Chairman Ben S. Bernanke

Semiannual Monetary Policy Report to the Congress

Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.

July 21, 2010

Chairman Dodd, Senator Shelby, and members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress.

Economic and Financial Developments
The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth. In particular, real consumer spending appears to have expanded at about a 2-1/2 percent annual rate in the first half of this year, with purchases of durable goods increasing especially rapidly. However, the housing market remains weak, with the overhang of vacant or foreclosed houses weighing on home prices and construction.

An important drag on household spending is the slow recovery in the labor market and the attendant uncertainty about job prospects. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, a pace insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount of time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers’ employment and earnings prospects.

In the business sector, investment in equipment and software appears to have increased rapidly in the first half of the year, in part reflecting capital outlays that had been deferred during the downturn and the need of many businesses to replace aging equipment. In contrast, spending on nonresidential structures–weighed down by high vacancy rates and tight credit–has continued to contract, though some indicators suggest that the rate of decline may be slowing. Both U.S. exports and U.S. imports have been expanding, reflecting growth in the global economy and the recovery of world trade. Stronger exports have in turn helped foster growth in the U.S. manufacturing sector.

Inflation has remained low. The price index for personal consumption expenditures appears to have risen at an annual rate of less than 1 percent in the first half of the year. Although overall inflation has fluctuated, partly reflecting changes in energy prices, by a number of measures underlying inflation has trended down over the past two years. The slack in labor and product markets has damped wage and price pressures, and rapid increases in productivity have further reduced producers’ unit labor costs.

My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared forecasts of economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The forecasts are qualitatively similar to those we released in February and May, although progress in reducing unemployment is now expected to be somewhat slower than we previously projected, and near-term inflation now looks likely to be a little lower. Most FOMC participants expect real GDP growth of 3 to 3-1/2 percent in 2010, and roughly 3-1/2 to 4-1/2 percent in 2011 and 2012. The unemployment rate is expected to decline to between 7 and 7-1/2 percent by the end of 2012. Most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal, and the majority saw the risks to growth as weighted to the downside. Most participants projected that inflation will average only about 1 percent in 2010 and that it will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced.

One factor underlying the Committee’s somewhat weaker outlook is that financial conditions–though much improved since the depth of the financial crisis–have become less supportive of economic growth in recent months. Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk-taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States. In response to these fiscal pressures, European leaders put in place a number of strong measures, including an assistance package for Greece and €500 billion of funding to backstop the near-term financing needs of euro-area countries. To help ease strains in U.S. dollar funding markets, the Federal Reserve reestablished temporary dollar liquidity swap lines with the ECB and several other major central banks. To date, drawings under the swap lines have been limited, but we believe that the existence of these lines has increased confidence in dollar funding markets, helping to maintain credit availability in our own financial system.

Like financial conditions generally, the state of the U.S. banking system has also improved significantly since the worst of the crisis. Loss rates on most types of loans seem to be peaking, and, in the aggregate, bank capital ratios have risen to new highs. However, many banks continue to have a large volume of troubled loans on their books, and bank lending standards remain tight. With credit demand weak and with banks writing down problem credits, bank loans outstanding have continued to contract. Small businesses, which depend importantly on bank credit, have been particularly hard hit. At the Federal Reserve, we have been working to facilitate the flow of funds to creditworthy small businesses. Along with the other supervisory agencies, we issued guidance to banks and examiners emphasizing that lenders should do all they can to meet the needs of creditworthy borrowers, including small businesses.¹ We also have conducted extensive training programs for our bank examiners, with the message that lending to viable small businesses is good for the safety and soundness of our banking system as well as for our economy. We continue to seek feedback from both banks and potential borrowers about credit conditions. For example, over the past six months we have convened more than 40 meetings around the country of lenders, small business representatives, bank examiners, government officials, and other stakeholders to exchange ideas about the challenges faced by small businesses, particularly in obtaining credit. A capstone conference on addressing the credit needs of small businesses was held at the Board of Governors in Washington last week.² This testimony includes an addendum that summarizes the findings of this effort and possible next steps.

