The Future of Supervision and Regulation
By: KAREN L. GRANDSTRAND
September 2009
The current economic crisis has caused events that many of us never thought would occur in our lifetimes. We are living in historic times. With that comes questions - questions on who to blame, what went wrong, how can we learn from this, how can we survive this, and what does this mean for the future of banking supervision and regulation.
Bankers are already experiencing the future; the rules of the game are changing. New expectations are evident in bank examinations, recent regulatory guidance, and the Obama Administration’s Financial Regulatory Reform proposal. These expectations focus on some key areas: (i) liquidity, (ii) capital, (iii) consumer protection, and (iii) business plans, products, and services.
Liquidity
The banking regulators have emphasized the importance of liquidity in speeches, examinations, and issuances such as the FDIC’s FIL 84-2008. This has led banks to increase available sources of funding, from local deposits to Federal Home Loan Bank (“FHLB”) advances to brokered deposits. However, the agencies’ focus on liquidity is evolving, and agencies appear to be expecting something more than increased sources of funding. Recent examinations emphasize the need to return to the balance sheet of the 1980s - to return to balance sheet liquidity consisting of cash and unpledged securities. In addition, the regulatory agencies expect a significant reduction in non-core funding from the levels deemed fully acceptable and normal only a year ago. To the surprise of many bankers, non-core funding is defined to include not only brokered deposits but FHLB advances and deposits from listing services such as QuickRate. So what level of non-core funding is now reasonable and acceptable? No regulation sets a definitive benchmark. However, the changes the FDIC proposed on October 7, 2008 to the deposit insurance rule provide some insight into what the FDIC considers risky. The October 7 proposal suggested higher deposit insurance premiums for banks with 10 percent brokered deposits and a growth rate of 20 percent over four years. This benchmark was modified in the final rule allowing a growth rate of up to 40 percent over four years.
As evidence of the continued focus on liquidity, the FFIEC just issued proposed new Guidance on Funding and Liquidity Risk Management. While the proposed 17-page liquidity guidance has not received much attention, issuance of this document is significant. These guidelines, like the FFIEC 2006 CRE guidelines, will be the standard against which banks are judged at future examinations; these guidelines provide the agencies with the ability to evaluate more critically a bank’s liquidity and cite bankers for contraventions of the guidelines when the regulators’ expectations are not met.
Capital
One of the reactions to the S&L debacle was new federal legislation making capital king. It was this legislation that led to the Prompt Corrective Action capital guidelines. The current crisis has again caused regulators and the industry to focus on capital. The Administration’s Reform proposal calls for the strengthening of capital and a reassessment of existing regulatory capital requirements. Further, the FDIC’s publication, “A Year in Bank Supervision: 2008 and a Few of Its Lessons,” states that “another issue receiving attention from financial regulators in the wake of this crisis is capital adequacy regulation. Concerns have been raised about the quality of bank capital…, whether banks have sufficient common equity as compared to debt-like or other instruments that qualify as regulatory capital….” Indeed, on July 13 the Basel Committee on Banking Supervision announced that it has agreed in principle to three important initiatives - the introduction of a leverage ratio as a “backstop” to the Basel II floor requirements, promoting the build-up of capital buffers by banks which can be drawn upon in times of financial stress, and strengthening the quality of capital banks hold in their reserves.
Consumer Protection
The centerpiece of the Administration’s Reform proposal is the creation of the Consumer Financial Protection Agency, or CFPA. The CFPA would consolidate under one roof all consumer financial protection functions currently under the Federal Reserve, OCC, OTS, FDIC, FTC, and NCUA. The industry and Federal Reserve have raised concerns over the structure, questioning whether it is prudent to separate safety and soundness supervision from consumer regulation and enforcement. Federal Reserve Chairman Ben Bernanke testified that “both the substance of consumer protection rules and their enforcement are complementary to prudential supervision. Poorly designed financial products and misaligned incentives can at once harm consumers and undermine financial institutions.” If such separation occurs, banks will most certainly experience inconsistent regulatory mandates and increased costs.
Business Plans, Products, and Services
Regulators historically have been careful to avoid dictating what products and services should be offered by banks or to mandate specific underwriting standards, recognizing that to do so can result in the regulators crossing the line and managing banks. Also, it is difficult to have a set of rules that fits banks of all types and sizes. This mindset has changed. Enforcement actions increasingly order banks to get out of certain lines of business, recent legislative proposals promote more direct government approval of particular bank products and services, and the regulators have questioned certain bank business models, e.g., a lawsuit is pending in Oklahoma testing the ability of the FDIC to mandate that a bank change its business model, a model which the bank contends complies with all current laws and regulations. Further, the FDIC publication noted earlier in this article states that “a future focus of supervision…may well include a careful look at where the line should be drawn between guidance and informal supervisory expectations on the one hand, and more tangible requirements on the other.”
Takeaway
Our world has changed, and we will not return to what many of us consider to be “normal.” The rules of the game are evolving, and it appears we are returning to the past views on liquidity, looking at increased capital levels (with renewed focus on common equity), and heading down a path of greater government oversight/intervention as to the products and services offered by banks to the public. All of this will have a cost and change the economics of banking. While many are asking for further study before additional legislation and change, the “train has left the station,” and change is already happening - regulatory agencies are moving forward with changed expectations whether new legislation is passed or not. Bankers need to be cognizant of these changes as they determine their business strategies, capital needs, and funding plans.