Ben S Bernanke: Bank regulation and supervision - balancing benefits and
costs
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the Annual Convention of the American Bankers Association, Phoenix, Arizona, and the
Annual Convention of America's Community Bankers, San Diego, California, (via satellite), 16 October
2006.
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Today I will discuss bank regulation and supervision from a cost-benefit perspective, focusing on how
the Federal Reserve and our fellow bank regulators take benefits and costs into account when we
develop rules and supervisory policies. As you know, the Federal Reserve's regulatory powers and
responsibilities derive ultimately from statutes passed by the Congress and signed by the President.
Historically, the goals of banking regulation have included the safety and soundness of bank
operations, the stability of the broader financial system, the promotion of competition and efficiency in
banking, assistance to law enforcement, consumer protection, and broader social objectives.
Whatever the motivation, once the Congress decides that a particular issue must be addressed, it
typically (though not always) gives the federal banking agencies significant discretion to devise the
regulations and supervisory policies that implement the statute. Often, the agencies collaborate in
developing rules, and we rely heavily on input from the public received both through formal requests
for comment and through other channels, such as consultations with industry or consumer groups.
In setting regulatory and supervisory policy, we are first concerned with ensuring that the rules reflect
the intent of the Congress. We also seek to implement the will of Congress in a manner that provides
the greatest benefit at the lowest cost to society as a whole. Perhaps I should emphasize the phrase
"society as a whole." We are ever mindful that banks and their customers bear a large share of the
costs of regulation. Minimizing the regulatory burden on banks is very important. But other parts of
society, besides enjoying some of the benefits of regulation, also share some of the costs, both direct
and indirect. Making good regulatory policy requires that we take a broad view of the way our rules
affect our economy and our society, while maintaining a suitable degree of humility about our ability to
accurately quantify the relevant benefits and costs.
In the rest of my remarks, I will briefly illustrate how the Federal Reserve, along with the other federal
banking agencies, applies these principles in three major areas of bank regulation and supervision:
the Bank Secrecy Act, bank capital standards, and the Community Reinvestment Act. Finally, I will
highlight some elements of the Regulatory Relief Act, which the Congress passed this year.
Periodically the Congress reviews the federal banking laws to determine if the costs imposed by some
laws are no longer justified by the associated benefits, and this act is its latest effort in this area. The
Federal Reserve supported and actively contributed to the development of this legislation.
The Bank Secrecy Act
The prevention and detection of the criminal misuse of the financial system, including threats to
national security such as the financing of terrorist activities, are among the highest of public policy
priorities. The primary goal of the Bank Secrecy Act (BSA), passed by the Congress in 1970, is to help
deter, detect, and investigate money laundering and other financial crimes, including terrorist
financing. As you know, this act gives U.S. banking institutions the responsibility to obtain sufficient
customer information to detect and report suspicious activity.
The potential benefits of the information obtained through the BSA are large, but implementation of the
act should not ignore other public policy considerations, including the need to maintain a reasonable
expectation of financial privacy for legitimate bank customers and to ensure that reporting
requirements do not unduly impede the efficient operation of the payments system. The principal
concern about the BSA that we hear from the banking industry, of course, is the cost of compliance.
The Federal Reserve recognizes that the provisions of the BSA require considerable effort by banks to
obtain, document, and provide the required information. Deterring and identifying misuse of the
financial system, as important as that is, should not be so onerous that it stifles innovation, interferes
with the critical economic functions of financial intermediaries, places undue burden on bank
shareholders and customers, or reduces the international competitiveness of U.S. banks. To address
these important concerns, the Federal Reserve has worked and will continue to work closely with the
other federal banking agencies and the Treasury Department's Financial Crimes Enforcement Network
(FinCEN), the administrator of the BSA, to look for ways to streamline the reporting processes created
by the BSA without diminishing the value to law enforcement of the information produced.
The regulatory burden of the BSA is also affected by supervisory policy. From a supervisory
perspective, I see at least three areas in which progress could be made in reducing the burden on
banks. First, the industry should have the opportunity to receive feedback about the usefulness of
reporting suspicious activity as well as guidance about how better to identify the most significant risks.
Some useful steps have been taken. For example, FinCEN's publication, The SAR Activity Review,
includes aggregate information and case studies about suspicious activity report (SAR) filings and use,
and law enforcement representatives have undertaken outreach efforts to communicate to the
financial services industry the importance of BSA reports in investigations and prosecutions. Efforts to
further increase feedback would help banks allocate their compliance resources more efficiently while
complying with the act and preventing misuse of the financial system.