Federal Reserve Policy
The Federal Reserve’s response to the financial crisis and the recession has involved several components. First, in response to the periods of intense illiquidity and dysfunction in financial markets that characterized the crisis, the Federal Reserve undertook a range of measures and set up emergency programs designed to provide liquidity to financial institutions and markets in the form of fully secured, mostly short-term loans. Over time, these programs helped to stem the panic and to restore normal functioning in a number of key financial markets, supporting the flow of credit to the economy. As financial markets stabilized, the Federal Reserve shut down most of these programs during the first half of this year and took steps to normalize the terms on which it lends to depository institutions. The only such programs currently open to provide new liquidity are the recently reestablished dollar liquidity swap lines with major central banks that I noted earlier. Importantly, our broad-based programs achieved their intended purposes with no loss to taxpayers. All of the loans extended through the multiborrower facilities that have come due have been repaid in full, with interest. In addition, the Board does not expect the Federal Reserve to incur a net loss on any of the secured loans provided during the crisis to help prevent the disorderly failure of systemically significant financial institutions.

A second major component of the Federal Reserve’s response to the financial crisis and recession has involved both standard and less conventional forms of monetary policy. Over the course of the crisis, the FOMC aggressively reduced its target for the federal funds rate to a range of 0 to 1/4 percent, which has been maintained since the end of 2008. And, as indicated in the statement released after the June meeting, the FOMC continues to anticipate that economic conditions–including low rates of resource utilization, subdued inflation trends, and stable inflation expectations–are likely to warrant exceptionally low levels of the federal funds rate for an extended period.³

In addition to the very low federal funds rate, the FOMC has provided monetary policy stimulus through large-scale purchases of longer-term Treasury debt, federal agency debt, and agency mortgage-backed securities (MBS). A range of evidence suggests that these purchases helped improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads.

Compared with the period just before the financial crisis, the System’s portfolio of domestic securities has increased from about $800 billion to $2 trillion and has shifted from consisting of 100 percent Treasury securities to having almost two-thirds of its investments in agency-related securities. In addition, the average maturity of the Treasury portfolio nearly doubled, from three and one-half years to almost seven years. The FOMC plans to return the System’s portfolio to a more normal size and composition over the longer term, and the Committee has been discussing alternative approaches to accomplish that objective.

One approach is for the Committee to adjust its reinvestment policy–that is, its policy for handling repayments of principal on the securities–to gradually normalize the portfolio over time. Currently, repayments of principal from agency debt and MBS are not being reinvested, allowing the holdings of those securities to run off as the repayments are received. By contrast, the proceeds from maturing Treasury securities are being reinvested in new issues of Treasury securities with similar maturities. At some point, the Committee may want to shift its reinvestment of the proceeds from maturing Treasury securities to shorter-term issues, so as to gradually reduce the average maturity of our Treasury holdings toward pre-crisis levels, while leaving the aggregate value of those holdings unchanged. At this juncture, however, no decision to change reinvestment policy has been made.

A second way to normalize the size and composition of the Federal Reserve’s securities portfolio would be to sell some holdings of agency debt and MBS. Selling agency securities, rather than simply letting them run off, would shrink the portfolio and return it to a composition of all Treasury securities more quickly. FOMC participants broadly agree that sales of agency-related securities should eventually be used as part of the strategy to normalize the portfolio. Such sales will be implemented in accordance with a framework communicated well in advance and will be conducted at a gradual pace. Because changes in the size and composition of the portfolio could affect financial conditions, however, any decisions regarding the commencement or pace of asset sales will be made in light of the Committee’s evaluation of the outlook for employment and inflation.

