Transcript

Transcript of a Press Briefing on the International Monetary Fund’s U.S. Financial Sector Assessment Program by Christopher Towe, Deputy Director, Monetary and Capital Markets Department

August 3, 2010

MR. MURRAY: Thanks for joining us today. This is an on-the-record briefing on the first U.S. Financial Sector Assessment. Leading the briefing is Chris Towe, deputy director of our Monetary and Capital Markets Department. What I’d like to do is maybe the Fund staff can introduce themselves and also Charlie—Charles—Charlie Kramer, the mission chief for the United States is with us today from the Western Hemisphere Department. I’d like everybody to introduce themselves along with the press. Let me start with the IMF staff.

MR. BHATIA: I’m Ashok Bhatia, senior economist in the Strategy, Policy and Review Department and on the FSAP I focused on regulatory issues mostly.

MR. KRAMER: I’m Charlie Kramer in the Western Hemisphere Department.

MR. NARAIN: My name is Aditya Narain. I’m an Advisor in the Monetary and Capital Markets Department.

MR. WAJID: I’m Kal Wajid, also in the Monetary and Capital Markets Department. I was one of the coordinators of the exercise.

MR. TOWE: My name is Christopher Towe. I’m a deputy director of the Monetary and Capital Markets Department and I led the FSAP mission.

MS. MAECHLER: I’m Andrea Maechler. I work for the—on the U.S. team and I focus primarily on the stress test and macro prudential issues.

MR. CIHAK: Martin Cihak, Deputy Division Chief in Monetary and Capital Markets Department.

MR. DURAND: I’m Christian Durand. I am Assistant Director in the Monetary and Capital Markets Department and was one of the co-deputies of this FSAP mission.

MR. MURRAY: Great, thanks everybody. I’ll turn the table now to Chris, for his opening remarks.

MR. TOWE: Thank you, Bill. So, all right, again, my name is Christopher Towe and thank you all for coming today. What I thought I would do is very briefly give you a little bit of a sense of why we’re here and what the exercise was that we undertook over the last year or so before getting into the specific conclusions.

So, why are we here? What I’d like to try to do is give you an overview of our Financial Sector Assessment Program for the United States. What is the Financial Sector Assessment Program, or FSAP? It was a program that was established in the wake of the Asia crisis. It was part of the new international architecture that was designed as a result of that crisis. It specifically provides both the IMF and the World Bank an opportunity to undertake an objective assessment of the strengths and weaknesses of a financial system in three dimensions. First, it involves an assessment of the system’s stability typically involving stress testing. Secondly, it involves a benchmarking of the regulatory and supervisory system against international standards and codes. And third, it provides an assessment of the system’s crisis prevention and management frameworks: the deposit insurance system, the resolution system, and the like.

Why is this particular assessment important? For a number of reasons. One, it’s a milestone because the assessment of the United States means that we have now completed FSAP assessments for all the G-7 countries. The United States was the last of the G-7 to participate in this program. Secondly, it is a welcome confirmation of the United States as a member of the G-20, of the G-20’s recent commitment to the FSAP program. And thirdly, it is the first assessment of an advanced economy post-crisis. And as a result it is going to provide, I think, an important springboard of the lessons that we’ve learned from this, will provide an important springboard for the assessments that we’re planning this fall and beyond for a number of European and other major industrial countries.

So, that’s by way of background. Let me now just quickly walk you through what the core conclusions are of this exercise and actually let me step even further back and just say, the assessment began essentially last fall. We had a series of meetings over the October/November period and then again in March/April with a range of both public and private agencies. We met at the highest level, heads of agencies, President of the New York Fed, Chairman Bernanke, Secretary of the Treasury, we had excellent cooperation with the U.S. authorities, and I just want to give every credit to the U.S. authorities for that.

So, the core conclusions are fivefold. First, I think what we try to do is acknowledge the impressive progress that’s been made in restoring stability to the U.S. financial system and we also give all credit to the U.S. authorities for the bold and decisive actions that they took to address the near collapse of the system.

We also give considerable credit to the impressive reforms that have recently been enacted, the Dodd-Frank Act, and view them as being a significant step forward in addressing the weaknesses and fragilities of the system that had led to the crisis. So, that’s conclusion one.

