Sarah Bloom Raskin: Community bankers and supervisors - seeking
balance
Speech by Ms Sarah Bloom Raskin, Member of the Board of Governors of the Federal
Reserve System, at the Federal Reserve Bank of New York Community Bankers
Conference, New York, 7 April 2011.
* * *
Thank you for the opportunity to join you this morning. Let me begin by saying that it's a
pleasure for me to be among community bankers. I used to be the banking commissioner in
Maryland and will always be grateful to the community bankers there who were crucial to
informing my views on effective bank regulation. At the height of the mortgage crisis, those
same community bankers partnered with regulators like me to survey the wreckage and to
stabilize our communities as best we could. Together, we confronted and weathered that
searing experience and learned many lessons along the way. I'm here today to share with
you some of those lessons.
Although decisive action by policymakers has been successful in containing the crisis, we
should not presume that the experience of the crisis is over. To be sure, the frantic days of
rushed mergers of major financial institutions; emergency applications of nonbanks to
become bank holding companies; and large-scale, targeted Federal Reserve programs to
stabilize markets and restore the flow of credit are behind us. If we were doctors, we'd say
that we had successfully treated the worst symptoms of the illness.
But as we've learned from the other crises that are buffeting our world today, both natural
and man-made, rescue and containment are only the first steps. Now we must address the
aftershocks of the subprime mortgage meltdown: dislocation, joblessness, and loss of
confidence.
From a regulatory and supervisory perspective, we will certainly be dealing with the
longterm consequences of the crisis for years to come. And, as we head toward an increasingly
healthy, but still highly complex and concentrated, post-crisis financial system, we must strive
to find the appropriate balance of responsibility between banks and supervisors. I'm hoping
to open the dialogue about that today.
A significant backdrop to the post-crisis financial architecture is the expansive federal
legislation that is known as the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank). Broadly speaking, Dodd-Frank gives us a roadmap for updating the regulatory
framework of our financial system post-crisis, but it does not give us turn-by-turn directions
for how to incorporate the new requirements into our supervisory processes. To that end, the
Federal Reserve and other federal regulators are devoting considerable time to implementing
the requirements of the Dodd-Frank Act. Translating all of the new legislative requirements
into rules and regulations, and then into an effective supervisory and examination program, is
a massive undertaking, but it is essential to moving beyond the stabilization phase of crisis
recovery and into that phase where we address the underlying fault lines in our financial
institution landscape.
As we work through Dodd-Frank implementation, we will need to ask: What constitutes
effective supervision in the post-crisis world? I expect that the answer will be the subject of
debate for months and possibly years.
The process of identifying the factors most important to constructing an effective supervisory
and examination program has already begun. For America's community banks, the vast
majority of which did not contribute to the subprime crisis, the contours of this program will be
of critical importance.
As we have learned all too well, a financial system dominated by a handful of large
institutions is unlikely to be resilient in the face of a crisis. My view is that a diffuse financial
system - one with a diverse range of institutions of varying size and complexity - is
preferable to a system that is highly concentrated.
In fact, the need for diversification is one of the great lessons of the crisis. Indeed, we found
that, irrespective of size, those banks most likely to weather the crisis were those with
diverse loan portfolios, management information systems capable of monitoring
concentrations, reasonably diversified funding sources and liquidity management processes,
and forward-looking analyses that considered how loan portfolios might perform and affect
bank conditions under periods of stress. We need many, many more banks with these
characteristics because these are the banks that absorbed the shocks of the crisis, remained
relatively healthy, and, most significantly, now have the potential to thrive as robust sources
of credit in their communities after the crisis.
As I see it, we need to create within the Dodd-Frank regulatory architecture a supervisory
and examination program that encourages diversification and forward-looking strategies as a
means to ensuring a healthy financial system and a steady flow of loans to creditworthy
borrowers.
Am I saying that it is the responsibility of examiners, in essence, to guarantee that the
banking system becomes more resilient and incapable of failure? No. A regulatory system
that guarantees against bank failures is not in my mind desirable, even if such a system
could be established in a cost-effective manner.
To illustrate, I'll borrow a concept from the field of statistics. When drawing conclusions
based on test results, statisticians and scientists often factor in the possibility of erroneous
results, or "false negatives" and "false positives." Some economists have extended this
concept to assessing the effectiveness of regulation.
