WASHINGTON (MNI) – The following is the third and final section of
the text of the remarks of Federal Reserve Gov. Elizabeth Duke, prepared
Tuesday for the Consumer Bankers Association Annual Conference in
Hollywood, Fla.:

For the moment, the contraction in consumer credit appears to be a
story both of diminished supply and weakened demand. While much of the
decline in outstanding credit reflects elevated charge-offs and tighter
lending standards, consumer cautiousness about debt appears to also play
a role. A significant net fraction of lenders still report reductions in
credit card line availability, and the volume of new credit card
offerings is only a fraction that of pre-crisis

(7 See Board of Governors of the Federal Reserve System (2010),
Statistical Release Z.1, “Flow of Funds Accounts of the United States:
Flows and Outstandings Fourth Quarter 2009″ (March 11),
http://www.federalreserve.gov/releases/z1/Current/z1.pdf. levels, which
in turn leads to fewer new accounts. At the same time, senior loan
officers at commercial banks continue to report weak borrower demand for
mortgages and for consumer loans.8)

The fact that consumers are shedding debt is not surprising, as
households report a heightened awareness of their debt burden. For
instance, in a recent survey, one in three households surveyed reported
that they are stressed about their ability to pay their debt. Among
delinquent borrowers, the stress is even more pronounced, with 84
percent reporting being particularly stressed and 86 percent reporting
being devoid of sufficient savings.9 One potentially positive outcome of
this stress would be if it gives consumers an incentive to save and
makes them wary to take on debt unless they are sure of their ability to
pay. In combination with regulations that require creditors to consider
the borrower’s ability to pay and disclosures that are clear about the
cost of credit, these hard lessons could lead to more sustainable credit
decisions by lenders and borrowers alike.

Balancing Access to Credit and Risk Management

In the course of our country’s history we have seen the standard of
living and economic prosperity that can result from a robust consumer
credit market. We have also seen the financial devastation and personal
tragedy that can result from weak underwriting and poor loan structures
recklessly marketed to consumers in ways that hide their potential cost.
Certainly the lessons of the recent crisis underscore the need for a
stronger, safer, but still robust system of consumer credit. As both
industry and policymakers explore what changes are necessary and what a
betterfunctioning system would look like, I would suggest five core
principles for balancing access to credit and sound risk management:

(8 See

http://www.federalreserve.gov/boarddocs/SnLoanSurvey/201005/fullreport.pdf.

9 See Fannie Mae, “2010 National Housing Survey,”
http://www.fanniemae.com/about/housing-survey.html. Adequate consumer
protection)

First and foremost, any new system must contain adequate
protections for consumers. In the aftermath of widespread abuses,
consumers need to feel confident that they can satisfactorily shop for
credit and anticipate the debt service burden of that credit over the
short run and the long term. Effective consumer protection, as events of
the past few years underscore, are integral to the promotion of sound
market practices, and are also a necessary precondition to the
restoration of consumer, lender, and investor confidence to the consumer
credit markets.

Prudent underwriting

Second, we have seen the results of underwriting based on
collateral values or the ability to refinance. Loans should instead be
underwritten on the basis of the consumer’s ability to repay according
to the terms of the loan. Many consumers have impaired credit coming out
of this cycle because they were unable to pay due either to poor
underwriting or loss of income. Consumer lenders will likely need to
develop innovative ways to assess credit histories during this period.
And they will need to be attentive to the risk of poor performance in
stressed economic conditions.

Transparency

Third, there must be transparency at all levels. Retail products
should be as transparent as possible, so that consumers find it easy to
understand the terms and risks of their credit. Lenders and servicers
should also make as much information as is reasonably feasible available
to investors. Indeed, adequate information for due diligence is likely a
prerequisite to attract capital back to the securitization market.

Simplicity

Fourth, the new system should encourage simplicity. Credit
disclosures and retail mortgage contracts ought to be as simple as
possible. Too often, the complexity of credit and lending products has
served to confuse borrowers and make it more difficult to make informed
decisions. Securitization structures will likewise need to be simpler
and conform to standardized contracts. The trickle of new mortgage
securitizations that are attracting investor interest today have
structures that are markedly simpler and more transparent than those of
the recent past.

Properly aligned incentives

Finally, the new system should feature clear roles and properly
aligned incentives for all players. In the recent turmoil, we saw
examples of misaligned interests and competing objectives. For instance,
there is evidence that some loan officers and mortgage brokers may have
been as concerned about whether loans were profitable to them personally
as they were about whether the borrower could actually repay.10
Servicers, too, turned out to have interests that were not always
aligned with investors, and different tranches of investors themselves
had competing interests that they tried to impose onto servicers.
Certainly, greater clarity about roles and responsibilities, and the
associated compensation of participants in the origination and servicing
chains, will help all parties understand, and properly align,
incentives.

Conclusion

Having survived the financial crisis, it is now time to work
together to build a consumer banking model for the future. It sure would
be nice if we could build it in a laboratory or test it in a simulation.
But we are all working in real time. The new model will be shaped by the
scars of the past. Policymakers will continue to craft regulation to
prevent the practices that led to

(10 See Benjamin Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant
Vig (2010), “Did Securitization Lead to Lax Screening? Evidence from
Subprime Loans,” Quarterly Journal of Economics, vol. 125, (February).
devastation in our entire economy as well as in the lives of individual
consumers. Investors will demand enough information to judge the ongoing
performance of credit underlying debt securities. Lenders will price and
underwrite products to conform to regulation and avoid a recurrence of
recent high loan loss experience. Consumers will reengage slowly as
confidence, income, and balance sheets strengthen.)

Reinvention will bring uncomfortable change and uncertainty, but I
believe that we are on the right path. We will need the active
cooperation and sustained efforts of many quarters- all segments of the
industry, consumers, and public policymakers-to get where I think we are
going: toward a reestablishment of a financial services sector that is
safe, transparent, efficient, and that effectively serves the needs of
the real economy. I am confident we will get there.

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** Market News International Washington Bureau: 202-371-2121 **

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