SRC Insights: Fourth Quarter 2011

Supervision Spotlight on the Evolution of Community Bank Supervision in a Post-Crisis World

by William W. Lang, Senior Vice President

In the Chinese language, the word “crisis” is allegedly composed of two characters, one representing danger and the other representing opportunity. The financial crisis and ensuing great recession have created major challenges for bankers and for bank regulators; however, this crisis also presents a unique opportunity to reflect on existing practices, consider the lessons learned from the events that transpired, and adjust accordingly to strengthen the resilience of the financial system.

In response to the crisis, the industry has seen a comprehensive re-thinking and reform of financial regulation, both in the United States and around the world. The Dodd-Frank Act, which has generated major changes in the regulatory framework, has engendered a great deal of analysis and will be a subject of ongoing discussion and debate. This article provides some thoughts on a related, but distinct, issue: the evolution of bank supervision in the aftermath of the financial crisis and the implementation of regulatory reform.

Re-Thinking Bank Supervision: Enhancing the Approach

Bank supervision involves the monitoring, inspection, and examination of banking organizations to assess their condition, risk management capacity, and compliance with relevant laws and regulations. Bank supervision policies and procedures establish a common and consistent framework, but a certain degree of discretion based on reasonable judgment is also inherent in the process.

Many of the fundamental principles that support prudential oversight proved effective and will remain intact. However, lessons learned are already serving as catalysts for change. A prime example is the implementation of a framework to address systemic risks. Based on gaps and weaknesses that became evident during the crisis, important steps in the evolution of the supervisory process will likely take place in the areas discussed below.

Improved Integration of Cross-Firm Quantitative Analytics in the Exam Process

Supervision staff and examiners must have greater access to a broader array of relevant and timely data sources to better conduct horizontal analysis across firms to understand the risks arising within the banking system. Such analytics are not only useful in off-site monitoring of banks between exam events, but they can also provide important input to an examiner's decision-making by providing a comparative baseline. Done properly, this can improve the consistency of supervisory practices without undermining examiners' ability to exercise appropriate judgment that considers the specific circumstances at an individual institution.

For example, information on investment securities valuations can be derived using data available to enable supervisors to see whether the impairments reported by a bank appear to fall within a comparable range. This will enable examiners to determine when more detailed review and discussion are needed. It may turn out that such further review may cause revisions or a logical explanation of the disparity to be made.

Greater use of analytical metrics can also help supervisors review whether similar institutions are being treated similarly. For example, horizontal data analysis can review whether firms with similar characteristics are receiving consistent responses by supervisors. Such analysis may show that a firm is receiving ratings or supervisory findings that differ from banks with similar characteristics. Again, upon further review, it may turn out that these differences can be explained by the individual facts and circumstances at the institution. However, enhanced use of horizontal analytics allows supervisors to better identify where inconsistencies may exist.

While enhanced use of quantitative tools has considerable merit, some limitations need to be considered. Models do not provide a standalone solution; their results are best considered in conjunction with other qualitative assessments. Flexibility in their application is also necessary, since at times, models can be pro-cyclical and undermine the exercise of discretion by supervisors. Ultimately, the analysis is meant to “supplement” the examination process, but not to be a “substitute” for examiner judgment.

Enhancing the Risk-Based Supervision Framework

Risk-based supervision is a “forward-looking approach where the supervisor assesses the various business areas of the bank and the associated quality of management and internal controls to identify the areas of greatest risk and concern. The supervisory focus is directed to these areas to allow the supervisor to identify problems at an early stage.”¹

The bank's individual risk profiles and the macroeconomic context are used to formulate effective supervisory plans. For instance, most types of concentrations are likely to garner attention. By focusing resources on key risks, both the examiners' and the bankers' time can be used more effectively.

When performed well, a risk-focused approach produces benefits for banks and supervisors. However, to maximize the benefits of this approach, banking organizations need to have strong risk management and management information systems. Therefore, banks with strong risk management systems and better data systems can expect a more streamlined examination process.

Improving Understanding of Business Strategy

Given lessons from the financial crisis, there will likely be an increased supervisory emphasis on understanding the sources and sustainability of revenue drivers, the prudence of new areas of pursuit, and the alignment of strategy with the bank's long-term health. Examiners will focus considerable attention of the internal and external factors that influence banker's decisions and risk appetites.

Sarah Dahlgren, head of supervision at the New York Fed, recently stated, “We had always focused on risk controls and risk management. Where we had not had as deep a focus was at the business line level, the front office. Where is a firm's particular strategic advantage, where are they trying to make money, where are they actually making money, and how and what does that imply about the risks they are taking?"²

Success going forward will continue to be centered on superior risk management practices, including establishing a risk appetite that is well understood and actionable. A bank should be able to demonstrate that exceptional short-term results are being derived using sound underlying banking practices and principles, not being driven by unreasonable risk-taking that creates longer-term vulnerabilities. Examiners will pay increased attention to the role of the board of directors in reviewing business strategy, establishing the risk appetite of the organization, and reviewing the incentive compensation structure of the firm to see that it is consistent with the firm's risk appetite.