Imagine that you visit your doctor for an annual checkup and have your cholesterol level
tested. When the results come back from the lab, they show that all is well. But what if your
cholesterol actually was high and an error in the test resulted in a clean bill of health? That
would be a false negative, and I'm sure you can see the problems it would pose. You might
not change your diet and exercise habits, and your doctor probably wouldn't refer you for
further testing or give you that firm lecture that they like to give about the importance of
taking better care of yourself. Instead, your rising cholesterol levels would go undetected and
untreated until your next checkup, or even worse, until you suffer a heart attack.
In the context of bank supervision, a false negative occurs when an examiner does not
identify and address a deteriorating or failing bank in a timely manner. History has shown
that the costs of these false negatives can balloon during times of broad economic and
financial stress, which results in a significant drag on the economy and weakens banks'
ability to lend. There were clearly too many of these false negatives in the recent crisis,
particularly among the largest financial firms, both here and abroad.
In addition to the billions of dollars of direct costs to the Deposit Insurance Fund as a result of
bank failures, the deep recession of 2007 to 2009 most likely would have been mitigated had
the risk of exposure to real estate at many banks been recognized earlier. Many of the
reform efforts that regulators and the Congress have undertaken - reforms that are clearly
needed - are aimed at improving regulators' ability to identify and address troubled
institutions earlier, and to limit the impact of failures when they do happen.
Now, returning to the medical analogy, imagine that your test results show that your
cholesterol level is worryingly high, only in this case you are actually the picture of health.
This is a false positive, and it poses problems of its own. While there may be some ancillary
benefits to improving your diet and exercise habits, the inaccurate test result likely would
cause you undue angst and, in an abundance of caution, subject you to a series of
expensive, and ultimately unnecessary, follow-up measures.
A false positive in banking supervision occurs when examiners inaccurately identify a sound
bank as having significant problems. When this happens, we may then take the step of
accelerating onsite examinations even though the bank remains in satisfactory condition. To
be clear, we err on the side of accepting some false positives because, as we saw during the
crisis, the costs of missing too many problems are so high. Having said that, we recognize
that false positives are not free: They impose a real cost on examiners in the form of
resource use and also on banks in terms of imposing the burden of an onsite review.
In one way, effective supervision is striking a balance between false negatives and false
positives, recognizing the costs of each. As we look forward, I think policymakers will need to
find a similar balance between the responsibilities of examiners and the responsibilities of
banks to ensure compliance with laws and regulations and to maintain a safe and sound
banking system. Make no mistake, the crisis made clear that more effective regulations and
more consequential examiner reviews of banks are needed. But, at the same time, banks
have a fundamental - arguably the fundamental - role to play in improving financial system
resilience.
So, how do the responsibilities of banks and examiners meet to maximize safety and
soundness? When I imagine the model of a healthy bank - no matter its size or complexity -
I picture a series of concentric circles. The inner circles are composed of the systems and
functions that keep the bank healthy and allow it to meet the credit needs of its community
while remaining financially sound and compliant with its legal and regulatory obligations.
Inner circle systems and functions help the bank identify, monitor, and remedy the various
problems that arise in its ordinary course of business. These would include, among other
things, internal audit, executive management committees, governance by a board of
directors, policies and procedures, and critical reporting relationships.
The outer circle, then, is effective supervision. This layering of circles implies that there are
multiple internal and external checks on behavior that make timely identification and
resolution of problems more likely.
We could probably spend the day arguing about the proper order of the outward progression
of these circles, but I think we can all agree that at the core of a healthy bank is an effective
corporate governance structure. A bank's board of directors should understand the bank's
exposure to risk, and its members should be willing and able to critically question senior
management about important matters affecting those risks. In my experience, specific
technical financial expertise - which may be somewhat more difficult to find in smaller
communities - is not nearly as important in this regard as board members' ability to exercise
sound and effective judgment regarding different risks confronting the bank and to take
seriously their responsibility for the long-term interests of the bank. The board of directors,
along with a strong senior management team, can contribute substantially to the safe and
sound operation of the bank by setting the "tone at the top" regarding activities and behaviors
that are either encouraged or frowned upon.
Well-informed managers and staff constitute another inner circle. Customer-facing
employees who know their business and know their customer base can play a critical role in
catching problems at inception. And institutional knowledge of this kind is an area of relative
strength for community banks.
