
lower levels of re-defaults and longer term sustainability than 
modifications that either increase payments or leave them unchanged.
---------------------------------------------------------------------------
    \6\ See OCC News Release 2009-118, September 30, 2009.
---------------------------------------------------------------------------
2. Credit Cards
    Credit card performance began to deteriorate sharply in the latter 
part of 2008 and has continued to weaken further this year, with record 
levels of losses and delinquencies. As with second lien mortgages, 
there have been some encouraging signs recently in the form of 
declining early stage delinquency rates, but loss rates continue to 
climb. As of June 30, the overall loss rate was 10.3 percent for 
national banks, and more recent data shows continued deterioration-with 
industry analysts predicting even higher loss rates into 2010.
    In response to these trends and the overall deterioration in the 
economy, many credit card issuers are adjusting their account 
management policies to reflect and respond to the increased risk in 
these accounts. In some cases these actions have resulted in credit 
lines being reduced or curtailed. In other cases, they have led to 
increased interest rates, effectively increasing the minimum payment to 
cover the higher finance charges. In still other cases they have 
resulted in an increase in minimum payments to extinguish the 
outstanding debt more quickly. Many credit card issuers are also re-
evaluating certain credit card product features, such as ``no annual 
fees'' or various reward programs, and are offering cards with simpler 
terms and conditions, in part due to the recently enacted Credit CARD 
Act.
    We are monitoring these changes in credit card account terms to 
ensure that they comply with all applicable limit and notice 
requirements, including those mandated by the Credit CARD Act. For 
example, in July we notified national banks that, effective August 22, 
2010, they must conduct periodic reviews of accounts whose interest 
rates have been increased since January 1, 2009, based on factors 
including market conditions and borrower credit risk. More recently, we 
issued a bulletin advising national banks abut the interim final rules 
issued by the Federal Reserve under the Credit CARD Act that became 
effective on August 20, 2009. The Federal Reserve's rules require 
lenders to notify customers 45 days in advance of any rate increase or 
significant changes in credit card account terms and to disclose that 
consumers can have the right to reject these changes. Under the rules, 
the new rates or terms can be applied to any transaction that occurs 
more than 14 days after the notice is provided--even if the customer 
ultimately rejects those terms. To address the risk of consumer 
confusion, the OCC directed national banks to include an additional 
disclosure not required by the rules to alert consumers, if applicable, 
to the imposition of the new terms on transactions that occur more than 
14 days after thenotice is provided, regardless of whether the consumer 
rejects the change and cancels the account.
    As with residential mortgages, we are encouraging national banks to 
work with consumers who may be facing temporary difficulties and 
hardships, and more banks are reaching out to assist customers before 
they become delinquent. Banks have a number of viable default 
management options to assist in this endeavor, although it is important 
that, as they do so, they continue to appropriately account for losses 
as they occur.
    Card issuers are also reevaluating the size of unused credit lines 
in response to current credit conditions, recent regulatory changes, 
and recent adoption by the Financial Accounting Standards Board (FASB) 
of two new accounting standards, Statement No. 166, Accounting for 
Transfers of Financial Assets--an amendment of FASB Statement No. 140 
(FAS 166) and Statement No. 167, Amendments to FASB Interpretation No. 
46(R) (FAS 167). These standards become effective for an entity's first 
fiscal year beginning after November 15, 2009, and will have a 
significant impact on many banking institutions. In particular, many 
securitization transactions, including credit card securitizations, 
will likely lose sales accounting treatment, prompting the return of 
the securitized assets to banks' balance sheets. Although we are still 
evaluating the impact of these changes, we anticipate that they will 
have a material effect on how banks structure transactions, manage 
risk, and determine the levels of loan loss reserves and regulatory 
capital they hold for certain assets, including credit cards. The net 
effect of these changes is that banks will most likely face increased 
funding and capital costs for these products.
    The combination of all these factors has resulted in a decline in 
overall credit card debt outstanding and--especially--overall unfunded 
credit card commitments, reflecting pullbacks by both consumers and 
lenders. For national banks, managed card outstandings (i.e., funded 
loans both on and off banks' balance sheets) declined by 4 percent thus 
far this year, or roughly $27 billion. Unfunded credit card commitments 
(lines available to customers) have declined more precipitously, by 
14.8 percent or $448 billion. These trends are consistent with overall 
industry data.
    In summary, retail credit quality issues continue to be an area of 
concern, especially for the larger national banks. Although there are 
some early signs of delinquency rates declining, with some bankers 
telling us they are beginning to see adverse trends leveling off, 
sustained improvements in this sector will largely depend on the length 
and depth of the recession and levels of unemployment.

B. Commercial and Industrial Loans
    The fallout from the housing and consumer sectors to other segments 
of the economy is evident in the performance of national banks' 
commercial and industrial (C&I) loan portfolios. Adverse trends in key 
performance measures, including 30-day or morepast due delinquencies, 
non-performing rates, and net loss rates, sharply accelerated in the 
latter part of last year and have continued to trend upward in 2009. 
For example, the percentage of C&I loans that are delinquent or 
nonperforming has risen from a recent historical low of 1.02 percent in 
2Q:2007 to 3.90 percent in 2Q:2009. Although this is the highest rate 
since the ratio peaked at 4.15 percent in 2Q:2002 during the last 
recession, it is still well below the 1991 recession peak of 6.5 
percent.
    In contrast to retail loans, which primarily affect the larger 
national banks, the effect of adverse trends in C&I loans is fairly 
uniform across the national bank population. This segment of loans 
represents approximately 20 percent of total loans in the national 
banking system, with levels somewhat more concentrated at larger 
institutions than at community banks, where C&I loans account for 
approximately 16 percent of total loans. While credit quality 
indicators are marginally worse at the larger national banks, the trend 
rate and direction are fairly consistent across all sizes of national 
banks.
    One measure of C&I loan quality comes from the Federal banking 
agencies' Shared National Credit (SNC) program, which provides an 
annual review of large credit commitments that cut across the financial 
system. These large loans to large borrowers are originated by large 
banks, then syndicated to other banks and many types of nonbank 
financial institutions such as securitization pools, hedge funds, 
insurance companies, and pension funds.\7\ This year's review, which 
was just recently completed, also found sharp declines in credit 
quality. The review, which covered 8,955 credits totaling $2.9 trillion 
extended to approximately 5,900 borrowers, found a record level of $642 
billion in criticized assets--meaning loans or commitments that had 
credit weaknesses--representing approximately 22 percent of the total 
SNC portfolio. Total loss of $53 billion identified in the 2009 review 
exceeded the combined loss of the previous eight SNC reviews and nearly 
tripled the previous high in 2002. Examiners attributed the declining 
credit quality to weak economic conditions and the weak underwriting 
standards leading up to 2008.\8\
---------------------------------------------------------------------------
    \7\ In fact, nonbanks hold a disproportionate share of classified 
assets compared with their total share of the SNC portfolio, owning 47 
percent of classified assets and 52 percent of nonaccrual loans, 
whereas FDICinsured institutions hold only 24.2 percent of classified 
assets and 22.7 percent of nonaccrual loans.
    \8\ See OCC News Release 2009-11, September 24, 2009.
---------------------------------------------------------------------------
C. Commercial Real Estate Loans
    The greatest challenge facing many banks and their supervisors is 
the continued deterioration in commercial real estate loans (CRE). 
There are really two stories here, with one related to the other.
    The first involves residential construction and development (C&D) 
lending, especially with respect to single family homes. Not 
surprisingly, given the terrible strains in the housing sector over the 
last 2 years, delinquency rates have already climbed tohigh levels, 
with significant losses already realized and more losses continuing to 
work their way through the banking system. For national banks as of 
June 30, total delinquent and nonperforming rates were at just over 34 
percent in the largest national banks; 23.4 percent in mid-size banks; 
and 17.5 percent in community banks. The relative size of these loss 
rates is somewhat misleading, however, because many community banks and 
some mid-size banks have much greater concentrations in residential C&D 
loans than the largest banks. As a result, the concentrated losses in 
these smaller institutions has had a much more pronounced effect on 
viability, with concentrated residential C&D lending constituting by 
far the single largest factor in commercial bank failures in the last 
two years. At this point in the credit cycle, we believe the bulk of 
residential C&D problems have been identified and are being addressed, 
although a number will continue to produce losses that result in more 
bank failures.
    The second story involves all other types of commercial real estate 
loans, including loans secured by income producing properties. Credit 
deterioration has spread to these assets as well, and trend lines are 
definitely worsening, but thus far the banking system has not 
experienced anywhere near the level of delinquency and loss as it has 
in C&D lending.
    Still, the signs are troubling. Declining real estate values caused 
by rising vacancy rates, increasing investor return requirements, 
falling rental rates, and weak sales are affecting all CRE segments. 
For example, Property and Portfolio Research reports that apartment 
vacancy rates have hit a 25-plus year high at 8.4 percent nationally, 
and there are similar patterns for retail, office, and warehouse space 
as demand falls across all segments. But unlike the CRE markets in 
1991, much of the current fallout is driven more by a decrease in 
demand than from an oversupply of properties.
    The outlook for these markets over the near term, especially for 
the income producing property sector, is not favorable. In general, 
deterioration in performance for these CRE loans lags the economy as 
borrowers' cash-flows may be sufficient during the early stages of a 
downturn, but become increasingly strained over time. There are 
alsogrowing concerns about the refinancing risk within the commercial 
mortgage-backed securities market (CMBS) where there is a currently 
moderate-but-growing pipeline of loans scheduled to mature. Permanent 
or rollover refinancing of these loans may be difficult due to the 
declines in commercial property values coupled with the return to more 
prudent underwriting standards by both lenders and investors. While 
this is an area that we are monitoring, the largest proportion and more 
problematic of these mortgages will not mature until 2011 and 2012.
    As with C&I loans, trends in total delinquent and nonperforming CRE 
rates (including C&D loans) have been fairly consistent across all 
segments of the national bank population, climbing to roughly 8.3 
percent in 2Q:2009. While C&D losses will continue to be most 
problematic for the banks that have the largest concentrations in these 
assets, theextent to which other types of CRE loan losses will continue 
to climb will depend very much on the overall performance of the 
economy.

D. Capital and Reserve Levels
    Perhaps the most critical tools for dealing with and absorbing 
credit losses are substantial levels of capital and reserves. As a 
result, in anticipation of rising credit losses over the last 2 years, 
the OCC has directed banks to build loan loss reserves and strengthen 
capital. In aggregate, the net amount of capital in national banks 
(i.e., the net increase after items such as losses and dividends and 
including capital as a result of acquisitions and net TARP inflows) has 
risen by over $186 billion over the last 2 years, and the net build to 
loan loss reserves (i.e., loan loss provisions less net credit losses) 
has been over $92 billion. These increases in loss-absorbing resources 
are critical contributors to the overall health of the national banking 
system.
    As illustrated by the dotted line in the chart below, the level of 
reserves to total loans in the national banking system has increased 
dramatically to a ratio of 3.3 percent, the highest in over 25 years. 
While such high reserves are imperative for dealing with the high level 
of noncurrent loans, the solid line in the chart below shows that more 
provisions may be needed, because the ratio of reserves to noncurrent 
loans has continued to decline, to under 100 percent--reflecting the 
fact that the substantial growth in reserves is not keeping pace with 
the even greater growth in noncurrents.



    Substantially building reserves at the same time as credit 
conditions weaken is often described as unduly ``pro-cyclical,'' 
because bank earnings decline sharply from provisioning well before 
charge-offs actually occur. That is certainly an accurate 
characterization under the current accounting system for loan loss 
reserving, although there will always be a need to build reserves to 
some extent as credit losses rise. The issue is really about how much; 
that is, if reserve levels are high going into a credit downturn, then 
the need to build reserves is far lower than it is when the going-in 
levels are low. Unfortunately, our current accounting standards tend to 
produce very low levels of reserves just before the credit cycle turns 
downward, especially after prolonged periods of benign credit 
conditions as we had in the first part of this decade. In such periods, 
the backward-looking focus of the current accounting model creates 
undue pressure to decrease reserve levels even where lenders believe 
the cycle is turning and credit losses will clearly increase. I 
strongly believe that a more forward looking accounting model based on 
expected losses would both more accurately account for credit costs and 
be less pro-cyclical. This is an issue that I have been working on as 
co-chair of the Financial Stability Board's (FSB) Working Group on 
Provisioning, and I continue to be hopeful that accounting standard 
setters will embrace this type of change as they consider adjustments 
to loan loss provisioning standards.

IV. Most National Banks Have Capacity to Weather This Storm
    The credit conditions I have just described are stark and will 
require considerable skills by bankers and regulators to work through. 
Despite these challenges, I believe the vast majority of national banks 
are and will continue to be sound, and that they have the wherewithal 
to manage through this credit cycle. Notwithstanding the negative 
trends and earnings pressures that banks are facing, we should not lose 
sight that, as of June 30, 2009,97 percent of all national banks 
satisfied the required minimum capital standards to be considered well 
capitalized, and 76 percent reported positive earnings.
    As previously described, the OCC has separate supervisory programs 
for Large Banks (assets generally exceeding $100 billion); Mid-Sized 
Banks (assets from $10 billion to $100 billion); and Community Banks 
(assets below $10 billion). Let me summarize our general assessment of 
the condition of each group.

A. Large Banks
    In some respects, large banks faced the earliest challenges, with 
the disruptions in wholesale funding markets, the significant losses 
they sustained on various structured securities. and the pronounced 
losses that emerged earlier in their retail credit portfolios. As I 
mentioned, there are some preliminary indicators that the rate of 
increased problems in the retail sector may have begun to slow, but as 
with credit conditions in general, much of this will depend on the 
timing and strength of the economy, and in particular, on unemployment 
rates. C&I and CRE loan exposures remain a concern for these banks, but 
they have more diversified portfolios and exposures than many smaller 
banks and thus may be in a better position to absorb these problems. 
Collectively, the fifteen banks in our Large Bank program raised $132 
billion in capital (excluding TARP funding) in 2008 and, over the past 
twenty 4 months, their net build to loan loss reserves totaled 
approximately $85 billion.
    Earlier this year we and the other Federal regulators conducted a 
detailed stress test of the largest U.S. banks as part of the 
Supervisory Capital Assessment Program (SCAP) to examine their ability 
to withstand even further deterioration in market and credit 
conditions. I believe that was an extremely valuable exercise for four 
reasons. First, the one-time public assessment of individual 
institution supervisory results--which was only made possible by the 
U.S. Government backstop made available by TARP funding--alleviated a 
great deal of uncertainty about the depth of credit problems on bank 
balance sheets, which a number of analysts had assumed to be in far 
worse condition. Second, the reduction of uncertainty allowed 
institutions to access private capital markets to increase their 
capital buffer for possibly severe future losses, instead of requiring 
more government capital. Third, the additional capital required to be 
raised or otherwise generated now--over $45 billion in common stock 
alone has already been issued by the nine SCAPinstitutions with 
national bank subsidiaries--provides these banks with a strong buffer 
to absorb the severe losses and sharply reduced revenue associated with 
the adverse stress scenario imposed under SCAP for the 2-year period of 
2009 and 2010, should that scenario come to pass. Fourth, as we track 
banks' actual credit performance against the SCAP adverse stress 
scenario to ensure that capital levels remain adequate, we have found 
that, through the first half of 2009--which constitutes 25 percent of 
the overall 2-year SCAP stress period--actual aggregate loan losses 
were well below 25 percent of the aggregate losses projected for the 
full SCAP period, and actual aggregate revenues were well above 25 
percent of the aggregate projected SCAP revenues. While those trends 
could change as the stress period continues, the early results are 
promising.

