The New Team in Banking Supervision and Regulation at the Federal Reserve Board
Alan Greenspan's retirement from the Federal Reserve Board is not the only major change that has taken place at the Board lately. The long-time director of the Division of Banking Supervision and Regulation, Richard Spillenkothen, also retired, and a new team has been put in place. Roger T. Cole now leads the division and has created three new deputy director positions, where only one existed before: 1) Supervision Program and Risk Management, headed by Deborah P. Bailey; 2) Accounting, Policy, and Quantitative Analysis, headed by Steven M. Roberts; and 3) Technology, Quality Assurance, and Staff Development, headed by Peter Purcell. The RMA Journal sat down with three members of the new crew in Sup&Reg, as it's called at the Board, and talked about what sort of changes, if any, the industry can expect with a new team in place.
RMAJ: There are now three deputy director slots where there was only one before. Can you tell us why you made the change?
Cole: The key thinking behind the move was that the three deputies provide a wide breadth of coverage overall and each has significant expertise in their area. Deborah has considerable examination experience and brings a lot to bear there, and Steve has a huge amount of experience with public policy issues. Peter Purcell has a lot of experience in IT, and bringing IT and staff development together is very useful in terms of developing synergy in that area. Given the key people that were available and what we want to accomplish, it makes good sense.
RMAJ: Have there been other, perhaps less visible, changes to the supervisory process within the Federal Reserve System relating to banking regulation and supervision?
Cole: Yes, a lot of what we are trying to do is to provide for succession planning going forward, and to create a good set of areas of expertise focusing very significantly on financial and quantitative analysis--that's so important in terms of the rapid evolution of financial markets and products. We are also creating more teamwork and leadership development opportunities in the division.
RMAJ: So there are still perhaps more changes to come?
Cole: Yes. I think this is a continuing process. We also implemented a committee structure that helps coordinate the division's work. The structure includes a Risk Committee and an Operating Committee that report to senior division leadership.
Roberts: The focus that I keep coming back to is enhancing corporate governance of the supervisory and regulatory function, both here at the Board and in the Reserve System, and clarifying roles and responsibilities. Risk identification and assessment is a key part of our business, so that is an area where we really have to focus more time and attention. It is very important for us to gather the information available throughout the Federal Reserve System and bring it together for consideration here at the Board.
Bailey: There is a tier of very strong officers on the Operating Committee and the Risk Committee, and we rely on them to help oversee this function and to provide analysis and recommendations so that the Board can make informed decisions.
RMAJ: Let's turn now to the industry itself and what you see in the institutions you examine. RMA's members have been telling us for the past two years that things are not going to get better in terms of credit quality--meaning they can only become more challenging. Do you think we've reached the turning point in the credit cycle?
Bailey: In my job I look at holding companies and other supervised institutions in terms of safety and soundness. I cannot really say at what point the cycle turns or changes. But what we still see, particularly in the credit markets, is that credit quality is still very good. We are seeing an increasing level of classified and non-performing assets in some areas, but they are still near their recent historical lows.
RMAJ: And you are already well into the Shared National Credit exam process.
Bailey: Yes, absolutely, and this looks good based on historical standards as well. While we are seeing a little bit more deterioration in the consumer portfolio, the commercial portfolio remains strong. And you are right; people do say that every year, that the environment is going to get worse. Based on what we are observing, things look good right now but we are not complacent. We are continually assessing the areas of weakness. But firms' credit risk management is much more advanced and much more mature than in the last downturn. Risk is also more diversified in the financial marketplace.
Roberts: One thing you can probably conclude from the last 15 years is that the focus the Board and the other banking agencies put on risk management in the early 1990s really has taken hold within banking institutions. And that probably will modulate credit cycles somewhat, vis-a-vis the banks and the holding companies.
Bailey: The techniques are now much more sophisticated, such as the hedging of risk in the portfolio and the use of derivatives. The management of the portfolio is much more sophisticated and effective, particularly in the regional and larger banks. These are the banks that have spent a lot of money on their MIS and IT structures so they will be able to look at things from a portfolio perspective in terms of concentrations and try to manage from that perspective. You really did not have that in the last downturn.
Cole: That improvement in the management of concentration risk has been the key to the industry's strong performance.
