Banks are unique among U.S. companies because they are not only subject to intense regulation but also directly overseen by an army of well over 5,000 government examiners. The banking agencies refer to this function as “supervision,” and that term itself illustrates the problem: by statute, the agencies are only authorized to examine banks for legal compliance and unsafe and unsound practices, but over time they have expanded their function to now “supervise” and micromanage banks’ operations and governance, and increasingly dictate their business choices based on how the government thinks they should operate.
Furthermore, this power is subject to no checks and balances: “supervision” operates in secret, and the agencies have created their own enforcement regime, not based in rule or law, to impose significant penalties on any bank that does not follow their mandates. These penalties can be severe and greatly impede the ability of banks to run their businesses; they range from limits on business growth, orders to divest from certain business lines and customers, denials of mergers and acquisitions and increases in deposit insurance fees, among other things.
Fixing this part of the federal oversight regime would allow banks to serve their customers and communities more efficiently and focus on how to unlock economic growth.
Below is an outline of the key problems with bank supervision and potential solutions.
Bank Supervision in Operation
Today’s examiners focus on process and immaterial issues, and not on the real financial risks that are their statutory mandate.
While by statute examiners should be laser-focused on identifying material risks to banks’ financial condition, most examination today is instead focused on corporate governance, IT systems, vendor management, committee structure, compensation practices and other matters, as was clearly the case with SVB. Examiners have become management consultants with little tolerance for error. The result is an examination culture that has become obsessed with check-the-box compliance.
- Clear evidence comes from the fact that the Federal Reserve now rates two-thirds of U.S. banking companies as poorly managed, but at the same time it publicly states that these same banks are well capitalized, highly liquid, have strong earnings and are in strong financial condition.
- Furthermore, while the Dodd-Frank Act specifically divested the federal banking agencies of all authority to examine for consumer law compliance and instead focused them on safety and soundness, they have willfully violated the law, increasing the frequency and intensity of consumer exams they no longer have any legal authority to conduct.
Today’s examiners are using the examination process to push banks out of legitimate activity that benefits economic growth.
Banks are authorized by statute to make loans and otherwise fund businesses and consumers. Capital and liquidity regulation ensures they do so safely. However, bank examiners now feel empowered to tell individual banks how to run their business by shedding business lines or clients, as they have a strong incentive to find problems and prevent banks from taking risks. As a result, this has deprived creditworthy businesses and consumers of access to steady, inexpensive credit funded by deposits.
- The primary occasion where such practices became public was Operation Choke Point, when it was revealed by Congressional investigations and media reports that examiners were pushing banks out of lending to politically unpopular businesses.
- More recent reports illustrate how “reputational risk” was used to mandate debanking of disfavored businesses or the people who worked for them. While no statute requires preapproval for any new banking product or process, the agencies coined the Orwellian term “supervisory non-objection” and effectively banned banks from opening accounts for crypto companies without individual examiner approval.
- Through their AML examinations, the agencies can designate certain industries or companies as “high risk,” a designation that comes with so high a compliance burden as to force the bank to expel the customers from the bank. This includes disfavored industries and the people who work in them.
- More recently, the shift of lending to private credit followed agency “guidance” mandating that banks strictly limit lending to leveraged, mid-sized companies. Even when this guidance was found to be illegal under the Congressional Review Act, the agencies continued to enforce it.
- Examiners have pushed banks out of the mortgage servicing business, leveraged lending and synthetic risk transfers, which enable banks to expand lending to households via mortgages, auto loans, commercial and industrial (middle-market loans) and commercial real estate loans. Lifting those and any future restrictions would power economic growth.
- Examiners have directed regional banks that are in full compliance with all liquidity rules to restrict lending and hold more government securities; they have directed regional banks that are in full compliance with all capital rules to raise capital.
Examiner overreach is undermining economic growth by forcing banks to misallocate resources. It’s also overwhelming boards and management, and shifting the focus from business strategy and material financial risk to placating examiner criticisms about immaterial matters.
Examiner mission creep has shifted the focus of boards and management away from business strategy and financial risk and toward responding to innumerable information requests, questions and examination findings that are focused on processes, policies and immaterial issues that have little to do with real financial risk. For example, a recent survey showed that cybersecurity teams spend more than half their time doing paperwork for, and meeting with, examiners.