Second, the banking industry should have effective channels for voicing concerns about burden or
about lack of clarity regarding regulatory standards and supervisory expectations. One such channel is
the Bank Secrecy Act Advisory Group, created by the Congress, which includes representatives from
government and the financial services industry. In particular, the examination subcommittee of the
advisory group can serve as a conduit for the industry to raise issues of supervisory concern. The
Federal Reserve will continue to seek industry input through a variety of channels, including meetings
with banking groups and as part of the supervisory process itself.
Third, supervisors should continue to work to improve the consistency of their approach to compliance
and to ensure that adequate guidance is provided to assist banks in the assessment and management
of risks. The release of the Bank Secrecy Act/Anti-Money Laundering Examination Manual in June
2005 was, I believe, an important step in that direction. The five federal banking agencies in
collaboration with FinCEN developed the manual, with input from state banking agencies and the
Office of Foreign Assets Control. The manual, which was revised this year, emphasizes that
supervision of compliance efforts should be risk-based; that is, supervisors should focus on banks'
policies and procedures, not on isolated incidents, with particular attention to the areas in which the
most serious problems might arise. In a difficult area like this one, it is also particularly important that
supervisors be flexible, using good judgment and a collaborative approach to help banks achieve the
objectives of the act. Your feedback on the manual and on the related supervisory procedures is
welcome.
Bank capital standards
Bank capital standards provide a second illustration of our efforts to balance the benefits and costs of
regulation and supervision. Capital regulation is the cornerstone of bank regulators' efforts to maintain
a safe and sound banking system, a critical element of overall financial stability. For example,
supervisory policies regarding prompt corrective action are linked to a bank's leverage and risk-based
capital ratios. Moreover, a strong capital base significantly reduces the moral hazard risks associated
with the extension of the federal safety net.
The banking regulators broadly agree that the current risk-based capital regime, known as Basel I, is
inadequate for the largest and most complex banking organizations. For this reason, in 2004, all the
U.S. banking agencies joined other members of the Basel Committee on Banking Supervision in
supporting a new international capital adequacy framework, called Basel II. Basel II capital
requirements will be much more risk-sensitive than those in Basel I and will provide stronger
incentives for institutions to improve the measurement and management of risk. Basel II will also give
supervisors a better framework for evaluating the adequacy of a bank's capital buffer above the
regulatory minimums and should improve market discipline by providing financial markets with better
information on banks' risk-taking.
The U.S. banking agencies recently asked for public comment on a Notice of Proposed Rulemaking
(NPR) for implementing the Basel II advanced approaches in the United States. In developing this
proposal, our paramount concern has been ensuring the safety and soundness of the U.S. banking
system. This concern can be seen, for example, in the proposal's transitional safeguards, which go
beyond those in the 2004 Basel Committee text by providing greater protection against unintended
declines in minimum capital requirements during the initial years of Basel II implementation.
At the same time, we have tried to reduce regulatory burdens in several ways. In particular, the
advanced elements of Basel II are intended to apply only to the very largest and most internationally
active U.S. banking organizations, not to the great majority of U.S. banks. For banks not adopting
Basel II, the agencies have been developing a modernized but easier-to-implement capital framework,
known as Basel IA. Under Basel IA, the capital treatments for certain activities will be more
risksensitive than those under Basel I, thus better aligning the treatments with those in Basel II. The NPR
for Basel IA should be issued soon. Some bankers have suggested that Basel I may still be suitable
for many small banks and that, consequently, they should have the option of whether to move to Basel
IA. We will consider this possibility carefully.
We have also been working to promote a level playing field internationally for U.S. banking
organizations that adopt Basel II. Indeed, maintaining competitive equity was one of our key
motivations for developing Basel II jointly with foreign supervisors through the Basel Committee. More
recently, we have been working through the Basel Committee's Accord Implementation Group to
mitigate home-host conflicts while promoting consistent implementation of Basel II internationally.
Despite these efforts, some significant differences do exist between the United States and other
countries in the proposed implementation of Basel II's advanced approaches, beyond the transitional
safeguards. Early comments on the Basel II NPR suggest that, whatever the merits of these
international differences in rules, they are likely to add to implementation costs and home-host issues,
particularly for globally active banks operating in multiple jurisdictions. Before we issue a final rule, we
intend to review all international differences to assess whether the benefits of rules specific to the
United States outweigh the costs. In particular, we will look carefully at differences in the
implementation of Basel II that may adversely affect the international competitiveness of U.S. banks.