RMAJ: RMA hears from member banks both large and small that the market is pumped with liquidity--the environment is extremely competitive, fueled in large part by new entrants that are not regulated. How do you as bank supervisors, and indeed representatives of the central bank, get a handle on overall credit quality in the financial system when so many participants are not subject to traditional bank examination procedures?
Roberts: In most cases, except for hedge funds, the largest entities are regulated by somebody, but not necessarily in the same way that banks are. There are a variety of lending institutions that are not regulated at the federal level.
Bailey: It's kind of a double-edged sword. Additional entrants add liquidity into the market and that's beneficial in terms of credit availability. But that makes everyone's job more challenging, and we need to utilize a lot of market intelligence to really understand what is going on. You cannot just focus on the regulated holding company to understand credit markets, and so we rely on market information and other indicators. Our supervisory staff also identify significant issues going on in the industry and provide key insights on how these institutions manage credit, market, and operational risks.
We meet with many different market participants, including RMA, to get a better sense of market conditions. We also conduct quantitative analysis and work with the Fed's research staff to gain a broad perspective.
Roberts: One thing we confirmed through the recent discussions on subprime lending is that the securitization process attracts capital from around the world. And it certainly is adding to the liquidity in our markets in a very impersonal way compared to how banking used to be conducted. There is money going into products where only the underwriter of the security knows who the investors are. That is not a problem when everything is going right, but it could be a real challenge when asset quality deteriorates. And I think the problems in the subprime market are an indication that even the broader financial market has something to learn about the behavior of new market entrants.
Cole: There will definitely be some learning experiences here in terms of understanding the various dimensions of credit risk. There probably is some asymmetry of knowledge in the market now since the institutions that are originating and selling loans into the market have a lot of experience managing credit risk, whereas a number of investors in the market may not have that experience.
Roberts: Given your question, you have to also recognize that the Fed is a central bank. Supervision and regulation provides insights into what we need to understand about financial markets, but also through information about bank participants, our role in payments, our role with the open market desk, and elsewhere. It brings us a lot of cumulative information and it is a challenge. As regulators, we need to think about what kinds of information banks have that can help us better understand the changes in financial products, practices, and risk profiles.
Bailey: That's a great point. Think about the hedge funds. Because of the large institutions that we do supervise, we have a window into that particular market because the large institutions are key counterparties of these hedge funds.
Roberts: As the financial markets change, adding new products and new players, it is a constant challenge for us to be able to understand the evolving role of the banks within that environment. It's important because of the dual role we play in banking supervision, and in helping the Board fulfill its larger financial stability responsibilities.
RMAJ: During the Shared National Credit exam process, do you get some level of understanding about those credits that are distributed outside the banking system?
Bailey: Banks still play a huge role on the front-end of origination. The larger financial companies are the ones that really put the deal together and distribute it into the market. So we see the totality of that credit. While numerous nonbanks buy different pieces of the exposure, by and large, the credits originate from the large banking organizations that have always dominated that market.
RMAJ: So you are still comfortable that the SNC exam process gives you a picture of what's happening in the large credit markets.
Bailey: The SNC program provides us with a broad view of underwriting trends, deal structures, distribution practices, and how credit is managed through the life cycle. But it does not cover the entire portfolio. And so we try to supplement our understanding of banks' portfolios through our ongoing supervisory process and working with the OCC and other regulators.
But back to the earlier point regarding excess liquidity, one of the things that we have seen is the significant increase in the size and number of leveraged transactions in the industry.
RMAJ: And the agencies have worked to improve the SNC examination process over the years.
Bailey: Yes, and I think it's getting better for the industry.
While it's time consuming and costs money on our side too, it is less expensive than reviewing the same credits many times at individual banks. Also, the risk-based sampling that the agencies have used the past few years has helped sharpen the program's focus.
Cole: It also provides some very good benchmarking data in terms of the Basel process and credit ratings and, frankly, it's also a reference on the credit derivative market.
RMAJ: Let's turn now to commercial real estate concentrations and the guidance that was issued last December. RMA's Community Bank Council met in May and reported that, to date, no major issues have arisen in the examination process. Can you tell us what your examiners are seeing in the banks they visit?
