Ben S Bernanke: Community banking
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Future of Community Banking Conference, sponsored by the Federal Deposit
Insurance Corporation, Arlington, Virginia, 16 February 2012.
* * *
It is a pleasure to speak at the Federal Deposit Insurance Corporation's (FDIC) conference
on the future of community banking. This conference is indeed an important and timely one.
Community banks make a critical contribution to the prosperity of both their localities and the
nation as a whole, which is why we at the Federal Reserve and the other banking agencies
are acutely interested in their long-term strength and viability.1
Today I will discuss the role community banking organizations play in supporting the health
of our economy, as well as some of the challenges they face. Because we greatly value our
ongoing dialogue with community banks, I will also speak about the Federal Reserve's efforts
to improve our understanding of the pressures affecting community banks and to foster
constructive supervisory relationships.
The role of community banks in a challenging economy
Although community banks provide a wide range of services for their customers, their
primary activities revolve around the traditional banking model - specifically, taking
shortterm deposits to fund longer-term investments, such as small business, agricultural, or
commercial real estate loans. Accordingly, risks at community banks tend to arise from their
lending, in the form of credit risk, interest rate risk, or concentration risk, rather than from the
trading, market-making, and investment banking activities associated with the largest banks.
However, by taking on and managing the risks of local lending, which larger banks may be
unwilling or unable to do, community banks help keep their local economies vibrant and
growing. Importantly, community banks are well positioned to go beyond the standardized
credit models used by larger banks and consider a range of factors when making credit
decisions. In particular, they often respond with greater agility to lending requests than their
national competitors because of their detailed knowledge of the needs of their customers and
their close ties to the communities they serve.
While community banks have certain natural advantages, they also face an array of
challenges, stemming from both the current economy and, to some extent, from their
business model. The close ties of community banks to local economies is a source of
strength, as I mentioned, but those close linkages have drawbacks as well, most notably the
resulting concentration of exposures to those same local economies. Strong community
banks take measures to counteract this risk, but it is not possible to fully manage it away.
Thus, the fortunes of communities and their banks tend to rise and fall together. Community
banks must also manage concentration risks arising from their specialization in certain
categories of lending. For example, larger banks have used their scale to gain a pricing
advantage over community banks in volume-driven businesses such as consumer lending.
This strategy, in turn, has exacerbated a long-standing trend toward a greater concentration
of community bank lending in certain areas less dependent on volume, such as loans
secured by commercial real estate. Community banks will need to continue their ongoing
efforts to prudently diversify their revenue sources.
Like larger banks, community banks are also being affected by the state of the national
economy. Despite some recent signs of improvement, the recovery has been frustratingly
slow, constraining opportunities for profitable lending. As I will discuss later, actual and
prospective changes in the regulatory landscape have also raised concerns among
community bankers. These headwinds notwithstanding, measures of the financial condition
of community banks appear to have strengthened somewhat, suggesting that, for the most
part, the industry is meeting its challenges. Profits of smaller banks have risen for the past
several quarters. Although the ratios of nonperforming assets remain high in many cases,
asset quality appears to be stabilizing, and bank provisions for loan losses are decreasing. In
addition, capital ratios are steadily improving at community banks, in part due to increases in
retained earnings and a greater ability to raise new capital.
Let me take this opportunity to mention one concern that is of particular relevance to the
Federal Reserve: A common complaint on the part of some community bankers is that very
low interest rates hurt their profitability by squeezing net interest margins. Since the onset of
the financial crisis, the Federal Reserve's monetary policy has been accommodative, as you
know. In particular, the federal funds target rate, which stood at 5-1/4 percent in mid-2007,
was lowered to a range of 0 to 1/4 percent by the end of 2008 and has since remained at that
level. Although these policies do not seem to have led to much change in aggregate
measures of net interest margins, at least thus far, we continue to hear that many banks are
feeling pressures from this source.
The effects of the configuration of interest rates on banks and other financial institutions are
certainly part of the discussion when we strive to determine the appropriate monetary policy.
Several points should be made, though. First, it is true that the difference between the yield
on safe assets such as Treasury securities and the rate paid on deposits is currently
relatively low. However, banks' net interest margins also depend importantly on the
difference between the return on the loans the banks make and the return on their alternative
investments in safe assets. When loan demand is weak, forcing banks to hold low-return
safe assets instead of lending, net interest margins suffer. The purpose of the Federal
Reserve's policy of low interest rates is to speed the economic recovery, which will increase
loan demand and opportunities for profitable lending, among many other benefits, and thus,
ultimately, lead to higher net interest margins. In short, it is necessary to set the negative
effects on net interest margins against the positive effects of a strengthening economic and
lending environment. Moreover, the benefits of a stronger economy for the performance of
existing assets should also be taken into account; as you know, delinquencies decline as the
economy improves. Putting all these considerations together, in the longer term the overall
effect on bank profitability of an appropriately accommodative monetary policy is almost
certainly positive.
