Bankers grew so sloppy about risks during good times that they may now need to cut dividends and raise more capital to prepare for coming problems, Federal Reserve Vice Chairman Donald Kohn warned.
In prepared remarks to the Senate Banking Committee, Kohn warned that weak earnings and asset value writedowns loom for bankers who didn't prepare in prosperous years for current problems with housing and other loans.
"The extended period of good times in the banking system bred a sense of overconfidence among many bankers and other market participants, causing them to underestimate risks and not fully consider the potential for those good times to end," Kohn said.
Loan quality may keep deteriorating for some time, he said.
"House prices are still declining sharply in many localities and losses related to residential real estate -- including loans to builders and developers -- are bound to increase further, Kohn said.
"Weak economic conditions could well extend problems to other segments of lending portfolios including consumer installment or credit card loans, as well as corporate loan portfolios," he added.
Loan loss reserves that banks have set aside have not kept pace with growth in problem assets and should be bolstered.
"In view of this uncertain outlook, additional capital injections and consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions," Kohn said.
He said banks need to take into consideration the fact that market liquidity "may erode quickly and unexpectedly," so they need to maintain "more robust" liquidity and capital cushions.
"This is a key point supervisors are reinforcing strongly," Kohn said.