Bailey: Yes, the guidance is really about good risk management. There was a lot of concern expressed during the development process that the examiners would have hard-line benchmarks and a trigger to criticize the institution. But one of the things that we have been doing is talking to Reserve Bank staff to ensure that the examiners in the field do not insist on hard triggers.
Roberts: I've been out on the road recently meeting with bankers and have not heard any complaints.
Cole: When I first took this job, I was committed to going around to the Reserve Banks. And so in the first few months of this year, I visited all 12 Reserve Banks and talked to a large portion of the supervisors and examiners. At that time, I conveyed the message that the commercial real estate guidance was about risk management, not concentration triggers. We have also made a major effort in terms of training and getting a consistent message out to examiners across the agencies.
Bailey: Absolutely. We are following up to make sure that implementation is going according to plan, both from our stance as well as for the industry. There are some banks that have concentrations they have to manage.
But we are starting to see that community banks are doing a better job of identifying different segments of the portfolio so they can have a better sense of what they have. They are identifying the different types of commercial real estate in terms of geography, in terms of the different builders, in terms of different products and are making better decisions about how much of their balance sheet--how much of their capital--they want to put at risk for this particular business. So I think we have started to see improvements in risk management, and from that standpoint, I think the guidance has been effective--that was the message we were trying to get out. We are not trying to restrict banks' CRE lending, but are trying to reinforce good risk management practices.
When you have a concentration in anything, to be perfectly honest, you need strong risk management in place.
RMAJ: That is what we hear--we know of institutions that have had to make some investments, but I think they would admit they needed to. Is there any other area where you see a concentration or other concern on your radar screen? You've mentioned leveraged structures a number of times.
Bailey: Yes, I would not call that a concentration, but it clearly is on our radar screen. You have probably heard or read speeches lately from the Board of Governors and Reserve Bank presidents mentioning that leveraged lending is something we are watching for the simple reason that there is a lot of liquidity in the market with a number of new participants, and it has not been accompanied by the type of underwriting standards we expect to see. In many instances, the governance and the covenants are very loose, very minimal--and that has been noted in the speeches. The market is incredibly active, and loan size seems to increase with each deal.
RMAJ: It's also a global marketplace.
Bailey: Yes. To echo Steve's comment, capital is coming in from all over the world and you do have many new participants. The biggest holders of leveraged credit are not necessarily the regulated banks anymore. Banks have become very good at originating and distributing these deals to nonbank investors, which reduces their credit risk.
Cole: Also today, there are noticeably more diversification avenues that are open, including credit derivatives and CDOs. But one potential concentration risk is that a few institutions are very dominant in a lot of this distribution we have discussed. There is potential for some operational and other risk concerns. Have they got the underwriting and covenants right? Are they really doing this in terms of crossing their T's and dotting their I's? And if they are not, then there could be significant challenges.
Roberts: As I mentioned, the subprime market is also changing markedly and we are monitoring that closely.
Bailey: Yes, we continue to watch subprime closely, and it represents another case in point where the credit was widely distributed. Originators, both regulated and unregulated, underwrote the deals but didn't keep the risk on their books. The fees were made up front. They sold it, presumably to sophisticated investors. But that is the other question--how sophisticated are they?
RMAJ: Yes, and how are they going to behave in a stressed environment?
Bailey: That's precisely the question. If things unravel, workouts will be different than in the past. It used to be that everyone would get together and lock themselves in a room and figure out a way to work it out. Now you have a different group of investors with different motivations.
Roberts: But if you think back to the mid-1980s, when we had the Latin American debt and the S&L issues, it was the depository institutions that were holding the credits. And that is not exactly the same anymore. That's why we are interested in what may happen.
Cole: Also, balance sheets continue to expand quite dramatically, and there is a lot more in the trading book on those balance sheets that is of considerable interest to us, obviously.
RMAJ: At a recent RMA round table, participants were equally divided about the market environment between those who are very active distributors and hold very little on their balance sheet, and those who are actually still keeping a significant portion on their balance sheet. They are really two different kinds of institutions.
Roberts: Well, there may be two different types of lending within an institution. Institutions not only hold loans on balance sheet but often originate to distribute, and this raises some interesting questions. What are the institution's underwriting standards? Are they underwriting to more than one standard?
