Back to the Future: Personal Reflections on the Evolution of Community Bank Supervision
In many aspects, how we view our role in an organization often determines how we approach our activities and responsibilities. And as with most things,
it's a good practice to take a step back periodically and assess our role and the manner in which we approach our responsibilities. This practice helps
ensure that we not only evolve relative to the environment around us, but that we grow in a direction that contributes to our success in fulfilling those
by Stephen Jenkins, Senior Vice President, Supervision & Regulation, Federal Reserve Bank of Cleveland
Such is the case in our professional roles. For me, that role is as a supervisor of banking organizations in the Fourth Federal Reserve District. When I take a step back and assess my current role, I can't help but recall the start of my career 32 years ago and all the changes that have taken place in both the banking industry and in the bank supervision profession.
One of my earliest and most poignant professional recollections relates to my first bank examination assignment. In preparation for this assignment, I was forewarned by colleagues of the reaction I would likely receive from the bank employees at the start of the examination. This was back in the days when bank examinations were conducted mostly on a surprise basis, and bank examiners descended upon banks so that the bank's records could be appropriately accessed. My directive, at the time, was to travel to the town in which the bank was located, check into the designated hotel (usually the only one in the town), and wait before going to the bank and entering the building on the cue of our lead examiner. Imagine my surprise when I arrived at the hotel and saw the hotel's marquee, which read, "Welcome Bank Examiners."
Of course, the hotel manager had all the best intentions. But an unintended consequence of this warm hospitality was informing the town — and therefore, the bank — of our impending arrival. As it turns out, the surprise was on the bank examiners, and not on the bank!
Needless to say, these days, surprise bank examinations are not only impractical but also unnecessary. Those examinations were viewed as appropriate when banking was much simpler, and the risks of loss to the bank were mostly related to the cash in the teller drawers and the thickness of the walls of the vault (which, yes, we actually measured as part of a bank examination!). Asset verification was the primary purpose of the examination. As a result, bank examinations were also much simpler and much narrower in scope than they are today. The examiners assessed the condition of that specific bank at that particular point in time, and the examination was completed. If the bank was in reasonably sound condition, the bankers would not hear from the examiner again until the next "surprise" examination, likely in about 12 months.
Technology and Banking Crises: Drivers of Change in Examinations
The bank examiner role was narrowly viewed, and, consequently, the manner in which that responsibility was fulfilled remained unchanged through the mid-1980s. It was around this time that the use of technology in banking became widespread and that the pace of change in the banking industry accelerated significantly. In addition, it was during this period when two significant events — the savings and loan crisis, which originated, in part, here in Ohio,1 and the failure of Continental Illinois, which for many years was the largest bank failure in U.S. history — rocked the banking industry and, together with the accelerated pace of change in banking, highlighted the inadequacies of "point-in-time" examinations. To effectively respond to these developments in the banking environment, examiners reassessed our approach to evaluating the condition of banks. Rather than relying on just the point-in-time examinations, examiners turned to technology to aid in monitoring the condition of banks in periods between examinations. Expanded regulatory reports submitted by banks were used as the basis of offsite surveillance so that the financial condition of any particular bank could be determined absent an onsite examination. With the greater use of ongoing monitoring, bank examiners became "bank supervisors" who both examined banks on a point-in-time basis and monitored them on an ongoing basis.
The Role of Regulatory Changes
Beyond technology, much of the increased pace of change in the 1980s and 1990s was fueled by changes in regulations. The elimination of parts of the Federal Reserve Board's former Regulation Q removed limits on interest rates during the 1980s, which allowed for greater flexibility in product pricing for banks. However, this also increased the complexity of banking. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 relaxed restrictions on interstate banking and branching, resulting in an increase in the numbers of mergers and altering the competitive landscape. Subsequently, the passage of the Gramm-Leach-Bliley Act in 1999 provided even greater flexibility for banks to engage in a wider range of financial activities, such as limited investment and insurance activities. This regulatory change also had an effect on compliance with consumer regulations, as it related to the sale of mutual funds and other investment products by banks. Furthermore, during this period, there was other significant legislation, including the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, and the Sarbanes-Oxley Act of 2002, all of which resulted in additional regulatory requirements for banks.
The primary effects on banks from the regulatory changes were twofold. First, banks began to engage in a wider array of financial activities, many of which were not considered traditional banking activities. Second, these new opportunities in banking marked the advent of the divergence between larger, more complex banking organizations and traditional community banks.