Successful business lines are profitable because they are run by those who understand and
can manage risk. Risk is best understood, I believe, by those who are engaged in the
day-to-day business of the bank. A bank in which every employee understands his or her
responsibility for managing risk is likely to be more sound than a bank in which risk
management is always seen as someone else's responsibility.
While risk management starts at the business-line level, a well-run bank also has in place an
effective program for enterprise-wide risk management that is supported by strong internal
controls. I know that many smaller community banks may not have the resources to establish
a separate risk management function, but that is not necessarily a problem if senior
management and other key personnel establish a system of internal, independent checks
and balances to ensure that risks are regularly identified, controlled or otherwise managed,
and monitored. These systems include not only core functions such as credit administration,
effective reporting of information to senior management and the board, and policies and
procedures that are documented and implemented, but also processes that try to look ahead
to potential risks on the horizon.
Another of the inner circles is a strong internal audit function that reviews the bank's
operations, risk management, and internal controls. In particular, an effective internal audit
function will: identify processes to be audited based on risk exposure, establish a schedule
and frequency for performing internal audits, ensure that there is accountability for fixing
problems identified in the audit, and escalate significant unresolved issues to the board of
directors or its audit committee.
This concentric circle model illustrates my belief that problem identification is first and
foremost the responsibility of the bank. A safe and sound banking system starts with banks
that take seriously the importance of sound governance, business judgment, risk
management, internal controls, and compliance. Banking supervision provides another level
of protection, but it was never intended to be a substitute for a bank's own risk management
processes, nor should it be.1
And this brings us to the outer circle: banking supervision. First and foremost, examiners
need to understand and work within the scope of their role. For example, examiners should
not substitute their judgment for that of bank management. A bank's board and senior
management are responsible for running the bank, and it is not appropriate for examiners to
be overly engaged in the routine business of a healthy bank. There will of course be times
when examiners are justified in questioning decisions or requiring action when a bank may
be operating in an unsafe and unsound manner or is not in compliance with law.
In that regard, we have heard from some community bankers that pressure from examiners
may affect a bank's willingness to lend to creditworthy small businesses and consumers. We
have worked hard to ensure that our examiners are well-trained and employ a balanced
approach to reviewing banks' credit policies and practices. We will continue to monitor this
closely.
I would also suggest that examiners are regulators and as such should not view banks as
their customers or clients. There are times when the interests of banks and regulators are
aligned, and there are many instances where our objectives diverge. This doesn't mean that
examiners and banks will inevitably have a contentious relationship. Indeed, I think many
banks, particularly those that are well run, would characterize their relationship with
examiners as professional and constructive, and would agree that examination findings are
not arbitrary and in fact help them to improve their internal systems. That is as it should be. A
regulator's relationship with a supervised bank must not get in the way of his or her
willingness and ability to make tough calls.
At the end of the day, some regulatory failures may be inevitable. Examiners are smart,
welltrained, diligent, and conscientious. They are committed to public service and take their
responsibilities seriously. But even the best examiners are no more prescient than the
managers of the banks they oversee and cannot be expected to head off every problem or
detect every risk. The risk management systems and functions that comprise those inner
concentric circles must be the primary mechanisms for heading off problems and detecting
risks before they grow.
Unfortunately, there is no panacea to eliminating risk: Even the combination of appropriately
designed risk management tools and thorough supervision can not completely eliminate the
risk of low-probability, high-impact events.
While I realize this sounds somewhat pessimistic, in fact I am quite optimistic about
examiners' ability to play a strong and effective role in a healthy banking system. In that
regard, let me return to the concentric circle model and describe what we should expect from
bank supervisors in the outermost circle.
One of the most important functions of supervisors in a healthy banking system is to set high
standards through the establishment of policies and through the design of a strong
supervisory program. Of course we should be vigilant about avoiding policies and practices
that add little value and impose great burdens on banks, and I can assure you that we take
that responsibility seriously, especially as it regards community banks. But we also should
set the bar high when it comes to our expectations for acceptable bank risk management and
business practices. We should be - and I believe we are - tough but fair.