B. Mid-Size Banks
    Although mid-size national banks engage in retail lending, the 
scope and size of their exposures are not as significant as those of 
the largest national banks. Mid-size banks also did not have the 
significant losses that larger banks did from various structured 
investment products. Nevertheless, loan growth at these banks turned 
negative in 2Q:2009, and although they experienced modest improvements 
in net interest margins in the second quarter, they still face downward 
earnings pressures, primarily due to increasing loan loss provisions. 
Given their exposures to the C&I and CRE markets, we expect these 
pressures will persist, notwithstanding the $3.5 billion in net reserve 
builds over the last twenty four months. These banks have also had 
success in attracting new capital, raising close to $5 billion thus far 
this year.

C. Community Banks
    Nearly all national community banks entered this environment with 
strong capital bases that exceeded regulatory minimums. As a group, 
they have been less exposed to problems in the retail credit sector 
that have confronted large and mid-size banks, and the vast majority of 
these banks remain in sound financial condition. As noted earlier, 
there is a small number of community banks that have concentrations in 
trust preferred and private label mortgage-backed securities that we 
are closely monitoring.
    Of more significance are the exposures that many community banks 
have to commercial real estate loans. As I noted in my June 2008 
testimony, we have been concerned for some time about the sizable 
concentrations of CRE loans found at many smaller national banks. While 
national banks of all sizes have significant CRE exposures, as shown in 
Chart 8, CRE concentrations are most pronounced at community and mid-
size banks.



    Because of this, the OCC began conducting horizontal reviews of 
banks with significant concentrations about 5 years ago. As credit 
conditions worsened, our efforts intensified in banks that we believed 
were at high risk from downturns in real estate markets. Our goal has 
been to work with bankers to get potential CRE problems identified at 
an early stage so that bank management can take effective remedial 
action. In most but not all cases, bank management teams are 
successfully working through their problems and have adequate capital 
and stable funding bases to weather additional loan losses and earnings 
pressures.

V. Resolution of Problem Banks
    Given the strains in the economy and banking system, it is not 
surprising that the number of problem banks has increased from the 
recent historical lows. In the early 1990s, the number of problem 
national banks--those with a CAMELS composite rating of 3, 4 or 5--
reached a high of 28 percent of all national banks. Thereafter, the 
number of problem national banks relative to all national banks dropped 
dramatically and then fluctuated in a range of three to 6 percent until 
2007. Since then, however, the number of problem banks has risen 
steadily, and it is now approximately 17 percent of national banks.
    As would be expected, this upward trend in problem banks also has 
resulted in an increased number of bank failures. In January, 2008, we 
had the first national bank failure in almost 4 years, the longest 
period without a failure in the 146-year history of theOCC. That began 
the current period of significantly increased failures. In total, since 
January 1 of 2008, there have been 123 failures of insured banks and 
thrifts. Of these, 19 have been national banks, accounting for 11 
percent of the total projected loss to thedeposit insurance fund from 
all banks that failed during this period. All of the 19 failed national 
banks have been community banks, although the total obviously does not 
include the two large bank holding companies with lead national banks 
that were the subject of systemic risk determinations and received 
extraordinary TARP assistance on an open-institution basis.
    While the vast majority of national banks have the financial 
capacity and management skills to weather the current environment, some 
will not. Given the real estate concentrations in community banks, the 
number of problem banks, the severe problems in housing markets, and 
increasing concern with CRE, we expect more bank failures in the months 
ahead. Some troubled banks will be able to find strong buyers--in some 
instances with our assistance--that will enable them to avoid failure 
and resolution by the FDIC. But that will not always be possible. When 
it is not, our goal, consistent with the provisions of the Federal 
Deposit Insurance Corporation Improvement Act, is to effect early and 
least cost resolution of the bank with a minimum of disruption to the 
community.

VI. OCC Will Continue to Take a Balanced Approach in Our Supervision of 
        National Banks
    Finally, I want to underscore the OCC's commitment to provide a 
balanced and fair approach in our supervision of national banks as 
bankers work through the challenges that are facing them and their 
borrowers. We recognize the important roles that credit availability 
and prudent lending play in our nation's economy, and we are 
particularly aware of the vital role that many smaller banks play in 
meeting the credit needs of small businesses in their local 
communities. Our goal is to ensure that national banks can continue to 
meet these needs in a safe and sound manner.
    I have heard some reports that bankers are receiving mixed messages 
from regulators: on one hand being urged to make loans to creditworthy 
customers, while at the same time being subjected to what some have 
characterized as ``overzealous'' regulatory examinations. In this 
context, let me emphasize that our messages to bankers have and 
continue to be straight-forward:

    Bankers should continue to make loans to creditworthy 
        borrowers;

    But they should not make loans that they believe are 
        unlikely to be repaid in full; and

    They should continue to work constructively with troubled 
        borrowers--but recognize repayment problems in loans when they 
        see them, because delay and denial only makes things worse.

    Let me also underscore what OCC examiners will and will not do. 
Examiners will not tell bankers to call or renegotiate a loan; dictate 
loan structures or pricing; or prescribe limits (beyond regulatory 
limits) on types or amounts of loans that a bank may make if the bank 
has adequate capital and systems to support and manage its risks. 
Examiners will look to see that bankers have made loans on prudent 
terms, based on sound analysis of financial and collateral information; 
that banks have sufficient risk management systems inplace to identify 
and control risks; that they set aside sufficient reserves and capital 
to buffer and absorb actual and potential losses; and that they 
accurately reflect the condition of their loan portfolios in their 
financial statements.
    Nevertheless, balanced supervision does not mean that examiners 
will allow bankers to ignore or mask credit problems. Early recognition 
and action by management are critical factors in successfully 
rehabilitating a problem bank. Conversely, the merepassage of time and 
hope for improved market conditions are not successful resolution 
strategies.
    We have taken a number of steps to ensure that our examiners are 
applying these principles in a balanced and consistent manner. For 
example, we hold both regular meetings and periodic national 
teleconferences with our field examiners to convey key supervisory 
messages and objectives. In our April 2008 nationwide call, we reviewed 
and discussed key supervisory principles for evaluating commercial real 
estate lending. In April of this year we issued guidance to our 
examiners on elements of an effective workout/restructure program for 
problem real estate loans. We noted that effective workouts can take a 
number of forms, including simple renewal or extension of the loan 
terms, extension of additional credit; formal restructuring of the loan 
terms; and, in some cases, foreclosure on underlying collateral. We 
further reiterated these key principles in a nationwide call with our 
mid-size and community bank examiners earlier this month.
    Through the FFIEC, we are also working with the other Federal and 
state banking agencies to update and reinforce our existing guidance on 
working with CRE borrowers and to help ensure consistent application of 
these principles across all banks. This guidance will reaffirm that 
prudent workouts are often in the best interests of both the bank and 
borrower and that examiners should take a balanced approach in 
evaluating workouts. In particular, examiners should not criticize 
banks that implement effective workouts afterperforming a comprehensive 
review of the borrower's condition, even if the restructured loans have 
weaknesses that result in adverse credit classification. Nor should 
they criticize renewed or restructured loans to borrowers with a 
demonstrated ability to repay, merelybecause of a decline in collateral 
values. Consistent with current policies, loans that are adequately 
protected by the current sound worth and debt service capacity of the 
borrower, guarantor, or the underlying collateral generally will not be 
classified. However, deferring issues for another day does not help the 
CRE sector or banking industry recover. It is important that bankers 
acknowledge changing risk and repayment sources that may no longer be 
adequate.

VII. Conclusion
    I firmly believe that the collective measures that government 
officials, bank regulators, and many bankers have taken in recent 
months have put our financial system on a much more sound footing. 
These steps are also crucial to ensuring that banks will be ableto 
continue their role as lenders and financial intermediaries. 
Nonetheless, it is equally clear that there are still many challenges 
ahead, especially with regard to the significant deterioration in 
credit that both supervisors and bankers must work through. There are 
no quick fixes to this problem, and there is the real potential that, 
for a large number of banks, credit quality will get worse in the 
months ahead. Notwithstanding the significant loan loss provisions that 
banks have taken over the past 2 years, more may be needed as 
provisions and resulting loan loss reserves have not kept pace with the 
rapid increase in nonperforming assets.
    The OCC is firmly committed to taking a balanced approach as 
bankers work through these issues. We will continue to encourage 
bankers to lend and to work with borrowers. However, we will also 
ensure that they do so in a safe and sound manner and that they 
recognize and address their problems on a timely basis.
                                 ______
                                 
                PREPARED STATEMENT OF DANIEL K. TARULLO
        Member, Board of Governors of the Federal Reserve System
                            October 14, 2009

    Chairman Johnson, Ranking Member Crapo, and members of the 
Subcommittee, thank you for your invitation to discuss the condition of 
the U.S. banking industry. First, I will review the current conditions 
in financial markets and the overall economy and then turn to the 
performance of the banking system, highlighting particular challenges 
in commercial real estate (CRE) and other loan portfolios. Finally, I 
will address the Federal Reserve's regulatory and supervisory responses 
to these challenges.

Conditions in Financial Markets and the Economy
    Conditions and sentiment in financial markets have continued to 
improve in recent months. Pressures in short-term funding markets have 
eased considerably, broad stock price indexes have increased, risk 
spreads on corporate bonds have narrowed, and credit default swap 
spreads for many large bank holding companies, a measure of perceived 
riskiness, have declined. Despite improvements, stresses remain in 
financial markets. For example, corporate bond spreads remain quite 
high by historical standards, as both expected losses and risk premiums 
remain elevated.
    Economic growth appears to have moved back into positive territory 
last quarter, in part reflecting a pickup in consumer spending and a 
slight increase in residential investment--two components of aggregate 
demand that had dropped to very low levels earlier in the year. 
However, the unemployment rate has continued to rise, reaching 9.8 
percent in September, and is unlikely to improve materially for some 
time.
    Against this backdrop, borrowing by households and businesses has 
been weak. According to the Federal Reserve's Flow of Funds accounts, 
household and nonfinancial business debt contracted in the first half 
of the year and appears to have decreased again in the third quarter. 
For households, residential mortgage debt and consumer credit fell 
sharply in the first half; the decline in consumer credit continued in 
July and August. Nonfinancial business debt also decreased modestly in 
the first half of the year and appears to have contracted further in 
the third quarter as net decreases in commercial paper, commercial 
mortgages, and bank loans more than offset a solid pace of corporate 
bond issuance.
    At depository institutions, loans outstanding fell in the second 
quarter of 2009. In addition, the Federal Reserve's weekly bank credit 
data suggests that bank loans to households and to nonfinancial 
businesses contracted sharply in the third quarter. These declines 
reflect the fact that weak economic growth can both damp demand for 
credit and lead to tighter credit supply conditions.
    The results from the Federal Reserve's Senior Loan Officer Opinion 
Survey on Bank Lending Practices indicate that both the availability 
and demand for bank loans are well below pre-crisis levels. In July, 
more banks reported tightening their lending standards on consumer and 
business loans than reported easing, although the degree of net 
tightening was well below levels reported last year. Almost all of the 
banks that tightened standards indicated concerns about a weaker or 
more uncertain economic outlook, and about one-third of banks surveyed 
cited concerns about deterioration in their own current or future 
capital positions. The survey also indicates that demand for consumer 
and business loans has remained weak. Indeed, decreased loan demand 
from creditworthy borrowers was the most common explanation given by 
respondents for the contraction of business loans this year.
    Taking a longer view of cycles since World War II, changes in debt 
flows have tended to lag behind changes in economic activity. Thus, it 
would be unusual to see a return to a robust and sustainable expansion 
of credit until after the overall economy begins to recover.
    Credit losses at banking organizations continued to rise through 
the second quarter of this year, and banks face risks of sizable 
additional credit losses given the outlook for production and 
employment. In addition, while the decline in housing prices slowed in 
the second quarter, continued adjustments in the housing market suggest 
that foreclosures and mortgage loan loss severities are likely to 
remain elevated. Moreover, prices for both existing commercial 
properties and for land, which collateralize commercial and residential 
development loans, have declined sharply in the first half of this 
year, suggesting that banks are vulnerable to significant further 
deterioration in their CRE loans. In sum, banking organizations 
continue to face significant challenges, and credit markets are far 
from fully healed.

Performance of the Banking System
    Despite these challenges, the stability of the banking system has 
improved since last year. Many financial institutions have been able to 
raise significant amounts of capital and have achieved greater access 
to funding. Moreover, through the rigorous Supervisory Capital 
Assessment Program (SCAP) stress test conducted by the banking agencies 
earlier this year, some institutions demonstrated that they have the 
capacity to withstand more-adverse macroeconomic conditions than are 
expected to develop and have repaid the government's Troubled Asset 
Relief Program (TARP) investments.\1\ Depositors' concerns about the 
safety of their funds during the immediate crisis last year have also 
largely abated. As a result, financial institutions have seen their 
access to core deposit funding improve.
---------------------------------------------------------------------------
    \1\ For more information about the SCAP, see Ben S. Bernanke 
(2009), ``The Supervisory Capital Assessment Program,'' speech 
delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets 
Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/
newsevents/speech/bernanke20090511a.htm.
---------------------------------------------------------------------------
    However, the banking system remains fragile. Nearly 2 years into a 
substantial recession, loan quality is poor across many asset classes 
and, as noted earlier, continues to deteriorate as lingering weakness 
in housing markets affects the performance of residential mortgages and 
construction loans. Higher loan losses are depleting loan loss reserves 
at many banking organizations, necessitating large new provisions that 
are producing net losses or low earnings. In addition, although capital 
ratios are considerably higher than they were at the start of the 
crisis for many banking organizations, poor loan quality, subpar 
earnings, and uncertainty about future conditions raise questions about 
capital adequacy for some institutions. Diminished loan demand, more-
conservative underwriting standards in the wake of the crisis, 
recessionary economic conditions, and a focus on working out problem 
loans have also limited the degree to which banks have added high 
quality loans to their portfolios, an essential step to expanding 
profitable assets and thus restoring earnings performance.
    These developments have raised the number of problem banks to the 
highest level since the early 1990s, and the rate of bank and thrift 
failures has accelerated throughout the year. Moreover, the estimated 
loss rates for the deposit insurance fund on bank failures have been 
very high, generally hovering near 30 percent of assets. This high loss 
level reflects the rapidity with which loan quality has deteriorated 
during the crisis and suggests that banking organizations may need to 
continue their high level of loan loss provisioning for some time. 
Moreover, some of these institutions, including those with capital 
above minimum requirements, may need to raise more capital and restrain 
their dividend payouts for the foreseeable future. Indeed, the buildup 
in capital ratios at large banking organizations has been essential to 
reassuring the market of their improving condition. However, we must 
recognize that capital ratios can be an imperfect indicator of a bank's 
overall strength, particularly in periods in which credit quality is 
deteriorating rapidly and loan loss rates are moving higher.

