Michelle W Bowman: Empowering community banks
Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal Reserve
System, at the Conference for Community Bankers, sponsored by The American Bankers
Association, Orlando, Florida, 10 February 2020.
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Thank you to the American Bankers Association for inviting me to address this year's
Conference for Community Bankers. I am delighted to be here with you again. Let me begin by
stating that the views I express today are my own, and not necessarily those of the Federal
Reserve.
As community bankers, you have worked hard to develop a deep understanding of your local
economies, while also keeping perspective on the broader economic picture. There is little I
could tell you about your local communities that you do not already know, but I thought I might
say a few words on the national economic outlook before turning to my main topic for today.
My colleagues and I on the Federal Open Market Committee had our most recent meeting about
two weeks ago, when we decided to keep our target range for the federal funds rate unchanged
at 1-1/2 to 1-3/4 percent. This policy setting should help support the economic expansion, which
is now in its 11th year. My outlook for the U.S. economy is for continued growth at a moderate
pace, with the unemployment rate-which is the lowest it has been in 50 years-remaining low. I
also see inflation gradually rising to the Committee's 2 percent objective. So on the whole, the
national economic backdrop looks very favorable, which should be broadly supportive of your
local economies. And of course, by ensuring that consumers and businesses in your
communities have access to financial services, you are key contributors to the health of our
national economy.
Let me now turn to my main topic for today, the interaction between innovation and regulation for
community banks. As the Federal Reserve Board's first designated governor with experience in
community banking, I am committed to maintaining a strong and thriving community bank sector.
Small banks are the lifeblood of their communities-and they ensure that consumers and
businesses have access to financial services. This capacity to address local needs is
fundamental to a strong and stable financial system. To community bankers, customers are
much more than their credit score or their annual income, and small businesses are far more
than their most recent revenues. By extending credit and offering specialized products and
services that meet the needs of their borrowers, these banks empower communities to thrive.
We live in an exciting time, when the face of banking is changing faster and perhaps more
fundamentally than it ever has. The first digital banks appeared on the scene about 25 years ago.
Since then, financial technology has evolved rapidly. Technology puts more information in the
hands of both the customer and the bank. As financial institutions succeed in digitizing more of
their offerings, customers are able to monitor cash flows, make direct payments, understand
changes in their credit scores, track spending, and budget more easily. Technologies like
predictive analytics, when supported with appropriate consumer protections, can improve bank
services and performance by enabling continuous tailoring of the customer experience. It also
helps banks identify products that are best suited for their customers and their business model
and strategy. For those account holders who are willing, an analysis of spending habits may
indicate that they could benefit from services they hadn't yet considered.
But successful innovation is not just about adopting the latest technologies. Successful
innovation has always required strategic vision and creativity. Community banks thrive when they
find creative ways to serve their communities, using everything they know to build relationships,
offer solutions, and make lending decisions. We need only look to the performance of community
banks during the financial crisis to see how well they leverage this local knowledge and their
relationships to make lending decisions.
After the onset of the crisis, community banks' superior loan quality resulted in lower aggregate
delinquency and charge-off rates compared to the largest banks. This superior performance was
widespread-community banks in the vast majority of states outperformed the largest banks in
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this way.
Even today, community banks continue to perform with distinction. In the third quarter of 2019,
community banks' pre-tax return on average assets was 1.5 percent, marking the highest pre-tax
return on assets ratio reported by community banks since 2006. Asset quality also remains
strong for community banks and is better than for larger banks. The community bank net
chargeoff rate for total loans and leases was less than 0.2 percent at the end of the third quarter 2019.
Let me state that again-the net charge-off rate was less than 0.2 percent, less than half of the
industry average. Community bank capital levels remain at continued high and increasing levels.
Community banks reported a total risk-based capital ratio of nearly 16 percent, as compared to
the industry average of less than 15 percent. This type of performance positions the community
banking sector for continued success this year and well into the future, helping ensure the
preservation of the community bank model for future generations of Americans.