Conclusion two, notwithstanding the credit that we give for restoring stability, we identify still important risks and pockets of weakness. The risks relate to the housing market, which we still see as vulnerable to further price declines. We also see a considerable share of households subject to underwater mortgages. We see the commercial real estate sector as being vulnerable with a very large proportion of Commercial Real Estate (CRE) loans coming due in the near term and roughly half of those seriously underwater or delinquent. We also identify the potential for crises of confidence related to the difficult fiscal position in the United States. And I think those concerns, I think, have been exacerbated by developments in Europe where we’ve seen what can happen when confidence in a public sector’s ability to respond to crisis is undermined by a fundamentally weak fiscal situation.

That said, our core conclusion is that the risks appear to be manageable and they do not rise to a level of systemic concern at this point. But, again, that said, we are particularly concerned about the situation among the small- and medium-sized banks which are most heavily exposed to the CRE sector and these institutions also have a much lesser access to capital markets. And even under our baseline macroeconomic scenario, banks generally—both U.S. banks and foreign banks located here in the U.S.—we estimate would need a further $41 billion in additional capital to meet a benchmark that we define as a 6 percent Tier 1 common capital ratio. And you can see that in—you’ve got a copy of the report.

Let me just, if I can, point you to Figure 5, which I think is on page 21, which illustrates the forecasts and projection that we’ve made for the capital positions of different segments of the banking sector. So, you may want to look at that at your leisure, but it illustrates the specific weaknesses that we’ve identified in the small and regional banking sector and among the foreign banks that are located here in the U.S. And under our adverse scenario, the capital needs we estimate could rise to a level close to $80 billion.

So, the third core conclusion that I’d like to point you to is that the crisis in our analysis, the benchmarking that we did against international standards and codes, has driven home the critical need to improve the regulation in both individual institutions and the system as a whole. And indeed our assessment of the system uncovered important shortcomings, which are enumerated in paragraphs 41 through 43. But, again, those relate to the complexity of the system and the multiplicity of regulators, weaknesses in consolidated supervision, poor oversight of risk management especially among the systemically important holding companies, and an underfunding of the regulatory agencies.

We, in the report, give considerable credit to the Dodd-Frank Act for addressing many of these weaknesses. And some of the things that we’ve tried to highlight in the report as being significant steps forward include the oversight of OTC, or over-the-counter derivatives; the tighter regulation of mortgage markets; the enhanced oversight of systemic risk through the FSOC, the Financial Stability Oversight Council; and I think we also have to recognize the potential importance of stricter rules and governance—of corporate governance and compensation.

That said, notwithstanding these important improvements in the regulatory framework and architecture, we do see important risks and challenges and, in some areas, we were a little bit disappointed by the act. And I think foremost of that area of disappointment and challenge is the fact that we see the system of regulatory agencies as still remaining exceptionally complex with a very large number of agencies involved, and we would have preferred to have seen a much more bold streamlining of the regulatory architecture, possibly including a merger of responsibility for the oversight of securities markets and a merger of responsibilities for bank regulation.

So, against that background, the FSOC, is going to face very difficult challenges in improving interagency cooperation and coordination, and ensuring effective information sharing, and ensuring a preemptive response to emergent systemic risk. And indeed, much of the effectiveness of this new legislation will really depend on how it’s implemented and will also depend on the important rules that have yet to be written.

So, fourth, the other issue that we tried to flag as being essential to tackle is the “too big to fail” problem. There we give, again, credit for the encouraging steps that the act has taken on this front. We think it’s very important that responsibility for consolidated supervision has been extended to systemically important nonbanks and clearing and settlement systems. We think that it’s very important that the FSOC is empowered to impose capital and other charges in proportion to the systemic risk of systemically important institutions. We think that there will be important dividends from the establishment in the requirement that systemically important firms prepare living wills and that the regulator now has the option to enforce changes in corporate structure in response to those. And we also think it’s very important that a new special resolution system has been put in place to address failures of systemically important nonbank and holding companies.

But I think it’s important that notwithstanding the credit that we give to these changes, they really cannot substitute and should not be seen to be substitutes for a strong and preemptive consolidated supervision, for the will to act in response to emerging risks, and for very careful diligence to ensure that risks, systemic or otherwise, don’t leak outside the regulatory perimeter and into a shadow banking sector.

