Bernanke: Economic Conditions Still Far from Where Would Like

STONE MOUNTAIN, Ga. — The U.S. banking system is much stronger today compared to the battered industry that emerged from the 2008-2009 recession, but despite its contribution to the recovery, economic activity has not yet reached satisfactory levels, Federal Reserve Chairman Ben Bernanke said Monday night.

Bernanke also said banks still have work to do in reducing their reliance on wholesale funding, and stressed the "critical" need for financial institutions to develop and fine tune their independent risk management setup in order to protect the health of the banking system.

In remarks prepared for delivery to the Atlanta Fed's Financial Markets Conference in Stone Mountain, Georgia, Bernanke did not comment on current monetary policy, but did note that "today the economy is significantly stronger than it was four years ago, although conditions are clearly still far from where we would all like them to be."

Aiding this improvement in the health of the economy is the banking sector, which he said is "notably stronger than they were a few years ago."

Since bank regulators began stress testing the largest U.S. banks in 2009 to better gauge how their capital levels would stand up in another financial crisis, Bernanke said the resilience of the U.S. banking system has greatly improved.

"Unforeseen events are inevitable, which is why maintaining a healthy level of capital is essential," he said.

The Fed chairman went on to warn, however, that with regard to liquidity and funding, continued improvement is still needed in some areas.

"Notably, supervisors will continue to press banks to reduce further their dependence on wholesale funding, which proved highly unreliable during the crisis," he said. "And, in analogy to the need for effective capital planning, banks of all sizes need to further strengthen their ability to identify, quantify, and manage their liquidity risks."

Bernanke went on to laud the benefits of the stress tests, but at the same time cautioned against an overreliance on them at the expense of independent risk management systems.

"From a macroprudential perspective, the use of a common scenario allows us to learn how a particular risk or combination of risks might affect the banking system as a whole — not just individual institutions. This experience with stress testing has indeed been very useful for our efforts to better monitor and evaluate potential systemic risks," he said.

On the other hand, he acknowledged the risk that firms could grow to rely on supervisory risk models, ditching their own risk-management systems in the process.

While doing so would certainly make it easier to "pass" the stress tests, Bernanke warned that "all models have their blind spots, and such an outcome risks a 'model monoculture' that would be susceptible to a single, common failure."

"The differences in stress test results obtained by supervisors' and banks' own models can be informative, and we do not want inadvertently to destroy the healthy diversity or innovation of the models and other risk-management tools used in the banking industry," he added.

This is especially important, Bernanke believes, because he views the development and ongoing refinement of banks' risk-management capacity as "critical" for protecting individual banks and the banking system.

Another challenge he highlighted is that the Fed's stress scenarios cannot encompass all of the risks that banks might face.

"For example, although some operational risk losses, such as expenses for mortgage put-backs, are incorporated in our stress test estimates, banks may face operational, legal, and other risks that are specific to their company or are otherwise difficult to estimate," he noted.

Still, the fact remains that banks have come a long way since 2009, with Bernanke pointing out that over the past four years, the aggregate tier 1 common equity ratio of the 18 firms that underwent the stress tests published last month has more than doubled, from 5.6% of risk-weighted assets at the end of 2008 to 11.3% at the end of 2012 — "a net gain of nearly $400 billion in tier 1 common equity, to almost $800 billion at the end of 2012."

Not only does having higher capital put these banks in a much better position to absorb future losses, but Bernanke said "a majority" already meet the proposed Basel III capital requirements, and the others are on track to meet the new standards as they are phased in over time.

Outside of U.S. banking giants, the news is mostly positive, Bernanke continued, as the broader banking system — larger and smaller banks included — "has generally improved its liquidity position relative to pre-crisis levels."

Going forward, Bernanke emphasized that the Fed will continue to adjust and seek ways to improve the stress tests — especially in terms of avoiding the "procyclicality" of the financial system.

"In other words, in applying stress tests, we do not want to inadvertently set a standard that is easier to meet in good times (when banks should be preparing for possibly tougher times ahead) than in bad times (when banks need to be able to use accumulated capital to support lending)," he said.

"Accordingly, we will want to ensure that the stress scenario remains severe in an absolute sense even when the economy is strong and the near-term risks to the outlook seem relatively modest," Bernanke concluded.

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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