Susan S Bies: Bank performance and corporate governance
Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System,
before the Pennsylvania Association of Community Bankers, Memphis, Tennessee, 28 September
2002.
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Good morning. Thank you for the invitation to speak to members of the Pennsylvania Association of
Community Bankers and to return to my home of twenty-four years, Memphis, Tennessee. 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 that the biggest surprise is the amount of required reading. 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--as chair of the Board's bank supervision committee--I am deeply involved in
bank regulation and operations issues. Even though I brought with me twenty-seven years of banking
experience, including an earlier stint with the Federal Reserve, I find that my current responsibilities
make me consider issues in new ways. Consequently, I look forward to meeting with groups like yours
so that I have a better understanding of emerging issues from diverse perspectives.
In my comments today, I will first address the recent financial performance of U.S. banks, and of
community banks in particular. I will then turn to improvements that banks large and small are making
in measuring and managing risk, the responsibilities of directors and senior managers in corporate
governance, and finally, to the importance of sound accounting practices. In my view, these topics are
inextricably linked and in light of continuing questions of confidence in America's corporations, they
are quite timely.
Financial condition of U.S. banks
Last year was exceptional in many respects, with the United States slipping into a recession, the
September terrorist attacks, the stock market declines, and all of the related events. 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. Since then, the Federal Reserve has shifted its bias from one in which we were
concerned more with weakness, to one in which the risks of inflation and weakness were balanced,
then back again--most recently--to a concern about economic growth.
The direct effects of the past year's stressful events were painful enough. In addition, abusive
accounting and corporate-governance practices made conditions worse, as large corporate
bankruptcies imposed substantial losses on investors, lenders, and employees. These domestic
events increased the uncertainty about earnings reported by other firms and dampened financial
markets that were already weak. Abroad, Argentina's economic and political difficulties reminded us,
yet again, that exposures to emerging economies can also present substantial risk.
Throughout this period, the U.S. banking system remained strong, reporting continuing record
earnings and profitability, despite a slip in asset quality. During the first half of this year, U.S. insured
commercial banks earned more than $44.5 billion and an annualized return on assets of 1.37 percent.
Both figures represent the industry's best six-month performance ever and reflect impressive growth
on top of what were already impressive results.
Net interest income was the primary driver of increased revenue, despite a notable decline in
commercial loan volume. Loan loss provisions remained relatively high by the standards of most of the
past decade but dipped notably from the second half of 2001. Net charge-offs, which were
concentrated among commercial loans of large banks and credit card specialty lenders, also dropped.
While this improvement since year-end may signal that problem assets have peaked, some large
institutions have not yet fully recognized the results of this year's supervisory assessment of shared
national credits. Consequently, we may see further deterioration in asset quality during the periods
ahead. Moreover, the general economy needs to strengthen further before we can be much more
comfortable that we're out of the woods.
As noted, current weaknesses appear to be largely within the commercial loan portfolios of large
regional and money center banks rather than those of smaller institutions. Even the problems of large
banks could be viewed as mild, however, given the shocks felt by many in their customer base. In
some respects, bank performance may reflect improvements in risk-management practices and also
the greater diversification of revenues and exposures that has occurred in the past decade. Bank
performance also reflects, I believe, a greater awareness by institutions throughout the banking
system that they should promptly address problems as they emerge.
During this recession and recovery, both the banking industry and the regulatory agencies appear to
have responded well, by acting in a timely manner and without unnecessarily constraining bank credit.
That positive outcome was made easier, of course, because the banking system was strong as
challenges began to build. Because the industry had the earnings and capital to absorb increased
losses, there was time and opportunity to deal more calmly with emerging weakness.
If smaller banks, generally, are not seeing the commercial loan weakness that some larger institutions
are facing, which areas may present them with heightened risks? A couple of possibilities come to
mind. 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 these portfolios from 13 percent to 22 percent of
aggregate assets.
