Academic journal article Review - Federal Reserve Bank of St. Louis

The Role of Supervisory Screens and Econometric Models in Offsite Surveillance

Academic journal article Review - Federal Reserve Bank of St. Louis

The Role of Supervisory Screens and Econometric Models in Offsite Surveillance

Article excerpt

Banking is one of the more closely supervised industries in the United States, reflecting the view that bank failures have stronger adverse effects on economic activity than other business failures. Bank failures can disrupt the flow of credit to local communities (Gilbert and Kochin, 1989), interfere with the operation of the payments system (Gilbert and Dwyer, 1989), and reduce the money supply (Friedman and Schwartz, 1963). Bank failures also can have lingering effects on the real economy. Indeed, a growing body of literature blames the length of the Great Depression on the disruption of credit relationships that followed the wave of bank failures during the early 1930s (Bernanke, 1983; Bernanke, 1995; and Bernanke and James, 1991).

The existence of unfairly priced deposit insurance bolsters the case for bank supervision. Without insurance, depositors have strong incentives to monitor and discipline risky institutions by withdrawing funds or demanding higher interest rates. Insured depositors, in contrast, have little incentive to monitor and discipline risk (Flannery, 1982). Moreover, deposit insurance premiums established under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) do not appear to punish risk adequately The spread between the premiums paid by the riskiest and safest banks is only 27 basis points, and just 562 of the 10,486 FDICinsured institutions paid any premiums during the first half of 1999 (Barancik, 1999). As a result, bank supervisors must act as agents of the taxpayers to limit risk. Supervisory limits on bank risk reduce the likelihood that failures will exhaust the deposit insurance fund and impose direct costs on the taxpayers.1

Bank supervisors use on-site examination and off-site surveillance to identify banks likely to fail. Supervisors then can take steps to reduce the likelihood that these institutions will fail. The most useful tool for identifying problem institutions is on-site examination, in which examiners travel to a bank and review all aspects of its safety and soundness. On-site examination is, however, both costly and burdensome: costly to supervisors because of its laborintensive nature and burdensome to bankers because of the intrusion into day-to-day operations. As a result, supervisors also monitor bank condition off-site. Off-site surveillance yields an ongoing picture of bank condition, enabling supervisors to schedule and plan exams efficiently Offsite surveillance also provides banks with incentives to maintain safety and soundness between on-site visits.

in off-site surveillance, supervisors rely primarily on two analytical tools: supervisory screens and econometric models. Supervisory screens are combinations of financial ratios, derived from bank balance sheets and income statements, that have, in the past, given forewarning of safetyand-soundness problems. Supervisors draw on their experience to weigh the information content of these ratios. Econometric models also combine information from bank financial ratios. These models, however, rely on a computer rather than judgement to combine ratios, boiling the information about bank condition in the financial statements down to one number. In some models this number represents the likelihood that a bank will fail. In others, the number represents the supervisory rating that would be awarded if the bank were examined today

In past statistical comparisons, econometric models have outperformed supervisory screens, yet screens continue to enjoy considerable popularity in the surveillance community. Cole, Cornyn, and Gunther (1995) demonstrated that the Federal Reserve's econometric model, the System for Estimating Examination Ratings (SEER), outperformed a surveillance approach based on screens (the Uniform Bank Surveillance System or UBSS), both as a predictor of failures and as an identifier of troubled institutions. Nonetheless, analysts at the Board of Governors and in each of the Reserve Banks continue to generate a variety of screens to aid in exam scheduling and scoping. …

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