Community banks understand their borrowers and their specific needs. While technology
continues to evolve and change the way we live and bank for the better, it still cannot by itself
fulfill that unique and vital role.
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Today, there are more than 4,800 community banks in the United States. Nearly 80 percent of
these have assets totaling less than $500 million, with roughly 40 full- and part-time employees,
on average. The vast majority of these community banks are financially strong, and are the
backbone of the towns and cities they serve, providing loans to individuals and businesses in the
local area. But as customers' needs and goals evolve, community banks will need to evolve to
meet them.
The successful integration of financial technology into the community bank business model is
proving to be enormously valuable to enable community banks to enhance the services they've
already proven they can deliver effectively. Access to technology and services to meet customer
needs is critical to ensuring community banks remain vibrant.
For the remainder of my remarks, I will focus on my vision for creating pathways to responsible
community bank innovation. In particular, I will discuss the promise and the challenges that
smaller banks face in identifying, integrating, and deploying transformative new technologies, and
I will offer some ideas for how the Federal Reserve can help community banks find and manage
their relationships with service providers.
Clearing a Path for Innovation
Community banks have always been innovators, but rapid technology adoption is challenging for
banks of all sizes. In most cases, realizing the potential that technology offers requires
community banks to obtain services from other companies or products from core service
providers, which I will refer to collectively as third-party providers. As I noted earlier, banks with
less than $500 million in assets employ roughly 40 people on average-nowhere near the
number required to exhaustively develop, test, and manage every element of novel technologies.
In my discussions with bankers, they note that the process of selecting, initially vetting, and
continuing to evaluate third-party service providers is onerous and presents obstacles to
successful innovation.
I agree that the cost of complying with some of our regulations and expectations for third-party
relationships can pose an outsized and undue burden on smaller banks. These compliance
costs are in some instances disproportionate to bank size, complexity, risk, and capacity and
can be the same for a bank with $10 million in assets and a bank with $10 billion in assets.
Further, expectations of due diligence when applied to a potential fintech partner may require
more financial history or information than that partner can provide.
Due diligence for new third-party relationships, even those that are not start-ups, can require a
community bank to collect and analyze a significant amount of complex information. Also, the
annual monitoring that is required adds an additional significant and ongoing burden. The
process for managing the annual collection and review of the financials, audit results, and other
operational compliance materials for multiple vendors can take weeks of time for several
employees. Bank employees must review thousands of pages of documentation, and the
workload per vendor can be the same for all banks, regardless of their asset size and number of
employees. And as someone who has been involved in this compliance work, I know that it's not
as if other responsibilities can wait-community bank employees often wear several hats.
Community banks must weigh the benefit of any third-party relationship against the additional
work required to evaluate the third party. And even when new product offerings emerge from
service providers that already serve the bank, contract terms can be complicated to adjust,
adding to the costs of obtaining technologies, which may ultimately be prohibitive. Flexible core
systems are important for this reason. Collaboration between a bank and its core system
provider is critical to ensure that technology solutions can be integrated quickly and cost
effectively within the core system.
Creating the Right Regulatory Environment
Responsible innovation, especially for smaller institutions, requires two key aspects: a clear idea
of how the technology serves a bank's strategic objectives and a regulatory environment that
supports innovation. I will touch today on the important interplay between these factors, and in
particular, the role that regulators can play in creating a regulatory environment that is conducive
to innovation, preserves the safety and soundness of the financial system, and protects
consumers. As regulators, we need to ensure that banks uphold sound risk-management
practices. Yet we also have information that can help community banks meet those standards.
We should closely examine opportunities to share that knowledge, subject to appropriate
safeguards, in order to support innovation.
Responsible innovation begins with a bank's strategy. Banks need to identify their goals and then
look to identify the kinds of products and services that can help them move forward to implement
that strategy. In the past, I have spoken about the importance of considering the impact of new
technologies and finding ways to leverage them, if a bank feels that it fits into its business model
and strategy. For community banks, a decision to embrace a new technology or innovation is
almost always synonymous with third-party engagement.
