Daniel K Tarullo: Large banks and small banks in an era of systemic risk
regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, at the North Carolina Bankers Association Annual Convention, Chapel Hill,
North Carolina, 15 June 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The financial crisis and its aftermath have revealed fundamental problems in both risk
management by financial institutions and supervision by government regulators. These
shortcomings arose in no small part from a failure by both the private and public sectors to
adjust to far-reaching changes in financial markets over recent decades. There is a growing,
though certainly not unanimous, view that supervision and regulation must be substantially
more oriented toward containing systemic risk and addressing the associated problems
posed by institutions considered too-big-to-fail. The public policy agenda will thus rightly be
dominated for some time by proposals for legislative and administrative measures directed at
systemic risk. In a moment I will offer some of my own views on the subject.
Even as we move into this era of systemic risk regulation, however, it is important to
recognize that changes in the financial services industry have affected every bank in
America, large and small. While smaller banks will not likely see the extensive supervisory
changes that have been proposed for the largest financial institutions, they too must adapt
their risk-management practices to new competitive and economic conditions. Only by doing
so will they continue to play their distinctive role in providing credit to individuals and small
businesses.
The changes in the financial services industry that preceded the crisis, the crisis itself, and
the regulatory changes that will follow together carry important consequences for all banks. It
seemed to me particularly appropriate to address the implications of these changes here in
North Carolina, home to institutions that range from the very large to the very small.1
Large banks
If we have learned anything from the present crisis, it is that systemic risk was very much
built into our financial system. This situation was the outcome of a decades-long trend,
during which traditional bank lending, trading, and other capital markets activities were
increasingly integrated. The most visible manifestations of this trend were the explosive
growth of securitization and the increasing involvement of banks and their affiliates in all
parts of the securitization process. And, as we learned during the course of the crisis, the
universe of institutions whose potential failure was regarded as having systemic
consequences extended well beyond banks, or even bank holding companies, to include
financial firms not subject to mandatory prudential regulation.
More generally, the emergence of the so-called shadow banking system changed important
features of the traditional banking model, particularly at the largest institutions. These banks
became increasingly dependent on the wholesale funding provided by securitization,
commercial paper issuance, and other sources - funding that was often poorly matched to
the maturity of the firm's assets.
The result was the rising vulnerability of these institutions to non-traditional sources of risk.
The new market-based liquidity problems arose from sudden, sharp movements in asset
prices that led to enormous market uncertainty concerning the values of those assets. As
now liquidity-strained institutions made increasingly distressed asset sales, they placed
further downward pressure on asset prices, leading to margin calls for leveraged actors and
mark-to-market losses for all holders of the assets. Since multiple firms were relying on
similar marketable assets as a ready source of liquidity, extreme price declines could ensue,
engendering a negative feedback loop that, if unchecked, would threaten the solvency of
firms operating on the assumption of liquidity through asset sales or borrowings secured by
such assets.
These and other changes in the competitive environment both prompted and advanced the
relaxation over the past few decades of many of the restrictions on bank activities and
affiliations that had been established in the 1930s. As a result of these changes, which had
taken place both through administrative action and by statute, banks could operate
nationally, had few practical restrictions on their ability to pay competitive deposit rates, could
conduct a much broader range of activities within their own operations, and could affiliate
with virtually any kind of financial firm. In response to now-permissible bank involvement in
more activities and affiliation with broker-dealers and other financial firms, regulatory
agencies imposed more detailed capital requirements and insisted on better risk
management. But there was no overhaul of financial regulation to take account of the impact
of trading and capital market activities on both traditional banking and systemic risk.
The financial crisis has focused the attention of policymakers on the need for just this kind of
regulatory reorientation. I have recently set forth a fairly extensive explanation of the changes
I believe should accompany this reorientation.2 I will not repeat this whole agenda today.
Instead, let me simply highlight a few of these items to illustrate concretely what an era of
systemic risk regulation would look like.
First, within the Federal Reserve, we are adjusting our consolidated supervision practices to
take greater account of the risks faced, and created, by affiliates principally involved in
trading and other capital market activities. Recent supervisory practices had not moved
quickly enough away from the traditional focus on bank holding company regulation as a way
to protect the insured depository institution subsidiaries, and toward more attention to such
factors as the common exposures of different affiliates within the consolidated entity.
Second, we must strengthen existing regulations and supervisory guidance, particularly in
areas in which bank involvement in trading and markets is most significant. The centrality of
liquidity problems to the crisis requires considerable attention to adequate liquidity
riskmanagement practices, particularly at firms substantially reliant on wholesale funding. While
the most serious liquidity problems occurred outside traditional commercial bank lending and
borrowing activities, the crisis revealed significant fragilities in financial institutions' extensive
use of short-term repurchase agreements and reverse repurchase agreements to finance
large portions of dealer inventory and trading positions. On the other side of the balance
sheet, capital requirements for assets in the trading book were revealed by the crisis to be
seriously deficient, based as they were on only a 10-day trading horizon. Along with our
colleagues in the other regulatory agencies and, indeed, with our international colleagues in
the Basel Committee on Banking Supervision, we are working on proposals to address these
problems.