Many other opportunities may exist to reduce the burden of the new capital regulations. Public
comments will be critical in shaping the final rules, and we will look to banking organizations for help in
identifying aspects of the NPR that would impose competitive inequities or undue costs. I am confident
that, working together, we can do more to level the competitive landscape and reduce burden without
compromising our primary objective of maintaining the stability of the U.S. banking and financial
system.
Community Reinvestment Act
I now want to shift from the role of bank regulation and supervision in the national and global context
and discuss one aspect of its place in local markets. Clearly, banks strengthen their local communities
by providing a range of services and facilitating the flow of credit necessary to support economic
development. However, economic development in some communities, particularly lower-income
communities, may be hampered by what economists call "market failures." For example, if information
about economic opportunities is particularly costly to obtain in lower-income neighborhoods, then
potentially profitable loans and investments may not get made. Another form of market failure may
arise because of so-called neighborhood effects: Because the values of homes and businesses are
affected by the overall economic vitality of the neighborhood in which they are located, the returns to
an individual bank's investments in a given area may depend on whether other banks are investing in
that area as well. But if no bank is willing to go first, so to speak, the neighborhood may be
underserved and potentially profitable opportunities may be missed.
To address these possible market failures, to ensure that depository institutions help to meet the credit
needs of their communities, and to achieve broader social goals such as expanding home ownership,
the Congress in 1977 passed the Community Reinvestment Act (CRA). A key goal of the CRA is to
induce banking institutions to invest in acquiring the knowledge and expertise needed to find profitable
lending opportunities in lower-income neighborhoods, thereby removing an important barrier to the
extension of credit in those neighborhoods. Likewise, to the extent that the CRA leads a number of
banks to provide credit and services to an underserved area, the returns to each bank's investments in
that neighborhood should improve, reducing the "first mover" problem. Indeed, many banks have
found that lending and investment in lower-income neighborhoods can be profitable, which has led
them to expand their activities in those areas.
As you know, the CRA requires that each banking institution's record of serving lower-income areas
be regularly evaluated and that these ratings be made public. The Congress has given the banking
agencies substantial discretion to determine the methods by which they assign CRA ratings. As
experience with the CRA has accumulated and as the economic environment has changed, the
agencies, with the benefit of public input, have exercised that discretion with an eye toward both
increasing the effectiveness of the act and reducing its costs. For example, the early CRA rules
emphasized process over performance, and major changes were made to the regulations in 1995 to
make the CRA evaluations more oriented toward performance. These changes increased reporting
burdens for some institutions, as the new rules required them to collect and submit data concerning
their lending performance. In the judgment of the agencies, the broader social benefits of a
morequantitative, performance-based method of assigning CRA ratings justified the increase in regulatory
burden. However, aware of that burden, the agencies exempted the smallest community banks and
thrifts from the data-reporting requirement and allowed them to undergo streamlined evaluations of
their retail lending and services.
Beginning in 2001, the agencies revisited the issue, undertaking a careful review of the benefits and
costs of the data-reporting requirements applied to non-exempt community banks and thrifts, as well
as the associated rules that determined eligibility for streamlined CRA evaluations. As part of this
effort, members of the Federal Reserve Board staff published a study comparing the retail lending and
services of community banks and thrifts eligible for streamlined evaluations and exempt from data
reporting with the activities of comparable institutions without those exemptions (Avery and others,
2005). The analysis suggested that exempting a larger number of relatively small institutions from the
more onerous requirements would not adversely affect the provision of retail lending or services in
lower-income communities. Consistent with that analysis, in 2005 the agencies substantially increased
the number of community banks and thrifts eligible for streamlined evaluation and exempt from the
data-reporting requirement. At the same time, the agencies also addressed several concerns about
the effectiveness of CRA regulations in encouraging these institutions to invest in community
development. Among the concerns expressed was that the method for evaluating the community
development records of larger community banks and thrifts was inflexible and produced unintended
costs. After reviewing public input and the available evidence on the costs and benefits of the current
process, the agencies adopted a new evaluation method that considers all of the community
development activities of such institutions under one test. Although we recognize that this change is
very recent, we welcome feedback on how well it is working for financial institutions and communities
alike.
