Fed's Kohn: Banks' Caution Poses Economic Threat

CHARLOTTE, N.C. -- Banks have become so wary about lending that credit costs are being pushed up despite sharp cuts in official interest rates, and that is adding to the risks of an economic downturn, the vice chairman of the Federal Reserve said Thursday.

"It is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy," Donald Kohn said.

"It is this tightening that is accentuating the downside risks for the economy as a whole," he added.

U.S. growth has stumbled after the collapse of the subprime mortgage market made financial firms seek refuge from spiraling losses, triggering global financial turmoil prompting the Fed to slash interest rates by 3 percentage points since September.

"It has been a formidable episode of financial turbulence that has revealed major weakness in our financial system, including the business practices of many banks," he said.

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In light of ongoing market strain, Kohn urged banks to consider increasing their capital cushions to help position themselves for future growth once markets settle.

"All banks — large and small — need to consider whether they need greater capital cushions," Kohn told a credit market symposium sponsored by the Richmond Federal Reserve Bank.

"Not only would more capital provide a cushion against the sorts of unexpected declines in credit-worthiness and asset values that have marked recent months, it would also position banks well for expansion," he added.

Kohn said regulators will need to ensure that minimum capital requirements and liquidity management plans are adequate to prevent shocks to the banking system from turning into broader threats to the economy.

"Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will," Kohn said.

He said the Fed was working with international regulators to raise capital requirements in the Basel II banking accord, especially for "specific exposures that have been troublesome" like certain collateralized debt obligations and off-balance sheet commitments.

Asked after his speech whether this meant rethinking how regulators rely on credit ratings as they review capital standards, Kohn said that this was certainly up for debate.

"I think part of the work-list for the regulators is to reexamine the extent to which we ourselves are relying on these rating agencies to gauge the risks that you guys are taking," he said. "I think there was far, far too much reliance on credit ratings all round."

He noted the U.S. central bank had taken the extraordinary step last month of opening its discount lending window to primary dealers.

"Given the changes to financial markets and banking that we've been discussing ... a pressing public policy issue is what kind of liquidity backdrop the central bank ought to supply to these institutions," Kohn said.

He said he had no "ready answers" but suggested that in the future banks will likely operate with much less leverage than they were before the current credit crisis hit, and that will help create a much more stable financial system.

However, he did not favor rolling back the traditional U.S. separation between investment and commercial banks which ended in the 1999 repeal of the Depression-era Glass-Steagall laws.

"I don't think...taking away Glass-Steagall contributed in such a way to the turmoil that we ought to roll it back. It is an advance to allow commercial banks into these other areas, but other parts of the bank need to keep up," he said, explaining that risk-management systems had failed to adapt.

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