In addition to setting high expectations, examiners should strive for balance and consistency
throughout the business cycle - that is, we should be careful not to be too hands-off when
times are good and not to overreact when times are bad. If you're driving a car on a curving
mountain road, accelerating too fast on the straight stretches leaves you with three choices
when the road bends: either you slam on the brakes, end up in a ditch on the side of the
road, or get lucky and make it through. It's far safer to maintain a relatively steady speed,
accelerating and decelerating gently as necessary, than to swing between extremes. So it is
with examination. If examiners do not evaluate banks' practices with sufficient rigor during
the boom years, then it may be necessary to take a more draconian approach during the
bust years, when problems are revealed.
It has emerged that a number of regulators and examiners became concerned about
concentrations in commercial real estate lending several years before the financial crisis.
Despite the red flags raised by this lending, it was difficult for examiners to challenge bank
management at a time when these loans were performing well and banks were generating
record profits. There was also strong pushback from the industry when the banking
regulators began raising alarms about the potential risks of excessive concentrations.
Regulators finally issued guidance on concentrations in commercial real estate in late 2006,
but in retrospect I think it is fair to wonder whether action should have been taken sooner.
That brings me to my next point, which is that examiners have a key role to play in reviewing
and assessing the quality of a bank's internal controls, compliance, internal audit, et cetera.
A central element of the Federal Reserve's supervisory programs is assessing the
effectiveness of these processes and functions. We should understand where a bank's
primary risks arise and use enforcement tools as necessary to ensure that management is
sufficiently focused on these risks. Examiners should clearly communicate their findings to
banks and maintain a regular dialogue about their risks and their risk management
processes. When examiners find weaknesses in any of these areas, we expect that banks
will address them in a timely manner.
One thing I would note here is that if done properly, effective examination requires looking
behind the numbers. The crisis made clear that a bank that appears to be in sound financial
condition may actually have a ticking time bomb on its books. As I said before, it can be
difficult for an examiner to tell a profitable bank with strong financial indicators that there are
management weaknesses. But that is exactly what we should empower our examiners to do
because we know that the seeds of financial crisis are planted during the good times. When
conducting an examination, an examiner should be attuned to weaknesses in governance,
risk management, and internal controls that may not pose a current problem but that may
expose the bank to losses in the future. And ultimately, as you know, it is easier to fix a
problem during the good times.
Finally, one of the key roles that examiners play in a healthy financial system is to provide
context and perspective. This is natural given the number of banking organizations that we
examine and inspect, and I believe the Federal Reserve's renewed financial stability
mandate under the Dodd-Frank Act will enhance our ability to assess not just individual
banks, but also the system as a whole. Examiners have a longstanding practice of assessing
a bank's performance and practices relative to its peers. This should not be a purely
mechanical exercise where the examiner demands that a bank meet or exceed financial
indicators for its peer group. Instead, we should use these assessments to understand a
bank's performance relative to peers in the context of its own unique facts and
circumstances.
The expectations that I have described for both banks and examiners are not just
heard
hypothetical. You may have much more about the banks that faltered under intense
credit and liquidity pressures, but the Federal Reserve has also been focused on the
performance of those community banks that have remained in sound condition throughout
the crisis. Many of the community banks supervised by the Federal Reserve that entered the
crisis with a supervisory rating of "1" or "2" - the highest ratings on the 1-to-5 scale used by
bank supervisors - have managed to keep these ratings. Most of these banks entered the
crisis with moderate exposures to commercial real estate, and continued to report strong
earnings and net interest margins throughout the crisis. They reported very limited reliance
on noncore funding and strong capital levels as they entered the crisis. They earned solid,
though not spectacular, returns and they reported steady performance. And, while this is less
quantifiable, many of these banks have effective boards of directors and strong and
experienced management teams. It is important that examiners keep this in mind as they
evaluate and refine their supervisory processes in the wake of the crisis.
Conclusion
I certainly don't claim to have all the answers when it comes to delineating the appropriate
roles and responsibilities between management and examiners in a healthy bank, but I hope
my remarks today will at least start a conversation about how best to structure a regulatory
and supervisory framework for the banking system that effectively supports the real economy
and encourages sound and sustained lending to creditworthy borrowers. We know that those
community banks that weathered the storm during the crisis are already doing this in their
own communities and we can learn from their experience. In order to sustain the economic
recovery, we need strong, well-run community banks that operate in a framework of smart
and effective supervision. I commend you for the work that you are doing every day in your
communities, and I look forward to continuing the dialogue on our respective priorities and
concerns.