So, finally, the last issue that I want to just flag is that we see the reforms of the U.S. housing finance policies as important, unfinished business. These policies that have been geared towards subsidizing U.S. mortgage lending, including through the major housing Government Sponsored Enterprises (GSEs), we see as being costly, inefficient, and having encouraged excessive risk-taking. They also led to a buildup of leverage, which left the system much more vulnerable to crisis. And while the U.S. authorities have opted to defer action on this front, it is very encouraging to see that steps are now being taken, including this month, to try to bring concrete proposals to the table, and we look forward to early and decisive action on this front.

And as for Fannie and Freddie, the report—and you’ll see in sort of the last section of the report, we have suggested one reform option that would involve privatizing and breaking up these two housing entities; privatizing their retained portfolio investments; and shifting their public policy responsibilities, including for affordable housing, to an explicitly funded public agency.

So, that, in a nutshell, is the core message of the FSAP assessment. And so I would just turn it back to you with any questions or comments that you might have.

QUESTION: So, on the stress test, it left me a little perplexed. As you say, there’s $40 billion or whatever, depending on the level of adversity, but that seems like nothing, basically, given what we’ve been through. And then there’s this other stress test called the “distress dependent loss,” which I don’t really understand what that is, where there seem to be potentially huge losses. So, maybe you could talk about that.

MR. TOWE: Sure. Well, your first point, are the numbers nothing? I mean, I think I tried to indicate that we see these as manageable, and yes, the numbers are not frightening. I think the size of the losses that we identify in our sort of baselines and adverse scenarios are, as I described, manageable. But it’s important to remember that the institutions that we have in mind are not unimportant and it does suggest that the supervisory agencies will need to be watchful and keep a close watch on the risks that are associated with some of these, specifically the smaller and regional banks.

In terms of the distress dependencies, these are estimates that essentially are tail risks, so they represent—as you see in the table, the so-called unexpected losses are essentially very much at the outer bound of risks and would represent, I believe, a 1 percent probability. So, again, they give you a sense of what the very worst-case scenario could be. But, again, we should treat those as very much out in the tail.

My colleague here is flagging a nice chart that illustrates that in a document that will be posted tonight, which I’m sure you won’t be up until midnight to read, but it does illustrate that these are very—relatively low probability events and should give you a benchmarking of how severe the vulnerabilities are relative to the recent past, but don’t give you an indication of what the likely outcome is going to be.

QUESTION: And can you just define simply what a distressed dependent loss means?

MR. TOWE: It is a measure of loss that takes into account the correlation between the system—between the individual institutions within the system, so we’re not looking at each individual institution in isolation, but we’re looking at each individual institution in isolation plus the feedback effects between them.

QUESTION: So, again, just so the system fails basically and this is the effect on the banking system?

MR. TOWE: What it does is it assesses at a 1 percent risk level what the risk is to the system as a whole.

QUESTION: Just to make sure I understand, the distressed dependent losses, that’s these nice numbers on page 22, or are we talking about some other numbers? Which numbers were you talking about that show this thing you’ve just defined for us?

MR. TOWE: That is 23.

QUESTION: Okay, it’s the chart on page 23, okay. That one. Sorry, for not knowing my way around your document that well. The questions I wanted to ask were about the foreign things. You really sort of single out the foreign subsidiaries operating in the U.S. as possibly needing a lot more capital. I’m wondering what sort of systemic issues are connected to that. And then I was wondering if you thought in your recommendation on page 7, you talk about how the Fed needs this authority over the infrastructure providers and clearing and settlement activities. Do you think that the legislation did enough or do you think that they need to go beyond the powers granted to the Fed just as a general systemic overseer?

MR. TOWE: Okay, so the first question was why we’re singling out the foreign banks. Well, the point there is that the system until recently provided U.S. regulators the authority to apply a lesser standard, capital standard, to the foreign banks, essentially deferring responsibility for their oversight to their home regulator. That, as a result, has meant that the foreign subsidiaries of—sorry, the domestic subsidiaries of foreign banks --have typically run lower capital ratios than domestic banks. Encouragingly, the Dodd-Frank Act takes steps to address that issue and address the potential asymmetries between the domestic subs to foreign banks and domestic banks.

QUESTION: But are the numbers—I mean, they’re much bigger numbers, so are they scary numbers? Are they okay numbers?

MR. TOWE: I would not call them scary. I would say that there’s an asymmetry there that needs to be addressed, because you are creating a scope for differential treatment of essentially institutions that are operating in the same, nearly the same, business lines as domestic institutions.

So the second question was oversight of clearing and settlement systems by the Fed. I think we feel comfortable that the Dodd-Frank Act gives the necessary authority to the Fed. Again, this is a parenthetical which is not really news, but, I mean, the system now does provide for the Securities and Exchange Commission (SEC) and the Commodity Futures and Trade Commission (CFTC) oversight of a number of clearing settlement system.

MR. TOWE: As I understand it, the Dodd-Frank Act, it does not supplant the authority that the SEC and the CFTC—the existing authority that the SEC and CFTC has over the clearing settlement systems, but only extends that oversight over other clearing settlement systems for which there is not presently appropriate oversight. It does, as I understand it—and I’m going to defer to my colleagues who have read the bill much more carefully than I have—I believe it does give a systemic oversight responsibility for even the SEC and CFTC overseeing settlement systems. But it does not supplant the SEC and CFTC’s responsibilities.

And, Ashok, does that sound right?

MR. BHATIA: Yeah. I think the only sort of big picture thing I’d add is that, most of you would be aware that Title 8 in the law, which addresses these issues, was missing from the version passed by the House in December. And it’s something that we were very strongly supportive of and are very pleased to see in the final law.

QUESTION: Will your annexes tonight have any institution-specific data?

MR. TOWE: I believe—oh, institution- specific. You mean named institutions?

QUESTION: Right.

MR. TOWE: No. The answer’s no. No, we were careful to do a peer group analysis to define the assessments according to, again, peer groups. We did build up from individual- and institution-specific data, though.

QUESTION: Thank you.

QUESTION The one issue I wanted to find out was, we’ve seen Geithner talking about the fact that credit conditions [are] also tough. Would you say a lot of this is coming from the fact that many banks feel restrained by the broader economic issues? Or do you think that a lot of them feel restrained by the capital that they have?

MR. TOWE: Okay, I’ll take a stab at that. But, Charlie Kramer, who led the Article IV consultation may want to step in because I think that falls closer into his realm than mine. I think it’s a two-edged sword. I remember during the 2000 recession, this was always that question: Is it a supply or demand issue on bank lending? And I think that that was a question that I think then ‘academic’ Ben Bernanke spent a lot of time trying to parse. And it took many years for us to come to reasonable conclusions on that front.

I think where I would guess we are now is that capital—bank capital, at least among the larger institutions, does not seem to be a significant impediment. We are seeing, at least on the basis of lending surveys, of loan officer surveys, that what had been a very restrictive environment is becoming less so.

That said, I think there is certainly an issue among that smaller and regional institutions, which are less well-capitalized, do face, as I’ve tried to indicate earlier, more significant and likely going to be more significant loan losses. And they tend to be the institutions that provide a lot of lending to small- and medium-size businesses as well. So I think that’s an issue.

I think there’s also an issue about regulatory uncertainty. I think we’ve seen this in some of our contact with market participants that institutions are still waiting to know and to find out what the implications are of domestic legislation and what’s going to come out of Basel. So I think that is leading to a certain hesitancy.

But I think we also can’t discount the fact that on the demand side we’re in a relatively weak economy, and the demand for borrowing is not that high. But, Charlie, any comments?

MR. KRAMER: I don’t have much to add except to say that one of our bellwethers for this is the Fed’s Senior Loan Officer Survey, and if you look in there, I guess you’d see some of the features that Chris describes. One is, across the board a pretty weak loan demand, which is consistent with what you see in the Fed, the flow of funds, sort of pretty widespread to leveraging the private sector.

But at the same time, the sort of success of tightening and bank lending standards has basically just come to an end. Standards are still on the tight side if you look at spreads, for example. So there’s probably elements of both, I’d say.

QUESTION: I was wondering, to draw your conclusions, what kind of access did the administration give you and the private sector to draw these conclusions? Not on the credit?

MR. TOWE: I think we have to give the U.S. authorities very high marks in terms of the access they provided to us, and we met with the heads of all the supervisory agencies. We met with the president of the New York Fed, we met with Secretary Geithner, we met with Chairman Bernanke. And that’s just at the top of the pyramid, and we went all the way down to the bottom of the pyramid. So I think that, relative to the similar assessments that we’ve done in other countries, the U.S. authorities score very, very highly on that front.

Data-wise we were limited to working with publicly available information, for confidentiality reasons. I think the regulatory bodies did not feel that they had the authority to provide us with bank-specific information. But that said, I think we also have to give incredibly high marks to the transparency of the U.S. system. It is very easy to get this information. It’s both of a high quality to the extent that published balance sheets are accurate, but it’s easily accessible. It’s of a high quality, and it’s available in a timely manner.