Outreach and communication with community banks
I think we would all agree that two-way communication between regulators and community
banks is critical. The Fed and other bank supervisors, at both the state and federal levels,
must clearly communicate their supervisory policies and expectations to banks, but they also
must listen to and understand banks' concerns. For the Federal Reserve in particular,
community banks not only provide insights into their industry, but they are also an
unmatched source of crucial grassroots information about developments in the economy as a
whole, which is necessary for effective monetary policy.
At the Federal Reserve, we pursue our dialogue with community bankers through many
channels. One such channel is the recently established Community Depository Institutions
Advisory Council (CDIAC).2 The council's membership is drawn from smaller banks, credit
unions, and savings associations. Each of the 12 Reserve Banks around the country has a
local advisory council, and one representative from each local council serves on the national
council that meets with the Board in Washington twice a year. These meetings allow the
Federal Reserve Board to hear directly from community bankers about supervisory and
regulatory issues that affect their institutions as well as about local economic trends.
At a recent meeting, for example, one of our CDIAC members asked us to be clearer about
whether particular rules and guidance apply to community banks. Having heard from this
banker as well as others, we are now working to more explicitly indicate which banks will be
affected when we issue new regulatory proposals, final rules, or regulatory guidance. As a
first step in this effort, when issuing supervisory letters, we have begun to state specifically if
and how new guidance will apply to community banks.3 Although this change seems
relatively simple, we hope it will help banks avoid allocating precious resources to poring
over supervisory guidance that does not apply to them. We also hope that it will provide
greater clarification to our examiners, who are on the frontline fielding questions from
bankers and working closely with their state regulatory counterparts.
In addition to the advisory council, the Board last year established a special supervision
subcommittee to more effectively address community banking issues. Because of their
professional backgrounds in community banking and bank supervision, I asked Governors
Elizabeth Duke and Sarah Bloom Raskin to serve on this subcommittee. Its primary role is to
improve our understanding of community and regional banking conditions and to review
policy proposals for their potential effect on the safety and soundness of, and the regulatory
costs imposed on, community and regional institutions.4 Governors Duke and Raskin are
also keenly interested in how our policies could affect the availability of credit to sound
borrowers, and their unique experiences and perspectives have contributed to the Board's
understanding of the issues that community bankers care most about.
We have other contacts with community banks that have proved valuable. For quite a few
years, the Reserve Banks have maintained local training and outreach programs for banks.
More recently, several of these programs have been expanded nationally. For example, the
Federal Reserve Bank of St. Louis organizes national "Ask the Fed" calls to provide bankers
with an opportunity to hear Federal Reserve staff discuss recent policy initiatives and issues
that examiners are encountering in the field. In addition, the Federal Reserve Bank of
San Francisco hosts consumer compliance webinars, and the Federal Reserve Bank of
Philadelphia publishes a quarterly overview of consumer compliance issues that allows
Federal Reserve staff to address questions from banks.5 We are exploring options for
building on these initiatives.
Research by economists throughout the Federal Reserve System is another means of
gaining a better understanding not only about current conditions in community banking, but
also about the more fundamental forces that drive their profitability and lending. Our
researchers have looked at such topics as the use of credit scoring in small business
lending, the willingness and ability of community banks to lend to small businesses that have
lost access to lending from large banks, and the determinants of community bank
performance both before and during the recent financial crisis - and the extent to which
these determinants were under the control of bank managers.6 Our hope is that this focused
research effort not only will hone our understanding of the key role that community banks
play in the U.S. economy, but also will help us to more effectively supervise these banks.
With that, let me shift to some supervisory and regulatory matters that are on the minds of
both supervisors and bankers.
The supervision of community banks
Unlike most other businesses, banks are subject to rigorous examination and supervision to
assess their safety and soundness, their ability to withstand risks, and their compliance with
a variety of laws.7 At community banks, these examinations involve off-site analyses and
on-site visits by teams of examiners, exit meetings between examiners and senior bank
managers to discuss examination results, and written reports with narratives and metrics
describing the examiners' findings. If necessary, of course, examiners may require actions by
the bank to remedy specific problems.