Third, we are augmenting our supervisory approach for bank holding companies to include a
more explicitly systemic perspective. "Horizontal reviews" of risks, risk management, and
other practices that are conducted across multiple financial firms and grounded in a uniform
set of supervisory stress parameters can help identify both common trends and firm-specific
weaknesses. We will incorporate into more routine supervisory practice some lessons
learned from our recently completed Supervisory Capital Assessment Program of the
nation's 19 largest bank holding companies.
Fourth, it is important to solve through legislation the so-called boundary problem in financial
regulation. Last year there was a series of runs on nondepository financial institutions that
raised systemic concerns. Institutions that may be considered too-big-to-fail, or at least
toointerconnected-to-fail, must be subject to regulatory requirements and consolidated
supervision.
Of course, these are not the only steps I would recommend, either within the Federal
Reserve or for the financial regulatory structure more generally. They should, however, give
you an idea of the kinds of changes that will be necessary as we shift to a focus on systemic
risk regulation.
Small banks
Let me turn now to the situation of smaller banks - here in North Carolina and around the
nation. The financial crisis did not originate in smaller banks, but they have hardly escaped
the fallout from the crisis itself, and from the serious recession that has followed. On
average, commercial banks with less than $1 billion in assets reported a modest net profit
during the first quarter of 2009, recovering from an average loss position in the fourth quarter
of 2008. But this average figure hides the fact that nearly one in five of these banks lost
money in the first quarter. As of March 31, nonperforming assets were twice the level of one
year ago, and when measured against total loans and the category of Other Real Estate
Owned, stood at an historic peak. Furthermore, capital ratios, although still strong for these
banks as a group, have fallen since early 2008.
At the same time, the importance of traditional financial intermediation services, and hence of
the smaller banks that typically specialize in providing those services, tends to increase
during times of financial stress. Indeed, the crisis has highlighted the important continuing
role of community banks. This seems an opportune moment both to review the virtues of
community banking and to identify some of the difficulties faced by community bankers
during this recession and beyond.
The dramatic changes in the U.S. financial services industry that I described earlier have
also produced a new competitive environment for community banks. Consolidation has
reduced the number of banking institutions (that is, commercial banks and thrifts) in the
United States by nearly 50 percent since 1989. The number of community banks has
declined by a similar percentage, leaving the share of all banking institutions that are
community banks virtually unchanged.3
Even as the number of banking institutions has been declining, the number of banking offices
(branches plus headquarters) has been growing. Not surprisingly, big banks have been the
drivers of the increase in banking offices. Since 1989, the number of community bank offices
has declined by about 14 percent. The number of offices per community bank did increase
from 2.4 to 3.9, but even this 60% growth must be understood in the context of the changes
in larger banks. In this same 20-year period, the number of big bank offices increased by
about 42 percent, and the number of offices per big bank more than tripled, from just under
17 to nearly 55. The net effect was a decline of more than 25 percent in the share of banking
offices operated by community banks. The shares of deposits, banking assets, and small
business loans held by community banks have declined substantially as well.
These declines can be explained by a number of factors, including legal developments,
technological advances, and changes in the business strategies of larger banks and
nonbank financial service providers. For example, deregulation has allowed banks to expand
their geographic reach, facilitating the formation of a number of large, geographically
diversified banking organizations. These large banking organizations can now be found in
many local markets, competing for business with the community banks that call those
markets home. Here in North Carolina, the number of large banks with a branch presence in
the state has more than doubled over the past twenty years, from 18 to 39.
At the same time, technological advances have made information about households and
small businesses more readily available, allowing some (typically large) institutions to
substitute credit scoring for more costly traditional techniques in the underwriting of some
types of consumer and small business loans. This development has allowed larger banks to
compete more effectively with community banks in providing these types of loans.
Another salient change in the competitive environment is that non-bank financial service
providers have become increasingly important participants in the financial services sector,
capturing a large and growing share of the retail financial services business. For example,
while the number of credit unions has declined by 42 percent since 1989, credit union
deposits have more than quadrupled, and credit unions have increased their share of
national deposits from 4.7 percent to 8.5 percent. In addition, some credit unions have
shifted from the traditional membership based on a common interest to membership that
encompasses anyone who lives or works within one or more local banking markets. In the
last few years, some credit unions have also moved beyond their traditional focus on
consumer services to provide services to small businesses, increasing the extent to which
they compete with community banks.
