The FDIC released the Supervisory Insights report today, detailing the costs and causes of the banking crisis.
It should not come as a surprise to anyone that the FDIC’s list of factors that caused the banking crisis center on the abandonment of traditional sound lending standards. The FDIC report does not struggle to come to this easy conclusion.
A look back on the buildup to the financial crisis reveals similarities to earlier cycles of boom and bust. During the expansion, financial firms engage in a competitive relaxation of credit standards and risk tolerances to gain and maintain revenue growth. Easy credit allows borrowers to refinance ever-greater obligations in lieu of repayment, driving down default rates. This fuels the perception that credit risk is minimal, stimulating further loosening of credit terms in a self-perpetuating cycle. To some banks operating in such an environment, traditional lending standards can appear an unnecessary impediment to revenue growth.
A decline in loan underwriting standards belongs on any list of the factors responsible for the current crisis. To varying degrees, subprime mortgages, Alt-A mortgages with little or no documentation of income, residential construction loans, loans to leveraged corporate borrowers, commercial real estate loans, and other consumer loans have exhibited weakness in underwriting standards.
This crisis also has demonstrated the linkages between safe-and-sound banking, and banking that complies with the letter and spirit of laws designed to protect consumers and investors. Indeed, the triggering event for this crisis was the origination, and often the subsequent securitization, of large volumes of mortgages with little or no documentation of income or consideration of the borrower’s ability to repay the loan under the contractual terms from sources other than the collateral.
After reading the FDIC’s report, it is obvious that everyone knew from common sense and past experience that unsound lending policies result in bad loans. In a remarkably ironic conclusion, the FDIC admits that although they have had guidance in place for curtailing credit risks, little was actually done to enforce adherence to sound underwriting guidelines. When the regulators did not enforce their own guidelines the banks went wild, lending vast amounts of money to borrowers with little capacity to repay.
The FDIC’s brilliant conclusion to the financial crisis is that in the future, “strong regulation and supervision of financial institutions is more important”. Excuse me for saying this, but if the various banking regulators had done their job properly to begin with, the banking crisis would never have occurred in the first place.
Over the years, the banking agencies have issued a number of supervisory guidance documents regarding adverse credit risk trends. These included guidance on managing the risks in leveraged corporate loans, credit cards, home equity loans, commercial real estate loans, non-traditional mortgages, and subprime mortgages. These guidance documents indicate that the agencies were generally aware of, and concerned about, emerging potential credit risks. A future focus of supervision in responding to such emerging risks may well include a careful look at where the line should be drawn between guidance and informal supervisory expectations on the one hand, and more tangible requirements on the other.
Lessons about the causes of the financial crisis are still being learned. If there is one overarching lesson, perhaps it is this. Strong regulation and supervision of financial institutions is more important, not less, than some have previously thought.