As I noted earlier, the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. At some point, however, the Committee will need to begin to remove monetary policy accommodation to prevent the buildup of inflationary pressures. When that time comes, the Federal Reserve will act to increase short-term interest rates by raising the interest rate it pays on reserve balances that depository institutions hold at Federal Reserve Banks. To tighten the linkage between the interest rate paid on reserves and other short-term market interest rates, the Federal Reserve may also drain reserves from the banking system. Two tools for draining reserves from the system are being developed and tested and will be ready when needed. First, the Federal Reserve is putting in place the capacity to conduct large reverse repurchase agreements with an expanded set of counterparties. Second, the Federal Reserve has tested a term deposit facility, under which instruments similar to the certificates of deposit that banks offer their customers will be auctioned to depository institutions.

Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.

Financial Reform Legislation
Last week, the Congress passed landmark legislation to reform the financial system and financial regulation, and the President signed the bill into law this morning. That legislation represents significant progress toward reducing the likelihood of future financial crises and strengthening the capacity of financial regulators to respond to risks that may emerge. Importantly, the legislation encourages an approach to supervision designed to foster the stability of the financial system as a whole as well as the safety and soundness of individual institutions. Within the Federal Reserve, we have already taken steps to strengthen our analysis and supervision of the financial system and systemically important financial firms in ways consistent with the new legislation. In particular, making full use of the Federal Reserve’s broad expertise in economics, financial markets, payment systems, and bank supervision, we have significantly changed our supervisory framework to improve our consolidated supervision of large, complex bank holding companies, and we are enhancing the tools we use to monitor the financial sector and to identify potential systemic risks. In addition, the briefings prepared for meetings of the FOMC are now providing increased coverage and analysis of potential risks to the financial system, thus supporting the Federal Reserve’s ability to make effective monetary policy and to enhance financial stability.

Much work remains to be done, both to implement through regulation the extensive provisions of the new legislation and to develop the macroprudential approach called for by the Congress. However, I believe that the legislation, together with stronger regulatory standards for bank capital and liquidity now being developed, will place our financial system on a sounder foundation and minimize the risk of a repetition of the devastating events of the past three years.

Thank you. I would be pleased to respond to your questions.

For immediate release

Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Most days for lunch I retire to the conference room and switch the TV on to CNBC.  During those segments when they go octobox and have eight people on at once discussing the generalia of the larger economy it always seems like it’s the bond guys and the commodoties gals who are fretting while the stock traders are pumping out the positives.

AP makes it a bit more clear:

To understand how this is all connected, you have to think like a bond trader. Inflation is their enemy because it means the purchasing power of the dollars they receive when bonds eventually are paid off will be diminished. The only question is by how much.

Yields on 10-year Treasury notes, a benchmark for home mortgages and other consumers loans, jumped from 2.5 percent in March around the time of the Fed announcement to as high as 3.7 percent in recent days as signs that efforts to stabilize the financial system and economy were starting to pay off. And 30-year mortgage rates jumped more than a quarter-point this week to 5.29 percent, the highest level since December, Freddie Mac reported.

“If the meltdown continues in the bond market, then mortgage yields will soon be at levels that choke off refinancing activity,” said economist Ed Yardeni, who runs his own investment firm. “Even worse, they could abort any necessary recovery in home sales and prices.”

Current economic and financial conditions and the federal budget

Before the Committee on the Budget, U.S. House of Representatives, Washington, D.C.

June 3, 2009

Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the federal budget.

Economic Developments and Outlook
The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market–the number of new and continuing claims for unemployment insurance through late May–suggests that sizable job losses and further increases in unemployment are likely over the next few months.

However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households’ spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline–a precondition for any recovery in homebuilding.

Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall’s sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production.

We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions; a relapse in the financial sector would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment.

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.

Conditions in Financial Markets
Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity.

Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector’s reliance on the Fed’s programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed our interventions. The issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans has also picked up this spring, and ABS funding rates have declined, developments supported by the availability of the Federal Reserve’s Term Asset-Backed Securities Loan Facility as a market backstop.

In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve’s program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings.

As you know, last month, the federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine, for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion, a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions over the next two years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook, losses at the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion.

Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9. We are in discussions with these firms on their capital plans, which are due by June 8. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being over-subscribed. In addition, these firms have announced actions that would generate up to an additional $12 billon of common equity. We expect further announcements shortly as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers, and their success in raising private capital, suggests that investors are gaining greater confidence in the banking system.