These examinations, in combination with work we undertake between examinations, are
critical for promoting safety and soundness while enhancing our understanding of the
condition of individual banks and the banking system as a whole. We know, however, that
supervision imposes costs on institutions. In particular, we recognize that new regulations
and supervisory requirements may impose disproportionate costs on community banks,
which have smaller staffs and less-elaborate information systems than larger banking
organizations. Thus, we take quite seriously the importance of evaluating the costs and
benefits of new rules.
As I have noted, the comparative advantage of community bankers is that they know and
work with their communities and customers in ways that may not be possible for larger, more
distant institutions. We tailor our examination and supervision to the size, complexity, risk
profile, and business model of each institution. For community banks in particular, our
examiners are expected to take local market conditions into account when assessing a
bank's management and credit decisions. The Federal Reserve's decentralized structure, in
which supervision is conducted through 12 regional Reserve Banks, helps facilitate our
understanding of local economies, as does our ongoing coordination with state banking
regulators. This connection to Main Street is vitally important to fulfilling both our supervisory
and monetary policy responsibilities.
Bank supervision requires a delicate balance - particularly now. The weak economy,
together with loose lending standards in the past, has put pressure on the entire banking
industry, including community banks. To protect banks from a possible race to the bottom
6
The use of credit scoring in small business lending is discussed in Allen Berger, Adrian Cowan, and Scott
Frame (2011), "The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the
Attendant Effects on Credit Availability, Risk, and Profitability", Journal of Financial Services Research, vol. 39
(April), pp. 1-17; the topic of community banks that lend to small businesses is discussed in Jihye Jeon,
Judit Montoriol-Garriga, Robert K. Triest, and J. Christina Wang (2010), "Evidence of a Credit Crunch?
Results from the 2010 Survey of First District Community Banks (PDF)", Federal Reserve Bank of Boston,
Public Policy Briefs, no. 10-3 (September); and the determinants of community bank performance are
discussed in Dean F. Amel and Robin A. Prager (2010), "Performance of Community Banks in Good Times
and Bad Times", unpublished paper, Board of Governors of the Federal Reserve System, Division of
Research and Statistics, May.
7
Examinations typically occur annually but may take place more or less frequently depending on the size and
condition of the banking organization. The Federal Reserve maintains a full-time, on-site presence at the
largest banking organizations.
and new problems down the road, and to safeguard the Deposit Insurance Fund, supervisors
must insist on high standards for lending, risk management, and governance. At the same
time, it is important for banks, for their communities, and for the national economy that banks
lend to creditworthy borrowers. Lending to creditworthy borrowers, after all, is how banks
earn profits. Getting that balance right is not always easy, but it is of utmost importance.
Regulatory challenges for community banking
Community bankers tell us repeatedly that they are concerned about the changing regulatory
environment. They touch on a number of areas, but one particular worry is the
implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(DoddFrank Act).
It is important to emphasize that the Congress enacted the Dodd-Frank Act largely in
response to the "too big to fail" problem, and that most of its provisions apply only, or
principally, to the largest, most complex, and internationally active banks. To mitigate the
threat to financial stability posed by systemically important financial firms, the act required
the Federal Reserve to implement enhanced prudential standards to regulate these firms.
The Board in December requested comment on proposed rules for systemically important
firms, including stronger capital, leverage, liquidity, and risk-management requirements.
Other aspects of the proposed rules are single-counterparty credit limits and requirements to
periodically produce resolution plans (known as living wills) and to conduct stress tests.8 The
proposed rules, in conjunction with other elements of the Dodd-Frank Act, are designed to
make these firms safer and to force large firms to take into account the costs that their
potential failure could impose on the broader financial system.
These new standards are not meant to apply to, and clearly would not be appropriate for,
community banks. Indeed, the Dodd-Frank Act explicitly exempts community banks from
these new enhanced standards. Community banks express concern that the more stringent
requirements for larger institutions will eventually find their way to smaller firms; that,
however, is not our intent, and we will work to ensure that it does not happen. An example
that predates the Dodd-Frank Act is the interagency guidance issued in June 2010 covering
incentive compensation.9 In that guidance, we were careful to note simplified expectations for
community banks that did not make extensive use of incentive compensation. We intend to
continue this practice for other policies and guidance and to continue to speak with
community bankers to respond to their questions and concerns and to clarify our supervisory
expectations.
