Mr. Ferguson looks at bank supervision from the consulting perspective
Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US
Federal Reserve System, before the Conference of State Bank Supervisors in Washington, DC
on 9/3/98.
It is my pleasure to join you today. The Federal Reserve has long enjoyed a
cooperative relationship with the Conference of State Bank Supervisors, and I expect that
relationship to continue.
As you are well aware, technological and financial innovation have become the
norm in banking and bank supervision. These innovations have accelerated the pace of
transactions and increased the complexity of transactions seen throughout the banking system.
This is a pattern we can expect to continue in the years ahead. Indeed, it is this complexity and
innovation that leads us, as supervisors, toward a more risk-focused supervisory approach with
a greater emphasis on sound management processes. Only by ensuring that a bank's
management and control processes are sound can we be confident that its risks will remain
contained throughout business and market cycles.
It is not my intention today to espouse the merits of risk-focused examinations,
since I trust we all recognize the value of that approach, especially in the case of larger,
more-complex banking institutions. I would like to focus on a challenge that we face as we
move more toward risk-focused examinations. This challenge or conundrum is captured in a
comment I heard last year at a dinner hosted by the Bank Administration Institute. A leading
banker at dinner complimented a regulator for having supervisors and examiners who provided
"consultations" at the end of examinations. Since reviewing management and control processes
is very much a "consultative" activity, I suspect such comments will become more
commonplace.
Being perceived as being like consultants is useful, but it is not an unalloyed
blessing. As I reflected on the compliment I heard, I wondered if the consulting metaphor was
really one we should encourage. We should all do what we can to maintain a strong and vibrant
banking system that is responsive to the needs of the public. That is part of our role as
supervisors. We should also work hard to ensure that the supervision and examination
processes are not unduly burdensome to the banks we examine. We should be supportive of
financial modernization, a process that is overdue in the banking industry. We also want to
provide guidance to banks on sound practices and to evaluate the extent to which they conduct
their activities in prudent ways. But we should be cautious in fully adopting the label
"consultants."
In my comments this morning, I would like to draw on my experience as a
consultant to banks and other financial institutions to discuss some similarities and differences,
as I see them, between the role of consultant and the role of supervisor.
I raise this topic today because the recent turmoil in Asia has some roots in poor
banking performance and poor banking supervision. I believe that the market is ultimately the
best regulator of financial services, but we will still need supervision and regulation to offset
the limitations inherent in regulation from the market. The recent turmoil in Asia serves as a
reminder of the risks that financial institutions take and the systemic impact that can emerge if
supervisors are not mindful of the important role that they continue to play in containing that
risk.
Why Do We Need Management Consultants and Supervisors
Let me begin with the basic question of why firms hire management consultants.
Many large companies that hire management consultants have substantial talent, resources and
expertise of their own. A key reason they seek outside guidance is that the employees of these
companies often lack the objectivity, the cross-company and cross-industry experience, or the
specific, technical expertise that the company needs. Companies also hire consultants simply
because they want to avoid distracting key individuals from their on-going operational duties in
order to conduct a project that an outsider can perform.
Why, on the other hand, do banks hire bank supervisors? The obvious answer is
that they do not hire them at all. Supervision is found to be necessary -- not only here but also
in virtually every country abroad -- to protect the public's interest in the lending and
deposit-taking process. The fact that we continue to regulate banks reflects the economic
concept of "externalities" and the need to protect the safety net that most societies extend to
banks. It is not the impact of one bank's decisions on the wealth of its owners and the job
security of its workers that worries us. Bank managers must be allowed to make managerial
decisions with a minimum amount of regulatory and supervisory interference. Bank directors
and managers have strong incentives to take care in their decisions due to a natural concern for
personal job security, personal wealth, and continuing control in the active market for bank
consolidation. Some will make wise decisions, and their institutions will thrive; others will
make decisions that prove to be incorrect and their banks will suffer.
However, we know that no single bank management team, regardless of how
well intentioned, can accurately value the cost of its decisions, good or bad, on the banking
system and economy as a whole. Therefore, supervision is a way of forcing banks, individually
and collectively, to recognize the broader impact that their risk-taking and risk-mediation
decisions might have on society at large. It also substitutes for some of the market discipline
lost, and attempts to offset the "moral hazard" that arises, due to the existence of the safety net.