Fiscal Policy in the Current Economic and Financial Environment
Let me now turn to fiscal matters. As you are well aware, in February of this year, the Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts and increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in federal purchases, and federal grants for state and local governments.

Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts; then again, heightened economic uncertainties and the desire to increase precautionary saving or pay down debt might reduce households’ propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO’s estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3-1/2 million jobs.

The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II.

Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8-1/2 percent of GDP today to 10 percent by 2020 and 12-1/2 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands.

Addressing the country’s fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation’s economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability–defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth–requires that spending and budget deficits be well controlled.

Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.

Federal Reserve Transparency
Let me close today with an update on the Federal Reserve’s initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the Joint Economic Committee, I asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public.¹ That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed’s balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve’s annual financial statements, including information regarding the System Open Market Account portfolio, our loan programs, and the special purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve’s actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public.

My remarks this evening will focus on the Supervisory Capital Assessment Program, popularly known as the banking stress test. The federal bank regulatory agencies began the assessment program in late February and concluded their review with the release of the results just last Thursday. This initiative involved an unprecedented, simultaneous supervisory review of the 19 largest bank holding companies in the United States. Its objective was to ensure that these institutions have sufficient financial strength to absorb losses and to remain strongly capitalized, even in an economic environment more severe than currently anticipated. A well-capitalized banking system is essential for the revival of the credit flows that will underpin a sustainable economic recovery.

Objectives of Supervisory Capital Assessment Program
As you know, the abrupt end of the credit boom in 2007 has had widespread financial and economic ramifications, including a sharp slowdown in global economic activity and the imposition of substantial losses on banks and other financial institutions. Economic and financial weaknesses have fed on each other, as a declining economy has exacerbated credit losses and the resulting pressure on banks and other financial institutions has constrained the availability of new credit.

A number of significant steps have been taken to restore confidence in the nation’s financial institutions, including a substantial expansion of guarantees for bank liabilities by the Federal Deposit Insurance Corporation (FDIC), injections of capital by the Treasury in many institutions both large and small, and Federal Reserve programs to provide liquidity to financial institutions and support the normalization of key credit markets. These efforts averted serious threats to global financial stability last fall and have contributed to gradual improvement in key credit markets, though many markets remain stressed.

These steps, however, did not fully address market concerns over the depletion of bank capital caused by write-downs and increased reserving for potential losses. At the beginning of this episode, bank losses were focused in a few asset classes, such as subprime mortgages and certain complex credit products. Today, following the significant weakening in the global economy that began last fall, concerns have shifted to more-traditional credit risks, including rising delinquencies on prime as well as subprime mortgages, unpaid credit card and auto loans, worsening conditions in commercial real estate markets, and increased rates of corporate bankruptcy.

The loss of confidence we have seen in some banking institutions has arisen not only because market participants expect the future loss rates on many banking assets to be high, but because they also perceive the range of uncertainty surrounding estimated loss rates as being unusually wide. The capital assessment program was designed to reduce this uncertainty by conducting a stringent, forward-looking assessment of prospective losses at major banking organizations. The objective was to identify the extent to which each of the 19 firms is vulnerable today to a weaker-than-expected economy in the future, and to measure how much of an additional capital buffer, if any, each firm would need to establish now to withstand the potential losses in more-adverse economic conditions.

To make this assessment, we began by stipulating a hypothetical, adverse economic scenario, under which growth, unemployment, and house-price outcomes were assumed to be more unfavorable than those implied by the consensus of private-sector forecasters. Using this hypothetical adverse scenario, examiners were asked to estimate the range of possible losses that our largest and most important banking organizations could experience over the next two to three years, as well as the resources, such as earnings and reserves, that those organizations would have available to offset those losses. It is important to note that this was not a solvency test. After including capital previously provided by the Treasury, all of these banking organizations currently have capital well in excess of the minimum stated capital requirements of the supervisors. Instead, the purpose of the exercise was to determine the size of the capital cushion that each organization would need to remain well capitalized and still be able to lend–even in an economic scenario more severe than expected.

