Raskin: Need to Identify Potential Bank Loss Exposures Early

Federal Reserve Governor Sarah Bloom Raskin became the latest Fed policymaker to openly brood about potential risks in the financial sector Thursday.

Raskin did not cite any specific areas of concern, but said that banks and their supervisors need to make a greater effort to identify potential losses before they happen.

This was not done adequately in the years leading up to the financial crisis, she said in remarks prepared for delivery to a banking conference hosted by the Atlanta Federal Reserve Bank.

She said financial institutions must take particular care to guard against "reputational risk," saying that banks' reputations among both counterparties and the general public suffered from the crisis and have not fully recovered.

There has been a flurry of warnings from Fed officials about financial risks in recent weeks, most notably from Fed Governor Jeremy Stein -- so much that Fed Chairman Ben Bernanke felt the need, in his last two days of
Congressional testimony, to tamp down speculation that concerns about financial stability might lead the Fed to tighten monetary policy earlier than previously thought.

Unlike Stein, who cited potentially excessive risk-taking in the junk bond market, Raskin did not focus on any particular market segment, but spoke more generally of the need to address risks early.

"Supervisors have a duty to see that all risks are fully understood, even those risks that, like reputational risk, are unquantifiable or have not fully emerged...," said Raskin, herself a former bank supervisor. "To the extent possible, supervision can unveil hidden loss exposures that may be building up through the accumulation of reputational risk elements."

In the pre-crisis years, she said "ineffective" supervision "may have encouraged the underpricing of risk. And the sudden correction of this underpricing of risk, in turn, accelerated the crisis."

"To mitigate the chances of such a crisis occurring again, supervisors need to redouble their efforts toward promoting greater transparency of risks and early confrontation of potential loss exposures," Raskin said. "We should view these efforts as a set of responsibilities for both banks and regulators that are aligned to assure the public and markets that risks can be fully understood and accurately estimated and priced."

Currently, the approach to managing risk is too "reactive" and amounts to "crisis management," not risk management.

"Instead, we should think about a supervisory approach that incentivizes bank managers to sufficiently contemplate, quantify if necessary, and control the factors that affect the level of such risks before they fully emerge in an unmitigated form," Raskin said.

She said the Fed's aim is to help banking organizations "identify risks sooner."

Through regular examinations and other monitoring, the Fed seeks to "identify emerging risks and communicate with other regulators and the banks an updated risk assessment and supervisory strategy based on these risks."

"When we contemplate a supervisory approach that illuminates reputational risk, we might be able to more fully uncover the interconnection of risks that certain activities could impose on investors, creditors, counterparties, and taxpayers," she went on. "In this approach, we would first and foremost need to encourage banks to assess the potential riskiness of particular operations, investments, products, and decisions to their reputations and, ultimately, to their enterprise value."

Prefacing those comments, Raskin said "many of the darkest manifestations of the financial crisis have finally begun to diminish," but she added, "even as the economy comes back to life, our memory of these events is still sharp and the reputational damage suffered by U.S. financial institutions during the crisis endures."

Banks' reputations remain vulnerable as they seek to supplement their income by raising fees.

"If bank profitability is going to improve in a context of low interest rates and higher compliance costs, lending income may remain low," she said. "Profits will need to come from elsewhere. One source of profits would be products that are not interest-rate dependent, but fee-dependent."

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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