Regulatory relief
My focus thus far has been on how the Federal Reserve and the other banking agencies develop
regulatory and supervisory approaches to implement the applicable laws. But regulatory agencies may
also play a role in the legislative process itself, for example by raising issues that may require
legislative remedy, commenting on proposed legislation, and providing technical assistance in the
drafting of bills. Our extensive practical experience in implementing legislation makes us particularly
well placed to advise the Congress when legislation is not achieving its intent or is imposing costs on
banks or on society that exceed its benefits.
In this regard, I am pleased that Congress recently passed, and the President signed, the Financial
Services Regulatory Relief Act of 2006. Certainly, the act does not address every concern that banks
and regulators have raised about regulatory burden, and I hope that the Congress will continue to
revisit these issues. But the legislation does include a number of provisions that, when implemented,
should provide substantial relief to banking organizations and increase efficiency in the banking
system while enhancing the Federal Reserve's tools for conducting monetary policy.
Among the act's most important provisions are two that relate to reserve requirements. Federal law
currently obliges the Board to establish reserve requirements on transaction accounts and prohibits
the Board from setting these reserve requirements below 8 percent for amounts above the so-called
low-reserve tranche. Because the Federal Reserve is not permitted to pay interest on the balances
held at Reserve Banks to meet reserve requirements, depositories have an incentive to reduce their
required reserve balances to a minimum. Institutions use various techniques to minimize required
reserves, such as sweep programs that move funds between deposit accounts subject to reserve
requirements and money market accounts not subject to those requirements. From the perspective of
society as a whole, sweep programs have little or no economic value to justify their cost of
implementation.
The Regulatory Relief Act will allow the Federal Reserve to pay depository institutions interest on the
balances held to meet reserve requirements; it also gives the Board the discretion to lower the ratio of
required reserves to transaction accounts. The Board has long sought these amendments, which were
also supported by the American Bankers Association and America's Community Bankers.
Unfortunately, for reasons related to congressional budget scoring, these amendments will not
become effective until October 2011. Nevertheless, when the Federal Reserve is able to begin paying
interest on required reserve balances, much of the regulatory incentive for depositories to engage in
resource-wasting efforts to minimize reserve balances will be eliminated, to the economic benefit of
banks, their depositors, and their borrowers.
The act will also allow the Federal Reserve to pay interest on contractual clearing balances and
excess reserve balances, two types of balances that depository institutions hold voluntarily at Reserve
Banks. By helping to stabilize the demand for voluntary reserve balances, this authority may allow the
Federal Reserve to implement monetary policy without the need for required reserve balances. In
these circumstances, the Board - as authorized by the act - could consider reducing or even
eliminating reserve requirements, thereby reducing a regulatory burden for all depository institutions.
Other important provisions of the act will provide banking organizations immediate regulatory relief.
For example, the act immediately raises to $500 million, from $250 million, the asset threshold below
which a well-capitalized and well-managed insured depository institution may qualify for an extended
eighteen-month cycle for safety and soundness examinations. We estimate that this change will allow
about 1,200 additional federally-insured institutions to qualify for an extended examination cycle
without compromising safety and soundness.
The act also requires that the Board and the Securities and Exchange Commission (SEC) jointly issue
a new, single set of rules to implement the "broker" exceptions for banks that were adopted as part of
the Gramm-Leach-Bliley Act. The act requires that our agencies jointly issue new proposed rules
within 180 days of enactment, but Chairman Cox of the SEC has actively engaged with the banking
regulators on this issue and has already indicated that he would like to have proposed rules ready for
public comment by the end of this year. We look forward to continuing to work with Chairman Cox, the
SEC's other commissioners and staff, and our fellow federal banking agencies in developing workable
rules that do not disrupt the traditional activities of banks.
Conclusion
I have covered a lot of ground today. My central theme has been that good regulatory and supervisory
policies should implement congressional intent in ways that maximize social benefits and minimize
social costs. The regulatory burden on banks is not the only element of social cost, but it is an
important component. Accordingly, in developing regulatory and supervisory policies, the Federal
Reserve and the other banking agencies will continue to pay close attention to the implications of
those policies for regulatory burden, competitiveness, and efficiency in banking. In practice, our ability
to accurately assess those costs and benefits depends greatly on close collaboration with and
feedback from the banking industry. We look forward to working with you on these issues.
Reference
Avery, Robert B, Glenn B Canner, Shannon C Mok, and Dan S Sokolov (2005). "Community Banks
and Rural Development: Research Relating to Proposals to Revise the Regulations That Implement
the Community Reinvestment Act" Federal Reserve Bulletin, vol. 91 (Spring), pp. 202-35.