We have now learned through this process that, if the economy were to track the more adverse scenario, additional losses at the 19 firms during 2009 and 2010 could total about $600 billion. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions will require, collectively, common or contingent common equity of $185 billion to ensure adequate capital cushions. Of this amount, the equivalent of $110 billion has already been raised or is contractually committed to be in place, or to a lesser degree reflects first-quarter pre-provision earnings above those assumed in the initial supervisory estimates. Consequently, the remaining common equity buffer that must be raised is $75 billion. The firms that are determined to need an additional capital buffer will have 30 days to develop a capital plan to be approved by their supervisors and six months to implement that plan. We have strongly encouraged institutions requiring additional capital to obtain it through private means, including, for example, new equity issues, conversions, exchange offers, or sales of businesses or other assets. To ensure that all of these firms can build the needed capital cushions, however, the Treasury has made a firm commitment to provide contingent common equity, in the form of mandatory convertible preferred stock, as a bridge to obtaining private capital in the future. Banking organizations will also have the option to exchange their existing preferred stock, issued under Treasury’s earlier Capital Purchase Program, for the new contingent common equity. The Treasury has indicated that it expects that any such exchange will be either accompanied or preceded by new capital raises or the conversion of private capital securities into common equity.

Process and Methodology
To properly understand the results of the capital assessment program, it is helpful to understand the process that produced the results. All U.S.-owned bank holding companies with year-end 2008 assets exceeding $100 billion were required to participate in the program. These 19 firms collectively hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system, supporting a very significant portion of credit intermediation in the United States. The assessment process can perhaps best be characterized as a simultaneous examination of 19 large bank holding companies that addressed all major categories of assets as well as revenue expectations.

The assessment was a resource-intensive undertaking, involving extraordinary efforts by more than 150 examiners and analysts from the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the FDIC. These staff members conducted a detailed, firm-specific analysis over a 10-week period. Their efforts were aided by access to data and management available only to bank supervisors. The supervisors also incorporated statistical tools and quantitative models in their evaluation of each firm’s data to facilitate comparative analysis across the 19 firms.

The analysis was a comprehensive one, which included an exhaustive review of loan portfolios, investment securities, trading positions, and off-balance sheet commitments. Typically, supervisory examinations focus on individual business lines or asset classes at a single firm. In this case, we simultaneously reviewed all of the major portfolios and business lines at each of the 19 firms, making unprecedented efforts to achieve methodological consistency across firms, portfolios, and supervisors.

Through it all, we tried to be as transparent as possible. The assumptions, processes, and results of the capital assessment program have been communicated in detail, taking into account legitimate supervisory and firm confidentiality concerns. We released a white paper on April 24 describing the process and methodology.¹ On May 6, we provided more information on the measures used to size the required capital buffer, as well as a preview of the information that would be disclosed.² The final release of results, this past Thursday, May 7, included the supervisory-determined indicative loss rates that were used in evaluating firm submissions, and, most importantly, aggregate and firm-specific estimates for losses, loss rates, resources to absorb losses, and the resulting capital buffer needs.³

Finally, as I have noted, the assessment was forward-looking. To project losses and offsetting resources two to three years in the future under the adverse scenario, we analyzed the historical relationships of losses and earnings to macroeconomic conditions and other determinants, and we dug deeply into cross-firm differences in portfolio compositions and vulnerabilities.

The process began in earnest in early March when each firm submitted its estimate of losses and earnings over a two-year scenario, under two alternative assumed paths for the U.S. economy. The baseline scenario reflected the consensus expectation for the economy among professional forecasters as of February 2009, and the more adverse scenario incorporated the possibility that the recession could be more severe than the consensus expectation and that house prices could fall even more sharply.

