Susan S Bies: Bank performance and corporate governance
Remarks by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System,
at the 112th Annual Meeting of the Tennessee Bankers Association, Hot Springs, Virginia,
11 June 2002.
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Good morning. Thank you for the invitation to speak to members of the Tennessee Bankers
Association today. I have really enjoyed getting to talk to many old friends. Some of you have asked if
I have had any surprises in my new role as a Governor of the Federal Reserve Board. I must say the
biggest surprise is the amount of reading that I do. I haven't read so much on so many different topics
since I was in graduate school! Not only do I get to discuss economics and monetary policy, but also
bank regulation and operations issues. Even though I have experience at a Federal Reserve Bank and
at First Tennessee Bank for a total of twenty-six years, I find that wearing the hat of a central banker
makes me consider issues facing the financial industry in new ways. I hope that over the years I can
continue to meet with groups like yours so that I stay up to date on issues important to bankers.
In my comments today, I will address: first, the financial performance of U.S. banks, in particular, of
community banks; second, the improvements that banks large and small are making in measuring and
managing risk; and, third, the responsibilities of directors and senior managers in corporate
governance. In my view, these topics are integrally linked and, in light of current questions of
confidence in America's corporations, quite timely.
Fourth and finally, I would also like to mention the proposal the Federal Reserve has issued for
comment on changes to the discount window.
Financial condition of U.S. banks
Last year was exceptional in many respects, with the United States slipping into what appears to have
been a mild recession, and with the terrorist attacks in September. In response, the Federal Reserve
reduced interest rates at every meeting of the Federal Open Market Committee in 2001 and an
additional three times between meetings, for a total of eleven rate cuts accumulating to 475 basis
points. The Federal Reserve has now moved from a policy bias to address weakness, to one where
the risks of inflation and weakness are balanced. Credit quality deterioration is concentrated in larger
corporations, with several filing for bankruptcy. Serious concerns have arisen about the integrity of
corporate management and financial reporting. Argentina's economic difficulties reminded us, yet
again, that exposures to emerging economies could present substantial risk.
Given these events, the U.S. banking system has remained strong, possibly in large part because the
recession in this country seems to have been relatively mild and short-lived. More directly, the strength
seems also to reflect improvements in risk management at many banks and a greater awareness
throughout the industry that institutions should promptly address problems as they emerge. This time
both the banking industry and the regulatory agencies appear to have done just that--acted
promptly-and without going too far and unnecessarily constraining credit.
Much of the weakness among banks recently has been concentrated in large regional and money
center banks, rather than in smaller institutions. Bank earnings reached a record level in the first
quarter of 2002, with one of the highest quarterly return-on-assets ratio ever reported of 1.33 percent.
Net interest income was the driver of stronger revenue, despite lower commercial loan volume. Loan
loss provisions were significantly above the first quarter of 2001, although below levels of the fourth
quarter. Higher charge-offs were concentrated in commercial loans at large banks and in credit card
specialty lenders.
What areas may present heightened risks to community banks today? First, for most of the past
decade, community banks--particularly those in the asset range of $100 million to $1 billion--have
actively expanded their commercial real estate lending. Since the early 1990s, larger community
banks have expanded their commercial real estate portfolios from 13 percent of aggregate assets to
22 percent.
To date, these credits have generally performed well, and my comments are not intended to suggest a
material concern. These credits, however, account for most of the group's increase in nonperforming
assets over the past year. Given the checkered history of commercial real estate lending and its
increased relevance to many community banks, this portfolio must be monitored and managed
carefully. We have often seen the cyclical nature of commercial real estate and its links to the general
level of economic activity. The loss of anchor firms such as K-Mart, for example, may reduce the
market value of certain shopping centers and the consumer traffic and the financial strength of nearby
businesses as well.
The second area of potential risk relates to interest rates. For the industry overall, the Federal
Reserve's rate cuts last year may have proved to be a mixed blessing. Lower interest rates
undoubtedly eased payment pressures on many borrowers and prevented further deterioration in the
quality of bank loan portfolios. Liability-sensitive banks saw their funding costs fall faster than loan and
investment yields, and more than half of all banks had a wider net interest margin in the first quarter of
2002 than in 2001. However, lower interest rates will begin to narrow net interest margins for some
institutions. Rates paid on deposits are close to their effective floors, and yields on loan portfolios are
lower because of a record volume of refinancings and the falling prime rate.
Many banks responded to the low rates by sharply reducing their investments in Treasuries and
shifting funds into mortgage-backed securities, as they searched for higher yields. Given the
historically low interest rates at which recent mortgages have been originated or refinanced one might
expect that these loans would be much slower to prepay than previous ones. As a result, the effective
maturity, or duration, of bank securities portfolios--and of many loan portfolios, as well--has been
extended.
Clearly, I am not about to forecast interest rates, something I've already learned that central bankers
never do. Nevertheless, the interest-rate environment could present banks with a greater challenge
later this year. Even stable rates could present increased risks, if savings and money market deposit
account deposits flow out of banks as quickly as they came in last year. We should all ask ourselves
how long depositors would be content earning the currently low rates as equity markets improve or
interest rates rise once again. At some point, even loyal customers--those on fixed incomes, in
particular--may blink and take steps to improve their returns.
Turning to the longer-term outlook, what are the prospects for community banks? They have
historically had higher profitability, as measured by the return on average assets, than large regional
and money center banks and, on an individual-institution basis, have enjoyed relatively strong asset
and deposit growth.
A study recently published in the Federal Reserve Bulletin examined growth rates during the past
fifteen years for large and small banks. Adjusting the data for mergers and acquisitions, the authors
found that small and medium-sized banks--defined as those below the 100 largest--grew faster than
the larger banks in virtually every year between 1985 and 2000. Moreover, the smallest banks, those
below the 1,000 largest in terms of assets, grew the fastest of all in both deposits and total assets.
The banks did this the old-fashioned way, by earning more on assets than larger institutions. Although
small banks have paid higher average deposit rates than the large banks have paid, their net interest
margins were still much higher, and by a growing differential in recent years. Measured by return on
assets, small banks have done as well as or better than large banks in all but a handful of years over
the past decade and a half.
Managing risks
The health of financial institutions today also reflects the improvement in risk management process
that has been ongoing at banks for years. Increasingly, the entire risk management process has
become more quantitative, reflecting not only the enhanced ability and lower costs of collecting and
processing data but also improved techniques for measuring and managing risk. Larger banking
organizations quantify a borrower's probability of default, the bank's loss given default and its likely
exposure at the time of default--practices upon which we are trying to construct new international
capital standards.
The greater use of credit scoring has, it seems, improved risk management as well. Such tools should
perform even better after the effects of the most recent economic slowdown are incorporated.
Consumer credit models were developed after the 1990-91 recession, and so their reliability in
predicting credit quality in the current slowdown is yet to be determined. Further, we are already
observing increases in delinquencies in subprime lending. Since many of these borrowers did not have
significant access to credit in previous recessions, their ultimate default rate will also help to validate
the strength of the new statistical models.
Community banks have greatly improved their management of interest rate risk in recent years.
Information developed from models that are used to identify sensitivity to market changes in the mix of
loans and deposits are now part of asset/liability committee meetings at community banks. As a result,
managers can better anticipate changes in net interest income and respond appropriately to their
unique competitive conditions.
Community bankers are also developing new revenue streams that will help to manage risk by
diversifying sources of earnings. In addition, the fee income streams help to increase the cross-sell
ratio with key customers. This in turn should improve customer loyalty, another factor that should help
manage risk by stabilizing revenue. Providing the personal touch has served community banks well,
but conducting sound market research and pricing to reflect competition, customer value, and risk are
becoming more important for success.
The Arthur Andersen matters and other corporate events currently being addressed provide good risk
management lessons for bankers as they try to increase earnings by cross selling more products.
When line officers are compensated on sales and cross selling, a strong, independent quality
assurance or risk review function becomes even more essential. For public accounting firms, strong
quality assurance functions are needed to protect the core business integrity of attestation services
when the firm is trying to win consulting contracts. In banks, where credit is still the dominant risk
exposure, the chief credit officer should make sure unacceptable credit risks are not taken to win fee
income business whose net revenue may not cover credit exposures.
Corporate governance
Another critical element of risk management is effective corporate governance. As bankers and bank
directors, you have specific responsibilities to manage the risks at your financial institution and
effectively oversee the system of internal controls. Not only are the activities of banks central to credit
intermediation, in this country banks fund those activities in part with federally insured deposits. These
deposits are the lowest cost source of funds for bankers because of the government's guarantee.
Bank directors are not expected to understand every nuance of banking or to oversee each
transaction. They can look to management for that. They do, however, have the responsibility to set
the tone regarding their institutions' risk taking and to oversee the internal control processes so that
they can reasonably expect that their directives will be followed. They also have the responsibility to
hire individuals who they believe have integrity and can exercise a high level of judgment and
competence.
Interagency policy holds boards of directors responsible for ensuring that their organizations have an
effective audit process and internal controls that are adequate for the nature and scope of their
businesses. The reporting lines of the internal audit function should be such that the information
directors receive is impartial and not unduly influenced by management. Internal audit is a key element
of management's responsibility to validate the strength of their internal controls. If internal audit is
outsourced, best practice is to not use the same firm for the external audit engagement.
Internal controls are the responsibility of line management. Line managers must determine the level of
risks they need to accept to run their businesses, and assure themselves that the combination of
earnings, capital and internal controls is sufficient to compensate for the risk exposures. Staff areas
such as accounting, internal audit, risk management, credit review, compliance, and legal,
independently monitor the control processes to ensure that they are effective and that risks are
measured appropriately. The results of these independent reviews should be routinely reported to
executive management and the board of directors. Both executive management and the board should
be engaged enough in the process to determine if these reviews are in fact independent of the
operating areas they are designed to review, and that the senior officers in those roles can speak
freely on issues that need to be addressed.
Audit committee members should have regular time in meetings to talk with the outside auditors
without managers present. Best practices for audit committee processes have been laid out many
times, including in the 1980s by the Treadway Commission and in 2000 by the Blue Ribbon
Committee. Beyond that, boards of directors and managers should periodically test where they stand
on ethical business practices. For example, they should ask, "Are we getting by on technicalities,
adhering to the letter but not the spirit of the law? Are we compensating others and ourselves based
on our contributions to the organization, or are we taking advantage of our positions?"
My intent today is to remind everyone of the importance of maintaining sound ethical practices to help
protect the reputation of your bank. As recent events have demonstrated, if we fail to do so the market
will enforce the discipline. And that discipline can be harsh.
Quality of accounting practices
The current framework of financial reporting in the United States effectively represents the
performance of most corporations most of the time. Indeed the high quality of accounting standards in
this country is one critical reason why capital markets are so efficient. But the lessons of the past few
months remind us that accounting rules can be bent. For six years I was a member of the Emerging
Issues Task Force of the Financial Accounting Standards Board. This is the rulemaking body that
deals with divergence in practice. The EITF's role is to provide timely financial reporting guidance
where divergence in practice is developing.
In the time I served on the EITF I came to understand that professionals could and did disagree on the
best accounting standard to apply to a new type of transaction. That is at the very heart of the struggle
to keep accounting standards current. The rapid pace of business innovations makes it impractical to
have a rule in place to anticipate every business transaction. Rather, the more complex and dynamic
the world of business becomes, the more important it is that accounting be based on strong principles
that are sufficiently robust to provide the framework for proper accounting of new types of transactions.
Further, we need to insist on higher professional standards and not permit financial officers and
auditors to benefit from "gaming" the rules-based accounting standards that are increasing in
complexity, particularly in the United States.
The core of these basic accounting principles should be professional standards followed by every
corporate accountant and every outside auditor that would insist that they can answer "yes" to these
questions: "Does the accounting method selected faithfully represent the economics of the
transaction? Does the disclosure provide the user of financial reports with sufficient information to
discern the nature of the significant transactions and risks of the organization?"
But rules alone do not guarantee good financial reporting. For Enron and other recent examples, weak
corporate governance practices apparently permitted sham transactions and misleading financial
reporting to occur. Outside auditors erred in trying too much to please a paying client. They forgot that
their professional role is to provide assurance to users of financial reports that the quality of financial
reporting meets the expectations of the marketplace.
Some observers have asserted that new accounting standards are needed. I do not know the specifics
of many of the irregularities that have recently come to light. But judging from the publicly available
information, I believe that what we need most is to restore the integrity of corporate accountants and
the quality of the audit process rather than extensive new accounting standards.
One reason that accounting in the United States has become so rule-based is that we tend to add new
accounting standards when abuses occur even when the abuses resulted from accounting and audit
failures. Discipline against auditors should occur when accounting standards have been manipulated.
The present industry-driven process clearly has not worked and a new oversight process is needed to
ensure audit quality. Given human nature, we must expect that rules will sometime be broken. But we
can expect oversight boards to enforce penalties appropriate to the situation that will discourage
others from breaking the rules in the future.
Corporate boards and accounting officers need to shoulder their responsibilities too. The surprises that
typically occur at banks are due to the nature of risk exposures and the quality of risk management
practices. In addition to applying sound accounting treatments, managers must ensure that public
disclosures clearly identify all significant risk exposures--whether on or off the balance sheet--and their
effect on the firm's financial condition and performance.
I particularly want to emphasize that disclosure need not be in a standard accounting framework or
exactly the same for all--otherwise we would be certain to create statistical artifacts and implications of
safe harbors. Rather, we should insist that each entity disclose what it believes its stakeholders need
to evaluate its risk profile. The uniqueness of risks and business lines in complex organizations means
that disclosures--to be effective--should be different for each bank. That is the approach being taken in
developing the Basel II Capital Accord. Disclosure rules that are built too rigidly while risk
management processes continue to evolve may make them less effective in describing the risk profile
of a specific organization. But if bankers do not voluntarily improve disclosures, rules will be written.
Proposed changes to Federal Reserve discount window operations
As you probably know, the Board of Governors recently requested public comment on a proposal to
revise the Federal Reserve's discount window programs. Before I get into details, I'd like to emphasize
that implementation of the proposal would not entail a change in the stance of monetary policy. There
is nothing in the proposal that would necessitate a change in the target for the federal funds rate or the
level of interest rates more generally.
The Board is proposing the establishment of a new type of discount window credit, to be called
primary credit, which would replace adjustment credit, currently the Federal Reserve's main lending
program. Primary credit would be available for very short terms as a backup source of liquidity to
depository institutions that are in generally sound financial condition. There would be no prohibition on
lending the proceeds of a primary credit loan to other depository institutions. Unlike adjustment credit,
which currently is extended at a below-market rate, primary credit would be extended at a rate that
would be above the usual level of short-term market interest rates, including the federal funds rate.
By restricting eligibility to generally sound institutions and by eliminating the incentive for institutions to
borrow to exploit the below-market discount rate, the primary credit program should considerably
reduce the need for Federal Reserve discount officers to review the funding situations of borrowers.
And since only sound institutions will be using primary credit, banks should be less concerned that
their use of the window would signal incorrectly that they were experiencing significant funding
difficulties. As a result, the Federal Reserve expects that institutions will be more willing to use the
window. This increased willingness, and the ability of institutions to resell the proceeds of discount
window loans, should improve the functioning of the window as a safety valve for the reserve market
and for individual institutions.
The interest rate for primary credit would be set through a procedure identical to that currently used for
the basic discount rate. That is, the boards of directors at Reserve Banks would set the rate, subject to
review and determination by the Board of Governors. In the proposal, it is envisioned that the interest
rate on primary credit would initially be set 100 basis points above the target federal funds rate. If
adopted, this program would align our lending practices to those of other major central banks.
The Board also is requesting comment on the seasonal credit program. The seasonal credit program
was established in 1973 to address the difficulties that relatively small banks with substantial
intrayearly swings in funding needs faced because of a lack of access to the national money markets.
However, funding opportunities for smaller depository institutions have expanded significantly over the
past few decades as a result of deposit deregulation and the general development of financial
markets, calling into question the continued need for the seasonal program. The Board is seeking
specific comment on whether small depository institutions still lack reasonable access to funding
markets and on the continued need for the seasonal lending program. The Board would also like
comment on the method for setting the seasonal credit discount rate, which is currently the average of
the federal funds rate and a certificate of deposit rate, well below the proposed primary credit rate.
We would value your comments on all aspects of the proposal. The ninety-day comment period ends
August 22. Information on where to address the comments, and more information on the proposed
revision, can be found on the Board of Governors' website.
Conclusion
In closing, I commend you and the industry, generally, for successfully dealing with the challenges of
2001. The industry has demonstrated that it is fundamentally sound and well positioned.
Bankers should support the development of risk management processes for those types of risk that
are most relevant for their particular institution.
Sound accounting, auditing, and disclosure, consistently applied, have long been at the heart of
efficient markets. Though the quality of bank accounting and control systems is strong, bankers should
heed lessons to be learned from Enron and other breakdowns in accounting and audit processes.
Strengthen corporate governance where needed to prevent such abusive practices from occurring at
your institutions.
As bankers and bank regulators, we are responsible for conducting our affairs with competence and
integrity. Let's take the opportunity times like this present and make our banking system even
stronger.