RMAJ: The Board of Governors traditionally spends more time examining larger institutions and has developed procedures for large complex banking organizations (LCBOs). Is there an asset size, or perhaps a level of business complexity, where you expect to see more robust risk management structures in place at an institution?
Bailey: It is much less about asset size than it is about complexity. It also has to do with the bank's role in the financial markets. If we think you are a significant player in a particular financial market, we expect you to have a corresponding level of risk management in that area because your actions don't just impact your particular institution, they could impact the system as a whole.
So size is not the only factor. In some cases you will see guidance directed at LCBOs to make sure we do not confuse the community banks. It is geared more toward saying we do not expect all institutions to have the same level of sophistication in risk management. And I think we are trying to get better at saying, "This is really more directed to the larger, complex institutions, and other institutions need to make sure they do what they need to do for their own business line. The sophistication of risk management should be commensurate with the complexity of the business line." So we are trying not to send the message to small institutions that they have to do something beyond what is appropriate.
Roberts: A good example of what Deborah has been talking about would be in the area of compliance with laws and regulation. The larger an institution is, the harder it is to manage over distances and products, and therefore they would naturally need more sophisticated frameworks, perhaps enterprise-wide, around compliance with laws and regulations than a smaller institution.
Bailey: But we are trying to have a more disciplined approach. We try to ensure that the guidance we issue is appropriately directed. We are also sensitive to the concern that community banks do not have the level of staff and the resources of larger institutions.
Roberts: And in many cases, community banks do not need it because their management and their boards are more hands-on, and they know what's going on within the bank.
RMAJ: How about an institution that is growing very fast? Does that get on your radar screen?
Roberts: If an institution is growing fast, we usually take a closer look at that.
Bailey: We run a series of monitoring and surveillance screens constantly--some that are standard--and one of the screens we run is for growth. And not only balance sheet growth, but also growth across different segments of the portfolio. And we have a process in place where, when certain growth triggers are hit, we engage with the Reserve Banks in a dialogue and say, "What is going on at this institution? How comfortable are we with the risk management and control structures in place?"
Roger T. Cole was appointed as director of the Division of Banking Supervision and Regulation on September 21, 2006. Cole joined the Board of Governors in 1979 as a senior financial analyst, was appointed to the Board's official staff in 1988, and was promoted to associate director in 1997 and senior associate director in 2001. Prior to his work with the Board, Cole was a financial analyst at the Federal Reserve Bank of Boston and worked at the Wyatt Company. Cole earned his B.A. in economics from Bucknell University and his M.A. in economics from Johns Hopkins University.
Deborah Bailey became deputy director for Supervision Program and Risk Management effective January 7, 2007. Bailey was previously an associate director in the Division of Banking Supervision and Regulation, responsible for large, complex banking organizations. She joined the Board of Governors in 1997 in the Foreign Banking Organizations Section and was appointed to the Board's official staff in 2000. In 1999, she received the Special Achievement Award for her contributions to the development of the Federal Reserve's global and foreign bank supervision programs. Before joining the Board, Bailey spent 24 years with the Office of the Comptroller of the Currency, most recently as the director of the New York field office. Bailey holds a B.A. in banking and finance from the University of Georgia.
Steve Roberts became deputy director for Accounting, Policy, and Quantitative Analysis effective January 7, 2007. Prior to that, Roberts was a senior adviser in the Division of Banking Supervision and Regulation. Between 1987 and 2004, he served as the partner in charge of the financial services regulatory practice for KPMG LLP in Washington, D.C. He previously served at the Board of Governors from 1983 to 1987, as assistant to Federal Reserve Board Chairman Paul Volcker, and from 1971 to 1977 as an economist in the Division of Research and Statistics. Roberts was also chief economist for the U.S. Senate Committee on Banking, Housing, and Urban Affairs from 1977 to 1981. He holds a B.S. in economics from Rutgers University and both an M.S. and a Ph.D. in economics from Purdue University.
PHOTOGRAPHED BY DENNIS DRENNER…
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Publication information: Article title: The New Team in Banking Supervision and Regulation at the Federal Reserve Board. Contributors: Not available. Magazine title: The RMA Journal. Volume: 90. Issue: 1 Publication date: September 2007. Page number: 16+. © 2007 The Risk Management Association. COPYRIGHT 2007 Gale Group.
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