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.

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.

Community banks today--to a somewhat greater degree than their larger money-center brethren--most clearly retain the traditional commercial banking approach to financial intermediation.  Community banks finance relatively opaque entities, such as private companies and households.  They raise funds primarily by issuing demand deposits.  They deploy capital by underwriting loans, monitoring borrowers, and retaining some loans in portfolio as long-term investments. 

Relationship finance continues to be at the heart of community banking. I believe that the most significant characteristics of community banks are: 1) their importance in small-business lending; 2) their tendency to lend to individuals and businesses in their local areas; 3) their tendency to rely on retail deposits for funding; and 4) their emphasis on personal service.  Hence, successful community banking today depends importantly on the same characteristics that formed the foundations of the U.S. banking industry two centuries ago--personal interactions among bankers, their customers, and their communities.

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Along with the benefits of relationship finance, however, come some risks, including the potential for conflicts of interest. This particular risk appears to have been mitigated significantly in the United States, although it is important for bankers to remain vigilant and to regularly review the corporate governance mechanisms they have in place.

In financial terms, community banks remain quite strong, and there is considerable entry into the business. New technologies and management methods have eroded some of the traditional informational benefits of relationship finance, however, and community banks have lost market share to larger banks and to nondepository institutions. But the data also show that many customers want to be served locally; they value proximity and convenience. In my view, the strong relationships and personalized services provided by community banks remain an important reason for their continuing success.

The federal banking agencies have recently proposed guidance that would focus examiners' attention on those loans that are particularly vulnerable to adverse market conditions--that is, loans dependent primarily on the sale, lease, or refinancing of commercial property as the source of repayment.  I emphasize that, in proposing this guidance, supervisors are not aiming to discourage banks from making sound loans in commercial real estate or in any other loan category. Rather, we are affirming the need for each bank to recognize the risks arising from concentration and to have in place appropriate risk-management practices and capital levels.

Community banks differentiate themselves by focusing on the specific needs of their local markets and by providing a high level of service and attention to the customers in those markets. [These] banks with assets of $1 billion or less continue to be quite successful.

[Commercial real estate lending] accounted essentially for all of the asset growth at these institutions in 2003 and 2004...There is no indication at this time that the overall credit quality of CRE exposures at community banks has deteriorated, although there are signs that some underwriting standards have been under assault from competitive pressures.