It is the possibility that poor managerial decisions by one bank will then spill over to other
banks and eventually to the public at large that provides the rationale for supervision and
regulation. That possibility is also a key factor driving the Federal Reserve's need to remain a
bank supervisor. Without such active, on-site experience supervising and evaluating bank
activities, the central bank would, I believe, be less prepared to deal with financial crises that
inevitably arise. In addition, the Federal Reserve is the operator of important parts of the
nation's payment system, both wholesale and retail, and as such has a stake in the proper
functioning of banks and the banking industry.
However, we should also recognize that supervision and regulation are not
without costs to banks and, in turn, to society. Therefore, I believe that we should aspire to the
minimum amount of regulation and supervision that is consistent with maintaining safety and
soundness of the banking system and with maintaining financial stability. After all, the
marketplace is ultimately the best regulator, and we should look to the market for guidance and
feedback, wherever possible.
Similarities between Consultants and Supervisors
Given these fundamentally different incentives for banks to have consultants and
supervisors, why would an obviously intelligent CEO of a major bank compliment us on
providing "consultations"? The answer is that a good examiner brings some of the same
strengths to an examination that a good consultant brings to a consulting assignment, namely
objectivity, cross-firm experience and critical technical expertise. Like consultants, the
independent assessments that examiners make are becoming more dependent on statistical
sampling and on the accuracy of a bank's internal information systems. Requiring banks to
have, on an on-going basis, sound internal procedures should reduce risks to the financial
system and lead to fewer surprises overall.
Reviewing procedures, though, entails a more subjective approach than
reviewing credits. Although analyzing credits can be complex, the potential resolutions are
few. The examiner reaches a conclusion about individual credits and the overall quality of the
loan portfolio, and his findings are communicated to the bank. Some loans are charged-off,
others are written down, and the results are clear. Addressing procedural problems, however, is
rarely so decisive because we get into judgmental areas and into a range of potentially
acceptable -- and unacceptable -- resolutions. In this, supervision and consulting are very
similar.
One approach consultants use to resolve the challenge of dealing with more
subjective judgments is to maintain open lines of communication between consultant and top
management. The results of a consulting assignment are rarely a surprise when the final report
is presented, and management has had an opportunity to respond to early findings and present
their perspectives. Similarly, the results of a bank examination should not come as a surprise to
bank leadership. Clear and frequent communication of supervisory guidance on sound practice
is of critical importance. Particularly in new or innovative activities, bankers need to hear
clearly which arrangements the supervisor will accept.
Another technique consultants use to analyze a subjective topic, such as bank
processes, in which several practices might be acceptable, is to have open lines of
communication within the consulting team. All team members have a chance to add their
perspectives to the potential solution. Similarly, examiners from different agencies examining a
single banking entity should be able to share perspectives and findings.
While both consultants and examiners may be forced to make judgments
regarding management processes, it is essential that such judgments be made only after
reviewing the relevant facts. For consultants, those facts may encompass a wide array of
market or company data. For examiners, those facts may be gleaned from a credit analysis and
the review of credit files. Despite all the innovation and structural changes we have witnessed
throughout the financial system, extending credit and limiting the volume of bad loans remain
the primary business of banks. Examiners will continue to need to evaluate whether a bank's
own internal assessment of its exposures is sound, which will by necessity involve a review of
a sample of loans.
In another, less appealing, way consultants and bank examiners are quite similar.
In both cases the process can be obtrusive, with outsiders asking for scarce time and attention
from bank employees. Consultants and examiners alike must learn to adjust their professional
approach to minimize the degree of disruption to the institution being served. In this regard, the
move toward more off-site work and preparatory work is to be commended, and I am certain
that it is appreciated by banks.
So in many ways, while the goals of the consultant and examiner are different,
the techniques used may be quite similar. One can imagine an effective examination process
resembling a good consulting process. Both rely, in part, on internal data. Both should be
characterized by frequent and candid conversations between bank leadership and the leadership
of the examination team. Both should help bank leadership to understand what is considered
sound practice. Both consultants and supervisors must at some level analyze the tangible results
of the management processes, be that loan quality or some other measure of corporate
performance. Finally, to be successful both consulting and examination must be carried out
with the minimum of on-site disruption after careful off-site planning.
Sharing Knowledge among Examiners
Another similarity between consultants and examiners is that there is much
practical experience gained by the professionals that must be shared with their co-workers or
team members or even more broadly among the community of professionals. For the
community of supervisors, these insights are the results of many years of first-hand experience
with banks. Consultants have developed the fancy phrase of "knowledge management" for the
process of building individual insights, sharing them with others, and finally applying the
collective knowledge through an individual professional working with a client. The challenge,
of course, is how to complete this cycle of "build-share-apply" when the community spans
several thousand people, across multiple locations and, possibly, multiple agencies. This
gathering is an example of one possible solution to this challenge. Technology, through group
software and the creation of more common, interagency tools, might prove to be another
solution. I shall return to the need for broadly shared common technology platforms.
Distinctions between Consultants and Supervisors
Now let me turn to the numerous differences between consultants and
supervisors. In adding value to the banking industry, supervisors have a major advantage over
consultants in that we have the standing and authority to influence actions industry-wide. That
ability to influence state or national policies is an important aspect of our work and one that
helps to motivate and retain our key people.
This fact ties directly to the sound practice papers we provide. As supervisors,
we need to share what we learn to help the industry manage and control its risk. To develop
industry guidance, we do well in looking to leaders within the industry, and to institutions that
know their business best. The knowledge we gain from our associations with so many banks
also accommodates the development of new regulatory paradigms. The recently adopted rule
for market risk that is based on the internal models of banks is a good example. Without the
in-depth access to virtually all of the world's leading trading banks and to their experiences and
observations, supervisors collectively could not have developed their own understanding and
the willingness to pursue this approach.
This new approach highlights a series of significant differences between
consultants and supervisors.
First, consultants often find themselves acting as "change leaders", attempting to
get their clients to take greater business risk based on consulting judgment. Supervisors
recognize that banks are in the business of taking risk, but our goal is not to encourage or to
discourage risk-taking by individual banks. Our goal is to have banks recognize and manage
well the risk they are taking, price the risk appropriately and avoid undue concentrations of
risk. In that way we hope to reduce systemic risk.
A second difference between consultants and supervisors is in the need for
consistency across banks. Consultants generally place little value on consistency across clients.
The best consultants tailor solutions to each individual client. Therefore, two clients served by
the same consulting firm on the same topic may receive different sets of recommendations.
Supervisors, by comparison, properly put a premium on consistency across banks and over
time. We do not want to create an unstable market by giving inconsistent examination advice.
A third difference that emerges is an appetite for novel professional approaches.
Senior consultants reward younger professionals who develop new approaches. Within the
fraternity of supervisors we want to maintain modern approaches to examination and
supervision, but should only adopt them widely once we are sure they lead to the desired
outcome.
Finally, you may recall that earlier I referred to the communication and feedback
required in order for an examination to have the impact of a good consultative process. The
challenge in providing this feedback is in knowing just how far to go. As supervisors, we need
to communicate our views, but we must avoid making operating decisions for banks.
Supervisors, unlike consultants, must let banks make independent judgments. The
responsibility for sound banking is with the banks, and it is they who must, ultimately, develop
and take full responsibility for their decisions. Supervisors must be free to criticize conditions
that, if not corrected, may lead to heightened risk in the future. Unlike consultants, supervisors
have in their arsenal the power to effect change not only through examination of findings but
also through moral suasion, a strong bully pulpit and ultimately, supervisory guidance,
regulations and enforcement actions.
One critical area where currently we are exercising the power of moral suasion
is in connection with the possible decline in credit underwriting standards that may be
becoming widespread. For more than two years now, we have heard persistent reports of
declines in lending terms, conditions, and standards. It is not just isolated reports from some
examiners. Leading bankers, such as John Medlin of Wachovia, and survey data, also support
these reports.
The question then becomes "what should we do?" We can certainly expect that
in the next economic downturn credit problems will rise and weaker lending standards, if they
exist, will only make matters worse. While the lending decision is ultimately that of the banks,
this is an important area in which we can offer advice and general counsel. We should not
create an artificial credit crunch, and I do not think that we are at risk of doing that, but we can
and should urge caution that is based simply on our long experience in watching business
cycles. We can continue to make sure that bankers, themselves, understand their own
procedures and the risks that they face. We all seem to be taking a more aggressive approach
on this issue, and I expect that we will remain vigilant to sound the alarm when necessary.