How We Got Here: Unchecked and Unbalanced Power
The banking agencies are able to impose severe mandates on banks for one reason: they have established a secret enforcement regime that allows them to impose massive sanctions without any due process or, in most cases, public disclosure. In the past, and under the law, a banking agency’s only recourse to force a bank to change its practices was a formal enforcement order that came with a right of the bank to receive notice of the charges and contest them in court. Now, there is effectively no way for a bank to contest a supervisory mandate. The agencies take the position that any objection to or public sharing of these mandates is a violation of examination secrecy and a criminal offense. However, the banking regulators have routinely leaked confidential supervisory information (CSI) on banks to various news outlets to create narratives justifying greater regulation without any repercussions themselves.
Examiners use the “M” in “CAMELS” as a weapon to dictate bank behavior.
As background, in the exam process, banks are assigned CAMELS ratings, which stands for Capital, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk including interest rate risk. The Management rating is uniquely subjective: it is not based on any empirical standard. It is also superfluous: management is considered in assigning each of the other components. Traditionally this was not a problem because the Management rating followed the others: a bank with satisfactory capital, assets, earnings and the rest was presumed to be well managed.
In 1999 (Gramm-Leach-Bliley), Congress conditioned the exercise of some expanded commodities and merchant banking powers on maintaining not only a satisfactory CAMELS composite rating but also a satisfactory Management rating. The banking agencies then expanded and weaponized that power in two significant ways:
- First, the Management rating was de-linked from the other ratings, and banks began being rated as unsatisfactory even when they were unquestionably in sound financial condition. Put another way, a bank that did not heed examiner mandates on how to manage its operations or conduct its business would receive an unsatisfactory Management rating, regardless of the bank’s financial strength.
- Second, the agencies, through guidance and undisclosed practice, significantly expanded the sanctions for having an unsatisfactory Management rating. For example, with no statutory basis, the agencies take the position that a poor Management rating standing alone is grounds for limits on acquisitions, branching and other types of growth; the rating also raises deposit insurance premiums and restricts access to some forms of government funding. Official and unofficial asset caps were imposed.
These grave consequences are typically imposed for years, as ratings are not upgraded until after multiple examination cycles — and after double and triple checking by compliance, audit and in many cases an outside consultant. As a result, in practical effect, a Management downgrade to a “3” is no longer an examination criticism but rather a large financial penalty, a multi-year cap on organic and inorganic growth, and potentially an order to divest whole businesses.
Lastly, the agencies currently issue the same exam finding to a large cohort of banks as a way to avoid notice-and-comment rulemaking. The basic examiner criticism is called an MRA, for Matter Requiring Attention, and they have created an “Industry MRA” — an illegal overreach.
Solution
The solution is simple: restoring the due process required by statute and eliminating the secret enforcement regime.
- The “M” component of the current CAMELS rating system should be eliminated. Management is already part of each of the other component ratings: for example, management is a key component of assessing the bank’s Liquidity component, as stress testing and backup planning are part of that exercise.
- An MRA should be defined by regulation as a material risk to the safety and soundness of the bank, and that regulation should specifically provide reputational risk, climate risk, vendor management, IT, compensation, committee staffing and operational risk cannot form the basis of an MRA unless they meet that standard.
- All agency guidance establishing non-statutory penalties for examination criticisms should be rescinded, and the agencies should return to using the numerous sanctions that Congress has enacted: cease and desist orders, capital directives, safety and soundness directives and the like.
- Examination reports and ratings should be properly limited to objective matters of financial condition, with all exam findings and ratings appealable to a neutral fact-finder and judge.
- The banking agencies should prohibit their examiners from announcing or applying any requirement or mandate that is not already established in public regulations. And examiners’ compliance with those rules should be subject to routine oversight by so-called second and third “lines of defense” – that is, independent compliance and audit controls – that are currently lacking but should be established inside each agency.
- The banking agencies should cease consumer compliance examinations for the banks for which Congress explicitly divested them of that power (those over $10 billion in assets, for which that power was transferred to the CFPB).
- The agencies’ approach to AML compliance, sanctions (where they also have no examination authority) and cyber should be completely rethought.