Most Reserve Banks are reporting generally weak commercial real estate markets, as failing
companies vacate office and retail space and renters move into single family homes. Commercial real
estate credits are still performing relatively well for this stage of the cycle, and my comments are not
intended to suggest a material concern. Nevertheless, they account for most of the increase in
nonperforming assets over the past year for large community banks. Given the checkered history of
commercial real estate lending and its increased relevance to many banks, this portfolio must be
monitored and managed carefully. We have seen before 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 interest rate cuts last year certainly appear to have helped bank earnings, but they present
management with new challenges, too. Lower rates undoubtedly eased payment pressures on many
borrowers and prevented further deterioration in the quality of bank loan portfolios. Nearly 60 percent
of all banks also saw wider net interest margins in the first six months of 2002 than in the comparable
period of 2001. At some point, however, lower interest rates may begin to compress net interest
margins for some institutions as deposit rates reach their effective floors. Those holding low-yielding,
long-term assets could get hurt.
Indeed, many banks have responded to the low rates by sharply reducing their investments in
Treasuries and shifting funds into mortgage-backed securities in the search for higher yields. Given
the historically low interest rates at which recent mortgages have been originated or refinanced, one
might expect these loans to be prepaid much more slowly than they have typically been in the past. 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. My point is that banking organizations, and investors generally, should recognize that
domestic interest rates are historically low and that the possibility for a rising rate environment should
not be overlooked. Even stable rates could present increased risks, if savings and money market
deposit accounts flow out of banks as quickly as they came in when equity markets declined. We
should all ask ourselves how long depositors would be content to earn the currently low rates when
those markets stabilize or 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 own yields.
Managing risks
The health of financial institutions today is also a result of improvement in the 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 to collect and process data at
lower cost, but also improved techniques for measuring and managing risk.
As you are aware, bank regulators are working to develop a more modern international approach to
bank capital--called Basel II. Although those standards, in the first instance, are being designed to
address changing practices at large, internationally active banks, we can expect the lessons learned
about risk management to have much broader effects. We do not anticipate, for example, that large
numbers of banking organizations in the United States would formally adopt the data and analytically
intensive and sophisticated processes to determine regulatory capital under development today. The
costs and resources to develop such systems and frameworks are beyond the resources of all but a
limited number of very large banks. We would expect, though, that the effort would eventually
strengthen risk management and provide best practice examples industry wide.
In quantifying credit risk, larger banking organizations are taking the lead, measuring a borrower's
probability of default, the bank's loss given default and its likely exposure to the borrower at the time of
default, taking into consideration future draw downs.
The greater use of credit scoring in retail transactions provides a stronger framework to assess risk
and ensure that loan pricing reflects the credit quality. Such tools should perform even better as the
effects of the most recent economic slowdown are incorporated into bank statistics. Most consumer
credit models were developed after the 1990-91 recession, and so their reliability in predicting default
rates and losses during a severe economic slowdown is yet to be fully tested. We are already
observing, for example, significant 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 should help validate the strength of the new statistical models.
The measurement and management of interest rate risk has also improved greatly in recent years,
perhaps particularly at community banks. Asset/liability committees at banks throughout the country
now routinely consider the results of models developed either internally or by vendors to identify the
market sensitivity of loans, investments, and deposits. As a result, managers can better anticipate
changes in net interest income and develop responses to their specific circumstances.
The industry is also developing new revenue streams and diversifying its earnings sources. Such
efforts help increase the cross-sell ratio with key customers, which in turn should improve customer
loyalty and further stabilize a bank's revenue base. Providing the personal touch has long served
community banks well, but personalized service alone may become less sufficient in the years ahead.
Conducting sound market research and pricing to reflect competition, customer value, and underlying
risk are becoming more important for success.
Recent abuses of corporate accounting practices and other matters provide good lessons in risk
management as bankers try to increase earnings by cross-selling more products. We have seen, for
example, how conflicts of interest and the lack of a strong quality-assurance function destroyed the
reputation and viability of a major accounting firm. Similarly, banks that compensate line officers on the
basis of sales and cross-selling must guard against the adverse incentives that those compensation
structures can provide. There, too, a strong quality-assurance function is essential. Given the
dominant role of credit risk at banks, the chief credit officer should ensure that pressures to increase
fee income do not lead to unacceptable levels of credit risk.