Interagency Coordination Efforts
Throughout my comments I have noted a number of points that bear directly on
initiatives of state and federal supervisors to work together toward a stronger supervisory
process. As the US banking system becomes more entwined through interstate banking and
branching, it becomes ever more critical that we all coordinate our efforts in maintaining a
healthy, viable, and attractive dual banking system. It is also important for states to work to
minimize unnecessary distinctions that slow the progress of interstate banking.
I mentioned, for example, the need to modernize US banking laws, share
practical supervisory experiences, maintain consistency, reduce intrusion during the bank
examination process and, in general, improve the overall efficiency of our staffs. These are not
new challenges and, indeed, are goals that we collectively have been working toward
successfully for some time through the State-Federal Working Group and other forums. As we
all know, state banking authorities have done much to advance interstate banking and
branching and to work together and with federal authorities toward a seamless oversight
process. The state-federal protocol has helped greatly to bring about that seamless approach
and is a crucial element in maintaining the viability of the state banking charter.
Individual states and the state charter, in turn, have provided the industry with
important flexibility to experiment in developing new banking products and delivery systems.
In this and in many other ways, the state charter and the dual banking system have served the
country well. Fortunately, the dual banking system seems healthy. Consider, for example, that
of the 207 new banking institutions chartered last year, 146 were state chartered.
Adapting available technology to examinations and to sharing insights among
examiners is another area in which significant progress has been made through our joint efforts
to produce more efficient examinations. As you may know, the FDIC's ALERT system now
permits examiners to download bank data onto their own PCs in order to analyze exposures and
prepare for upcoming examinations. It is being used widely by many states and by a number of
Federal Reserve Banks; more are likely to learn about and use it in the months ahead. The
Fed's own ELVIS program is another important advance that assists examiners through the
risk-focused process for community banks that is being used by the Fed and FDIC and by most
states.
Looking forward, examiners should soon be able to use the "GENESYS" system
to access a broad range of automated information contained in supervisory databases and
download it into their examination reports. Together, these and other initiatives -- including
greater use of analyst and examiner electronic desktops, new web pages, and expanded data
access techniques between state and federal supervisors -- have helped significantly to improve
the efficiency of our examiners and to create a less intrusive supervisory process. We should all
be pleased with these results and should expect the process to become even better in the months
and years to come.
Conclusion
In closing, I see many challenges ahead for us all, as we adapt the supervisory
process to keep pace with events in financial markets. In some respects consultants and bank
supervisors have much to share and can learn from one another:
1. Consultants and supervisors must have open, trust-based channels of
communication with bank management and among their peers. Both must add value by
analyzing both processes and the outcomes of those processes. They are both well advised to
limit their intrusiveness while not foregoing a thorough and professional inquiry.
2. Both consultants and supervisors face the challenge of building, sharing and
applying professional knowledge and skills in a rapidly changing business environment. The
failure to manage our knowledge within teams, within agencies and even across agencies will
certainly result in wasted effort and may even result in a caliber of supervision that does not
keep pace with changing financial technology and increased sophistication by banks. The
Federal-state coordination efforts that I mentioned are an example of this needed cooperation.
However, while it might be quite appealing to speak of supervisors as acting
more like consultants, in many critical ways the consulting metaphor does not work very well
for supervisors. There are at least three factors that make consulting an inappropriate model for
supervisors to follow:
1. Consultants are hired by management and work to add value to the
shareholders that management represents. Supervisors, in contrast, ultimately work for the
public at large. Rather than adding shareholder value, supervisors seek to reduce or eliminate
excessive risks to the financial system and the federal safety net.
2. Supervisors have much more impact in the banking industry than even the
most savvy or articulate consultant. We must be willing to exercise that moral and legal
authority to forestall as best we can practices that we know might become harmful even before
the full results of such practices become evident. In this we may not always be popular.
3. Finally, consultants can be wrong with only relatively limited consequences.
The caliber of their advice is rarely subject to after-the-fact scrutiny. When a consulting firm
makes a mistake, it may lose a client and that company may lose some money. When a banking
agency fails to act, the consequences can be widespread for the economy and the public at
large.
To keep the public's trust, we need to be ever mindful of whose interests we
serve. We do want to minimize the burden of supervision. We do want to foster modernization.
We must stay current with the latest financial techniques. We can assist institutions by
identifying weaknesses and, at times, we can offer views toward resolution. Ultimately,
however, we are forced to supervise and regulate banks in the interest of the public.