Regulators and supervisors can contribute to an environment where banks are empowered to
achieve these strategic objectives, simplifying and clarifying the process of third-party selection,
due diligence, and monitoring.
A bank may decide that its business model should evolve, and that offering a new product or
partnering with a fintech company will help it position itself for future growth. This decision is an
essential one, but what comes next? This is a new world for most community banks, and
supervisors and regulators can lend their expertise to those banks seeking to navigate the
unfamiliar landscape.
To that end, the Federal Reserve recently launched a web page on innovation and announced
several upcoming Reserve Bank events. The innovation page on our website (
is intended to be a one-stop shop for supervisory information,
www.federalreserve.gov/innovate)
publications, research, and international work that is related to technology innovation. Most
importantly, the web page also facilitates interaction with Federal Reserve System specialists, to
enable bankers and tech industry participants to submit questions about all aspects of
technology in the financial services industry, or to request an in-person meeting. Essentially, to
open a dialogue.
We have also launched a series of Innovation Office Hours events hosted by Reserve Banks.
These events incorporate panel discussions and face-to-face meetings for bankers with
regulators and supervisors, which are intended to be a resource for both state member banks
and fintech companies seeking partnerships with or offering services to banks. During these
meetings, banks that attend the office hours will have an opportunity to share specific projects or
proposed partnerships and learn about how regulators approach and consider risk management
in those contexts. Regulators can also share their observations about effective implementation
and risk-management practices across the sector. Equally important, the events provide
regulators an opportunity to hear directly from banks and fintech companies about challenges to
innovation. The office hours events will also include a panel discussion on innovation topics that
will help to provide additional insights into new financial technologies. Our first office hours event
will be held at the Federal Reserve Bank of Atlanta later this month. Additional events are planned
later in the spring and throughout the rest of the year. These are an important opportunity for us
to learn, and I look forward to hearing your feedback on these events.
I'd like to turn next to another step in this process-the selection of a third-party provider. This
step can be challenging given a lack of information about potential partners when many firms,
and their product offerings, are new. Notably, in the 2019 National Survey of Community Banks,
community bankers voiced a desire for more transparency into third-party service providers, to
inform decisions about whether to enter into contracts with these providers and the type of
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contract that may be appropriate.
In this regard, I believe the Federal Reserve should consider several possible steps. First, we
should explore the possibility of publishing the list of service providers subject to supervision by
the agencies. This could provide a starting point for community banks by sharing information
about the types of companies providing services to a large number of financial institutions.
Second, I believe we should increase transparency around our own practices. Through the
banking agencies' service provider program, we regularly conduct examinations for and produce
independent evaluations of certain providers of critical services. These exams are focused on
risk management, audit, and internal controls. The Fed and other agencies have the statutory
authority to oversee third-party providers that serve the banks they supervise. Providers that
represent a significant level of risk to their clients are part of an interagency supervisory program.
The agencies make the outcomes of those exams available to banks that are clients of a
supervised service provider.
I believe we can take a step further with increasing transparency on our supervisory program by
making information that may be useful about our supervision of key service providers available to
banks. This could take a number of forms, such as being more transparent about who and what
we evaluate. Of course, moving forward in these areas requires careful consideration and
interagency collaboration, and I have asked our staff to work with other agencies to develop and
propose workable options for giving banks the benefit of the knowledge that supervisors have
about their potential providers in an appropriate manner.
Once banks seeking to innovate have navigated the selection process and identified a partner,
they now face a complicated due-diligence process. I believe that regulators and supervisors
have a role in easing the burden of that process for community banks in several respects.
First, we could help by implementing clear third-party guidance that is consistent across all
regulatory agencies. The Federal Reserve is in the process of working with the other banking
agencies to update our third-party guidance. I believe that the banking agencies should all have
consistent expectations for third-party relationships, and that the Federal Reserve should, as a
starting point, move toward adopting the Office of the Comptroller of the Currency's (OCC)
guidance. It is incredibly inefficient to have banks and their potential fintech partners and other
vendors try to navigate unnecessary differences and inconsistencies in guidance across
agencies.
