The ultimate purpose of financial stabilization, of course, was to restore the normal flow of credit, which had been severely disrupted. The Federal Reserve did its part by creating new lending programs to support the functioning of some key credit markets, such as the market for commercial paper--which is used to finance businesses' day-to-day operations--and the market for asset-backed securities--which helps sustain the flow of funding for auto loans, small-business loans, student loans, and many other forms of credit; and we continued to ensure that financial institutions had adequate access to liquidity. Additionally, we supported private credit markets and helped lower rates on mortgages and other loans through large-scale asset purchases, including purchases of debt and mortgage-backed securities issued or backed by government-sponsored enterprises.
Partly as the result of these and other policy actions, many parts of the financial system have improved substantially. Interbank and other short-term funding markets are functioning more normally; interest rate spreads on mortgages, corporate bonds, and other credit products have narrowed significantly; stock prices have rebounded; and some securitization markets have resumed operation. In particular, borrowers with access to public equity and bond markets, including most large firms, now generally are able to obtain credit without great difficulty. Other borrowers, such as state and local governments, have experienced improvement in their credit access as well.
However, access to credit remains strained for borrowers who are particularly dependent on banks, such as households and small businesses. Bank lending has contracted sharply this year, and the Federal Reserve's Senior Loan Officers Opinion Survey shows that banks continue to tighten the terms on which they extend credit for most kinds of loans--although recently the pace of tightening has slowed somewhat. Partly as a result of these pressures, household debt has declined in recent quarters for the first time since 1951. For their part, many small businesses have seen their bank credit lines reduced or eliminated, or they have been able to obtain credit only on significantly more restrictive terms.2 The fraction of small businesses reporting difficulty in obtaining credit is near a record high, and many of these businesses expect credit conditions to tighten further.
To be sure, not all of the sharp reductions in bank lending this year reflect cutbacks in the availability of bank credit. The demand for credit also has fallen significantly: For example, households are spending less than they did last year on big-ticket durable goods typically purchased with credit, and businesses are reducing investment outlays and thus have less need to borrow. Because of weakened balance sheets, fewer potential borrowers are creditworthy, even if they are willing to take on more debt. Also, write-downs of bad debt show up on bank balance sheets as reductions in credit outstanding. Nevertheless, it appears that, since the outbreak of the financial crisis, banks have tightened lending standards by more than would have been predicted by the decline in economic activity alone.
Several factors help explain the reluctance of banks to lend, despite general improvement in financial conditions and increases in bank stock prices and earnings. First, bank funding markets were badly impaired for a time, and some banks have accordingly decided (or have been urged by regulators) to hold larger buffers of liquid assets than before. Second, with loan losses still high and difficult to predict in the current environment, and with further uncertainty attending how regulatory capital standards may change, banks are being especially conservative in taking on more risk. Third, many securitization markets remain impaired, reducing an important source of funding for bank loans. In addition, changes to accounting rules at the beginning of next year will require banks to move a large volume of securitized assets back onto their balance sheets. Unfortunately, reduced bank lending may well slow the recovery by damping consumer spending, especially on durable goods, and by restricting the ability of some firms to finance their operations.
The Federal Reserve has used its authority as a bank supervisor to help facilitate the flow of credit through the banking system. In November 2008, with the other banking agencies, we issued guidance to banks and bank examiners that emphasized the importance of continuing to meet the needs of creditworthy borrowers, while maintaining appropriate prudence in lending decisions.3 This past spring, the Federal Reserve led the Supervisory Capital Assessment Program, or SCAP--a coordinated, comprehensive examination designed to ensure that 19 of the country's largest banking organizations would remain well capitalized and able to lend to creditworthy borrowers even if economic conditions turned out to be worse than expected. The release of the assessment results in May increased investor confidence in the U.S. banking system. A week ago, the Federal Reserve announced that 9 of 10 firms that were determined to have required additional capital were able to fully meet their required capital buffers without any further capital from the U.S. Treasury, and that aggregate Tier 1 common equity at the 10 firms increased by more than $77 billion since the conclusion of the assessment.
The Federal Reserve will continue to work with banks to improve the access of creditworthy borrowers to the credit they need. Lending to creditworthy borrowers is good for the economy, but it also benefits banks by maintaining their profitable relationships with good customers. We continue to encourage banks to raise additional capital to support their lending. And we continue to facilitate securitization through our Term Asset-Backed Securities Loan Facility (TALF) and to support home lending through our purchases of mortgage-backed securities. Normalizing the flow of bank credit to good borrowers will continue to be a top priority for policymakers.
While I am on the topic of bank lending, I would like to add a few words about commercial real estate (CRE). Demand for commercial property has dropped as the economy has weakened, leading to significant declines in property values, increased vacancy rates, and falling rents. These poor fundamentals have caused a sharp deterioration in the credit quality of CRE loans on banks' books and of the loans that back commercial mortgage-backed securities (CMBS). Pressures may be particularly acute at smaller regional and community banks that entered the crisis with high concentrations of CRE loans. In response, banks have been reducing their exposure to these loans quite rapidly in recent months. Meanwhile, the market for securitizations backed by these loans remains all but closed. With nearly $500 billion of CRE loans scheduled to mature annually over the next few years, the performance of this sector depends critically on the ability of borrowers to refinance many of those loans. Especially if CMBS financing remains unavailable, banks will face the tough decision of whether to roll over maturing debt or to foreclose.
Recognizing the importance of this sector for the economic recovery, the Federal Reserve has extended the TALF programs for existing CMBS through March 2010 and newly structured CMBS through June. Moreover, the banking agencies recently encouraged banks to work with their creditworthy borrowers to restructure troubled CRE loans in a prudent manner, and reminded examiners that--absent other adverse factors--a loan should not be classified as impaired based solely on a decline in collateral value.
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