Comparative Performance of Banking Institutions by Asset Size
    Although the broad trends detailed above have affected all 
financial institutions, there are some differences in how the crisis is 
affecting large financial institutions and more locally focused 
community and regional banks. Consider, for example, the 50 largest 
U.S. bank holding companies, which hold more than three-quarters of 
bank holding company assets and now include the major investment banks 
in the United States. While these institutions do engage in traditional 
lending activities, originating loans and holding them on their balance 
sheets like their community bank competitors, they also generate 
considerable revenue from trading and other fee-based activities that 
are sensitive to conditions in capital markets. These firms reported 
modest profits during each of the first two quarters of 2009. Second-
quarter net income for these companies at $1.6 billion was weaker than 
that of the first quarter, but was still a great improvement over the 
$19.8 billion loss reported for the second quarter of last year. Net 
income was depressed by the payment of a significant share of the 
Federal Deposit Insurance Corporation's (FDIC) special deposit 
insurance assessment and a continued high level of loan loss 
provisioning. Contributing significantly to better performance was the 
improvement of capital markets activities and increases in related fees 
and revenues.
    Community and small regional banks have also benefited from the 
increased stability in financial markets. However, because they depend 
largely on revenues from traditional lending activities, as a group 
they have yet to report any notable improvement in earnings or 
condition since the crisis took hold. These banks--with assets of $10 
billion or less representing almost 7,000 banks and 20 percent of 
commercial bank assets--reported a $2.7 billion loss in the second 
quarter. Earnings remained weak at these banks due to a historically 
narrow net interest margin and high loan loss provisions. More than one 
in four of these banks reported a net loss. Earnings at these banks 
were also substantially affected by the FDIC special assessment during 
the second quarter.
    Loan quality deteriorated significantly for both large and small 
institutions during the second quarter. At the largest 50 bank holding 
companies, nonperforming assets climbed more than 20 percent, raising 
the ratio of nonperforming assets to 4.3 percent of loans and other 
real estate owned. Most of the deterioration was concentrated in 
residential mortgage and construction loans, but commercial, CRE, and 
credit card loans also experienced rising delinquency rates. Results of 
the banking agencies' Shared National Credit review, released in 
September, also document significant deterioration in large syndicated 
loans, signaling likely further deterioration in commercial loans.\2\ 
At community and small regional banks, nonperforming assets increased 
to 4.4 percent of loans at the end of the second quarter, more than six 
times the level for this ratio at year-end 2006, before the crisis 
started. Home mortgages and CRE loans accounted for most of the 
increase, but commercial loans have also shown marked deterioration 
during recent quarters. Importantly, aggregate equity capital for the 
top 50 bank holding companies, and thereby for the banking industry, 
increased for the third consecutive quarter and reached 8.8 percent of 
consolidated assets as of June 30, 2009. This level was almost 1 
percentage point above the year-end 2008 level and exceeded the pre-
crisis level of midyear 2007 by more than 2 percentage points. Risk-
based capital ratios for the top 50 bank holding companies also 
remained relatively high: Tier 1 capital ratios were at 10.75 percent, 
and total risk-based capital ratios were at 14.09 percent. Signaling 
the recent improvement in financial markets since the crisis began, 
capital increases during the first half of this year largely reflected 
common stock issuance, supported also by reductions in dividend 
payments. However, asset contraction also accounts for part of the 
improvement in capital ratios. Additionally, of course, the Treasury 
Capital Purchase Program also contributed to the increase in capital in 
the time since the crisis emerged.
---------------------------------------------------------------------------
    \2\ See Board of Governors of the Federal Reserve System, FDIC, 
Office of the Comptroller of the Currency, and Office of Thrift 
Supervision (2009), ``Credit Quality Declines in Annual Shared National 
Credits Review,'' joint press release, September 24, 
www.Federalreserve.gov/newsevents/press/bcreg/20090924a.htm.
---------------------------------------------------------------------------
    Despite TARP capital investments in some banks and the ability of 
others to raise equity capital, weak earnings led to modest declines in 
the average capital ratios of smaller banks over the past year--from 
10.7 percent to 10.4 percent of assets as of June 30 of this year. 
However, risk-based capital ratios remained relatively high for most of 
these banks, with 96 percent maintaining risk-based capital ratios 
consistent with a ``well capitalized'' designation under prompt 
corrective action standards.
    Funding for the top 50 bank holding companies has improved markedly 
over the past year. In addition to benefiting from improvement in 
interbank markets, these companies increased core deposits from 24 
percent of total assets at year-end 2008 to 27 percent as of June 30, 
2009. The funding profile for community and small regional banks also 
improved, as core deposit funding rose to 62 percent of assets and 
reliance on brokered deposits and Federal Home Loan Bank advances edged 
down from historically high levels.
    As already noted, substantial financial challenges remain for both 
large and small banking institutions. In particular, some large 
regional and community banking firms that have built up unprecedented 
concentrations in CRE loans will be particularly affected by emerging 
conditions in real estate markets. I will now discuss the economic 
conditions and financial market dislocations affecting CRE markets and 
the implications for banking organizations.

Current Conditions in Commercial Real Estate Markets
    Prices of existing commercial properties are estimated to have 
declined 35 to 40 percent since their peak in 2007, and market 
participants expect further declines. Demand for commercial property 
has declined as job losses have accelerated, and vacancy rates have 
increased. The higher vacancy levels and significant decline in the 
value of existing properties have placed particularly heavy pressure on 
construction and development projects that generate no income until 
completion. Developers typically depend on the sales of completed 
projects to repay their outstanding loans, and with the volume of 
property sales at especially low levels and with prices depressed, the 
ability to service existing construction loans has been severely 
impaired.
     The negative fundamentals in the CRE property markets have caused 
a sharp deterioration in the credit performance of loans in banks' 
portfolios and loans in commercial mortgage-backed securities (CMBS). 
At the end of the second quarter of 2009, approximately $3.5 trillion 
of outstanding debt was associated with CRE, including loans for 
multifamily housing developments. Of this, $1.7 trillion was held on 
the books of banks and thrifts, and an additional $900 billion 
represented collateral for CMBS, with other investors holding the 
remaining balance of $900 billion. Also at the end of the second 
quarter, about 9 percent of CRE loans on banks' books were considered 
delinquent, almost double the level of a year earlier.\3\ Loan 
performance problems were the most striking for construction and 
development loans, especially for those that finance residential 
development. More than 16 percent of all construction and development 
loans were considered delinquent at the end of the second quarter.
---------------------------------------------------------------------------
    \3\ The CRE loans considered delinquent on banks' books were non-
owner occupied CRE loans that were 30 days or more past due.
---------------------------------------------------------------------------
     Almost $500 billion of CRE loans will mature each year over the 
next few years. In addition to losses caused by declining property 
cash-flows and deteriorating conditions for construction loans, losses 
will also be boosted by the depreciating collateral value underlying 
those maturing loans. These losses will place continued pressure on 
banks' earnings, especially those of smaller regional and community 
banks that have high concentrations of CRE loans.
    The current fundamental weakness in CRE markets is exacerbated by 
the fact that the CMBS market, which had financed about 30 percent of 
originations and completed construction projects, has remained 
virtually inoperative since the start of the crisis. Essentially no 
CMBS have been issued since mid-2008. New CMBS issuance came to a halt 
as risk spreads widened to prohibitively high levels in response to the 
increase in CRE-specific risk and the general lack of liquidity in 
structured debt markets. Increases in credit risk have significantly 
softened demand in the secondary trading markets for all but the most 
highly rated tranches of these securities. Delinquencies of mortgages 
backing CMBS have increased markedly in recent months. Market 
participants anticipate these rates will climb higher by the end of 
this year, driven not only by negative fundamentals but also by 
borrowers' difficulty in rolling over maturing debt. In addition, the 
decline in CMBS prices has generated significant stresses on the 
balance sheets of financial institutions that must mark these 
securities to market, further limiting their appetite for taking on new 
CRE exposure.

Federal Reserve Activities to Help Revitalize Credit Markets
    The Federal Reserve, along with other government agencies, has 
taken a number of actions to strengthen the financial sector and to 
promote the availability of credit to businesses and households. In 
addition to aggressively easing monetary policy, the Federal Reserve 
has established a number of facilities to improve liquidity in 
financial markets. One such program is the Term Asset-Backed Securities 
Loan Facility (TALF), begun in November 2008 to facilitate the 
extension of credit to households and small businesses.
    Before the crisis, securitization markets were an important conduit 
of credit to the household and business sectors; some have referred to 
these markets as the ``shadow banking system.'' Securitization markets 
(other than those for mortgages guaranteed by the government) have 
virtually shut down since the onset of the crisis, eliminating an 
important source of credit. Under the TALF, eligible investors may 
borrow to finance purchases of the AAA-rated tranches of certain 
classes of asset-backed securities. The program originally focused on 
credit for households and small businesses, including auto loans, 
credit card loans, student loans, and loans guaranteed by the Small 
Business Administration. More recently, CMBS were added to the program, 
with the goal of mitigating a severe refinancing problem in that 
sector.
    The TALF has had some success. Rate spreads for asset-backed 
securities have declined substantially, and there is some new issuance 
that does not use the facility. By improving credit market functioning 
and adding liquidity to the system, the TALF and other programs have 
provided critical support to the financial system and the economy.

Availability of Credit
    The Federal Reserve has long-standing policies in place to support 
sound bank lending and the credit intermediation process. Guidance 
issued during the CRE downturn in 1991 instructs examiners to ensure 
that regulatory policies and actions do not inadvertently curtail the 
availability of credit to sound borrowers.\4\ This guidance also states 
that examiners should ensure loans are being reviewed in a consistent, 
prudent, and balanced fashion to prevent inappropriate downgrades of 
credits. It is consistent with guidance issued in early 2007 addressing 
risk management of CRE concentrations, which states that institutions 
that have experienced losses, hold less capital, and are operating in a 
more risk-sensitive environment are expected to employ appropriate 
risk-management practices to ensure their viability.\5\
---------------------------------------------------------------------------
    \4\ See Board of Governors of the Federal Reserve System, Division 
of Banking Supervision and Regulation (1991), ``Interagency Examination 
Guidance on Commercial Real Estate Loans,'' Supervision and Regulation 
Letter SR 91-24 (November 7), www.Federalreserve.gov/BoardDocs/
SRLetters/1991/SR9124.htm; and Office of the Comptroller of the 
Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, 
and Office of Thrift Supervision (1991), ``Interagency Policy Statement 
on the Review and Classification of Commercial Real Estate Loans,'' 
joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/
SRLetters/1991/SR9124a1.pdf.
    \5\ See Board of Governors of the Federal Reserve System, Division 
of Banking Supervision and Regulation (2007), ``Interagency Guidance on 
Concentrations in Commercial Real Estate,'' Supervision and Regulation 
Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/
2007/SR0701.htm.
---------------------------------------------------------------------------
    We are currently in the final stages of developing interagency 
guidance on CRE loan restructurings and workouts. This guidance 
supports balanced and prudent decisionmaking with respect to loan 
restructuring, accurate and timely recognition of losses and 
appropriate loan classification. The guidance will reiterate that 
classification of a loan should not be based solely on a decline in 
collateral value, in the absence of other adverse factors, and that 
loan restructurings are often in the best interest of both the 
financial institution and the borrower. The expectation is that banks 
should restructure CRE loans in a prudent manner, recognizing the 
associated credit risk, and not simply renew a loan in an effort to 
delay loss recognition.
    On one hand, banks have raised concerns that our examiners are not 
always taking a balanced approach to the assessment of CRE loan 
restructurings. On the other hand, our examiners have observed 
incidents where banks have been slow to acknowledge declines in CRE 
project cash-flows and collateral values in their assessment of the 
potential loan repayment. This new guidance, which should be finalized 
shortly, is intended to promote prudent CRE loan workouts as banks work 
with their creditworthy borrowers and to ensure a balanced and 
consistent supervisory review of banking organizations.
    Guidance issued in November 2008 by the Federal Reserve and the 
other Federal banking agencies encouraged banks to meet the needs of 
creditworthy borrowers, in a manner consistent with safety and 
soundness, and to take a balanced approach in assessing borrowers' 
ability to repay and making realistic assessments of collateral 
valuations.\6\ In addition, the Federal Reserve has directed examiners 
to be mindful of the effects of excessive credit tightening in the 
broader economy and we have implemented training for examiners and 
outreach to the banking industry to underscore these intentions. We are 
aware that bankers may become overly conservative in an attempt to 
ameliorate past weaknesses in lending practices, and are working to 
emphasize that it is in all parties' best interests to continue making 
loans to creditworthy borrowers.
---------------------------------------------------------------------------
    \6\ See Board of Governors of the Federal Reserve System, FDIC, 
Office of the Comptroller of the Currency, and Office of Thrift 
Supervision (2008), ``Interagency Statement on Meeting the Needs of 
Creditworthy Borrowers,'' joint press release, November 12, 
www.Federalreserve.gov/newsevents/press/bcreg/20081112a.htm.
---------------------------------------------------------------------------
Strengthening the Supervisory Process
    The recently completed SCAP of the 19 largest U.S. bank holding 
companies demonstrates the effectiveness of forward-looking horizontal 
reviews and marked an important evolutionary step in the ability of 
such reviews to enhance supervision. Clearly, horizontal reviews--
reviews of risks, risk-management practices and other issues across 
multiple financial firms--are very effective vehicles for identifying 
both common trends and institution-specific weaknesses. The SCAP 
expanded the scope of horizontal reviews and included the use of a 
uniform set of stress parameters to apply consistently across firms.
    An outgrowth of the SCAP was a renewed focus by supervisors on 
institutions' own ability to assess their capital adequacy--
specifically their ability to estimate capital needs and determine 
available capital resources during very stressful periods. A number of 
firms have learned hard, but valuable, lessons from the current crisis 
that they are applying to their internal processes to assess capital 
adequacy. These lessons include the linkages between liquidity risk and 
capital adequacy, the dangers of latent risk concentrations, the value 
of rigorous stress testing, the importance of strong governance over 
their processes, and the importance of strong fundamental risk 
identification and risk measurement to the assessment of capital 
adequacy. Perhaps one of the most important conclusions to be drawn is 
that all assessments of capital adequacy have elements of uncertainty 
because of their inherent assumptions, limitations, and shortcomings. 
Addressing this uncertainty is one among several reasons that firms 
should retain substantial capital cushions.
    Currently, we are conducting a horizontal assessment of internal 
processes that evaluate capital adequacy at the largest U.S. banking 
organizations, focusing in particular on how shortcomings in 
fundamental risk management and governance for these processes could 
impair firms' abilities to estimate capital needs. Using findings from 
these reviews, we will work with firms over the next year to bring 
their processes into conformance with supervisory expectations. 
Supervisors will use the information provided by firms about their 
processes as a factor--but by no means the only factor--in the 
supervisory assessment of the firms' overall capital levels. For 
instance, if a firm cannot demonstrate a strong ability to estimate 
capital needs, then supervisors will place less credence on the firm's 
own internal capital results and demand higher capital cushions, among 
other things. Moreover, we have already required some firms to raise 
capital given their higher risk profiles. In general, we believe that 
if firms develop more-rigorous internal processes for assessing capital 
adequacy that capture all the risks facing those firms--including under 
stress scenarios--and maintain adequate capital based on those 
processes, they will be in a better position to weather financial and 
economic shocks and thereby perform their role in the credit 
intermediation process.
    We also are expanding our quantitative surveillance program for 
large, complex financial organizations to include supervisory 
information, firm-specific data analysis, and market-based indicators 
to identify developing strains and imbalances that may affect multiple 
institutions, as well as emerging risks to specific firms. Periodic 
scenario analyses across large firms will enhance our understanding of 
the potential impact of adverse changes in the operating environment on 
individual firms and on the system as a whole. This work will be 
performed by a multidisciplinary group composed of our economic and 
market researchers, supervisors, market operations specialists, and 
accounting and legal experts. This program will be distinct from the 
activities of onsite examination teams so as to provide an independent 
supervisory perspective, as well as to complement the work of those 
teams. As we adapt our internal organization of supervisory activities 
to build on lessons learned from the current crisis, we are using all 
of the information and insight that the analytic abilities the Federal 
Reserve can bring to bear in financial supervision.

