An Historic Opportunity to Renovate Bank Supervision & Regulation in the U.S.

Inherent Conflicts & Irreconcilable Mandates in Bank Supervision

Many expect that the Trump presidency will result in meaningful change to the regulation and supervision of banks in the United States.[1] At the same time, there is collective hope that government spending can be subdued. This is an historic opportunity to evaluate the complex, conflicted, and overlapping bank oversight system in our country and create a safer banking system and more efficient oversight apparatus. To achieve this desired outcome, we need to consider how our current system has developed and recognize that fundamental realignments of existing mandates and powers need to occur to return the oversight agencies to their core and original missions. Doing so will result in less regulatory burden, more efficient capital allocation, better bank oversight, and improved risk identification and response.

The Latest Manifestation of a Recurring Problem

A spate of bank failures between March and May of 2023 triggered a systemic risk designation that resulted in the all-too-familiar creation of moral hazard that regularly follows the wake of a supervisory failure. Well-run banks were forced to make whole uninsured depositors of poorly run banks that failed and were put on notice they could also be on the hook to insure all uninsured deposits in the system. These regular episodes of supervisory failure are too frequent and the moral hazard that accumulates because of them strenuously resists reversal.

The regulatory post-mortems on the failures of SIVB and SBNY could be summarized as “round up the usual suspects.” Michael Barr blamed the Federal Reserve’s implementation of the “tailoring” requirement in the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) as a major factor in the staff’s failure to detect and act to remediate SVB’s deficiencies in managing its liquidity and interest rate risks. The FDIC blamed staff shortages for its failure to properly supervise its banks.

The OIG report got closer to the truth when it concluded that the supervisors failed to identify and tailor supervision to SVB’s salient risks. The underlying implication of the OIG’s assessment is that the way to reduce regulatory burden while simultaneously addressing risk in the banking system is to know a risk when you see one and to address it quickly and efficiently before it results in a systemic risk.

That said, the problem that I have observed over my 30 plus years as a stakeholder in insured depositories as a regulator, operator, and investor is that our bank regulatory and supervisory system isn’t designed well to identify and address risks as they emerge. Instead, our oversight system has evolved not due to the orderly influence of natural selection but through disorderly mutations influenced by committees of especially interested parties.

At present our bank oversight system is inefficient and regularly ineffective. In order to create a bank regulatory and supervisory structure that will significantly and efficiently sustain the stability and smooth functioning of our financial system over time, we need to confront the core structural misalignments that have developed in the bank oversight apparatus and re-justify the roles and responsibilities of its key components.

The recommendations briefly put forth below aren’t merely academic and theoretical; they are practical measures, the convictions for which come from mine and others’ first-hand experience with banking and bank oversight in the U.S. through many cycles and crises. These are lessons learned in the trenches. Some of these reforms will face more resistance than others due to entrenched interest; but quality progress in any of them will improve bank oversite.  

The Necessary Reforms

The inherent conflicts of interest, irreconcilable mandates, and unnecessary overlap that exist in bank oversight must be resolved. These goals can be accomplished by correcting layered misalignments in the oversight system by implementing the following reforms:

• Remove inefficient and ineffective supervisory overlap. Consolidate bank and bank holding company (BHC) supervision under the Office of the Comptroller of the Currency (OCC), removing bank and BHC supervisory authority from the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). This would result in all Federal safety and soundness examinations of insured depositories, including bank holding companies being performed by the OCC.  States would continue examining state-charted banks alternating with the OCC. The OCC has proven itself to be the most competent of the banks supervisors. This reform is not merely a matter of correcting an unjustifiable inefficiency but is also necessary to remove malignant competition among supervisors.
• Move all bank examination personnel from the Federal Reserve Board (FRB) and FDIC to the OCC. We have already done this once. Following the global financial crisis (GFC), the Office of Thrift Supervision (OTS)—having demonstrated its incompetence and untrustworthiness leading up to the GFC—was subsumed by the OCC.[2] The difference between the Federal Savings Banks and the large National Banks that the OCC already supervises is far greater than the differences in the banking organizations that remain supervised by the FDIC and the FRB. Also, on average 90% of a BHC’s assets are bank subsidiaries already supervised by a bank regulator that also analyzes the holding company to determine if it is a source of strength to the bank. While the FRB may argue that that it should examine SIFIs, its bank supervisory authority should end there.
• Ensure that bank supervisors and regulators compete based on risk management techniques and specialties, NOT laxity. Competition in the private sector generally results in more efficient companies and better products. The conditions that result from the influence of Adam Smith’s invisible hand, however, are difficult to replicate when the hand is necessarily visible and prone to nebulous reward as it is in bank oversight. Mission creep, the absence of objective synchronous measures of success, and incentives that are more power-based than financial-based have resulted in malignant competition among bank supervisors. Consolidating supervision under the OCC is part of the solution. The other side of the solution is about creating incentives for managing risks in ways other than onsite supervision to encourage diverse approaches to risk management.
• Assure that the FDIC has the tools it needs to address its original mandate as deposit insurer and remove its off-mission, supervisory mandate. The consolidation of supervision under the OCC will not work unless there is credible challenge to its approach and accountability that evaluates the ongoing effectiveness of its bank examination programs. The FDIC needs the tools necessary tools to identify and address the agency problem that results when regulations are inadequately enforced and so-called “prudential” supervision is too late or functionally nonexistent.
• To realign the clarified missions of the OCC and the FDIC, reconstitute the FDIC’s Board of Directors to remove representatives from other bank supervisors and replace them with members who are requisitely qualified in risk management, insurance/actuarial, and bank operations, and rotate a head of one of the Federal Reserve Banks. The effectiveness of the FDIC’s role as backup supervisor has been impeded by the composition of its Board. Resistance to this reform may prove the most stubborn because the FDIC’s board composition is specified by statute. Still, the important heart of the recommendation is the FDIC should not need the approval of the “back’ee” to exercise its backup authority.  
• Remove the inherent conflict of mandates that exists between the Fed’s already difficult mandate of achieving full employment and price stability and its role in bank supervision and capital policy setting. As the Fed moves to tighten or loosen economic accommodations from a macroeconomic perspective, its involvement in overseeing banks is regularly out of step with these moves.  For example, consider when the Fed is actively purchasing debt in the open market to increase the money supply but is at the same time working to raise capital and reserve requirements, thus reducing the velocity of money.  
• Move BHC stress testing from the Fed to the FDIC and maintain an oversight role for the Fed and OCC through the Financial Stability Oversight Council (FSOC). Since bank capital is what stands between depositors and the FDIC, the FDIC is natural place for capital stress testing to reside. This may seem like the largest talent mismatch among these recommendations; but it won’t seem so once the FDIC’s Board is reconstituted, and the stress testing teams are moved from the Fed to the FDIC.[3]
• Enhance the FDIC’s backup supervisory role by giving it enhanced audit authority to check the examination procedures and conclusions of OCC exams, authorize it to accompany the OCC on examinations when it sees fit, and vest the FDIC with full authority to conduct independent, horizontal (issue-based) examinations of groups of banks when it believes a particular set of risks in the sector pose a potential threat that needs to be better monitored and measured. This increased authority will safeguard the supervision and examination of banks and assure an objective 2nd line of defense in the integrity of supervision. A part of the FDIC’s backup role should resemble the PCAOB’s role overseeing the integrity of public accounting firms.
• Vest the FDIC with greater authority over the composition of the Call Reports and Y9-C forms. These are the offsite reporting mechanisms available to bank regulators and give the FDIC unfettered access to all data collected by the OCC from the banks and BHCs that it supervises. The FDIC needs sufficient information to assure that its interests as deposit insurer are being served by the supervisory agents. The current process for changing the bank reports is hopelessly sluggish and responds too slowly to changing economic and banking risks under the current process, which is run through the Federal Financial Institutions Examination Council (FFIEC).
• Employ explicit GAAP/RAP differences when necessary for bank oversight bodies to assure that their interests are reflected in bank financial statement accounting and to encourage greater coordination and cooperation between the FASB and the bank regulatory community. At present, the FFIEC has authority to specify increased conservatism within the range of standards allowed by GAAP. Although I believe the bank regulators have erred by dismantling securities accounting under FAS 115 as superseded by ASC 30, there have been other occasions when the Financial Accounting Standards Board (FASB) has implemented standards that have had the unintended consequences of increasing risk at banks. I believe this was the case, for example, with hedge accounting and the accounting for mortgage servicing rights.
• Change the OCC’s source of funding from examination fees to deposit insurance premiums as the FDIC’s is already. The immediate need for this reform is reduced by consolidating examinations under the OCC (which is the most important component of a plan to eliminate malignant competition from supervision). Still, it is important to align the OCC’s source of funding to the rationale for its existence. Therefore, it makes more sense to fund the apparatus that makes deposit insurance possible with deposit insurance premiums. Through the risk-based deposit insurance premium system, banks that create more risk in the system will be charged more for being costlier to insure and supervise.
• Finally, revisit the risk-based deposit insurance system for the purpose of making it less procyclical. At present, the criteria that raises the premium calculations for banks kicks in higher premiums when risk levels are already very high and exacerbates the probability of resolution. The determinations of insurance premiums were originally intended to charge earlier for increased risks as they are developing based on actuarial predictive models and risk characteristics known to predict bank failure. As it is currently implemented, high insurance premiums kick in only after risks are well developed and these high premiums reduce the financial flexibility of the subject bank to navigate out of its risky condition, which actually increases the probability of failure.

I believe that this set of reforms addresses the source of regular oversight failures and are superior to alternatives such as lowering the asset level of banks subject to stress tests, indiscriminately raising capital requirements on all banks, or increasing the unilateral authority of bank supervisors.

[1] “Regulation” is the corpus of written requirements that banks must follow. “Supervision” comprises the regular examinations and other monitoring techniques that the bank oversight agencies use to enforce regulation. They are not the same thing, and I will refer to the combination of regulation and supervision as oversight.

 [2] I experienced the seamless transition of the OTS to the OCC as a board member of OneWest Bank, FSB, which later applied to replace the FSB with an NA.

[3] In fact, the Senior Associate Director at the Board over the Fed’s stress testing units is an FDIC alumnus with whom I had the pleasure to build stress tests with at the FDIC (IndyMac, FSB was the first insured depository to fail a stress test, and it was devised by the FDIC by this senior associate director and others).