Although we began the process by asking the firms to submit their own estimates of expected losses and revenues, we by no means accepted these submissions uncritically. Senior supervisors and on-site examiners evaluated the firms’ estimates to identify methodological weaknesses, missing information, over-optimistic assumptions, and other problems. Examiners had detailed conversations with bank managers, which led to numerous corrections to and modifications of the firms’ submissions, including sensitivity analyses based on alternative assumptions.

As a second step, supervisors made judgmental adjustments to the firms’ loss and revenue estimates. This process used both firm-specific and comparative analyses. For example, supervisors sometimes disagreed with the technical assumptions underlying a firm’s loss forecast. In these cases, they adjusted the loss rates based on sensitivity analyses performed by the firm, results from other firms, and the supervisors’ own expert judgments.

Third, the supervisors’ judgmental assessments were supplemented by objective, model-based estimates for losses and revenues that could be applied on a consistent basis across firms. For example, we used statistical models to estimate residential mortgage losses at firms based on loan data submitted by the firms as part of the exercise. Each participating institution was asked to supply detailed information, in a standardized format, about the composition of its residential real estate portfolios, including breakdowns by type of product, loan-to-value ratio, FICO score, year of origination, and so on. These data allowed supervisors to consistently estimate potential future losses across firms using a variety of independently constructed models. Some of these models were already in use to monitor risk as part of the ongoing supervisory oversight process, while others were developed or refined specifically for the capital assessment exercise.

Similarly, to assess firms’ revenue projections for 2009 and 2010, the agencies examined the components of expected revenue in detail, compared the projections to historical results, and cross-checked the underlying assumptions with projections of portfolio growth, funding costs, and the like. The agencies also used more-formal statistical analyses to develop firm-by-firm forecasts that would reflect the historical relationship between revenues and macroeconomic conditions, thereby enabling them to assess which components were less likely to be sustainable in a weaker economy. Information from all of these sources was incorporated into the final revenue projections. Finally, the supervisors systematically incorporated all of these inputs into loss, revenue, and reserve estimates for each institution.

Determining the Size of the Capital Buffer
A key question in this assessment was the appropriate size of the capital buffers that these firms would be required to hold, as well as the quality of those buffers. Recall that our analysis of the firms’ financial conditions focused not on current capital levels alone but also on how capital levels might evolve over a two-year horizon, assuming a more adverse economic environment than currently anticipated. In other words, the assessment was not a forecast of expected outcomes but rather a “what-if” exercise, intended to help supervisors gauge the capital buffers needed to keep banks well capitalized and able to lend across a range of economic scenarios.

In judging the needed buffer, we understood that no single measure of capital adequacy is universally accepted or would guarantee a return of market confidence. Fortunately, our existing capital framework is well understood and addresses the key concerns that have been voiced by the market. Under our existing standards, banks are considered “well capitalized” with Tier 1 capital at 6 percent of risk-weighted assets. Using that benchmark in the context of bank holding companies, we sized the capital buffer so that each of the 19 companies would be expected to meet that threshold at year-end 2010 if the losses and revenues implied by the adverse case were realized.

In addition, common equity ratios in various guises are viewed by stockholders, bondholders, and counterparties as key measures of solvency, because common equity provides superior loss absorption and greater financial flexibility than other forms of capital. Because of these attributes of common equity, our bank holding company capital rules require that voting common stockholders’ equity make up the dominant portion of Tier 1 capital elements. In the context of the assessment program, we have structured the required capital buffer to ensure that, under the adverse scenario, each of the 19 firms would have a minimum 4 percent Tier 1 Common ratio at year-end 2010. (Tier 1 Common is simply common equity subject to the same deductions from capital as are required when determining Tier 1 capital–for example, deducting goodwill.) Importantly, the “6-4″ metric used to size the appropriate capital buffer does not represent a new capital standard and is not expected necessarily to be maintained on an ongoing basis. Going forward, with the required initial buffer in place, supervisors will work with banks and bank holding companies to ensure that capital levels are appropriate for the level of risk in banks’ portfolios and in the economic environment.