Corporate governance
Sound corporate governance is an essential element of a strong risk-management process. As
bankers and bank directors, you have specific responsibilities to manage the risks at your financial
institutions and effectively oversee the systems of internal controls. Not only are the activities of banks
central to credit intermediation, but, in this country, banks fund their activities in part with federally
insured deposits. Those deposits are the lowest-cost source of funds that banks have, specifically
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 institution's 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.
In the light of recent events, I might add that directors have the further responsibility to periodically
consider whether their initial assessment of management's integrity remains correct.
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 that
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 a bank's internal controls. In the limited
cases in which that function must be outsourced, best practice is to avoid using the same firm for the
external audit as well.
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 must assure themselves that the combination of
earnings, capital, and internal controls is sufficient to compensate for the risk exposures. Supporting
functions such as accounting, internal audit, risk management, credit review, compliance, and legal,
should 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 boards of directors. Both executive management and directors should be
sufficiently engaged in the process to determine whether these reviews are in fact independent of the
operating areas under review and whether the officers conducting the reviews can, indeed, speak
freely.
The level of independence from executive management that a board can demonstrate has, of course,
become a far more visible and more important factor in evaluating corporate governance. Recent audit
failures have highlighted the value of sound practices, such as having audit committee members
regularly meet privately with an institution's outside auditors to discuss matters without management
present. The recent Conference Board and New York Stock Exchange recommendations, or prior
reports by the Blue Ribbon Committee and the Treadway Commission in the 1980s describe best
practices for audit committees and are worthy of your review.
This summer, the Sarbanes-Oxley Act took the matter of independence a step further, in the case of
publicly traded firms, by incorporating specific requirements of independence into law. For example, all
members of a company's audit committee must now be outside directors. Moreover, at least one of
those committee members should be a so-called financial expert. If not, the firm must disclose why
not. The legislation also assigns audit committees sole and direct responsibility for appointing,
compensating, and overseeing the company's auditors.
Other provisions of the act set forth potentially broad ranging standards affecting the way public
companies compensate their executives and directors and disclose their operating results. To
strengthen the role of outside auditors, the act also limits the non-audit work such firms may perform
for audit customers and creates an oversight board to regulate and oversee audit work.
Precisely how some of these legislative provisions will affect firms has yet to be decided by the
Securities and Exchange Commission. Other provisions, though, are in effect now or will become
effective soon and warrant immediate attention. Although the act applies only to institutions that
register their shares with the Securities and Exchange Commission, its elements should be considered
by virtually all commercial banks and by most other companies of any material size. They could well
highlight weaknesses in your own procedures.
Indeed, beyond legal requirements, boards of directors and managers of all firms should periodically
test where they stand on ethical business practices. They should ask, for example, "Are we getting by
on technicalities, adhering to the letter but not the spirit of the law? Are we compensating ourselves
and others on the basis of contribution, or are we taking advantage of our positions?"
Ultimately, of course, markets correct their excesses, and in this context "markets" include both the
public and private sectors. Obviously, during the past year we've seen reactions not only from
investors and creditors, but also from lawmakers and regulators, to observed failures within corporate
boardrooms. All of the actions affect market practice.
My intent today is to remind you that as business and community leaders, you should recognize the
value of exercising self-discipline within your own institutions. That includes maintaining sound ethical
practices in protecting the reputations of your banks. As we have seen from recent events, the
market's response can be harsh.
Quality of accounting practices
Uncertainty regarding the quality of corporate accounting standards strikes at the heart of our capitalist
system and threatens the efficiency of our markets. Investors and lenders must be confident that they
understand the risks they accept and that their counterparties are playing fair.