Utilizing Stress Analysis

The recent crisis has demonstrated the importance of considering the potential consequences of low-probability, but highly-adverse events. Dodd-Frank now mandates that stress testing be performed periodically at larger banks (e.g., those over $10b). While smaller institutions are not subject to the rule and typically do not need the more sophisticated techniques employed by larger institutions, all institutions should consider how well their bank can withstand unexpectedly-adverse events. All banks are encouraged to incorporate this thinking into their assessment of liquidity, capital, and credit risk. Sophisticated models are not required, but the assessment should reflect the institution's complexity and risk profile.

“The Making of Good Supervision: Learning to Say 'No'” suggests that “Supervisors must form a view not only of how institutions are currently placed, but how they will be able to cope with changing circumstances.”³ For example, bankers today should have a well-formulated assessment of how their bank is positioned for a prolonged or uneven recovery in the economy or housing markets.

Robust Vetting of Exam Findings

A strong vetting process complements the on-site exam process. A robust review of the factual basis, logic, and rationale behind supervisory conclusions by qualified individuals is very important in promoting consistency and high-quality supervisory decisions. Continued enhancement of vetting processes will be an important focus for bank supervisors.

The supervisory process would also benefit from increased interaction, coordination, and discussion with fellow regulatory agencies. The communication aspect is particularly important today, given the structural and responsibility changes associated with regulatory reform.

Timely and Effective Actions to Mitigate Excessive Risk-Taking

Regulators strive to address inadequate risk management, insufficient controls, and excessive risk concentration issues before they become detrimental to the bank. Regulators are sometimes criticized for recognizing risk at early stages, but not mitigating the risk in time to minimize losses. However, determining the optimal technique, timing, and forcefulness of intervention is rarely easy.

Excessive risk buildups often develop during “good times,” when favorable conditions support product performance. This can contribute to an overly optimistic perception that the underlying risk will remain benign throughout the cycle, and that current concerns are unwarranted. It is unrealistic to expect bank supervision to prevent any serious bank problems or to prevent all bank failures. However, it is reasonable to expect that supervisors will be willing and able to take timely and effective action that reduces the incidence of serious bank problems or bank failures.⁴

Regulators and bankers are working on methods to better assess the future consequences of today's risk exposures. Sufficient lead time is required to curb risk, implement corrective actions, and unwind existing risk in an orderly manner. Therefore, it is crucial to identify potential emerging risks at their earliest stages. Examiners should focus more attention on early signs or leading indicators, such as rapid growth, expanded use of leverage, a shift away from sound credit underwriting, and widespread adoption of financial innovation. Examiners should investigate trends with a healthy skepticism, a “trust but verify” mentality, a balanced outlook, and a will to act when needed.

The development of innovative products frequently outpaces the regulatory response. Earlier and greater scrutiny of new or emerging product offerings and their potential risks is needed, but must not unduly stifle innovation. The challenge of the Federal Reserve and other regulators will be to manage the balance between effective regulation that allows the markets the freedom to innovate and creates the appropriate incentives that will encourage market discipline and self-correction.

Effective and Timely Remediation of Problems

Once significant problems in bank conditions or risk management are identified, examiners should convey clear expectations for remedying the issues, develop actionable items, establish accountability for taking action, and set reasonable deadlines for completion. Both bankers and examiners should take responsibility for ensuring that momentum is maintained and that identified issues transition through the supervisory process until the proper closure is reached. Matters requiring attention should be dealt with proactively and receive timely response. The bank's board should be updated routinely on pertinent developments and remain engaged throughout the process. Banking supervisors should strongly encourage prompt write-downs for losses and encourage banks to conserve or bolster capital when deemed necessary.

Relevant and Timely Training

Many of the basic principles behind supervision remain constant, but examiner and banker skill sets must constantly evolve to keep pace with dynamic changes in an innovative and evolving industry. The sweeping regulatory reform that occurred in the aftermath of the crisis has resulted in a plethora of new regulations. Examiners must keep abreast of the latest developments. In response, brief but frequent supplemental training sessions are being provided to keep examiners updated on key regulatory developments and industry trends. The Federal Reserve Bank of Philadelphia has also maintained its strong commitment to external outreach during this historic time for the banking industry.

Conclusion

We are continuing to navigate through the post-crisis world of supervision. There is much to be learned from the financial crisis experience. The insights gained will be used to bring about constructive changes to the supervision process and, ultimately, to better position the banking industry to avoid or mitigate future crisis.

¹ Basel Committee on Banking Supervision “Supervisory Guidance on Dealing with Weak Banks: Report of the Task Force on Dealing with Weak Banks,” Bank for International Settlements , March 2002.
² Fest, Glenn, “The Dodd-Frank Effect,” The American Banker , November 1, 2011.
³ Vinals, Jose, and Fiechter, Jonathan, “The Making of Good Supervision: Learning to Say 'No',” IMF Staff Position Note , May 18, 2010.
⁴ ibid.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.