Evaluating the Results
Projecting credit losses in an uncertain economic environment is difficult, to say the least, but the intensive, painstaking nature of this process gives us confidence in our results. In particular, we believe that our estimates of needed capital buffers are appropriately conservative. Notably, a comparison to historical loss rates shows that the loss estimates we obtained significantly exceed those experienced in past recessions. The estimated two-year cumulative losses on total loans under the more adverse scenario averaged 9.1 percent across the 19 participating bank holding companies. This two-year rate is higher than any two-year period dating back to 1920, including the historical peak loss years of the 1930s. In particular, estimated loss rates for mortgage and consumer credit are high, reflecting the combination of high unemployment and steep declines in house prices that were specified in the more adverse scenario.

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario.⁴ One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.⁵ More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.

When making comparisons, it should be kept in mind that studies differed in the ways that losses were estimated and reported. Four particular sources of differences are notable.

First, studies differed in the time frames over which losses were calculated. Some outside reports included cumulative losses from the beginning of the financial crisis in mid-2007, and others included projections of losses over the lifetimes of currently held loans and securities. Our estimates are for potential losses in 2009 and 2010 and, indirectly, for 2011, through the estimate of the end-2010 loan loss reserve. Our estimates do not include the sizable losses that have already been recognized by the 19 banks–about $325 billion of loans and securities in the last six months of 2007 and in 2008–because they are already reflected in the firms’ balance sheets. Moreover, while we exclude losses beyond 2011, this limit would only be material for sizing the capital buffer if those losses were expected to substantially exceed pre-provision earnings after 2011, an outcome that we do not expect.

Second, a few private-sector estimates implicitly or explicitly assumed mark-to-market or liquidation prices for loans, which effectively incorporate a substantial liquidity discount in today’s market. However, because banks are portfolio lenders with core deposit funding and the ability to hold loans to maturity, our estimated valuations are based on projected cash flow credit losses related to a borrower’s failure to meet its obligation, not a liquidation value.

Third, some private-sector studies may not have taken into account the markdowns in asset valuations that occurred in the context of acquisitions of other firms. In particular, in the course of acquisitions by the 19 bank holding companies in 2008, the value of troubled loans was written down by almost $65 billion.⁶ These potential losses should only be realized once and thus are excluded from our estimates of prospective losses for 2009 and 2010. Of course, we took full account of these writedowns in our sizing of required capital buffers.

Fourth, in contrast to some outside estimates, estimated losses for the capital assessment program are for the 19 firms, not the entire banking system. Moreover, numerous adjustments were necessary to reflect particular facts and circumstances at these firms. That level of analysis simply has not been done–nor could it be done–by outside observers without the level of access available to supervisors.

Despite the care and rigor of this process, I would be the first to acknowledge that any loss forecast is inherently uncertain. The assessment program did not address some risks that institutions still need to consider in their own internal stress tests, such as operational, liquidity, and reputational risks. For all 19 firms, and particularly those with trading and investment banking businesses, those risks are important and will need to be monitored by both the firms and the supervisors. Ideally, the stress tests used in the assessment program should be part of a broader palette of internal stress tests conducted by firms; indeed, we do not intend that the capital assessments should be taken as all that those firms need to do.

A principal goal of the capital assessment process is to help increase confidence in the banking system. In particular, if it helps reduce uncertainty among investors regarding future losses and capital needs, and thereby improves the banking system’s access to private capital, one of the key objectives of the program will have been achieved. It will be some time before we can evaluate the success of the program on this criterion. However, the initial indications are encouraging. Each of the 10 banks requiring an additional capital buffer has pledged to have the necessary buffer in place by the November 9 deadline. Many of the banks are well ahead in finding private-sector options for increasing their common equity, and several have announced plans for new equity issues. In another positive sign, several have announced plans to issue long-term debt not guaranteed by the FDIC.

Lessons from the Assessment Program for the Supervisory Process
We’ve learned important lessons in the capital assessment process that will inform our supervisory efforts in the future. Notably, the process of comprehensively evaluating 19 major firms represented an important step forward in consolidated supervision, as it gave us insights into the challenges posed in understanding risks and exposures across complex organizations.

