All banks--large and small--need to consider whether they need greater capital cushions. The largest banks should consider whether their changing business model means that they need to hold more capital against some of the newer risks I discussed earlier. It is especially concerning that so many of these newer risks have arisen at the same time. Smaller banks must make sure their capital is sufficient to protect against the risk associated with the greater concentrations that have seemed to accompany the increased competition from securities markets.

Banks might find the current circumstances to be especially favorable for raising new capital. Not only would more capital provide a cushion against the sorts of unexpected declines in creditworthiness and asset values that have marked recent months, it would also position banks well for expansion.

The case for opportunistic capital is improving. Some curative steps by incumbent financial institutions are in the offing. Financial institutions should continue to reassess their sources and uses of funding, their risk-management systems, risk tolerance, and human capital. Generally, they should not hesitate to pare their dividend and share repurchase programs. And, they should raise new capital to strengthen their balance sheets. These actions, in my view, are important signs of strength, and will ensure that financial institutions thrive in the emerging financial architecture replete with new opportunities. These actions will have concomitant benefits on real economic activity.

The U.S. banking system remains well capitalized. The quality of capital and capital ratios are still quite good.

From Q&A as reported by Market News International

Despite the adverse developments in recent months, large U.S. banking organizations, in the aggregate and individually, have maintained capital ratios in excess of regulatory requirements, in part because of steps taken by many to replenish equity positions. Indeed, since last fall, large U.S. bank holding companies have raised more than $50 billion in capital. Although the U.S. banking system will continue to face a challenging environment, it remains in sound overall condition, having entered the period of recent financial turmoil with solid capital and strong earnings.

During times of systemwide stress, such as the one we are currently experiencing, significant liquidity demands can emanate from both the asset and the liability side of a bank's balance sheet.  For example, we have recently seen how unanticipated draws on liquidity facilities by structured investment vehicles, commercial paper conduits, and others can lead to significant growth in bank assets.  Moreover, some organizations have also encountered difficulty in selling whole loans or securitizing assets as planned.  There were also cases in which reputational concerns have prompted banks or their affiliates to provide liquidity support to a vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet, even when the bank had no legal obligation to do so.  In a few cases, these unexpected increases in the balance sheet created some pressures on capital ratios, even when capital levels remained unchanged. 

I think progress is being made in the financial markets. It looks very shaky everyday there is some more bad news, I don't know what's happen today other than this set of testimony and I hope that's not bad news, but I think there are some signs out there that we're working through the problem. There is greater transparency by firms with problems on their banks. There is capital coming into the system that several of my colleagues have mentioned on the panel. So people are raising capital, they are being much more open about what the issues are. I think part of this problem is about uncertainty so increased transparency by lenders and others with problems on their books is going to be very helpful to letting people know what the downside risks are, how to price them in. I do think the markets have gotten to a point that they are anticipating some pretty adverse kinds of outcomes in the housing market and in the economy to a certain extent.

From Q&A as reported by Market News International

Looking at your dividend policy ought to be an essential component of looking at all the sources of capital...

Dividend policies definitely should be on the table, as they have been for a number of institutions already.

From the Q&A session, as reported by Reuters

U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector.

To date, the resulting potential capital constraints are concentrated in the largest banks with the largest exposure to securities tied to subprime mortgages. While some of the capital losses have been mitigated by new capital, the losses in combination with involuntary growth in assets can potentially restrain the willingness of these institutions to engage in activities that would further swell their balance sheet.

Because these institutions are actively engaged in structured products and loans to finance leveraged deals, it is not surprising that participants in these markets are finding tighter financial constraints. For some markets where these banks are major market makers, the unwillingness to further increase balance sheets has impacted the liquidity in those markets.

Many small and medium-sized businesses are not complaining about credit conditions. This reflects the lack of exposure that many small and medium-sized banks had to securitized products or the subprime market. However, should housing prices continue to fall, losses in prime residential mortgages and construction loans are likely to cause these institutions to be more capital constrained. Banks under $100 billion still retain significant exposure to residential mortgages and construction loans which account for 26 percent of assets or $750 billion. Should housing prices continue to fall and the housing sector get worse, it is likely that these institutions will begin being impacted more significantly.

[I] n today’s situation we are fortunate that most financial institutions have entered the current problems with significant capital cushions and that many U.S. financial institutions are moving to proactively address the problems. However, the potential for a credit crunch remains. Commercial banks are still an important source of liquidity and there are troubling developments at work.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

As questions have been asked on ratings of securities, many investors have chosen not to roll over commercial paper that was not backed by solid assets and did not have liquidity provisions provided by banks. This freeze-up, of course, means problems for financing a variety of assets, including mortgages, student loans, and home-equity loans.

...

The alternative to securitizations and financing assets with commercial paper is financing by commercial banks. Fortunately, most banks are very well capitalized and have the ability to finance these assets. In fact, bank balance sheets did expand in both August and September, reflecting in part banks holding assets on their balance sheet that have been difficult to securitize. However, while banks have the capacity to finance many of these assets, it is likely that the cost of financing for these assets will increase if they are done by banks rather than through financial markets.

My expectation is that over time, investors will gain more confidence in their ability to evaluate the quality of ratings, and that conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors. A reevaluation of ratings and the models used to determine ratings, and a greater onus on investors to understand the underlying assets and securities they are purchasing is likely to make these markets more resilient. However, this process of evaluation may take some time. While we have seen improvement in financial markets over the past month, we continue to observe wider spreads and reduced volumes on securitized products, which may remain until investor confidence has been restored.

These efforts have most notably manifested themselves in increased levels of risk-adjusted capital in the core of the system relative to what prevailed in the early 1990s. In the United States, for example, tier-one risk-based capital ratios have stabilized near 8.5 percent, considerably higher than the estimated levels around 6.5 percent for the early 1990s. This is based on a relatively crude measure of risk, but the direction of the improvement is right and the magnitude of the change is significant.

Relative to the conditions that prevailed in the early 1990s, the higher levels of capital in the core now provide a larger buffer against shocks and enhance the ability of the banking industry to act as a critical stabilizer in times of stress by providing liquidity to the corporate sector. When financial markets dry up, firms turn to banks and their unused loan commitments and lines of credit. Banks are in a position to fund this liquidity because transaction deposits tend to flow into the banking sector. In times of crisis, it appears that U.S. investors now run to banks, not away from them.

{Central banks} have all chosen implicitly, if not in a more overt fashion, to set our capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.

I am obviously referring to far more adverse outcomes than I was alluding to in my earlier remarks on the need for private risk-management systems to adjust for crises in their estimates of risk distributions. However, where that dividing line rests is an issue that has not yet been addressed by the international banking community. Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

 At a conference honoring Anna Schwartz