With regard to the first effect, banks increasingly engaged in activities and offered products that represented a change from traditional banking. Many banks diversified their longstanding banking services with activities such as investments and insurance brokerage, mutual fund sales, and even merchant banking activities. This broader range of activities prompted bank supervisors, who were still responsible for assessing the condition of banks, to broaden our skills and knowledge to understand the risks associated with these new activities. While still technically chartered as banks, these entities became viewed more broadly as financial institutions to reflect the wider spectrum of products and services they offered. Correspondingly, bank supervisors progressed to become "financial institution supervisors" to reflect the more expansive activities we oversaw.
The other significant effect of the new regulations from that period was the beginning of the marked distinction between large banking organizations and smaller community banks. Because of the relaxed restriction on interstate banking and branching, banking consolidations through mergers and acquisitions increased during that period, resulting in a smaller number of banks nationwide, with a greater concentration of U.S. banking assets held at large banks. In addition, these large banks were more likely to engage in newer, more complex, and less traditional banking activities, due in part to their greater access to resources that helped design new product and service offerings and ensure compliance with the new regulations. Smaller community banks were more limited in their appetite and ability to experiment with newer financial activities.
Correspondingly, supervisors began to approach the supervision of large and small banks differently. Supervision of large banks evolved to having a team of supervisors responsible for the ongoing monitoring and supervision of a single large bank. This team would maintain constant, close communications with management of the particular large bank and conduct reviews of various activities of the bank throughout the year. On an annual basis, these reviews would be rolled up into an overall comprehensive assessment of the condition of the entire bank.
The supervision of small banks remained generally unchanged. Periodic onsite examinations would take place and were augmented by offsite surveillance activities and periodic communications with bank management.
Recognizing the challenges faced by banks — particularly smaller community banks — in understanding the requirements of the wide array of new regulations, the Federal Reserve launched initiatives to promote greater outreach to bankers. A primary objective of outreach was to help bankers better understand regulations and to provide education related to various aspects of banking operations. For example, starting in the mid-1990s, the Federal Reserve developed the view that our supervision of banks and financial institutions should not focus solely on identifying deficiencies; rather, to the extent possible given our continued responsibility for assessing banks' safety and soundness, our supervisory processes should add value to banks. In Cleveland, we referred to initiatives to implement this approach as "value-added supervision." This initiative emphasized communications and responsiveness to bankers and promoted the principle that a more informed banking sector would result in greater compliance with banking laws and regulations and stronger financial institutions.
Banks' management and staff were not the only focus of the outreach and education efforts. Banks' directors were also encouraged to participate in educational outreach sessions. Tailored Director Programs were developed whereby a topic of interest was selected by a particular bank board of directors, and supervisors designed and delivered a presentation to the directors to discuss that topic. The program was particularly valuable in cases in which a directorate was considering a new strategy and wanted to learn more about a particular topic, or those in which a bank was facing a particular challenge and its board needed to develop a greater understanding of that area.
Value-added supervision represented a significant cultural shift in the supervisory process. The "gotcha" approach to examinations of community banks was replaced with a focus on adding value to the supervisory process without sacrificing the common objective shared by both community bankers and supervisors: the safe and sound condition and long-term value of the banking organization.
This focus also paved the way for supervisors to direct resources more effectively and efficiently. Through an ongoing dialogue with bankers, the Federal Reserve adopted a risk-based approach to establishing the scope of examinations and reviews, whereby examination resources were directed to those banks and activities with the greatest risks. Conversely, areas of lower risk were reviewed less frequently or in less depth. This risk-based approach minimized the burden on bankers whose operations exhibited lower levels of risk and allowed supervisors to be more effective in directing resources to banks with higher-risk profiles.
Impact of the Recent Financial Crisis
The mutual focus on a shared objective served bankers and supervisors well for a number of years. However, the confluence of many factors — including, but not limited to, technological advances and changes in regulations — resulted in a perfect storm that became the financial crisis beginning in 2007-2008. Banks across the industry, both small and large, were adversely affected by the crisis that had its genesis in subprime mortgage loans that were originated by banks and other financial firms, sold to the secondary market, and repackaged into securities ultimately purchased by banks and other investors. This "originate-to-distribute" business model transformed and transferred the risks associated with subprime mortgage loans in a way that masked the significant exposures to loss that returned to the banking industry, albeit in another form. Though few community banks were directly involved in subprime lending, many faced losses as real estate values supporting commercial real estate loans fell. As supervisors, we maintained our focus on individual financial institutions and paid less attention to risks that were building up across the financial system but had not yet materialized.