These changes have posed significant challenges for community banks. Even so, many
community banks have thrived, in large part because their local presence and personal
interactions give them an advantage in meeting the financial needs of many households,
small businesses, and agricultural firms. Their business model is based on an important
economic explanation of the role of financial intermediaries - to develop and apply expertise
that allows a lender to make better judgments about the creditworthiness of potential
borrowers than could be made by a potential lender with less information about the
borrowers.
A small, but growing, body of research suggests that the financial services provided by large
banks are less-than-perfect substitutes for those provided by community banks.4 Consistent
with this view, one study finds that the increase in competition from large, geographically
diversified banking organizations has not affected the profitability of community banks in
urban areas. There is some evidence of a profitability effect in rural areas, but it is actually
more likely to be positive than negative.5 Thus, for most community bankers, the increased
presence in their local markets of large, geographically diversified banking organizations
appears not to adversely affect profitability. This circumstance may be due to the fact that a
branch manager at a large depository institution typically does not have the same local
connections and relationships as a community bank president.
Furthermore, although survey data indicate that small businesses have increased their
reliance on large banks and non-bank financial service providers in recent years, the data
show that these same firms have not reduced the average number of financial services they
obtain from community banks. Rather, small businesses are, on average, using more
financial services and types of services than they have in the past, and are obtaining these
services from a greater number and wider variety of financial institutions, often including
community banks.6
To remain successful, any business must adapt to a changing competitive environment. The
adaptation of community banks over the past two decades is evidenced by the substantial
changes in their balance sheets, on both the asset and liability sides. On the asset side, both
the average ratio of total loans to total assets and the average share of lending comprised by
commercial real estate loans have increased markedly. On the liability side, reliance on
deposits of individuals, partnerships, and corporations has declined somewhat, and there
has been a dramatic increase in the share of community banks that hold brokered deposits.
In addition, community banks have become more reliant on non-interest sources of revenue.
These changes in business strategy, which undoubtedly helped to maintain community bank
profitability over much of the past two decades, may in the current financial environment
exacerbate the risks faced by community banks. In this difficult operating environment,
Federal Reserve examiners are encouraging community banks to focus on maintaining
sound loan quality and strong credit administration practices. In addition, they are working
with community banks to ensure that they maintain appropriate capital planning, credit
administration, and liquidity management policies.
For example, earlier this year, the Federal Reserve issued supervisory guidance (SR letter
09-4) that reemphasized the importance of capital planning and prudent dividend policies for
bank holding companies (BHCs) and their bank subsidiaries. This guidance - which was
directed at all BHCs, both large and small - reminded them to ensure that they remain
sources of strength to their bank subsidiaries and to curtail dividends when their financial
condition is under stress.
A key part of any effective capital planning process is an evaluation of the risk posed by
concentrations in specific portfolios of loans or other assets, and of the buffers necessary to
offset potential losses on these holdings. In late 2006, the banking agencies issued guidance
addressing concentrations in commercial real estate lending. This guidance set forth
supervisory expectations for the management of risks stemming from these and other
concentrations, including consideration of the effects of stressed market conditions on a
bank's assets and capital. In the time since this guidance was issued, examiners report that
many community banks have conducted rigorous and effective stress tests. But examiners
have also visited many institutions that have only recently begun the essential step of
ensuring that their management information systems are sufficiently detailed to support a
robust analysis of bank concentration, and identifying where more work on stress testing is
needed.
Funds management has also been an area that has received a renewed supervisory focus at
banks of all sizes. As depositors and other funds providers have become more sensitive to
bank risk, many banks have reinforced their contingency funding plans and developed
sophisticated systems to more closely track their sources and uses of funds. These steps are
particularly important for banks facing weaker asset quality.
Conclusion
The differences in the business models of systemically important financial firms and
community banks are obvious. Yet the financial crisis and ensuing recession have revealed
deficiencies in risk management in institutions of both types. Changes in competitive
environments require banks to respond with changes in their business strategies. But the
financial crisis has also revealed the importance of banks adopting risk-management
strategies appropriate to these strategic changes, and of bank regulatory agencies adapting
their supervisory models to both these kinds of changes in financial institutions.
The characteristics of the financial services industry have changed enormously in the last 30
years. Along with the nature of the regulatory regime that will be effective, the key aim of
prudential regulation remains what it has always been - to encourage the efficient allocation
of capital to productive uses while protecting the system from the defects and excesses that
are inherent in financial markets. As we recover from the crisis and the recession, we will
likely be entering a new era in which systemic risk regulation assumes much greater
importance for supervisors. But the role of bank management, and of risk management at
banks, will also remain what it has always been - to allow these institutions to play an
effective intermediating role in a safe and sound fashion.