Conclusion
    A year ago, the world financial system was profoundly shaken by the 
failures and other serious problems at large financial institutions 
here and abroad. Significant credit and liquidity problems that had 
been building since early 2007 turned into a full-blown panic with 
adverse consequences for the real economy. The deterioration in 
production and employment, in turn, exacerbated problems for the 
financial sector.
    It will take time for the banking industry to work through these 
challenges and to fully recover and serve as a source of strength for 
the real economy. While there have been some positive signals of late, 
the financial system remains fragile and key trouble spots remain, such 
as CRE. We are working with financial institutions to ensure that they 
improve their risk management and capital planning practices, and we 
are also improving our own supervisory processes in light of key 
lessons learned. Of course, we are also committed to working with the 
other banking agencies and the Congress to ensure a strong and stable 
financial system.
                                 ______
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 
                                 ______
                                 
               PREPARED STATEMENT OF JOSEPH A. SMITH, JR.
                 North Carolina Commissioner of Banks,
         on behalf of the Conference of State Bank Supervisors
                            October 14, 2009

INTRODUCTION
    Good afternoon, Chairman Johnson, Ranking Member Crapo, and 
distinguished members of the Subcommittee. My name is Joseph A. Smith, 
Jr. I am the North Carolina Commissioner of Banks and the Chairman of 
the Conference of State Bank Supervisors (CSBS).
    Thank you for the opportunity to testify today on the condition of 
the banking industry. In the midst of a great deal of discussion about 
reform and recovery, it is very important to pause to assess the health 
of the industry and the factors affecting it, for good and ill.
    My testimony today will present the views of state bank supervisors 
on the health of the banking industry generally and the banks we 
oversee in particular--the overwhelming majority of which are 
independent community banks. The states charter and regulate 73 percent 
of the nation's banks (Exhibit A). These banks not only compete with 
the nation's largest banks in the metropolitan areas, but many are the 
sole providers of credit to less populated and rural areas (Exhibit B). 
We must remember 91 percent of this country's banks have less than $1 
billion in assets but share most of the same regulatory burdens and 
economic challenges of the largest banks which receive the greatest 
amount of attention from the Federal Government. Community and regional 
banks are a critical part of our economic fabric, providing an 
important channel for credit for consumers, farmers, and small 
businesses.
    I will address: the key challenges that state-chartered banks face, 
regulatory policies that we are pursuing to improve supervision and the 
health of the industry, and recommendations to improve the regulation 
of our banks and ultimately the health of the industry.

CONDITION OF THE BANKING INDUSTRY
    While the economy has begun to show signs of improvement, there are 
still many areas of concern. Consumer confidence and spending remains 
low, deficit spending has soared, and unemployment rates continue to 
slowly tick upward. The capital markets crisis, distress in the 
residential and commercial real estate markets, and the ensuing 
recession have greatly weakened our nation's banking industry. And 
despite recent positive developments, the banking industry continues to 
operate under very difficult conditions. While there are pockets of 
strength in parts of the state bank system, the majority of my fellow 
state regulators have categorized general banking conditions in their 
states as ``gradually declining.'' Not surprisingly, the health of 
banks is directly affected by the economic conditions in which they 
operate. Times of economic growth will usually be fueled by a banking 
industry with sufficient levels of capital, a robust and increasing 
volume of performing loans, ample liquidity, and a number of new market 
entrants, in the form of de novo institutions. Conversely, this 
recession is characterized by a banking industry marred by evaporating 
capital levels, deteriorating and increasingly delinquent loans, 
liquidity crunches, and a steady stream of bank failures.
    The Federal Deposit Insurance Corporation (FDIC) reports in its 
most recent Quarterly Banking Profile that the banking industry 
suffered an aggregate net loss of $3.7 billion in the second quarter of 
2009. These losses were largely caused by the increased contributions 
institutions made to their loan-loss provisions to counter the rising 
number of non-performing loans in their portfolios and realized losses. 
Further, additional writedowns in the asset-backed commercial paper 
portfolios and higher deposit insurance assessments impacted banks' 
earnings significantly.\1\
---------------------------------------------------------------------------
    \1\ FDIC Quarterly Banking Profile, Second Quarter 2009: http://
www2.fdic.gov/qbp/2009jun/qbp.pdf.
---------------------------------------------------------------------------
    Across the country, my colleagues are experiencing deteriorating 
credit quality in their banks, which is straining earnings and putting 
extreme pressure on capital. Deterioration in credit quality is 
requiring greater examination resources as regulators evaluate a higher 
volume of loans. Concentrations in commercial real estate (CRE) loans 
in general, and acquisition, development, and construction (ADC) loans 
in particular, are posing the greatest challenge for a significant 
portion of the industry. This is an important line of business for 
community and regional banks. Banks with less than $10 billion in 
assets comprise 23 percent of total bank assets, but originate and hold 
52 percent of CRE loans and 49 percent of ADC loans by volume. Reducing 
the concentrations that many of our institutions have in CRE lending is 
an important factor in restoring them to health; however, it is our 
view that this reduction needs to be done in a way that does not remove 
so much credit from the real estate market that it inhibits economic 
recovery. Striking an appropriate balance should be our goal.
    Deteriorating credit quality has a direct and destructive effect on 
bank capital. Reduction in capital, in turn, has a direct and 
destructive effect on a bank's liquidity, drying up its sources of 
funding from secondary sources, including capital markets, brokered 
deposits, home loan and bankers' banks and the Federal Reserve. This 
drying up of liquidity has been a significant challenge for a 
substantial number of the failures.

CAPITAL IS KING
    As we entered the financial crisis, we touted the overall strong 
capital base of the industry, especially compared to previous periods 
of economic stress. While this was true, banks are highly leveraged 
operations, and when losses materialize, capital erodes quickly. While 
this is true for all institutions, it is more pronounced in our largest 
banks. According to the FDIC, as of December 31, 2007, banks over $10 
billion in assets had an average leverage capital ratio of 7.41 
percent. This was 200 basis points (b.p.) less than banks with assets 
between $1 billion and $10 billion; 256 b.p. less than banks with 
assets between $100 million and $1 billion; and an astonishing 610 b.p. 
less than banks with assets less than $100 million. As the financial 
crisis was unfolding and the serious economic recession began, these 
numbers show our largest institutions were poorly positioned, leading 
to the extraordinary assistance by the Federal Government to protect 
the financial system. Even with this assistance, this differential 
continues today with the largest institutions holding considerably less 
capital than the overwhelming majority of the industry.
    Last year, the Federal Government took unprecedented steps to 
protect the financial system by providing capital investments and 
liquidity facilities to our largest institutions. Financial holding 
company status was conferred on a number of major investment banks and 
other financial concerns with an alacrity that was jaw-dropping. We 
trust the officials responsible took the action they believed necessary 
at that critical time. However, Federal policy has not treated the rest 
of the industry with the same expediency, creativity, or fundamental 
fairness. Over the last year, we have seen nearly 300 community banks 
fail or be merged out of existence, while our largest institutions, 
largely considered too big to fail, have only gotten bigger. State 
officials expect this trend to continue, with an estimated 125 
additional unassisted, privately negotiated mergers due to poor banking 
conditions.
    Additional capital, both public and private, must be the building 
block for success for community and regional banks. While TARP has 
provided a source of capital for some of these institutions, the 
process has been cumbersome and expensive for the community and 
regional banks, whether they actually received the investment of funds 
or not. There has been a lack of transparency associated with denial of 
a TARP application, which comes in the form of an institution being 
asked to withdraw. This should of deep concern to Congress. If TARP is 
to be an effective tool to strengthen community and regional banks, the 
Treasury must change the viability standard. We should provide capital 
to institutions which are viable after the TARP investment. Expanded 
and appropriate access to TARP capital will go a long way to saving the 
FDIC and the rest of the banking industry a lot of money. To date, this 
has been a lost opportunity for the Federal Government to support 
community and regional banks and provide economic stimulus.
    There are positive signs private capital may be flowing into the 
system. For the 6 months ending June 30, 2009, over 2,200 banks have 
injected $96 billion in capital. While capital injections were achieved 
for all sizes of institutions, banks with assets under $1 billion in 
assets had the smallest percentage of banks raising capital at 25 
percent.
    There has been and, to our knowledge, there still is a concern 
among our Federal colleagues with regard to strategic investments in 
and acquisitions of banks, both through the FDIC resolution process and 
in negotiated transactions. While these concerns are understandable, we 
believe they must be measured against the consequence of denying our 
banks this source of capital. It is our view that Federal policy should 
not unnecessarily discourage private capital from coming off the 
sidelines to support this industry and in turn, the broader economy.

SUPERVISION DURING THE CRISIS
    There are very serious challenges facing the industry and us as 
financial regulators. State regulators have increased their outreach 
with the industry to develop a common understanding of these 
challenges. Banks are a core financial intermediary, providing a safe 
haven for depositors' money while providing the necessary fuel for 
economic growth and opportunity. While some banks will create-and have 
created-their own problems by miscalculating their risks, it is no 
surprise that there are widespread problems in banks when the national 
economy goes through a serious economic recession.
    We will never be able, nor should we desire, to eliminate all 
problems in banks; that is, to have risk-free banking. While they are 
regulated and hold the public trust, financial firms are largely 
private enterprises. As such, they should be allowed to take risks, 
generate a return for shareholders, and suffer the consequences when 
they miscalculate. Over the last year, we have watched a steady stream 
of bank failures. While unfortunate and expensive, this does provide a 
dose of reality to the market and should increase the industry's self-
discipline and the regulators' focus on key risk issues. In contrast to 
institutions deemed too big to fail, market discipline and enhanced 
supervisory oversight can result in community and regional banks that 
are restructured and strengthened.

Recognizing the Challenges
    The current environment, while providing terrific challenges with 
credit quality and capital adequacy, has also brought an opportunity 
for us to reassess the financial regulatory process to best benefit our 
local and national economies. To achieve this objective, it is vital to 
step back and make an honest assessment of our regulated institutions, 
their lines of business, management ability, and capacity to deal with 
economic challenges. This assessment provides the basis for focusing 
resources to address the many challenges we face.
    With regard to financial institutions, as regulators we must do a 
horizontal review and engage in a process of ``triage'' that divides 
our supervised entities into three categories:

    I. Strong

    II. Tarnished

    III. Weak

    Strong institutions have the balance sheets and management capacity 
to survive, and even thrive, through the current crisis. These 
institutions will maintain stability and provide continued access to 
credit for consumers. Further, these institutions will be well-
positioned to purchase failing institutions, which is an outcome that 
is better for all stakeholders than outright bank failure. We need to 
ensure these institutions maintain their positions of strength.
    Tarnished institutions are under stress, but are capable of 
surviving the current crisis. These institutions are where our efforts 
as regulators can make the biggest difference. Accordingly, these 
institutions will require the lion's share of regulatory resources. A 
regulator's primary objective with these institutions should be to 
fully and accurately identify their risks, require generous reserves 
for losses, and develop the management capacity to work through their 
problems. We have found that strong and early intervention by 
regulators, coupled with strong action by management, has resulted in 
the strengthening of our banks and the prevention of further decline or 
failure. By coordinating their efforts, state and Federal regulators 
can give these banks a good chance to survive by setting appropriate 
standards of performance and avoiding our understandable tendencies to 
over-regulate during a crisis.
    Weak institutions are likely headed for failure or sale. While this 
outcome may not be imminent, our experience has shown that the sooner 
we identify these institutions, the more options we will have to seek a 
resolution which does not involve closing the bank. It simply is not in 
our collective best interest to allow an institution to exhaust its 
capital and to be resolved through an FDIC receivership, if such an 
action can be avoided. Institutions we believe are headed toward almost 
certain failure deserve our immediate attention. This is not the same 
as bailing out, or propping up failing institutions with government 
subsidies. Instead, as regulators our goal is an early sale of the 
bank, or at least a ``soft landing'' with minimal economic disruption 
to the local communities they serve and minimal loss to the Deposit 
Insurance Fund.

AREAS REQUIRING ATTENTION
    This is the time for us to be looking forward, not backwards. We 
need to be working to proactively resolve the problems in the banking 
industry. To do this, we need to ensure our supervisory approach is 
fair and balanced and gives those banks which deserve it the chance to 
improve their financial positions and results of operations. The 
industry and regulators must work together to fully identify the scope 
of the problems. However, I believe we need to consider the response 
which follows the identification. We should be tough and demanding, but 
the response does not need to send so many banks toward receivership. A 
responsive, yet reasonable approach, will take a great deal of time and 
effort, but it will result in less cost to the Deposit Insurance Fund 
and benefit communities and the broader economy in the long-run. I 
would like to highlight a few areas where I have concerns.

Increase Access to Capital
    First, as discussed earlier, we need to allow capital to flow into 
the system. There is a significant amount of capital which is seeking 
opportunities in this market. We need to encourage this inflow through 
direct investments in existing institutions and the formation of new 
banks. To the extent that private investors do not themselves have bank 
operating experience or intend to dismantle institutions without 
consideration of the social and economic consequences, such 
shortcomings can and should be addressed by denial of holding company 
or bank applications or through operating restrictions in charters or 
regulatory orders. Where private equity groups have employed seasoned 
management teams and proposed acceptable business plans, such groups 
should be granted the necessary regulatory approvals to invest or 
acquire. While we cannot directly fix the capital problem, we should 
ensure the regulatory environment does not discourage private capital.

Expedite Mergers
    Second, we need to allow for banks to merge, especially if it 
allows us to resolve a problem institution. Unfortunately, we have 
experienced too many roadblocks in the approval process. We need more 
transparency and certainty from the Federal Reserve on the process and 
parameters for approving mergers. To be clear, I am not talking about a 
merger of two failing institutions. Facilitating the timely merger of a 
weak institution with a stronger one is good for the system, good for 
local communities, and is absolutely the least cost resolution for the 
FDIC.

Brokered Deposits
    Third, over the last several years the industry has explored more 
diversified funding, including the use of brokered deposits. Following 
the last banking crisis, there are restrictions for banks using 
brokered deposits when they fall below ``well capitalized.'' I 
appreciate the efforts of FDIC Chairman Bair in working to provide more 
consistency and clarity in the application of this rule. However, I am 
afraid the current approach is unnecessarily leading banks to fail. We 
allowed these banks to increase their reliance on this funding in the 
first place, and I believe we have a responsibility to assist them in 
gradually unwinding their dependency as they work to clean up their 
balance sheet. My colleagues have numerous institutions that could have 
benefited from a brokered deposit waiver granted by the FDIC. As noted 
above, many of the recent failures of community and regional banks have 
been the result of a sudden and precipitous loss of liquidity.

Open Bank Assistance
    Fourth, the FDIC is seriously constrained in providing any 
institution with open bank assistance. We are concerned that this may 
be being too strictly interpreted. We believe there are opportunities 
to provide this assistance which do not benefit the existing 
shareholders and allows for the removal of bank management. This is a 
much less disruptive approach and I believe will prove to be much less 
costly for the FDIC. The approach we suggest was essentially provided 
to Citibank and Bank of America through loan guarantees without 
removing management or eliminating the stockholders. As discussed 
previously, we believe that the Capital Purchase Program under TARP can 
be a source of capital for transactions that restructure banks or 
assist in mergers to the same effect. We are not suggesting that such 
support be without conditions necessary to cause the banks to return to 
health.

Prompt Corrective Action
    Finally, Congress should also investigate the effectiveness of the 
Prompt Corrective Action (PCA) provisions of the Federal Deposit 
Insurance Corporation Improvement Act in dealing with problem banks. We 
believe there is sufficient evidence that the requirements of PCA have 
caused unnecessary failures and more costly resolutions and that 
allowing regulators some discretion in dealing with problem banks can 
assist an orderly restructuring of the industry.

LOOKING FORWARD
    There will be numerous legacy items which will emerge from this 
crisis designed to address both real and perceived risks to the 
financial system. They deserve our deliberate thought to ensure a 
balanced and reasoned approach which provides a solid foundation for 
economic growth and stability.
    The discussions around regulatory reform are well underway. We 
would do well to remember the instability of certain firms a year ago 
which put the U.S. financial system and economy at the cliff's edge. We 
must not let the bank failures we are seeing today cloud the real and 
substantial risk facing our financial system--firms which are too big 
to fail, requiring extraordinary government assistance when they 
miscalculate their risk.
    We need to consider the optimal economic model for community banks, 
one that embraces their proximity to communities and their ability to 
engage in high-touch lending. However, we must ensure lower 
concentrations, better risk diversification, and improved risk 
management. We need to find a way to ensure banks are viable 
competitors for consumer finance and ensure they are positioned to lead 
in establishing high standards for consumer protection and financial 
literacy.
    We must develop better tools for offsite monitoring. The banking 
industry has a well established and robust system of quarterly data 
reporting through the Federal Financial Institutions Examination 
Council's Report of Condition and Income (Call Report). This provides 
excellent data for use by all regulators and the public. We need to 
explore greater standardization and enhanced technology to improve the 
timeliness of the data, especially during times of economic stress.
    Over the last several years, the industry has attracted more 
diversified sources of funding. This diversification has improved 
interest rate risk and liquidity management. Unfortunately, secured 
borrowings and brokered deposits increase the cost of resolution to the 
FDIC and create significant conflicts as an institution reaches a 
troubled condition. We need to encourage diversified sources of 
funding, but ensure it is compatible with a deposit insurance regime.
    We need to consider how the Deposit Insurance Fund can help to 
provide a countercyclical approach to supervision. We believe Congress 
should authorize the FDIC to assess premiums based on an institution's 
total assets, which is a more accurate measure of the total risk to the 
system. Congress should revisit the cap on the Fund and require the 
FDIC to build the Fund during strong economic times and reduce 
assessments during period of economic stress. This type of structure 
will help the entire industry when it is most needed.

CONCLUSION
    The banking industry continues to face tremendous challenges caused 
by the poor economic conditions in the United States. To move through 
this crisis and achieve economic stability and growth, Members of 
Congress, state and Federal regulators, and members of the industry 
must coordinate efforts to maintain effective supervision, while 
exercising the flexibility and ingenuity necessary to guide our 
industry to recovery.
    Thank you for the opportunity to testify today, and I look forward 
to any questions you may have.





                                 ______
                                 
                 PREPARED STATEMENT OF THOMAS J. CANDON
     Deputy Commissioner, Vermont Department of Banking, Insurance,
               Securities, and Health Care Administration
on behalf of the National Association of State Credit Union Supervisors
                            October 14, 2009

Introduction
    Honorable Chairman Johnson, Ranking Member Crapo and the 
distinguished members of the Financial Institutions Subcommittee of the 
Senate Banking, Housing and Urban Affairs Committee, thank you for the 
opportunity to testify before this Subcommittee on the State of the 
Banking Industry. I am Thomas J. Candon, Deputy Commissioner of Banking 
and Securities for the Vermont Department of Banking, Insurance, 
Securities and Health Care Administration. I am pleased to be here on 
behalf of state credit union regulators as Chairman of the National 
Association of State Credit Union Supervisors \1\ (NASCUS). In this 
prepared testimony, I will share state credit union regulators' 
perspectives on the condition of state-chartered credit unions and 
areas for reform.
---------------------------------------------------------------------------
    \1\ NASCUS is the professional association of the 48 state credit 
union regulatory and territorial agencies that charter and supervise 
the nation's 3,100 state-chartered credit unions.
---------------------------------------------------------------------------
    NASCUS has been committed to enhancing state credit union 
supervision and advocating for a safe and sound state credit union 
system since its inception in 1965. NASCUS is the sole organization 
dedicated exclusively to the promotion of the dual chartering system 
and advancing the autonomy and expertise of state credit union 
regulatory agencies.
    The state credit union system is 100 years old. Today, there are 
3,065 state-chartered credit unions with a combined $404 billion in 
assets.\2\ State-chartered credit unions represent 40 percent of the 
nation's nearly 7,700 credit unions.
---------------------------------------------------------------------------
    \2\ As of June 30, 2009.
---------------------------------------------------------------------------
    At this hearing, the Subcommittee is assessing the state of 
financial institutions, areas of concern as well as capital and lending 
needs. In this testimony, I will detail information from state 
regulators on the following:

    Condition of state-chartered credit unions

    Corporate credit union impact

    Credit union capital needs

    Regulatory considerations for member business lending

    Trends and regulatory response

    Value and strength of state supervision

Condition of state-chartered credit unions
    Like all financial institutions, state credit unions have been 
adversely affected by the economic downturn. However, at this point, 
state natural person credit unions remain generally healthy and 
continue to serve the needs of their members and their communities. For 
the most part, natural person credit unions did not engage in many of 
the practices that have precipitated the current market downturn.
    Nationally, the average credit union net worth is down to 10.03 
percent, with 96 percent of all federally insured credit unions having 
more than 7 percent in capital as of June 30, 2009. Further, the 
percentage of delinquent loans is 1.58 percent for all credit union 
loans.
     State-chartered credit unions in my state of Vermont have the 
capability to lend due to an increase in deposits that we attribute to 
a flight to safety. Consumer loans are available to members although 
underwriting continues to be based on a member's ability to repay. At 
this time, Vermont credit unions do not make many member business loans 
and have nominal commercial real estate loans on their balance sheets. 
Our regulatory focus is on the amount of capital held by some of our 
credit unions and the impact of the growing unemployment picture on 
delinquencies.
    The capital of Vermont credit unions is affected by the growth of 
deposits which were up 24.73 percent in Vermont as of June 30, 2009, 
and the impact of the corporate credit union losses (which I will 
discuss later). Income is also being reduced as margins are squeezed 
and credit union members are struggling to make loan payments.
    In Vermont, our small credit unions like many around the country 
are not only affected by a downturn in the economy but also by 
increasing regulatory burden. We continue to see mergers as long-time 
managers retire and volunteer boards cannot keep up with the increased 
demands. As state regulators we monitor our credit unions closely. If 
there is any sign of distress, we have an examiner communicating with 
the credit union to make sure we understand what needs to be done to 
correct the problems.
    As the Subcommittee knows, the effect of the economy on financial 
institutions varies from region to region. Some regions are weathering 
significant impacts from the destabilized real estate market, while 
others are addressing more localized economic issues. In many cases, 
state regulators are concerned about unemployment and its impact on 
members' ability to meet their obligations. State regulators are also 
concerned about the growing number of delinquencies, charge-offs and 
pressures on earnings, especially in smaller state-chartered credit 
unions. While loan delinquency and net charge-offs have generally 
increased for state-chartered credit unions, state regulators indicate 
that the levels remain manageable.
    State regulators also report increased scrutiny on consumer credit 
products, including auto loans, credit cards and other consumer credit 
portfolios given the nation's economic condition. State credit union 
regulators are cognizant of credit unions' future financial performance 
as commercial credit problems begin to affect consumer credits. The 
weak economy creates a tightening of commercial credit, an issue being 
closely monitored by state regulators.
    Some states, including my home state of Vermont, have not 
experienced the fallout from commercial or subprime lending as our 
state-chartered credit unions did not engage in those activities. State 
regulators continue to encourage their credit unions to exercise sound 
underwriting, proper risk management and due diligence, the elements 
that have kept credit unions in a better position throughout this 
economic downturn. Further, state regulators are monitoring red flags 
closely, fully utilizing offsite monitoring and using early warning 
systems to detect risk.
    The growing trend toward consolidation is also on the minds of 
state regulators as credit union mergers continue to occur, both 
voluntarily and for regulatory purposes. As economic pressures persist, 
finding suitable merger partners may become more difficult. State 
regulators recognize this dilemma and see merger issues as an ongoing 
concern in 2010.
    In addition, growth is an issue state regulators are paying close 
attention to in today's environment. The National Credit Union 
Administration (NCUA) reported in its Financial Trends in federally 
Insured Credit Unions for January-June 2009 an annualized asset growth 
rate of 14.53 percent. This growth gives rise to concerns about 
interest rate risk and the need to ensure quality asset/liability and 
balance sheet management among credit unions.

Corporate Credit Union Impact
    As I noted earlier, one of the issues affecting both state and 
Federal credit unions is the impact of problems in the corporate credit 
union network. Allow me to elaborate. In addition to direct economic 
pressures, credit unions are addressing indirect economic pressures by 
way of the impact of losses from corporate credit unions. The 
deterioration of asset-backed securities held by two Federal corporate 
credit unions (U.S. Central Corporate Federal Credit Union and Western 
Corporate Federal Credit Union) and their consequent conservatorship by 
the NCUA have resulted in considerable balance sheet impact on natural 
person credit unions.
    For the first time in nearly 20 years, the NCUA Board approved a 
credit union premium in September 2009 with the assessment of 0.15 
percent of insured shares. The premium will both restore the National 
Credit Union Share Insurance Fund (NCUSIF) equity to 1.30 percent and 
begin to repay a portion of the Temporary Corporate Credit Union 
Stabilization Fund borrowings from the U.S. Treasury.
    State regulators, in consultation with Federal regulators, are 
working to address the impact of corporate losses and to make 
regulatory improvements to mitigate recurrence. As the NCUA develops 
its proposed rule for regulation of corporate credit unions, state 
regulators continue to stress the following principles:

    Enhance supervision and tighten regulatory standards

    Properly assess risk problems

    Preserve equal opportunity for all corporates to compete as 
        long as they remain safe and sound and retain the support of 
        their members

    Guard against preemption of state authority and 
        homogenization of the corporate system

    State regulators have also cautioned the NCUA against regulation 
that would unnecessarily or adversely impact safe and sound corporate 
credit unions that have properly managed their investments and remain 
fully supported by their members.
    NCUA has been working cooperatively with state regulators to 
institute revisions to the agency's Part 704 corporate credit union 
regulations to strengthen the safety and soundness of the corporate 
system. Regulators should continue to focus on ensuring any credit 
union, natural person or corporate, has robust risk management and 
mitigation policies in place to balance its investment portfolios. Such 
policies should include adequate reserves, requisite expertise, 
meaningful shock testing and valuation mechanisms as well as 
concentration limits. NASCUS believes there is no question that after 
recent events corporate credit unions must retain higher capital 
reserves. NCUA should work with NASCUS and state regulators to develop 
more comprehensive capital requirements, including risk-based capital.
    The regulatory capital program for corporate credit unions should 
consider an institution's status as a wholesale or retail corporate, 
its mix of products and services (investment, payment systems, pass 
through, etc.) and establish parameters of actions for state and 
Federal regulators if capital falls below defined thresholds.
    Capital is important to both the corporate credit union system and 
the natural person credit unions that support the corporate credit 
unions. During the corporate stabilization process, supplemental 
capital may have mitigated some of the unintended consequences to net 
worth categories at natural person credit unions. Further, access to a 
risk-based capital system would foster safety and soundness for the 
entire credit union system.

Credit Union Capital Needs
    The majority of credit unions are weathering conditions today; 
however, as stated previously, credit unions' earnings are suffering 
and credit unions are losing money. We need to act now to ensure credit 
unions remain as safe and sound as possible. NASCUS has long supported 
comprehensive capital reform for credit unions and believes that given 
the current economic climate, reform in this area is critical and 
timely. Credit unions need more ways to raise capital, notably access 
to supplemental capital. NASCUS continues to encourage the Senate 
Banking Committee to consider credit union capital reform as part of 
its financial reform efforts.
    Unlike other financial institutions, credit union access to capital 
is limited to reserves and retained earnings from net income. Since net 
income is not easily increased in a fast-changing environment, state 
regulators recommend additional capital-raising capabilities for credit 
unions. Access to supplemental capital will enable credit unions to 
respond proactively to changing market conditions, enhancing their 
future viability and strengthening their safety and soundness. 
Supplemental capital would serve as an extra layer of protection for 
the credit union deposit insurance fund as well.
    Allowing credit unions access to supplemental capital with 
regulatory approval and robust oversight will improve their ability to 
react to market conditions, grow safely into the future and serve their 
members in this challenged economy. It would also provide a tool for 
credit unions to use if they face declining net worth or liquidity 
needs. We feel strongly that now is the time to permit this important 
change.
    NASCUS follows several guiding principles in our quest for 
supplemental capital for credit unions. First, a capital instrument 
must preserve the not-for-profit, mutual, member-owned and cooperative 
structure of credit unions. Next, it must provide for full disclosures, 
investor protection and robust safeguards. Prudential safety and 
soundness requirements must be maintained for these investments and 
supplemental capital must preserve credit unions' tax-exempt status. 
Finally, regulatory approval would be required before a credit union 
could access supplemental capital.
    It is NASCUS' studied belief that a change to the Federal Credit 
Union Act could provide this valuable tool to the credit union system 
without altering the not-for-profit, mutual, cooperative structure of 
credit unions as tax exempt member owned financial institutions. We 
realize that supplemental capital will not be appropriate for every 
credit union, nor would every credit union need access to supplemental 
capital. This is why NASCUS supports regulator approval as a pre-
condition for credit unions issuing supplemental capital.
    A task force of NASCUS state regulators is currently studying 
supplemental capital for credit unions with the NCUA. This regulatory 
group is researching the appropriate regulatory parameters for 
supplemental capital for credit unions.
    As this Subcommittee addresses regulatory reform and other 
legislation this fall, NASCUS encourages favorable consideration of 
access to supplemental capital for credit unions.

Regulatory Considerations for Member Business Lending
    Credit union member business lending, when conducted within proper 
regulatory controls, has proved beneficial for credit unions, their 
members, and their communities. However, while some credit unions are 
actively engaged in member business lending, many are not. As Congress 
considers changes to credit unions' member business lending 
capabilities, state regulators will work with the NCUA in its capacity 
as the insurer to build regulatory parameters for proper oversight 
through the examination and supervision process. Further, credit unions 
must have a thorough understanding of member business lending and be 
diligent in their written policies, underwriting and controls for the 
practice to be conducted in a safe and sound manner. From a prudential 
regulator view, an arbitrary cap on member business lending is less 
important than proper underwriting and thorough reporting of all 
business loans.

Trends and Regulatory Response
    I would like to respond to the Subcommittee's request for 
information regarding developing trends, concerns and state regulatory 
responses to today's challenges. Rising unemployment continues to be a 
concern and we expect that it will continue to negatively impact state 
credit unions well into 2010 as delinquencies and bankruptcies continue 
to increase.
    Some state regulators have seen a marked increase in loan 
delinquencies and net charge-offs at June 2009; however, the levels 
remain manageable. Earnings pressures continue so credit unions are 
seeking ways to reduce overhead expenses. Loan demand has slowed 
somewhat in the mid-to smaller credit unions; a contrast to the 
increased indirect lending activities experienced in the larger credit 
unions. State regulators are closely monitoring both lending and 
investment activities within their credit unions and continue to stress 
the importance of sound underwriting and due diligence at the board 
level. State regulators also continue to supervise their institutions 
closely through offsite monitoring and onsite examinations and 
visitations. Credit unions need to understand their portfolio makeup 
and the impact that an increasing rate environment will have on their 
institutions.
    Another economic stressor affecting small credit unions is the 
uncertainty of losing their core field of membership if comprised of 
select employee groups. Because some small credit unions still rely on 
one or two employers for their members, if those businesses do not 
survive, the credit union will not survive either.
Value and Strength of State Supervision
    In this challenged economic environment, state regulators have 
demonstrated the importance of local supervision of state-chartered 
institutions and the value of a dual regulatory regime. State 
regulators are properly tuned into both their institutions and the 
specific needs of local consumers. Further, state regulators have the 
expertise to identify risk areas and take enforcement actions where 
necessary. With respect to consumer protection, state regulators are 
directly accountable to Governors and state legislatures, who in turn 
are directly accountable to their consumer citizens. It is for this 
reason that many states have always emphasized consumer protection 
along with safety and soundness in financial services oversight. As 
regulatory modernization efforts are considered by the Senate Banking 
Committee, we encourage you to retain state supervision and uphold 
state authority. Further, we ask you to recognize the essential value 
of dual chartering to financial institution's ability to innovate.
    Finally, as we talk about dual chartering, I wanted to note our 
regulatory partners, the National Credit Union Administration. In my 
state of Vermont, all of my credit unions are federally insured, and 
therefore subject to share insurance oversight from NCUA in addition to 
state safety and soundness and compliance regulation and supervision. 
We work extremely well with NCUA, and I believe our strong cooperative 
relationship has contributed substantially to the stability of the 
credit union system in my region. Indeed, this cooperative relationship 
between state regulators and the NCUA exists throughout the Nation as 
well.
    NASCUS would be pleased to provide any additional information you 
deem appropriate as you work through these matters. While the current 
economic climate has an unquestionable adverse impact on the state 
credit union system, I remain confident that the generally sound 
management of credit unions combined with ongoing vigilant state 
regulatory oversight has enabled the credit union system to prudently 
meet their members' needs. Thank you for your attention.

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM SHEILA C. 
                              BAIR

Q.l. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

A.l. Small and medium-sized financial institutions hold a 
significant dollar amount of commercial real estate loans on 
their balance sheets. Many of these smaller institutions were 
not active in the commercial real estate mortgage 
securitization market because of the comparatively small dollar 
amount of the loans and the nature of customer-focused 
relationships in community banking. Therefore, we do not 
believe the TALF has had a significant effect on the 
availability of credit for smaller commercial real estate 
loans.
    In terms of encouraging commercial real estate lending, the 
Federal banking agencies issued a policy statement on October 
30, 2009, titled Prudent Commercial Real Estate Loan Workouts. 
The Statement encourages banks to continue making good loans to 
commercial real estateborrowers and work with borrowers 
experiencing difficulties in their repayment capacity because 
of the economic downturn.
    The TALF was designed to increase credit availability for 
businesses and consumers by facilitating renewed issuance of 
securities backed by loans to consumers and businesses at more 
normal interest rate spreads. Based on recent TALF transactions 
involving commercial real estate mortgage loans, the program 
appears to have encouraged capital to enter the securitization 
market. As the Federal Reserve Bank of New York is facilitating 
the TALF program, the Senator may want to consult with the 
Reserve Bank on the program's performance and success in 
encouraging capital to return to the commercial real estate 
market.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.2. Following publication of the Notice of Proposed Rulemaking 
on September 15, 2009, the bank regulatory agencies received 41 
comments from banks, bank holding companies, banking industry 
associations, mortgage companies, investment and asset 
management firms, and individuals. A number of commenters 
indicated that implementation of FAS 166 and FAS 167 without 
changes to the Agencies' risk-based capital rules would 
negatively impact financial markets and curtail lending due to 
higher regulatory capital requirements resulting from the 
consolidation of significant amounts of assets onto banking 
organizations' balance sheets. Commenters also argued that such 
implementation would inappropriately align capital requirements 
with GAAP's control-based approach to consolidation, in 
contrast to the credit risk focus of the Agencies' risk-based 
capital rules. The commenters overwhelmingly supported a delay 
or phase-in of the regulatory capital requirements resulting 
from the implementation of FAS 166 and FAS 167.
    In response the FDIC, working with the other Federal bank 
regulatory agencies, developed a final rule to better align 
regulatory capital requirements with the actual risks of 
certain exposures. Banks affected by the new accounting 
standards generally will be subject to higher minimum 
regulatory capital requirements. The final rule provides an 
optional delay and phase-in for a maximum of 1 year for the 
effect on risk-based capital and the allowance for loan and 
lease losses related to the assets that must be consolidated as 
a result of the accounting change. The final rule also 
eliminates the risk-based capital exemption for asset-backed 
commercial paper assets. The transitional relief does not apply 
to the leverage ratio or to assets in conduits to which a bank 
provides or has provided implicit support.
    The Final Rule was passed by the FDIC Board of Directors on 
December 15, 2009. The rule provides temporary relief from 
risk-based measures in order to avoid abrupt adjustments that 
could undermine or complicate government actions to support the 
provision of credit to U.S. households and businesses in the 
current economic environment. Banks will be required to rebuild 
capital and repair balance sheets to accommodate the new 
accounting standards by the beginning of 2011. The optional 
delay and phase-in provides capital relief to ease the impact 
of the accounting change on bank's regulatory capital 
requirements, and enable banks to maintain consumer lending and 
credit availability as they adjust their business practices to 
the new accounting rules.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOHN DUGAN

Q.l. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other steps should regulators be taking to address 
this problem?

A.l. The Federal Reserve's Term Asset-Backed Securities Loan 
Facility (TALF) is intended to help make credit available to 
consumers and businesses by facilitating the issuance of asset-
backed securities (ABS) and by improving the conditions for ABS 
more generally. Until recently, most of the financing conducted 
with TALF facilities has been concentrated in automobile and 
credit card ABS securities. The use of TALF to help restart the 
commercial mortgage-backed securities (CMBS) markets has lagged 
due to the complexity and level of due diligence required for 
these types of transactions.
    The use of the TALF program to assist the CMBS market took 
a positive step forward on November 16, 2009, when U.S. mall 
owner Developers Diversified Realty Corp sold $400 million of 
securities with the help of TALF financing. The $323 million 
TALF eligible AAA-rated portion was priced at under 4 percent, 
a much better rate than originally anticipated. This issuance 
is indicative of a key potential benefit of CMBS TALF: it 
provides a reasonable cost for senior debt, allowing liquidity 
to flow back into the market. However, it does not by itself 
solve the problem of overleveraged borrowers. Since TALF 
financing is only available for AAA-rated debt, it would likely 
not directly benefit many of the problem borrowers sitting on 
the books of the banks today. However, there is an indirect 
benefit in that it provides market liquidity. Investors will 
likely use this initial deal as a benchmark, which could 
encourage other capital into the commercial real estate market. 
Because of this potential benefit, many market participants 
would like to see the current deadlines for the TALF program 
extended beyond the current deadlines of June 30, 2010, for 
newly issued CMBS and March 31, 2010, for legacy CMBS (i.e., 
deals issued before 1/1/09).
    Although there has been some modest improvement in 
liquidity within the CMBS market, the underlying fundamentals 
for many commercial real estate segments are still weak with 
delinquency, nonaccrual, and loss levels still increasing. 
Ultimately, the credit fundamentals of the industry need to 
stabilize in order for investors, bankers, and borrowers to 
fully understand pricing of commercial real estate assets.
    Banking regulators have a limited ability to directly 
encourage capital investment into the commercial real estate 
industry. We are mindful, however, that our actions must not 
put up unreasonable barriers to take flow of capital. At the 
OCC, we are encouraging bankers to work with their borrowers, 
and we continue to stress to examiners the need to take a 
measured, balanced approach when evaluating loan and borrower 
performance in this economic environment. We have stressed that 
we expect and encourage bankers to work with borrowers who may 
be facing financial difficulty, and to extend new credit to 
creditworthy borrowers when these actions are done in a prudent 
and safe and sound manner. In an effort to promote clarity and 
consistency in the industry, the OCC, in conjunction with the 
other Federal banking agencies and the FFIEC's State Liaison 
Committee, recently issued a Policy Statement on Prudent 
Commercial Real Estate (CRE) Loan Workouts. The policy 
statement reiterates the agencies' view that prudent CRE loan 
workouts are often in the best interest of the financial 
institution and the borrower, and establishes clear regulatory 
expectations for the industry when working with borrowers. The 
statement notes that examiners should not criticize banks for 
engaging in an effective workout program even if the 
restructured loan has a weakness that results in an adverse 
credit classification. The statement also reiterates our policy 
that loans should not be classified simply because the 
underlying values have declined to amounts that are less than 
the current loan balance. Instead, classifications must be 
based on an analysis of the borrower's ability and capacity to 
repay. To help promote greater consistency both within and 
across the agencies in making such determinations, the policy 
statement provides real world examples that our examiners are 
seeing, and provides guidance on when classification and write-
downs are and are not warranted.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend, and how do you 
intend to implement the changes?

A.2. Upon implementing FAS 166 and FAS 167, banking 
organizations will be required to consolidate certain assets 
and liabilities that are currently held in variable interest 
entities (VIEs)\1\ that these organizations do not consolidate 
under current generally accepted accounting principles (GAAP) 
standards. Certain banking organizations have reported that the 
consolidation of variable interest entities will result in a 
significant increase in assets reported on-balance sheet at the 
time the new accounting standards become effective, which will 
be January 1, 2010, for banking organizations with a calendar 
year end. Moreover, except for VIEs that a banking organization 
consolidates at fair value, consolidation will require the 
banking organization to recognize an allowance for loan and 
lease losses for loans held in consolidated VIEs.
---------------------------------------------------------------------------
    \1\ A VIE is a business structure that allows an investor to hold a 
controlling interest in the entity, without that interest translating 
into possessing enough voting privileges to result in a majority. VIEs 
generally are thinly capitalized entities and include many ``special 
purpose entities'', or ``SPEs.''
---------------------------------------------------------------------------
    On September 16, 2009, the Federal banking agencies 
(Agencies) published in the Federal Register a notice of 
proposed rulemaking (NPR) regarding the effect of the 
accounting changes under FAS 166 and FAS 167 would have on 
capital requirements under the regulatory capital rules. The 
NPR noted that banking organizations had provided non-
contractual support to VIEs that they sponsored in order to 
prevent senior securities in the structure from being 
downgraded, thereby mitigating reputational risk and the 
associated alienation of investors, and preserving access to 
cost-effective funding. In light of these actions taken by 
banking organizations, the NPR stated that the Agencies believe 
that the broader accounting consolidation requirements of FAS 
166 and FAS 167 will result in a regulatory capital treatment 
that more appropriately reflects the risks to which banking 
organizations are exposed. For these and other reasons, the NPR 
did not propose changing the regulatory capital rules to 
mitigate the effect of FAS 166 and FAS 167 on banking 
organizations' minimum regulatory capital requirements.\2\
---------------------------------------------------------------------------
    \2\ The NPR proposed the following three changes to the agencies 
regulatory capital rules: (1) eliminate provisions in the agencies' 
risk-based capital rules that allow banking organizations to exclude 
consolidated asset-backed commercial paper (ABCP) program assets from 
risk-weighted assets and instead assess a risk-based capital 
requirement against contractual exposures of the organization to such 
ABCP programs (ABCP exclusion); (2) eliminate a provision in the risk-
based capital rules that excludes from tier 1 capital the minority 
interest in a consolidated ABCP programs subject to the ABCP exclusion; 
and (3) add a new reservation of authority for the agencies' risk-based 
capital rules to permit a banking organization's primary Federal 
supervisor to treat entities not consolidated under GAAP as if they 
were consolidated for risk-based capital purposes, commensurate with 
the risk relationship of the banking organization to the entity.
---------------------------------------------------------------------------
    Before issuing the NPR, the Agencies carefully considered 
the probable effect on banking organizations' financial 
regulatory capital ratios and financial condition that will 
result from implementing FAS 166 and FAS 167. Among other 
sources, the Agencies considered information obtained through 
the Supervisory Capital Assessment Program (SCAP)--the recent 
stress test of the nineteen largest U.S. banking organizations. 
The SCAP directly considered the likely on-boarding of assets 
resulting from changes in accounting standards in the 
assessment of risk-weighted assets and the associated ALLL 
needs of the stress-tested banks. Moreover, the NPR sought 
information and comments on a number of questions, including 
the effect of the accounting changes on banking organizations' 
financial position and lending, as well as the effect on 
financial markets. The NPR also solicited comments on whether 
there are significant costs or burdens associated with 
implementing FAS 166 and FAS 167, and whether the Agencies 
should consider a phase-in of the capital requirements that 
would result from the GAAP changes.
    Based on an analysis of available information, including 
comments received on the NPR, the Agencies have finalized work 
on this rulemaking and expect to publish a final rule in the 
Federal Register shortly. The Agencies have long maintained 
that banking organizations should hold capital commensurate 
with the level and nature of the risks to which they are 
exposed. The Agencies use risk-based capital rules, 
supplemented by a leverage capital rule (collectively, 
regulatory capital rules) to evaluate capital adequacy of 
banking organizations. In the regulatory capital rules, the 
Agencies use GAAP as the initial basis for determining whether 
an exposure is treated as an on- or off-balance sheet asset. In 
the final rule, the Agencies continue to make use of GAAP 
concepts within the regulatory capital regime by recognizing 
VIEs consolidated under FAS 167, and the risks associated with 
those assets, in their risk-based capital ratios. However, in 
order to avoid abrupt adjustments that could undermine or 
complicate government actions to support the provision of 
credit to U.S. households and businesses in the current 
economic environment, the Agencies are providing banking 
organizations with an optional two-quarter implementation delay 
followed by an optional two-quarter partial implementation of 
the effect of FAS 167 on risk-weighted assets and ALLL 
includable in tier 2 capital.
    During this rulemaking process, the Agencies have 
determined that while regulatory capital ratios at banking 
organizations most effected by implementation of FAS 166 and 
FAS 167 would decline, those ratios would remain significantly 
above regulatory minimums subsequent to the implementation of 
FAS 166 and FAS 167. In addition, the Agencies continue to 
believe that the new GAAP consolidation standards of FAS 167 
more closely align the risk banking organizations face with 
respect to VIEs with which they are involved than current GAAP 
standards.\3\ The Agencies are aware, however, that several 
government programs supporting the securitization market are 
scheduled to terminate in the first quarter of 2010. In 
addition, Congress and the regulatory agencies are considering 
a number of legislative and regulatory changes that would 
affect the securitization activities. Given that the Agencies 
cannot precisely assess the combined effect of these changes on 
the securitization market, and because securitization 
activities remain an important source of funding for banking 
organizations, the Agencies are providing banking organizations 
a delay or phase-in period in the final rule.
---------------------------------------------------------------------------
    \3\ Determining whether a company is required to consolidate a VIE 
under FAS 167 depends on a qualitative analysis of whether the company 
has a ``controlling financial interest'' in the VIE. A company has a 
controlling financial interest if it has (1) the ability to direct 
matters that most significantly impact the activities of a VIE and (2) 
either the obligation to absorb losses of the VIE that could be 
significant to the VIE, or the right to receive benefits from the VIE 
that potentially could be significant to the VIE, or both.