In retrospect, supervisors now acknowledge that the previous focus on the soundness of an individual entity such as a bank or financial institution was not enough. Attention must also be paid to risks in the broader financial system and the environment in which banks operate, as those risks have a high likelihood of adversely affecting the condition of banks of all sizes. As such, the focus on supervising individual financial institutions, while still important, is clearly too narrow. Oversight of the broader financial system, including the individual entities, is now necessary. As a result, our role as supervisors has once again evolved as we have become "financial system supervisors" with a broader perspective that considers the financial entities, instruments, and environment within our scope.
In practice, as it relates to the supervision of community banking organizations, supervisors consider a much broader range of factors in addition to the individual community bank and its overall condition. Our financial system supervisors also consider macro risks that may exist in the financial system to which community banks may be exposed. These macro risks may take the form of newer or more complex financial instruments or investments, the risks of which may not be well understood by or apparent to bankers. Supervisors are also including assessments of the macroeconomic environment in which community banks operate to ensure that banks are prepared for potential changes in the economy that may adversely impact the banks. In addition, a greater degree of information sharing and coordination occurs among supervisors of community banks nationwide so that a more holistic view is taken. This broader view allows for trends and emerging risks to be identified in a more timely way, and interconnections between banks — even smaller community banks and regional banks — can be identified. Lastly, our financial system supervisors are developing various quantitative tools and predictive analytics to aid in the early identification of risks that may originate within or outside of a community banking organization.
As the term implies, our financial system supervisors continuously monitor the condition of individual financial institutions, as well as the financial system in which these institutions operate. This dual focus helps to ensure that the risks that may affect these institutions, regardless of their origin, are identified in a more timely way so that appropriate actions may be taken to mitigate those risks.
Evolution of the Bank Supervisor
Tiered Framework for Regulation and Supervision
As a result of the recent financial crisis, there is greater awareness of the importance of the amount of risk a particular financial institution contributes to the overall financial system. The largest and most complex banking organizations clearly pose the highest level of risk to the financial system. Regional and moderately complex banking organizations individually contribute a modest level of risk to the financial system, and smaller, noncomplex community banking organizations individually pose little risk. Given these distinctions, the Federal Reserve has increasingly adopted an approach to develop regulations and conduct supervision of banks based on such a tiered framework. This can be thought of as a risk-based approach to supervision and regulation, applied across the range of supervised financial institutions. In this framework, banking organizations that pose the highest level of risk to the financial system should be subject to the most restrictive regulations and greatest amount of supervisory scrutiny, and conversely, small, noncomplex community banking organizations that pose little risk to the financial system should be subject to the least restrictive regulations and less intensive supervisory oversight. This tiered framework allows supervisors to direct resources to banking organizations based on their risk and minimize regulatory burden on organizations whose risk profiles are lower.
Future of Supervision
To paraphrase the folksinger Bob Dylan, "There is nothing so stable as change." As the financial system and banking industry continue to change and evolve, the role and approach of supervisors must also evolve.
Given the significance of technology in transforming both the financial industry and the supervisory process, there is no doubt that technology will continue to be a significant factor in future change. As it relates to examinations, technology will continue to reduce the burden placed on bankers by allowing for a greater portion of examinations to be conducted offsite. Document-sharing technology, data downloads, and videoconferencing all facilitate the ability to conduct reviews offsite and reduce disruptions to a bank's operations during an examination. An added benefit is the greater efficiency of the examination, which translates into shorter durations of bank examinations and also reduces the burden on bankers.
Technology will also continue to have a significant influence on the manner in which ongoing monitoring and risk identification are conducted. Greater use of quantitative assessments is made possible by more robust software applications, and the greater availability of data combined with advances in technology facilitate the development of advanced analytic tools designed to identify emerging risks.
Notwithstanding the benefits of technology, future supervision will still require a human touch. Onsite presence of supervisors at banking organizations will continue to be valuable as a way of assessing the corporate culture and risk appetite of supervised institutions. Quantitative models are no substitute for personal dialogue and direct interaction with bankers in understanding the strategic initiatives and direction contemplated by bank leadership.
Commensurate with the continued personal interaction, I believe the value-added supervisory approach will remain an emphasis of supervisors. The objective is to ensure that the overall supervisory process adds value through ongoing communications with bankers, responsiveness to concerns and inquiries, and outreach designed to address issues before they become problems.
While the tools and scope of supervisors continue to evolve with the changing financial system, the fundamental approach and objectives remain unchanged. Our mission is to preserve the stability of our nation's financial system, in large part through the effective supervision of the banking organizations that comprise a significant portion of that system. I believe the principles of value-added supervision and risk-based supervision will continue to guide our processes and help balance our effectiveness and efficiency in achieving this mission.
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