Given the ongoing supervisory and regulatory changes, the Board and its senior-level staff
members have made it a priority to work with other regulators to increase the coordination
and consistency of regulation across a banking industry that has multiple regulators and
charters. We regularly consult on these matters with the Consumer Financial Protection
Bureau, the Securities and Exchange Commission, and other agencies.10 The new Financial
8
See Board of Governors of the Federal Reserve System (2011), "Federal Reserve Board Proposes Steps to
Strengthen Regulation and Supervision of Large Bank Holding Companies and Systemically Important
Nonbank Financial Firms", press release, December 20, www.federalreserve.gov/newsevents/press/
bcreg/20111220a.htm.
9
See Board of Governors of the Federal Reserve System (2010), "Federal Reserve, OCC, OTS, FDIC Issue
Final Guidance on Incentive Compensation", joint press release, June 21, www.federalreserve.gov/
newsevents/press/bcreg/20100621a.htm.
10
See Board of Governors of the Federal Reserve System, Consumer Financial Protection Bureau, Federal
Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the
Currency (2011), "Agencies Issue Statement to Clarify Supervisory and Enforcement Responsibilities for
Federal Consumer Financial Laws", joint press release, November 17, www.federalreserve.gov/
newsevents/press/bcreg/20111117a.htm.
Stability Oversight Council also provides a forum for agencies to discuss the coordination of
policies and initiatives. It is important that we at the Federal Reserve continue to work closely
with other agencies on supervisory matters, particularly in cases in which a common
regulatory approach across agencies and across banking organizations with different
charters has the potential to reduce compliance costs and risks.
One of the areas where communication between banks and examiners is especially
important is in the ongoing supervisory process. We conduct extensive training for our
examiners, perform internal reviews and studies to ensure that the examiners are properly
interpreting supervisory guidance, and stress that a main goal of supervision is to help
bankers sustain sound lending and risk-management practices. We emphasize that open
dialogue with bank management is an essential component of effective supervision.
Although we hope that bankers are able to resolve all examination issues through discussion
with the examiner-in-charge or Reserve Bank management, it is inevitable that examiners
and bankers will sometimes differ over examination findings despite our best efforts. For
those cases, the Federal Reserve has a robust appeals process, as well as an independent
ombudsman, to provide institutions with a fair and thorough review of complaints.11 A banking
organization's board or management may appeal any material supervisory determination to a
review panel composed of Reserve Bank staff that were not involved in the original
supervisory determination and that were selected after consultation with staff at the Board in
Washington. Bank managers may submit relevant information to this panel in writing and
may appear in person.
If the bank's managers or board believe this panel's decision did not address their concerns
in a satisfactory manner, the bank may make a second appeal to the president of the
relevant Reserve Bank. A third review - undertaken by the member of the Board of
Governors with oversight responsibility for the Federal Reserve's banking supervision, who
at present is Governor Tarullo - can be requested if the institution is still not satisfied that its
concerns have been addressed.
The Federal Reserve's ombudsman mediates complaints, facilitates appeals, and, where
appropriate, refers matters to committees of the Board.12 We are working to increase
awareness of the ombudsman's office and encouraging bankers to use the ombudsman for
matters that cannot be resolved at the local level. Importantly, the ombudsman reaches out
to every institution that has filed an appeal within six months after the appeal has been
decided to ensure that no retaliation or other unjustified reactions have taken place. The
ombudsman has broad authority to investigate claims of retaliation, and, when appropriate,
will report complaints to the Board. The Board will not tolerate retaliation against banking
organizations that file appeals or raise concerns about the supervisory process. Beyond
simple fairness, hearing concerns from banks about supervisory practices gives us extremely
valuable feedback that will help us improve supervision and better understand the issues that
banks and examiners confront in the field.
Conclusion
To conclude, I would like to reemphasize the importance that my colleagues on the Board
and I place on the Federal Reserve's relationship with community banks. The Fed is
committed to fair, consistent, and informed examinations that take into account the size,
complexity, and individual circumstances of each bank we oversee. We will continue to rely
on the many channels of communication I discussed today to improve our supervision, and
we will do all we can to eliminate unnecessary costs. By engaging in a constant dialogue with
community banks through various communication channels and through the examination
process, the Federal Reserve is able to collect important information about local economies
and better inform banks about the applicability and expectations of new rules and regulations
intended to help keep them safe and sound. Despite economic uncertainties, the condition of
community banks is improving, which is reassuring given their undeniable importance to the
health of our nation's economy.
My thanks to the FDIC and Marty Gruenberg for convening this important conference.