Q.3. What is the impact of the proposed action by the Office of 
the Comptroller of the Currency and the Office of Thrift 
Supervision to end ``no payment'' deferred interest financing 
promotions on consumers and businesses? I understand the impact 
to be very large and I would appreciate the agencies working to 
clarify that ``no payment'' deferred interest financing 
promotions can be used in the future albeit perhaps with 
---------------------------------------------------------------------------
revised disclosures and marketing.

A.3. In January 2003, the OCC, the Office of Thrift 
Supervision, the Board of Governors of the Federal Reserve 
System, and the Federal Deposit Insurance Corporation (the 
Agencies), issued the Credit Card Account Management and Loss 
Allowance Guidance (AMG). This guidance addressed regulatory 
concerns with the easing of minimum payment requirements as 
well as concerns with other account management practices. The 
AMG states, in part, that the Agencies expect lenders to 
require minimum payments that will amortize the current balance 
of the account over a reasonable period. The guidance does not 
differentiate between general purpose and private label card 
programs.
    The receipt of regular monthly payments is important in 
consumer lending for several reasons. For borrowers, well 
designed payment structures promote a fundamental understanding 
of their debt burden in terms of monthly cash-flow and total 
income. Regular, budgeted payments help avoid the potential 
pitfalls associated with payment shock when payments begin or 
significantly increase under the loan amortization schedule. 
Regular payments also allow borrowers to demonstrate to 
existing and prospective lenders the willingness and capacity 
to repay their debts while systematically reducing those debts.
    For lenders, regular payments are an efficient way to 
monitor borrowers' willingness and ability to repay without the 
operational expense associated with requiring ongoing payment 
capacity information. Regular payment streams also allow the 
identification of early warning measurements such as 
delinquencies, roll rates, payment rates, and credit scores to 
be effective. Furthermore, they help lenders manage Portfolio 
risk by providing important inputs into the determination of 
adequate capital and reserve levels.
    On June 18, 2009, the OCC issued a Supervisory Memorandum 
to remind our examiners that the increased use of ``No 
Payment'' programs being offered by banks, and their retail 
partners, are not consistent with the AMG. We asked our 
examiners to ensure that national banks cease any ``No 
Payment'' programs by February 22, 2010. This gives national 
banks, and their retail partners, time to make necessary 
changes and coincides with the implementation date for other 
changes dictated by the Credit CARD Act.
    As a matter of clarification, the OCC does not object to 
``No Interest'' programs. These promotions are very attractive 
to consumers and often provide real, tangible benefits. 
However, the OCC believes that any benefits associated with 
``No Payment'' programs are outweighed by the negative impacts, 
including the loss of discipline associated with a regular 
payment stream, potential payment shock, a prolonged repayment 
schedule, and bank safety and soundness concerns.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DANIEL K. 
                            TARULLO

Q.l. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.l.-A.2. At the end of the second quarter of 2009, 
approximately $3.5 trillion of outstanding debt was associated 
with commercial real estate (CRE), including loans for 
multifamily housing developments. Of this amount, $1.7 trillion 
was held on the books of banks and thrifts, and an additional 
$900 billion represented collateral for commercial mortgage-
backed securities (CMBS), with other investors holding the 
remaining balance of $900 billion.
    Before the crisis, securitization markets were an important 
conduit of credit to the household and business sectors. 
Securitization markets (other than those for mortgages 
guaranteed by the government) closed in mid-2008, and the TALF 
was developed to promote renewed issuance. Under the TALF, 
eligible investors may borrow to finance purchases of the AAA-
rated tranches of various classes of asset-backed securities 
(ABS). The program originally focused on credit for households 
and small businesses, including auto loans, credit card loans, 
student loans, and loans guaranteed by the Small Business 
Administration. Investors may also use the TALF to purchase 
both existing and newly issued CMBS, which were included to 
help mitigate the refinancing problem in that sector.
    The TALF has been successful in helping restart 
securitization markets. Issuance has resumed and rate spreads 
for asset-backed securities have declined substantially. The 
TALF program has helped finance 2.5 million auto loans, 750,000 
student loans, more than 100 million credit card accounts, 
480,000 loans to small businesses, and 100,000 loans to larger 
businesses. Included among those business loans are 4,700 loans 
to auto dealers to help finance their inventories. Perhaps even 
more encouraging, a substantial fraction of ABS is now being 
purchased by investors that do not seek TALF financing, and 
ABS-issuers have begun to bring non-TALF-eligible deals to 
market.
    The TALF program provided financing to investors in the 
first new CMBS deal, totaling $400 million, since June 2008 on 
November 16. Significant investor demand drove down the spread 
on the AAA-rated TALF-eligible portion, with demand for the 
non-TALF eligible AA and A-rated tranches also higher than 
anticipated. The strong demand from cash investors and 
resulting low yield discouraged some TALF investors, resulting 
in the request for only $72.2 million in TALF loans for the 
purchase of $85.0 million of the $323.4 million AAA-rated TALF-
eligible portion of the deal. However, without the availability 
of TALF financing, it is unlikely that the deal would have come 
to market. Since then, we have seen another CMBS deal come to 
market, totaling $460 million, which did not apply for TALF 
support. There are reports of a third deal, which would also 
not apply for TALF financing, totaling $600 million, due to be 
priced in December. We believe that the demonstration of 
investor demand for the DDR deal has encourage other lenders to 
bring similar conservatively underwritten single-borrower deals 
to market irrespective of the availability of TALF financing. 
Both non-TALF deals reportedly declined TALF financing in order 
to structure the securities with terms that are longer than the 
TALF loans.
    The Federal Reserve continues to inject liquidity into the 
commercial real estate market through the TALF program, and is 
working with market participants to increase transparency and 
investor protections in this market. We have issued guidance to 
banks to encourage modifications of maturing CRE loans on 
properties with sufficient rental income to continue to service 
the debt payments, but due to the continuing credit crunch are 
unable to obtain refinancing. And we continue to support broad 
economic growth that would improve the fundamentals of 
commercial real estate.
    As part of the lessons learned process, the President's 
Working Group on Financial Markets and the Securities and 
Exchange Commission encouraged the FASB to re-assess its 
accounting standards for off-balance sheet vehicles. In 
response, and following a period of public comment on the 
proposal, FASB recently modified FAS 166 and 167.
    Under these modifications, an enterprise (e.g., company, 
individual, or group of bond holders) is required to 
consolidate certain special purpose entities (SPEs) whenever it 
has a ``controlling financial interest'' in the SPE, that is, 
the enterprise has the power to direct the SPE's most 
significant activities and the right to receive benefits from, 
or obligation to bear losses of, the SPE. The accounting 
standards also require disclosure of the enterprise's 
involvement with such SPEs and any significant changes in risk 
exposure that result.
    Whether an enterprise will be required to consolidate an 
SPE will depend on the specific facts and circumstances of each 
transaction. Beginning in 2010, many banking organizations that 
sponsor securitizations will be required to consolidate the 
associated SPEs. Certain asset-backed commercial paper 
conduits, revolving securitizations structured as master trusts 
(such as credit card securitizations), mortgage loan 
securitizations not guaranteed by the U.S. Government or a U.S. 
Government-sponsored agency, and term loan securitizations 
(such as auto and student loan securitizations), are among the 
types of securitization SPEs that will likely require 
consolidation by their sponsoring banking organization. In 
almost all cases, the SPE consolidation requirements will not 
apply to investors in the asset-backed securities, because such 
investors generally do not have power to direct the SPE's most 
significant activities.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM DANIEL K. 
                            TARULLO

Q.l. Mr. Tarullo, I am concerned about the Federal Reserve 
overstepping the authority Congress has granted. News reports 
about the Federal Reserve giving itself the authority to veto 
pay packages is beyond the pale.
   LCan you please submit for the record, where in the 
        Federal Reserve Act the Fed [is] given the authority to 
        regulate compensation agreements?

   LWhy should the Federal Reserve be allowed to veto 
        pay agreements that are approved by a company's board 
        of directors?

   LHow involved has Chairman Bernanke been in drafting 
        this illegal rulemaking?

   LWhich Federal Reserve Governor has been pushing the 
        Federal Reserve's policy on this issue?

A.l. The Federal Reserve's proposed supervisory guidance and 
related supervisory initiatives regarding incentive 
compensation practices derive from our statutory mandate to 
protect the safety and soundness of the banking organizations 
we supervise. The proposed guidance was developed in 
consultation with all Board members and all Board members voted 
in favor of issuing the proposed guidance for public comment.
    Recent events have highlighted that improper compensation 
practices can contribute to safety and soundness problems at 
financial institutions and to financial instability. 
Compensation practices were not the sole cause of the crisis, 
but they certainly were a contributing cause--a fact recognized 
by 98 percent of the respondents to a 2009 survey conducted by 
the Institute of International Finance of banking organizations 
engaged in wholesale banking activities.\1\ The Federal Reserve 
and the other Federal banking agencies regularly issue 
supervisory guidance to identify practices that the agencies 
believe would ordinarily constitute an unsafe or unsound 
practice, or to identify risk management systems, controls, or 
other practices that the agencies believe would ordinarily 
assist banking organizations in ensuring that they operate in a 
safe and sound manner.
---------------------------------------------------------------------------
    \1\ See The Institute of International Finance, Inc. (2009), 
Compensation in Financial Services: Industry Progress and the Agenda 
for Change (Washington: IIF, March).
---------------------------------------------------------------------------
    The proposed supervisory guidance, which currently is out 
for public comment,\2\ is based on three key principles: (1) 
incentive compensation arrangements at a banking organization 
should not provide employees incentives to take risks that are 
beyond the organization's ability to effectively identify and 
manage; (2) they should be compatible with effective controls 
and risk management; and (3) they should be supported by strong 
corporate governance, including active and effective oversight 
by the organization's board of directors. Consistent with these 
principles, the Federal Reserve's efforts are focused on 
ensuring that the way in which banking organizations structure 
their incentive compensation arrangements do not--intentionally 
or unintentionally encourage excessive risk-taking, and that 
banking organization's have the types of policies, procedures, 
internal controls, and corporate governance structures to 
promote and maintain sound incentive compensation arrangements.
---------------------------------------------------------------------------
    \2\ Board of Governors of the Federal Reserve System (2009), 
``Federal Reserve Issues Proposed Guidance on Incentive Compensation,'' 
press release, October 22, 2009.
---------------------------------------------------------------------------
    Importantly, the proposed guidance does not mandate that 
banking organizations follow any particular method for 
achieving appropriately risk-sensitive incentive compensation 
arrangements. In fact, the guidance expressly recognizes that 
the methods used to achieve risk-sensitive compensation 
arrangements likely will differ across and within firms, and 
that use of a single, formulaic approach is unlikely to 
consistently promote safety and soundness.

Q.2. Is it the Federal Reserve's official position that 
executive compensation is a cause of systemic risk?
   LIf so, can you please provide this Committee with 
        documentation to support this position?

A.2. Pay practices for risk-taking employees at many levels in 
banking organizations, not just top executive pay practices, 
were one among many contributors to the crisis. The role of 
compensation practices in the crisis has been widely recognized 
by both industry and supervisors, both here and overseas. For 
example, in their responses to a survey conducted by the 
Institute of International Finance, a global association of 
major financial institutions, 36 of 37 large banking 
organizations engaged in wholesale activities agreed that 
compensation practices were a factor underlying the crisis.\3\ 
The Senior Supervisors Group, which is composed of senior 
financial supervisors from seven major industrialized countries 
(the United States, Canada, France, Germany, Japan, 
Switzerland, and the United Kingdom), also reported that many 
firms and their supervisors had determined that failures of 
incentives and controls throughout the industry, including 
those related to compensation, contributed to systemic 
vulnerability during the crisis.\4\ Moreover, the Financial 
Stability Board, a group composed of senior representatives of 
national financial authorities, international financial 
institutions, standard setting bodies, and committees of 
central bank experts, has identified compensation practices as 
a factor contributing to the crisis.\5\
---------------------------------------------------------------------------
    \3\ See The Institute of International Finance, Inc. (2009), 
Compensation in Financial Services: Industry Progress and the Agenda 
for Change (Washington: IFF, March).
    \4\ See Senior Supervisors Group (2009), Risk Management Lessons 
from the Global Banking Crisis of 2008.
    \5\ See Financial Stability Board (2009), Principles for Sound 
Incentive Compensation Practices.

Q.3. What comments has the Federal Reserve received on this 
---------------------------------------------------------------------------
proposal from the banks it regulates?

A.3. The comment period closed on November 27, 2009. The Board 
has received 29 comments on the proposed guidance, four of 
which were submitted on behalf of individual banking 
organizations, five of which were submitted on behalf of groups 
representing multiple banking organizations, and two of which 
were submitted on behalf of groups representing both banking 
and nonbanking organizations. Public comments on the proposal 
are made available on the Board's website at http://
www.federafreserve.gov/generalinfo/foia/index.
cfin?doc_id=OPpercent2D1374&doc_ver=l.

Q.4. Mr. Tarullo, regarding the specifics of the proposal:

   LWould the Federal Reserve require companies to 
        ``clawback'' money that's already been paid to 
        employees?

   LIs there a threshold a bank must meet to qualify 
        for a review of executive compensation arrangements?

A.4. The proposed guidance provides that incentive compensation 
arrangements should not encourage excessive risk-taking, and 
describes several methods that are currently used by banking 
organizations to make compensation more sensitive to risk. 
These methods can be broadly described as risk adjustment of 
awards, deferral of payment, longer performance periods, and 
reduced sensitivity to short-term risk. As noted in the 
proposed guidance, the deferral of payment method is sometimes 
referred to in the industry as a ``clawback.'' The term 
``clawback'' also may refer specifically to an arrangement 
under which an employee must return incentive compensation 
payments previously received by the employee (and not just 
deferred) if certain risk outcomes occur.
    Importantly, the proposed guidance does not require a 
banking organization to use any particular method, including 
those described in the guidance, to ensure that its incentive 
compensation arrangements do not encourage employees to take 
excessive risks. In fact, the proposed guidance expressly 
recognizes that the methods discussed in the guidance have 
their own advantages and disadvantages, and that banking 
organizations will need flexibility in determining how best to 
achieve balanced incentive compensation arrangements in light 
of the particular activities, structure, and other 
characteristics of the organization.
    The proposed supervisory guidance would apply to all 
banking organizations that are supervised by the Federal 
Reserve. These organizations are primarily responsible for 
ensuring that their incentive compensation arrangements do not 
encourage excessive risk-taking or pose a threat to the safety 
and soundness of the organization. To help promote and monitor 
the development of safe and sound incentive compensation 
arrangements, the Federal Reserve also has announced two, 
separate supervisory initiatives. These two separate programs 
are designed to reflect the differences among the universe of 
banking organizations supervised by the Federal Reserve. The 
first initiative involves a special, horizontal review of 
incentive compensation practices at large, complex banking 
organizations (LCBOs). LCBOs warrant special supervisory 
attention because they are significant users of incentive 
compensation arrangements and because flawed practices at these 
institutions are more likely to have adverse effects on the 
broader financial system.
    A separate program will apply to the thousands of other 
organizations supervised by the Federal Reserve, including 
community and regional banking organizations. Supervisory staff 
will review incentive compensation arrangements at these 
organizations as part of the regular risk-focused examination 
process. These reviews, as well as our supervisory expectations 
for these organizations, will be tailored to reflect the more 
limited scope and complexity of these organizations' 
activities--a fact also recognized in various aspects of our 
guidance.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DEBORAH K. 
                              MATZ

Q.1. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

A.2. For the most part, credit unions have not participated in 
TALF. As cooperatives, many credit unions maintain a whole 
membership philosophy and seek to retain all of their members' 
financial business in-house. While federally insured credit 
unions hold less than 1.5 percent of all commercial real estate 
loans, the credit union industry's involvement in commercial 
lending has increased. Loans to members for business purposes 
have more than quintupled from December 2002 to June 2009, 
rising from $6.7 billion to $33.7 billion. Of the $33.7 billion 
member business loan portfolio, 76 percent are secured by real 
estate.
    The credit union industry has continued to grant member 
business loans even when most other financial service providers 
are contracting. For the first half of 2009, member business 
loans experienced 11.9 percent growth.
    NCUA is encouraging the flow of credit in these difficult 
economic times. Below are some examples of recent actions taken 
to promote balancing safety and soundness issues with the 
credit unions' desire to meet their members' financial needs. 
This month, NCUA hosted a webcast for credit unions and 
examiners entitled ``Member Business Lending: Regulators' 
Perspective,'' which provided guidance, best practices, and 
insight into the underwriting and examination of member 
business lending. This webcast provided a balanced view of the 
needs of the industry with safety and soundness considerations.
    Additionally, NCUA recently released a joint policy 
statement with the Federal Financial Institutions Examination 
Council (FFIEC) supporting prudent commercial real estate (CRE) 
loan workouts. This statement provides guidance for examiners 
and financial institutions that are working with CRE borrowers 
who are experiencing diminished operating cash-flows, 
depreciated collateral values, or prolonged delays in selling 
or renting commercial properties. This guidance discusses 
another component of the current lending environment that the 
financial industry is currently facing.
    In order to further encourage credit union involvement in 
commercial lending, Congress could consider raising or removing 
the current statutory limitation on member business lending. 
The Federal Credit Union Act currently limits federally insured 
credit unions to 1.75 times the actual net worth of the credit 
union or 1.75 times the minimum net worth required for the 
credit union to be considered well capitalized. Raising or 
eliminating this limitation on member business loans will 
increase credit unions' ability to generate and hold more loans 
to small businesses served by those credit unions, while 
providing NCUA with the ability and obligation to set standards 
and benchmarks for this activity based on the needs of the 
industry. NCUA understands an increase or elimination of this 
limitation without prudent regulatory oversight could pose 
significant risk to individual credit unions, and is prepared 
to provide the necessary oversight.
    NCUA is also aware of the importance of increasing lending 
in the commercial real estate market in order to stimulate the 
economy, while ensuring the safety and soundness of the 
institutions the NCUA regulates and insures. There is a fine 
balance between these two objectives that the NCUA is 
encouraging the credit union industry to find. In fact, a 
Letter to Credit Unions that promotes best practices of member 
business lending is currently in process. NCUA will continue to 
issue guidance to examiners and the credit union industry to 
address issues related to the current financial and economical 
environment.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.2. The FASB's new rules will make it more difficult for 
credit unions to sell loans or portions of loans and gain the 
benefit of removing those assets from their books through sales 
treatment. For a small number of credit unions who engage in 
securitization transactions, the new rules will make it 
difficult to avoid consolidation accounting with the 
securitization trust. In either case, the net worth ratio will 
be diluted by the ``transferred'' financial assets that must 
remain on the credit unions' books even though ``sold''. In the 
former case, NCUA anticipates that credit unions will 
restructure legal transfer agreements to conform loans sales 
and partial loan sales to the ``participating interest'' rules 
of the new standard and proceed with business as usual. In the 
latter case, the small number of credit unions that engage in 
securitization structures will most likely cease and desist 
from this activity.
    The larger and more onerous impact of the new accounting 
rules will fall on the NCUA Board and the Funds it oversees. 
The NCUA Board oversees the National Credit Union Share 
Insurance Fund (``NCUSIF''), the Corporate Credit Union 
Stabilization Fund (``Stabilization Fund''), the Central 
Liquidity Facility (``CLF''), the NCUA Operating Fund, and the 
Community Development Revolving Loan Fund. NCUA prepares its 
financial statement under U.S. generally accepted accounting 
principles (``GAAP'') for commercial enterprises.
    As the NCUA Board acts under its statutory authorities to 
``workout'' troubled credit unions with the least cost to the 
NCUSIF and the Stabilization Fund, the new accounting rules 
will most likely require NCUSIF to consolidate with the 
Stabilization Fund as well as conserved, troubled credit unions 
under the NCUA Board oversight. Financial statement 
consolidation of the NCUSIF, the Stabilization Fund, and 
troubled, conserved credit unions solely due to the NCUA Board 
exercising its statutory powers as it acts within its mission 
under moral obligation to protect credit union and taxpayer 
resources is not a plausible outcome of applying accounting 
rules. The new rules assume a ``profit making'' incentive 
behind NCUA's actions when, in fact, its actions are statutory 
in nature--supervision and Federal deposit insurance.
    The primary readers of the NCUSIF financial statements--
credit union members, the public, and the U.S. Treasury 
Department--are not better served by the consolidated 
presentation of governmental with non-governmental entities. A 
scope exception for government entities from consolidating with 
the entities it supervises and insures would be the optimal 
outcome. The FASB has not been receptive to such a scope 
exception primarily because it would not have wide 
applicability and there is an existing scope exception within 
the standard for non-profit entities.
                                ------                                


 RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM TIMOTHY 
                              WARD

Q.1. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small- and medium-sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

A.1. The Term Asset-Backed Securities Loan Facility (TALF) 
program was primarily created to help restore liquidity in the 
asset-backed securities markets. Since the Federal Reserve 
Board (the FRB) announced an expansion of the TALF to include 
commercial mortgage-backed securities (CMBS), the Federal 
Reserve Bank of New York (FRBNY) has received loan requests 
totaling $6.5 billion to help fund the purchase of legacy CMBS 
(those created prior to January 1, 2009).
    Improvements in CMBS market liquidity and confidence have 
occurred since the severe dislocations in these markets during 
late summer/early fall of 2008. Most notably, the yield spreads 
between CMBS and 10-year Treasury securities have narrowed 
significantly from over 10 percent in late summer/early fall 
2008 to about 4.5 percent in November 2009. Though still wider 
than typical spreads of about 1.5 percent, the narrowing of 
spreads is evidence of normalization of the CMBS markets. And 
it is likely the TALF program contributed to these 
improvements.
    It is important to note that only a small percentage of 
commercial real estate loans are in CMBS. According to 
estimates from the Commercial Mortgage Securities Association, 
only about 25 percent of total commercial real estate loans are 
held in CMBS. This may point to the need to expand TALF, or 
similar programs, beyond the CMBS markets to help address 
rising problems in commercial real estate. And this is 
especially true for small- and medium-sized banks and thrifts.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.2. As a result of the FASB accounting changes, generally 
effective the beginning of 2010 for most institutions, many 
securitizations previously off-balance sheet will come on-
balance sheet and many new securitizations will stay on-balance 
sheet. Consequently, higher regulatory capital requirements 
will result from the larger balance sheets and some 
institutions may need to raise additional capital or shrink 
their balance sheet size, which could result in a downward 
pressure on lending activity and increase the costs of 
borrowing.
    The Federal banking agencies require that regulatory 
reports comply with Generally Accepted Accounting Principles 
(GAAP). By law, reports filed with the Federal banking agencies 
must be uniform and consistent with and no less stringent than 
GAAP (as required by Section 37 of the FDI Act). Consequently, 
securitization accounting must be reported by financial 
institutions in accordance with GAAP. GAAP serves as the 
starting point for regulatory capital treatment.
    Due to these GAAP accounting changes, an Interagency Notice 
of Proposed Rulemaking (NPR) for the regulatory capital 
treatment of securitizations was issued. The comment period for 
the NPR closed on October 15, 2009. The NPR proposed to follow 
the new GAAP treatment for regulatory capital purposes as, 
unless determined otherwise based upon information provided 
through the comment process, the agencies believe the new GAAP 
more appropriately reflects the securitization risks to which 
financial institutions are exposed. The comments are currently 
being evaluated by the banking agencies with the expectation of 
issuing a final rule before the regulatory reporting of these 
accounting changes.

Q.3. What is the impact of the proposed action by the Office of 
the Comptroller of the Currency and the Office of Thrift 
Supervision to end ``no payment'' deferred interest financing 
promotions on consumers and businesses? I understand the impact 
to be very large and I would appreciate the agencies working to 
clarify that ``no payment'' deferred interest financing 
promotions can be used in the future albeit perhaps with 
revised disclosures and marketing.

A.3. Over the past year, OTS and OCC have worked closely to 
develop their respective policy statements, which are 
substantially identical. On September 24, 2009, OTS issued CEO 
Letter 321--``No Interest, No Payment'' Credit Card Programs to 
remind savings associations of certain requirements contained 
in the 2003 interagency ``Account Management and Loss Allowance 
Guidance for Credit Card Lending.'' That guidance articulated 
sound account management, risk management, and loss allowance 
practices for all institutions engaged in credit card lending.
    CEO Letter 321 reminds savings associations of OTS's 
longstanding position that minimum monthly payments are a key 
tenet of safe and sound retail lending and should be required 
on credit card accounts. It states that regular monthly 
payments add structure and discipline to the lending 
arrangement, provide regular and ongoing contact with the 
borrower, and allow the borrower to demonstrate and the bank to 
assess continued willingness and ability to repay the 
obligation over time. Conversely, the absence of a regular 
payment stream may result in protracted repayment and mask true 
portfolio performance and quality. Further, in accordance with 
the OTS Examination Handbook, it indicates that the minimum 
monthly payment should cover at least a 1-percent principal 
reduction plus all assessed monthly interest and finance 
charges. CEO Letter 321 neither prohibits nor discourages the 
practice of ``no interest'' credit card promotions.
    Finally, the CEO Letter states that savings associations 
will be given a reasonable time to implement any changes to 
their existing programs as a result of the policy 
clarification. All savings associations are expected to be in 
full compliance for all new credit card transactions no later 
than February 22, 2010.
    OTS has no precise data on the expected impact of the OTS 
and OCC ending the no payment programs offered by banks and 
savings associations. Because of the increased delinquencies 
associated with certain customers of no-pay accounts, we expect 
a decline in loan delinquencies and chargeoffs. While there may 
be a curtailment in the number of purchases that these programs 
facilitate, OTS believes that the primary affect will be for 
borrowers who cannot afford the purchases.
    In arriving at the decision to issue a letter on these 
programs, OTS considered, among other things, that recent 
examinations of OTS-supervised savings associations that offer 
``no interest, no payment'' credit card programs revealed 
increasing past due and losses related to these accounts. OTS 
examination staff noted that:

        No payment promotions present substantially higher credit risk 
        (unexpected loss) to banks than regular revolving accounts. 
        This is not necessarily because the accounts/customers 
        themselves are riskier; but because the structure of the 
        promotion results in an inability to adequately monitor and 
        assess risk. These promotions also present problems for 
        customers who are less adept at managing their finances. The 
        best way to address these problems is to require some level of 
        minimum monthly payments.

    No payment promotions are most prevalent on big ticket 
purchases such as furniture, or big screen televisions. These 
types of purchases often result in balances of $5,000 or more. 
Many view promotional programs that offer no payments until 
next year as being designed to entice customers into making a 
large purchase that they may not otherwise have considered or 
thought they couldn't afford. It allows customers to acquire 
these items without worrying about paying for them for a long 
period of time. For those customers who are not as adept at 
managing their finances, it may be very difficult to make a 
$5,000 payment at the end of the promotion--at which time they 
will incur high financing costs, in some cases (back-billing) 
all of the costs they thought they were avoiding.




RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOSEPH A. 
                             SMITH

Q.1. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

A.1. Did not respond by printing deadline.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.2. Did not respond by printing deadline.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM THOMAS J. 
                             CANDON

Q.1. According to a recent New York Times article, about $870 
billion, or roughly half of the industry's $1.8 trillion of 
commercial real estate loans, now sit on the balance sheet of 
small and medium sized banks. To what extent has TALF 
encouraged capital to enter the commercial real estate market 
and what other step should regulators be taking to address this 
problem?

A.1. The financial institutions supervised by NASCUS members--
state-chartered credit unions--do not have access to TALF.

Q.2. How will FASB's new rules on off-balance sheet accounting 
impact financial institution's ability to lend and how do you 
intend to implement the changes?

A.2. State-chartered credit unions have not made substantive 
use of the new FASB provisions related to off-balance sheet 
accounting and accordingly, it is not anticipated that these 
changes by FASB will have a material impact on the ability of 
credit unions to lend to their members. Credit unions will be 
minimally impacted, if at all. The two areas of primary 
structural constraint regarding credit union lending continue 
to be field of membership restrictions and the limitations 
imposed by Federal restrictions on member business lending. 
FASB's new rules regarding off-balance sheet accounting are 
likely to have a more substantial impact on large commercial 
banks which may have utilized off-balance sheet structures to 
mitigate on-balance sheet risk.
