Banks have become so wary about lending that credit costs are being pushed up despite sharp cuts in official interest rates and that is adding to the risks of an economic downturn, the vice chairman of the Federal Reserve said Thursday.
"It is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy," Donald Kohn said in prepared remarks.
"It is this tightening that is accentuating the downside risks for the economy as a whole," he added.
Kohn said, in light of ongoing market turmoil, banks should consider increasing their capital cushions to help position themselves for future growth once markets settle.
"All banks -- large and small -- need to consider whether they need greater capital cushions," Kohn told a credit market symposium sponsored by the Richmond Federal Reserve Bank.
"Not only would more capital provide a cushion against the sorts of unexpected declines in creditworthiness and asset values that have marked recent months, it would also position banks well for expansion," he added.
Kohn said regulators will need to ensure that minimum capital requirements and liquidity management plans are adequate to prevent shocks to the banking system from turning into broader threats to the economy.
"Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will," Kohn said.
He said the Fed was working with international regulators to raise capital requirements required by the Basel II banking accord, especially for "specific exposures that have been troublesome" like certain collateralized debt obligations and off-balance sheet commitments.
He noted the U.S. central bank had taken the extraordinary step last month of opening its discount lending window to primary dealers.
"Given the changes to financial markets and banking that we've been discussing ...
a pressing public policy issue is what kind of liquidity backdrop the central bank ought to supply to these institutions," Kohn said.
He said he had no "ready answers" but suggested that in the future banks will likely operate with much less leverage than they were before the current credit crisis hit, and that will help create a much more stable financial system.