Bank regulators: 'Asleep at the switch'

NEW YORK (CNNMoney.com) -- Lawmakers grilled bank regulators Tuesday about why they didn't intervene as lax lending standards led to a meltdown in the mortgage market and a credit crunch that threaten the economy.

"Again and again the question has been asked over the past year as our credit markets have grown increasingly impaired: Where were the regulators?," said Sen. Christopher Dodd, D-Conn., chairman of the banking committee. "Why didn't they do more? Were they asleep at the switch? And when the alarm went off, did they merely hit the snooze button?"

Federal Reserve Vice Chairman Donald Kohn and Comptroller of the Currency John Dugan were among those who said they were aware of the loosening of underwriting standards before the collapse and spoke to banks about it.

"We did recognize the risk in a general way somewhat better than the banks did," Kohn said. "We tried to warn people in speeches and in conversations that we thought they were taking risks. ... It's quite possible we could have been more forceful."

In response, Sen. Jack Reed, D-R.I., questioned whether talking with the banks about risk was the best way to regulate them.

"That might not be the most effective way to make a point when there is literally billions of dollars at stake," Reed said.

Years of loose underwriting guidelines have now come back to haunt the financial industry as homeowners increasingly fall behind in their mortgage payments. These defaults and foreclosures have sent tremors through the credit markets, chilling lending in many sectors including commercial real estate and municipal bonds. Banks are pulling back on all sorts of credit, including mortgages to student loans to credit cards.

The crisis has forced Wall Street banks to write down more than $130 billion in assets and to get capital infusions of more than $100 billion. More of both are expected, regulators said. Credit losses will continue to tick up as more people struggle to pay their mortgages, Federal Deposit Insurance Company Chairwoman Sheila Bair told the committee.

Regulators sought to assure the senators that the current troubles will not topple the banking industry. Banks entered this difficult period after years of record profits and strong capitalization, a measure of a bank's soundness. Bair repeatedly said that 99% of all insured institutions met or exceeded capital standards.

"Despite these strains, the banking system remains fundamentally sound, in part because it entered this period of stress in such strong condition," Dugan said.

But the senators were concerned that banks' soundness might be jeopardized when they implement new capitalization and risk management standards under Basel II, as new global banking guidelines are called. The new guidelines rely more heavily on internal bank risk models, which helped lead to the current crisis, Dodd said.

Regulators responded that they will still oversee banks' capitalization levels and can require adjustments.

Dodd said he will hold another hearing within 60 days to learn what measures regulators are putting into place to address the industry's current problems.