MR. TOWE: Oh, in the private sector, we met with most of the major investment and commercial banks, and, again, we got very good access.

QUESTION: Could you elaborate a little on your critique of the U.S. system and financial regulation and the lack of consolidation?– What are the risks that that poses and what would you like to see change?

MR. TOWE: Well, there are a couple of issues there. I think one is, historically, although the Fed, as a result of the Gramm-Leach-Bliley Act, was given the oversight of financial holding companies, the architecture of that legislation imposed impediments on the Fed’s ability to work at a granular level and look at, in a granular way, at the subsidiaries of holding companies. And a particular legislation required the Fed to defer to the functional supervisors in terms of its access to exams and other information. So that’s one issue.

The second is related to insurance companies where we did an assessment of the quality of insurance supervision and regulation, which scored well, notwithstanding the fact that the system is highly fragmented and based on a state-based system of oversight. But where it clearly fell short was in terms of consolidated supervision of insurance groups. And, you know, the obvious example is AIG.

So, essentially, the weaknesses are and have been that the competent authorities have tended to focus either too much at a sort of a top-tier level and not gotten into the granular level of the subsidiaries, or have been precluded from doing so by existing legislation.

I guess the third element is systemically important nonbanks, and there, again, the Dodd-Frank Act does an excellent job in extending the oversight of the Fed to cover systemically important nonbank holding companies.

QUESTION: In one vein, as we just had this stress test published in Europe, if you compare the macroeconomic scenario, you have taken a year to analyze the U.S. system. Can you please compare that to the scenario which was taken in Europe? If I look at the numbers between, it seems to me that the macroeconomic shock in Europe, which was assumed was just slightly bigger than the macroeconomic shock that was assumed in these numbers.

MR. TOWE: Well, first, I would not want you to assume that we undertook this exercise with reference to the same exercise in Europe. I mean, this was a completely separate and distinct exercise. So in response to the question, is the macro scenario—the adverse scenario that we adopted—is it not stringent enough? You know, what I would say is we simulated, in effect, a double-dip recession because we have growth below 1 percent in 2011, and growth below that level is typically associated with at least two quarters of negative growth. Again, we don’t see that as a likely outcome, but it was a stress scenario that we thought was appropriate. We also in that adverse scenario included a fairly significant shock to real estate prices relative to the baseline. We also are shocking a system that is already very weak. So I think in those three dimensions we felt it was sufficiently stringent.

QUESTION: I’m sorry if you went through this already, but could you explain on the first page when you write, “Bolder action could have been envisaged,” what you had in mind?

MR. TOWE: Yes. What we had in mind, specifically, was with regard to the consolidation of the supervisory agencies.

QUESTION: So two things. You describe the complexity of the regulatory and supervisory system as contributing to the meltdown, and then you go on to describe in the Act that was just published the administration has failed to take advantage of an opportunity to streamline the system and there remains considerably complexity. So are you intimating that that exposes the U.S. system and then the global system to another crisis because of that oversight?

MR. TOWE: I’m not supposed to joke in these things, but remember that line from “Yes, Minister”: “You could say that, but I couldn’t possibly comment.” But more seriously, I think it’s going to be a challenge, given the complexity to the system for the FSOC to address the weaknesses of a supervisory framework that is so complex and so fragmented. I think that the strengths of the FSOC are that it’s chaired by the Secretary of the Treasury, who will bring all the authority of the administration to the table. But it will be a challenge to ensure that the agencies work together; that the overlaps and duplications that still exist are addressed; that they share the information that’s needed to effectively exercise systemic oversight; and to ensure that there’s as prompt and effective response to risks when they are identified.

QUESTION: So let’s say FSOC does not perform up to your recommended standards. Does that impose a realistic probability of another crisis?

MR. TOWE: In some sense that’s a metaphysical question, which I would only answer by saying that, this was an important and almost all-consuming topic of conversation with the U.S. authorities throughout the process, because we asked many times why bolder action could not be undertaken. The answer was, typically, that this was a system that was pre-existent and not easy to change, given the history of the regulatory framework, and this was the best that could be done given those constraints.

At the same time, I think we all have to acknowledge that if you look internationally, there is no obvious model that fared better than others. There are very good examples of financial systems that had single regulators that failed, and there are good examples of those that had fragmented systems that failed. And, similarly, there are good examples of fragmented systems that survived and good examples of single regulators that also survived.

So, I think the lessons of the crisis are not necessarily how you organize your regulatory system, but what you do with it. And the will to act, which is a phrase you’ll see in our report, is an essential component of that.

QUESTION: Can we go back to the stress test? Usually, the IMF line is that, one, you have a stress test, you should immediately act afterwards to raise capital. So are you recommending that the banks, especially the regional ones, should be recapitalized? And, if yes, according to which scenario: the adverse one or the baseline one? And maybe more for Mr. Kramer, so the bad loans that are coming up, do you feel that they’re well taken into account and how would they possibly impact your growth scenario?

MR. TOWE: Okay, so let me try to answer the first question and maybe Charlie can pick up the second. You know, I think one of the core recommendations we make is that the experience of the staff was, I think, a sea change for the system. It illustrated the benefits and the power of a good and effective horizontal review of the system, and so our recommendation would be that that exercise be conducted on as regular a basis as possible. And when and if individual institutions are identified as being deficient in terms of their capital, there should be early remedial action taken.

QUESTION: Your study suggests the case, right?

MR. TOWE: We have to be humble in the sense that we don’t have access to the detailed data that would allow us to make that type of recommendation. But, again, in some sense I’m deferring the answer, but what I would say is if supervisors were to undertake such an exercise and on the basis of much more detailed access to information and data, if they came up with the same conclusion, then, yes, I would imagine that we would recommend that the authorities take action.

QUESTION: Have you told the regulators which of these four regional banks and seven smaller banks? I mean, did you tell them who they are in case they want to act on this?

MR. TOWE: I think we shared the information. Although we were not privy to confidential supervisory information, the various regulatory bodies that exercises this type of oversight participated in our analysis or provided us with comments on the analysis. I think their view was that one has to be very careful about drawing very strong conclusions of the type suggested because, you know, there’s an enormous confidence interval and uncertainty that surrounds these types of estimates. So in some sense that’s why we didn’t take as definitive a position on recapitalization because the level of uncertainty that surrounds the numbers is high. Let me turn it to Kal Wajid.

MR. WAJID: Yeah, I was just going to add to that, just to be clear, that the stress testing exercises in FSAPs don’t automatically lead to a recommendation to increase capital by that amount. They are definitely illustrative exercises and as Chris has said, there are confidence bands around them in almost every exercise. So they are indicative and the purpose of them is for the supervisors to then follow up and see what the appropriate action would be because these are arm’s length. We are not in the institutions so it’s in that spirit.

QUESTION: We’ve heard the IMF a lot for commending Europe to have something ready right after results so that’s why I was curious.

MR. TOWE: I shouldn’t be speaking about Europe, but I think the distinction is in those regions that undertake a supervisory assessment, if it’s done using the care and using the detailed information, it is important that you have a response ready once that information and once the analysis is done. Charlie perhaps would like to comment on the other question.

MR. KRAMER: The question was sort of where are we in the credit cycle basically?

QUESTION: You know, your warning about these bad loans coming up and I just want to have your feeling of how much this is taken into account by all the actors, financial actors. And also what you estimate will be the impact on the economy.

MR. KRAMER: I think where we are in the credit cycle is very much a focus of the discussion for all of the people we talked to. And I guess the sense—the bigger question that comes out of what we’ve asked is sort of, where are we now, where are we going from here? Well, I guess based on the sort of very preliminary numbers that we’re seeing rolling out for the second quarter, the sense is—and, again, this is very preliminary because obviously it’s pretty hard to gauge where you are in any kind of cycle at the turning point—but the sense is that maybe credit costs are peaking or even coming down a little bit at the margin and so from sort of a very preliminary point of view. But our sense is that, based on the historical experience with these sorts of episodes, we’ll probably have a prolonged period of elevated credit costs. So while the worst might be over, we’re sort of not necessarily in a sort of good territory anytime very soon.

I think the bigger question that comes out of this is sort of where are profits going, right? Because you basically have a couple of sources of capital. One is to raise capital and the market’s another that’s retained earnings. And a lot of the work in stress tests revolved around sort of where are earnings going and how much retained earnings we’ll be able to use for internal capital generation?