The cross-firm aspects of the assessment program were also instructive from a supervisory point of view. As I have mentioned, unlike traditional examinations focused on individual banks, the assessment process specifically incorporated cross-firm and aggregate analyses of a set of firms that constitute a majority of the banking system. This approach allowed a broader analysis of risks than is possible within the traditional supervisory focus on individual institutions. Supervisors evaluated loss rates for similar portfolios using consistent data and metrics, allowing them to identify outliers and more effectively evaluate the quality of individual firm estimates. The process was an iterative one, with both the firms and supervisors conducting sensitivity analyses around key assumptions.

The federal bank regulators–the Federal Reserve, OCC, and FDIC–cooperated extensively throughout this process, from the design to the implementation. In addition, within each agency, many resources across a range of skills were brought to bear. For example, quantitative experts supported examiners by incorporating statistical tools to facilitate benchmarking across institutions and to develop consistent loss estimates.

We learned from this effort that it is not a simple matter to simultaneously evaluate the consolidated risks for two-thirds of the assets in the U.S. banking system, using a common forward-looking framework and common metrics. But it was an enlightening exercise that will improve the toolkit we use to help ensure the safety and soundness not just of individual firms, but of the financial system more broadly.

Conclusion
In summary, the Supervisory Capital Assessment Program is an important element of broader and ongoing efforts by the Federal Reserve, other federal bank regulators, and the Treasury to ensure that our banking system has sufficient resources to navigate a challenging economic downturn. A collateral benefit is that many lessons of the exercise can be used to improve our supervisory processes. In particular, the supervisory capital assessment has demonstrated the benefits of using cross-firm, cross-portfolio information and the simultaneous review of a number of major firms to develop a more complete and fine-grained view of the health of the banking system.

Whether the objectives of the assessment program were achieved will only be known over time. We hope that in two or three years we will be able to reflect on the banking system’s return to health with a sharply diminished reliance on government capital. More immediately, we hope and expect that the public and investors will take considerable comfort from the fact that our largest financial institutions have been evaluated in a comprehensive and rigorous fashion; and that they will, as a consequence, be required to have a capital buffer adequate to weather future losses and to supply needed credit to our economy–even if the economic downturn is more severe than is currently anticipated.

This afternoon marks the culmination of the Supervisory Capital Assessment Program. Three independent federal banking supervisory agencies–the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation–have worked closely and collaboratively since late February to simultaneously assess the financial conditions of the 19 largest bank holding companies in the United States. These institutions play a vital role in our economy, holding among them two-thirds of the assets and more than one-half of the loans in the U.S. banking system. More than 150 examiners, economists, accountants, and other specialists conducted a rigorous and comprehensive review of these firms, one unprecedented in scale and scope.

These examinations were not tests of solvency; we knew already that all these institutions meet regulatory capital standards. Rather, the assessment program was a forward-looking, “what-if” exercise intended to help supervisors gauge the extent of the additional capital buffer necessary to keep these institutions strongly capitalized and lending, even if the economy performs worse than expected between now and the end of next year.

The results released today should provide considerable comfort to investors and the public. The examiners found that nearly all the banks that were evaluated have enough Tier 1 capital to absorb the higher losses envisioned under the hypothetical adverse scenario. Roughly half the firms, though, need to enhance their capital structure to put greater emphasis on common equity, which provides institutions the best protection during periods of stress. Many of the institutions have already taken actions to bolster their capital buffers and are well-positioned to raise capital from private sources over the next six months. However, our government, through the Treasury Department, stands ready to provide whatever additional capital may be necessary to ensure that our banking system is able to navigate a challenging economic downturn.

The capital assessment results we are reporting today are just one important element of the government’s broader and ongoing efforts to strengthen the financial system and the economy. The current crisis has been one of the most challenging financial and economic episodes in modern history, but we face no problems that cannot be overcome with insight, patience, and persistence. The Federal Reserve, through its independent actions and in collaboration with the other agencies represented here, will certainly do its part in our common effort to restore stability and prosperity.

While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added.

By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough.