Kevin Stiroh: The theory and practice of supervision
Remarks by Mr Kevin Stiroh, Executive Vice President of the Financial Institution Supervision
Group of the Federal Reserve Bank of New York, at the SIFMA Internal Auditors Society
Education Luncheon, Harvard Club, New York City, 11 April 2016.
* * *
Introduction
Good afternoon. I'm Kevin Stiroh, the head of the Supervision Group at the Federal Reserve
Bank of New York. I'd like to thank SIFMA for the opportunity to speak today about the theory
and practice of supervision.
By way of background, I took over my current role in October of 2015, after spending time in
the New York Fed's Research, Markets and Integrated Policy Analysis Groups, as well as
earlier positions within Supervision. I am an economist by training and I spent much of my
career studying the performance and function of financial institutions in the U.S., the critical
role of bank capital, and the potential link with financial stability.
I'd like to cover three topics today related to the theory and practice of supervision. First,
what is supervision? Second, why is it necessary? Third, what are some of the emerging
issues in the execution of supervision?
Before beginning, let me emphasize that my comments today are my own and do not
necessarily represent those of the Federal Reserve Bank of New York or the Federal
Reserve System.
What is supervision?
The Federal Reserve has many responsibilities, most closely linked to the execution of U.S.
monetary policy and the regulation and supervision of the U.S. financial system. In fact, the
official title of the Federal Reserve Act includes the phrase "to establish a more effective
supervision of banking in the United States," so supervision has been a core responsibility of
the Federal Reserve from the beginning.
But what does "a more effective supervision of banking" mean? At the highest level, the
Federal Reserve's mission for supervision and regulation is to promote a safe, sound, and
stable banking and financial system that supports the growth and stability of the U.S.
economy and a fair and transparent consumer financial services market. That's a lot, so it is
useful to drill down a little; I can do that by describing what we do on an ongoing basis at the
Federal Reserve Bank of New York.
At the New York Fed, we operate under delegated authority to supervise the financial
institutions in the Second Federal Reserve District, which encompasses New York, parts of
New Jersey and Connecticut, the Commonwealth of Puerto Rico, and the U.S. Virgin Islands.
This area includes enormous diversity in institutions from state member banks with total
assets of less than $100 million operating in a local community to bank holding companies
with trillions of dollars of assets operating on a global scale.
Our staff assesses the safety and soundness of domestic banking institutions and operations
of foreign banking organizations in the district through onsite evaluations and offsite financial
analysis and surveillance. One of our fundamental responsibilities is to ensure that each
institution has in place the appropriate risk identification and risk management processes that
are necessary for prudent banking. We also analyze issues and industry developments to
identify emerging risks and to contribute to the development of domestic and international
supervisory policy. I'll return to a discussion of emerging risks later in my talk.
The Supervision Group at the New York Fed works with our colleagues around the Federal
Reserve System to develop and implement the System's supervisory programs. This
includes working through governance structures like the Large Institution Supervision
Coordinating Committee (LISCC) that oversees supervision for the largest, most systemically
important institutions in the U.S. We are also involved in similar System-wide committees for
other types of institutions such as community banks, regional banks, foreign banks, and
other large banking institutions, as well as consumer protection. I'll speak mostly today about
our supervisory responsibilities for the largest firms, but will note that we recently hosted a
conference at the New York Fed focusing on the role of community banks.
For the largest firms, we actively participate in System-wide horizontal examinations such as
the Comprehensive Capital Analysis and Review, or CCAR, which is the annual process for
evaluating capital adequacy of the largest firms that began last week. We are actively
involved in other horizontal programs such as the Comprehensive Liquidity Analysis and
Review (CLAR), and the Supervisory Assessment of Recovery and Resolution Preparedness
(SRP). CLAR is the Federal Reserve's annual, horizontal, forward-looking program to
evaluate the liquidity position and liquidity risk management practices of LISCC firms. SRP is
the Federal Reserve's annual horizontal review of the LISCC firms' options to support
recovery and progress in removing impediments to orderly resolution. These three programs
form the foundation for the horizontal aspects of the System's supervisory program for the
largest firms. The Supervision Group at the New York Fed plays a strong role in developing
and executing these initiatives.
In parallel to the horizontal work for the largest firms, the Federal Reserve has a dedicated
supervisory team for each of the largest firms. These teams execute supervisory strategies
for each firm that align with Federal Reserve System priorities. Through the execution of
firmspecific supervision, these dedicated supervisory teams play a critical role in helping to
achieve these objectives. Given the location of the headquarters of many of the largest firms
in New York, the Supervision Group at the New York Fed plays a central role within the
Federal Reserve System in the execution of supervisory activities through the dedicated
supervisory teams.
To conclude this section, I'll note that my colleagues in the Research Group at the New York
Fed recently hosted a conference entitled "Supervising Large Complex Financial Institutions:
Defining Objectives and Measuring Effectiveness."1 This conference brought together
academic economists, policymakers and senior supervisors to talk about the goals and
objectives of supervision and different approaches to assessing supervisory success and
effectiveness. While this conference focused on the largest institutions, the main themes
apply more broadly to the objectives of supervision.
One important theme of the conference was the conceptual distinction between regulation
and supervision. Both are designed to help the Fed achieve its objectives and they are
mutually reinforcing, complementary efforts. Broadly speaking, regulation involves writing the
rules that govern what financial institutions can and cannot do. Supervision focuses on
monitoring, oversight and enforcing compliance with law, and supervisory expectations for
firms' governance, internal processes and controls, and financial condition.
Why is supervision necessary?
I think it is useful to take a step back and talk about what motivates the need for public sector
intervention in the form of ongoing supervision. Why doesn't the market provide sufficient
discipline on financial intermediaries as is presumed for some other industries? In the
language of an economist, what are the frictions that lead to a market failure so that financial
institutions, left to their own incentives and choices, won't necessarily make optimal choices
from a societal perspective?
I'll talk about two types of market frictions that create the need for public sector intervention.
The first is asymmetric information - the difference in what the borrower knows about an
investment opportunity and what the lender or funder of that investment knows. The second
is externalities - the ability of one firm's decisions or actions to affect other unrelated market
participants. Both of these forces can drive a wedge between private and socially - desired
outcomes and motivate the need for public sector intervention. Conceptually, either
supervision or regulation can help solve these problems and their relative efficacy depends,
in part, on the type of information being assessed or the problem being solved.
• Asymmetric Information
There is considerable academic research describing how asymmetric information
can create a special role for financial intermediaries. The basic issue is that lending
requires the production of private information about things like the probability of a
successful investment outcome, but this can be difficult to convey to third parties
who might be providing the funding. This creates a role for a financial institution to
bridge the gap between borrowers and savers.
Moreover, these information asymmetries create the scope for two problems
endemic to credit markets: adverse selection where the riskiest borrowers are the
most likely to seek credit and moral hazard where borrowers pursue riskier behavior
after credit has been extended because their own funds are not invested. In both
cases, mitigation requires costly screening and monitoring, which creates a role for
a specialized financial intermediary.
Asymmetric information also creates issues on the liability side of a bank's balance
sheet. The banks' creditors - depositors or providers of funding - don't have as
much information about the health of the institution as insiders do. This asymmetry
makes banks opaque and inherently fragile, which can subject them to runs. This
type of "run risk" has been largely mitigated, at least in the case of retail depositors,
by deposit insurance, access to lender of last resort facilities, and other elements of
the bank safety net. Importantly, however, a broad safety net weakens market
discipline of banks and can create incentives for excessive risk-taking. This
contributes to the need for risk-sensitive regulation and supervision.
Regulations can control risk-taking through a variety of means such as setting
minimum requirements for capital and liquidity positions, while supervision can
identify and constrain activities that are not well-captured through regulation but still
affect a firm's risk management, governance and control infrastructure. One
common objective is to counter the incentive for excessive risk-taking by
intermediaries.
Externalities
•
A second and distinct type of market failure that creates a need for public sector
intervention stems from the externalities that the failure of a large, systemically
important bank failure can have on the rest of the financial sector or the economy as
whole. For example, the financial crisis vividly demonstrated how the distress of a
large financial firm can destabilize broader financial markets and impact other
financial firms. These effects can be seen through direct linkages via counterparty
exposures. They can also be seen through less direct linkages such as
confidencerelated behaviors that are manifest in higher haircuts and margins or reluctance to
do business with certain firms or types of firms, uncertainty about the true health of a
firm, or the impact of fire sales on the valuation of a broad class of assets held by a
broad range of investors. The fact that these costs are external to a given financial
firm can lead to excess risk-taking.
The realization of these externalities during the financial crisis has had a profound
impact on the Federal Reserve's approach to supervision. Most specifically, they
provided the practical experience to support the conceptual case for tightened
prudential requirements for the largest, most systemically important institutions. This
focus is seen in the mandate from the Dodd-Frank Act for the Federal Reserve to
implement enhanced prudential standards, including higher capital standards, to
mitigate the risks posed to financial stability by systemically important financial
institutions.
For example, both the Basel Committee for Banking Supervision and the Federal
Reserve System have identified factors that contribute to a financial firm's systemic
importance through these types of externalities. These mechanisms are proxied for
by observable metrics such as the size of the balance sheet, interconnectedness
between firms, complexity of the business, cross-jurisdictional activity, short-term
wholesale funding, and substitutability of certain activities. These metrics then
determine the capital surcharge for systemically important banks as outlined in the
Federal Reserve rule and white paper from July 2015.2
More generally, these types of differences across firms provide one of the
conceptual underpinnings for differentiating supervisory expectations for different
types of financial institutions. This concept - often referred to as "tailoring" - has
long been part of the supervisory approach, and has received considerable attention
recently. It is reflected in our organizational structure as seen in things like the
LISCC and in application of supervisory guidance across different types of firms.
As a specific example, the Federal Reserve issued two Supervisory and Regulation
letters in December of 2015 that consolidate previously-issued guidance on capital
planning and more clearly differentiate supervisory expectations between financial
institutions with more complex operations and those with less complex operations.
This tailoring of guidance applies to capital planning expectations related to
governance, risk management, internal controls, capital policy, scenario design and
projection methods. This guidance further clarifies how capital planning expectations
are moderated for firms that pose more limited risk to financial stability.
Key issues
I've discussed some of the conceptual underpinning of supervision and I'll now turn to some
of the practical implications and issues that I'm thinking about.
We continue to strive to provide clarity and transparency on our supervisory expectations
and concerns. This can be seen through a variety of mechanisms, including public
discussion and private communications with supervised firms. I've mentioned some of the
most useful sources of information such as Supervision and Regulation letters that provide
public guidance on specific topics to supervised firms, rules and white papers that outline
and implement the underlying conceptual thinking on key issues such as the surcharge for
systemically important banks or the expectations around CCAR, and public speeches by
policymakers.
Of course, we engage regularly in private communications with supervised firms. This is both
to provide feedback on a firm's progress relative to supervisory expectations and to gain
information about the developments in the financial industry and the efficacy or our
supervisory programs. We do this on a regular and continuous basis through both formal and
informal channels, and this is a key part of the supervisory program for firms of all sizes.
I also want to highlight three specific developments that are relevant for us as we execute
our supervisory responsibilities. I expect these topics - cybersecurity, fintech and
reputational risk - will be familiar and I'll provide a supervisory perspective on each.
• Cybersecurity
The Federal Reserve, in its supervisory role, collaborates with the Federal Financial
Institutions Examination Council (FFIEC) to coordinate work on enhancing
cybersecurity supervisory programs. We are also interested in working with the
industry on a coordinated approach for cybersecurity to strengthen the resiliency of
the financial services sector against cyberattacks.
Internally, the Federal Reserve has organized a supervisory program on
cybersecurity that consists of subject matter experts from across the Federal
Reserve System. Work is underway to enhance the analysis of IT examination data
in conjunction with threat information to enhance risk-focused reviews during
examinations.
Through our discovery work with financial institutions, we have found that the state
of cybersecurity readiness varies across firms. Supervisors are seeking to develop
common principles to address cybersecurity issues and will work with other
agencies to ensure that firms are dedicating resources and taking the appropriate
actions to defend the operations that are critical to the financial services sector
against cyber threats. This is particularly true for those risks that could be channeled
through interconnected organizations and that could potentially have an impact on
other firms and more broadly across the sector.
• Fintech
The financial sector, like the broader U.S. economy and society, is becoming
increasingly digital and there is considerable discussion of "fintech" - defined simply
as the intersection between financial services and new technologies. A recent
industry study, for example, reports that investment in fintech companies grew from
$1.8 billion in 2010 to $19 billion in 2015.3 It is unclear, however, whether fintech will
enhance or fundamentally disrupt the financial service and payments industries, or
perhaps it is some combination of both. In any of these cases, however, supervisors
will have a keen interest in monitoring the impact on the business models and risks
of financial institutions and the way financial intermediation is done.
We observe financial firms engaging in a variety of ways with fintech companies.
This can be through the development of in-house projects such as setting up
innovation labs or encouraging developers to code on open application program
interfaces (APIs). This can also be through collaboration with industry consortiums
to come up with unified industry standards that enhance operability and enable
future technological advancements, or it can be through partnering with or investing
directly in fintech companies.
Some of the interesting questions for supervision revolve around things like: what
new benefits might these new technologies bring? Will they enhance existing
processes or bring about entirely new solutions to existing financial sector
problems? Will they create risk, mitigate risk, or simply reallocate existing risks?
How should the current supervisory framework evolve to incorporate these types of
developments?
The New York Fed is assessing the implications of fintech developments through
participation in a wide range of Federal Reserve System, interagency, and
international efforts. In addition, we meet regularly with supervised firms, fintech
companies, and industry groups to follow these developments. Our supervisory
program will continue to evolve with the underlying technologies.
• Reputation risk
Over the past few years, the New York Fed has been challenging the financial
industry to consider the many factors that have contributed to recent, widespread
misconduct and the perceived lack of trust in the financial sector.
The various forms of misconduct impose direct costs such as fines, legal fees in
investigating allegations and defending lawsuits, and internal monitoring costs that
should matter to firms. In this view, a principal benefit to a financial firm of having a
strong culture that builds trustworthiness is the avoidance of the bad behavior that
can carry significant monetary costs and can inflict destructive damage to the
organization's reputation. Firms should have every incentive to manage and
internalize those potential costs.
More broadly, there may be additional adverse effects on other firms or the financial
sector as a whole if there is a widespread lack of trust in financial services. Similarly,
my colleague Michael Strine has argued that the financial industry exists, in part, to
enhance the public good and thus faces a higher degree of social responsibility due
to its role in supporting the broader economy.4 Both of these effects suggest a role
for the public sector in facilitating appropriate behavior and conduct in the financial
services industry. Supervision can contribute to this through support for the
development of effective internal governance regimes, prudent risk management
policies, and strong compliance and control structures, all within a framework of
effective oversight from the Board of Directors.
Conclusion
To conclude, I've spoken today about the conceptual rationale for public sector intervention
through supervision and some practical issues related to how we execute on our supervisory
responsibilities at the Federal Reserve Bank of New York. Our goal is to promote a safe,
sound, and stable banking and financial system that supports the growth and stability of the
U.S. economy, and we will continue to strive to meet these responsibilities.
Thank you very much for your attention this afternoon. I'd be happy to take some questions.