And so I think one point worth noting is another thing we saw in the second quarter earnings is that one of the major sources of revenue for the banks, which is trading revenue, has come down a lot. So during the crisis, a lot of volatility, steep yield, fat spreads. There’s a lot of trading revenue for the banks. Now we’re seeing the edge come off of that a little bit.

MR. TOWE: One final thought which is in terms of the stress testing and the estimates that were prepared, it’s important—you’ll see this written in the report—that we are relatively mechanistic in these exercises insofar as we assumed that dividends would continue to be paid, and we didn’t take into account that the individual institutions might access capital through capital markets. So these estimates do have built in them a certain buffer that could be accessed.

QUESTION: Could you tell us, go into a little more detail about this, the Fannie/Freddie model you all are proposing? And also can you tell us what you think the impact of the new Basel III agreement, the potential agreement, could have on all this?

MR. TOWE: I’ll start off on our view. Our view is that there is a significant hole in their balance sheets, that their position is not sustainable. And more importantly, we worry that the incredibly expensive and inefficient public policy responsibilities that they have been assigned over the last decade or so has made their situation untenable. We really do wonder whether or not there is a role, still a role needed for these bodies in terms of promoting securitization of mortgages. And the model we have in mind is actually—I think it’s not dissimilar from the ones that have been discussed by a number of senior administration officials. It’s one that would involve breaking them up, privatizing their retained portfolios, and then assigning their responsibilities for affordable housing to a government agency with explicit funding. Ashok, is that—anything you want to add?

MR. BHATIA: What we had in the past was a system where firstly their guarantees were implicit and tied up in a whole bunch of special privileges they enjoyed, and, secondly, that a lot of the benefit of those guarantees accrued to private shareholders. So in a sense, we emphasized that that was worst of all those. And it’s important going forward that whatever solution we end up with is one that is clear, to the extent its guarantees are still required. They are explicit and not—and hence, whatever public policy objectives need to remain should be under what we call a public utility as opposed to—and we see the retained portfolios as kind of peripheral to their bundling securitization role and something that could readily be transferred to the private sector.

QUESTION: What is your report’s view on the new rules coming out of Basel?

MR. TOWE: In many respects I think our report is silent on that. It’s in part because the focus was on U.S. national policies and also in part because the analysis was done before the resolution, and we’re still waiting for the full details of so-called Basel III. So, I don’t think there’s really—we don’t have a strong position on that. I think that the only thing that we would say—and I think it is emphasized in the report—is that in many respects what the U.S. authorities have introduced in the context of the Dodd-Frank Act is going to be a precursor for what other countries are doing and will have an impact on the way in which both the U.S. and other countries implement the new Basel Accords. And so what we have tried to do is stress the importance that the U.S. authorities coordinate closely with other countries and work effectively in the context of the Basel Committee and other fora to make sure the reforms that are taking place here act as a race to the top if you like and are not implemented in a way that creates, go for regulatory arbitrage.

QUESTION: Why did your report come out now after the debate’s over on the financial bill as opposed to during the middle of it where it might have more effect?

MR. TOWE: Well, that was unfortunate. This was an exercise that was a long time in gestating. The discussions on when and how to do this had been underway for a number of years. The President’s Working Group, I believe, had ultimately decided for the United States to participate in this program because I think the U.S. authorities wanted to demonstrate a commitment to this multilateral effort, and that commitment was undertaken or taken about two years ago. I think we have to give enormous credit to the U.S. authorities for not deferring it, given that the system was in the middle of a crisis, the authorities were incredibly engaged in crisis management. They still, I think, very generously made the time to meet with us extensively.

I think it is also fair to say that it would have been preferable to have done this, if not a year ago, several years ago because I think many of the recommendations that we’ve made, much of the analysis that was done, I think would have been helpful. That said, our discussions took place as the reform legislation was gestating. We did publish, I think, 11 documents some 4 or 5 months ago. I do hope that in the conversations that we had with the regulatory agencies and others that we’ve had, if not a chance to influence, an opportunity to enrich the public debate.

QUESTION: Can I go back one more time to the technical issues?

QUESTION: Just one point, did you have consultations with Congress.

MR. TOWE: We didn’t meet just simply with U.S. officials, but we met with staffers on the Hill who were involved in the formulation of the legislation. The other thing to recognize, too, is that we have conversations with U.S. authorities annually in the context of our Article IV consultations. So this is—although this exercise is somewhat discreet—our engagement with U.S. authorities is much more continuous than that and it includes discussions on regulatory and financial issues.