For six years I was a member of the Emerging Issues Task Force of the Financial Accounting
Standards Board, which provides the accounting industry with guidance in areas where financial
reporting practices are diverging. During that time, I developed a better appreciation for the challenges
that standard-setters face when dealing with topics that are becoming increasingly complex.
Informed and objective professionals can legitimately disagree on the best accounting standard to
apply to new types of transactions. That is part of the challenge of keeping accounting standards
current. The rapid pace of business innovations makes it impractical to have rules in place to
anticipate every business transaction. Rather, the more complex and dynamic the business world
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.
At the core of such accounting principles should be professional standards that every corporate
accountant and every outside auditor must follow. In part, auditors should be required to ask
themselves whether a particular accounting method adequately represents the economics of the
transaction and whether it provides readers with sufficient information to evaluate the risks. If not, it is
likely that the procedure is not the best accounting method to apply.
Rules alone, however, do not ensure good financial reporting. At Enron and other companies, weak
corporate governance practices apparently permitted sham transactions and misleading financial
reporting. Outside auditors erred in trying too hard to please an important client. They forgot that their
professional role is to assure users of financial reports that the statements fairly represent the
condition of the corporation and that they communicate, not conceal, the level of risk. Some observers
have asserted that new accounting standards are needed. In some minor ways that may be true. But
judging from 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 impose extensive new rules.
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. Rather than creating new rules, forming the new Public Company Oversight Board
established by Sarbanes-Oxley may provide a better approach and help to refocus public accountants
on core principles and away from more aggressive and misleading practices. Given human nature and
the complexity of many accounting issues, we must expect that rules will sometimes be broken or
misapplied. But a new, authoritative oversight board--combined with more-rigorous reviews by
corporate boards--should be able to discourage and address severe abuses.
For its part, the Federal Reserve is also willing to challenge accounting interpretations that it sees as
too aggressive. By no means do we intend to supplant accounting authorities in making rules, but we
do intend to provide discipline, when necessary, in their interpretations--particularly in the context of
regulatory reporting and in light of the weaknesses in quality-assurance processes in public
accounting firms. For example, the Federal Reserve has required loan pools at one large bank to be
re-consolidated into their financial statements when it was determined that risk and control were not
removed from that organization through the creation of special purpose vehicles.
In another example, the banking regulators have jointly issued for comment new guidance related to
credit cards. This guidance not only deals with unacceptable practices, but also clarifies that revenue
recognition of fees billed to customers should reflect the expected ability to collect those fees. In
addition to the recognition and measurement aspects of financial reporting, we need to continually
evaluate the effectiveness of disclosures. Public disclosures by banks, as well as other firms, need not
follow a standard framework that is exactly the same for all. Rather, we should insist that each entity
disclose the information it believes its stakeholders need to evaluate its risk profile.
Each business line in a complex organization is unique, and--to be most effective--the specific
disclosures of its risks should be different, too. Even in smaller organizations, disclosures should be
tailored to reflect the activities of the organization. A summary of the information that is important for
executive management and the board of directors in monitoring the health of the bank is an excellent
place to start to tailor the information that would be useful to investors and customers. That is the
approach being taken in developing the Basel II Capital Accord. Disclosure rules that are too rigid may
be, or become, incompatible with risk-management processes that continually evolve. In this area and
many others, the best results are likely to come from bankers and regulators working together.
Conclusion
In closing, I congratulate you and the industry, generally, for successfully dealing with the challenges
of the past year. The industry remains fundamentally sound and has consistently demonstrated that it
can deal with stress.
Nevertheless, no business can afford to remain static, and banks of all sizes should continually pursue
better ways to manage risk. Following sound accounting, auditing, and disclosure practices
consistently is also crucial to maintaining the confidence of capital and financial markets. We should
learn from the experiences of this past year and ensure that our own accounting and control systems
practices are sound. We should also take the opportunity to strengthen areas of corporate governance
that may be weak.
As bankers and bank regulators, we are responsible for conducting our affairs with competence and
integrity. As we do so, our banking system should grow stronger still.