Second, this guidance should allow banks to conduct shared due diligence on potential partners.
If several banks use the same third-party service provider and are open to collaborating, they
should be allowed to pool resources instead of duplicating one another's work.
Third, the guidance should explain what due diligence looks like for a potential fintech partner,
because the standards applied to other third parties may not be universally applicable. For
example, many fintech companies lack the kind of long financial history associated with more
traditional bank vendors. Perhaps a fintech company has been around for only a few years. On
its own, the fact that a bank cannot evaluate more than five years of the company's financials
should not necessarily stop this company from being considered as a partner. Every bank has
different objectives, and potential partnerships are not one-size-fits-all. Regulators should
especially support partnerships that combine the strengths of community banks and fintech
companies, which have a track record of success. The guidance should reflect some
supervisory flexibility, and not impede prudent, strategic partnerships between community banks
and potential partners.
Fourth, in order to give community banks a better picture of what success in due diligence looks
like, and where it begins and ends, I also believe that we should release more information on its
necessary elements. This change would provide clarity and assist community banks in
completing their work. In particular, I believe that regulators can provide more clarity on the types
of questions that should be asked of a prospective third-party provider and our view of a
satisfactory answer. Such a handbook would not only have the benefit of increasing transparency
for community banks but could also be beneficial for fintech companies that hope to become
third-party providers.
Finally, I know from experience that once due diligence has concluded, the evaluation of
thirdparty relationships is not over. As I noted earlier, monitoring can take weeks of work every year
for community bank employees. To be sure, this work is an important part of risk management.
But I believe regulators and supervisors have a role to play in ensuring that the burden is tailored
to bank size, risk, complexity, and capacity. Knowing the burden that third-party monitoring can
present to employees of the smallest banks, I have encouraged Federal Reserve staff to
consider options for further tailoring our expectations for community banks with assets under $1
billion in this area. We should be mindful that when we apply the same expectations to banks
with starkly different asset sizes, we are creating the same workload for a bank with about 30
employees as for a bank with roughly 180 employees, even though their resources and risk
profiles are quite different.
Closing Remarks
To conclude, I believe that we can create a regulatory environment in which community banks
are empowered to innovate, in which supervisors leverage their own knowledge to help banks
understand what to look for in a service provider. It's a regulatory environment in which guidance
is clear and supervisors are appropriately flexible, and due diligence and third-party evaluations
are appropriately scaled.
Every bank must decide for itself whether and how to adapt their business models to new
technologies, but supervisors and regulators can facilitate innovation at a few key milestones on
that path forward. First, supervisors and regulators can serve as a resource for banks navigating
the financial technology landscape for the first time, and make subject-matter experts
accessible. Second, we can make the process of selecting a partner appropriate for a bank's
business strategy a more informed one, by being more transparent about our own supervisory
program for certain service providers. Third, we can facilitate vetting of potential partners by
allowing shared due diligence, providing in our guidance specific expectations for partnerships
with fintech companies, and publishing a handbook of sound practices in due diligence. Finally,
we can reduce burden on banks as they continue to evaluate risk at third-party providers, by
rightsizing our expectations and sharing more information about our supervisory program.
Capacity, in addition to complexity and size, should be considered as we continue to tailor
supervisory expectations.
As we work toward the environment I described, communication between regulators,
supervisors, banks, and fintech partners must be frequent, and confusion about compliance
requirements must not be an impediment to banks who wish to partner with third parties. I
believe the steps I have laid out today are a promising beginning to making this regulatory
environment a reality.
1
See Jeffrey W. Gunther and Kelly Klemme, Financial Stability: Traditional Banks Pave the Way (PDF) (Dallas:
Federal Reserve Bank of Dallas, 2012).
2
See Federal Deposit Insurance Corporation, FDIC Quarterly Banking Profile (PDF) 13, no. 4 (Third Quarter
2019).
3
See www.communitybanking.org/~/media/files/publication/cb21publication_2019.pdf.