QUESTION: And one technical question back to the stress-dependent losses, so it’s a 1 percent chance, right? I understand that. And then in 2008, it has a loss of $427 billion. But we had—was that period considered to have occurred?

MR. TOWE: Yes. This is a tricky issue. That number is—if you backcast the estimates, that would have been what the model would say would have happened with a 1 percent probability. Unfortunately, that 1 percent, the roll of the dice came up that year. So in some sense, what that tells you is, going forward, it gives you useful benchmarking for what that 1 percent probability really means.

QUESTION: Right, so substantial afterwards, but not on the scale of 2009?

MR. TOWE: Correct.

QUESTION: Just a quick one—and sorry if this seems a little off topic—but have you guys weighed in either in any of these documents or anywhere else on the buildup of reserves and what effect that might have on the economy or in the banking system if the banks are building up a lot of reserves at the Fed because of the way monetary policy is right now?

MR. TOWE: Yeah, we had, in the context of this exercise, fairly significant discussions on monetary policy implementation post-crisis. We didn’t feature it in the report, but I think we were confident on the basis of the conversations that we had and the analysis that we did that the Fed has the instruments available to it to effectively manage monetary policy, even given the swollen nature of its balance sheet. A very significant proportion of those reserves are likely to run off simply through the maturation of the underlying instruments, and new instruments are being and have been developed including interest on reserves and term deposits auctions.

QUESTION: What about the quantity of the interest—or the reserves that interests are being paid on, specifically the part of the reserves that the banks have control of that they’re keeping with the Fed?

MR. TOWE: I think your question is, are we worried that the amount of excess reserves in some sense represents an overhang and a potential risk going forward? I think the answer is no, because the Fed has available instruments to, in effect, sterilize those by paying interest on them. Charlie, do you want to add anything to that?

MR. KRAMER: First of all, there’s a lot of slack in the economy. Core inflation is at pretty low levels. Inflation I don’t think is on anybody’s radar screen as like a major risk at this stage. The forward-looking questions—

QUESTION: Deflation?

MR. KRAMER: Inflation, sorry, inflation.

QUESTION: No, but, I mean, is deflation a risk?

MR. KRAMER: Is deflation a risk? Deflation at this point we would say is a tail risk. I think the sort of key thing to remember about this is even though there’s a lot of slack in the economy and core inflation is low, it’s pretty stable at low levels. If you look at inflation expectations, it’s clear they’re pretty well anchored. You look at Consumer Price Index, for example, it’s anchored at about 2.25 percent or so over the sort of medium to longer term. So the Fed’s got a lot of credibility there obviously. They’ve done a good job of explaining it, in preparing for the exit without actually making people think they’re going to jump the gun and do the exit in a kind of premature way. So, you know, at this point I think you’d need a pretty big shock to raise the specter of deflation in a more significant way than we have right now. Just a tiny add-on to your question. You could refer to paragraphs 36 through 39 in the report where some of this stuff is touched.

MR. MURRAY: I guess we can wrap this up soon, but it’d probably be helpful, Chris, if you gave a quick overview. I believe this is the first advanced economy FSAP we’ve done in the wake of the financial crisis. Maybe you could give just a quick overview for a few minutes and then we’ll wrap up.

MR. TOWE: Sure. As Bill said and as I tried to flag at the outset, we see this exercise as really providing an important springboard to our work in the financial sector going forward. But also, specifically, the assessments that we’re going to be doing in a number of countries in the next year, we are anticipating similar assessments in the U.K. and Germany. And we have a number in systemically important G-20 emerging market economies that are either underway or close to completion. And I think this exercise has provided us with an enormously rich analytical and experience basis for doing that work and hopefully will ensure and help ensure that we can both build on the experience that we’ve had here in the U.S., the lessons that have been learned by the various officials that we’ve worked with over the last year, and help promote a more effective FSAP program and more effective IMF oversight of financial stability going forward.

MR. MURRAY: Great. Thanks, Chris, Charlie, and everyone else on the FSAP team. Appreciate you guys attending. Again, embargo on all this is 12:01 a.m. Friday. If you have any questions—I’m sure things will pop in—just send me an e-mail, WMurray@imf.org, and I’ll follow up with these guys for you.

QUESTION: Any chance you could send around a list of everybody’s name and title?

MR. MURRAY: I’ll do that, too. I’ll send an e-mail with everybody’s names and titles.