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Community Bank Supervision: Facilitating "Right-Sized" Supervision for a Diverse Portfolio
by Kevin J. Stiroh, Executive Vice President, Supervision Group, Federal Reserve Bank of New York

At the Federal Reserve Bank of New York (New York FRB), we supervise a diverse range of financial institutions in the Second District. This includes small community banks of significant importance to their communities and local economies, as well as some of the largest and most systemically important banks in the United States. The diversity in financial institution size and complexity provides us with a unique perspective that a one-size-fits-all methodology for supervision is not an optimal approach. As discussed widely in recent years, we need to tailor our supervisory approach to the risks of individual institutions in order to be as effective as possible.

Overview of the Second District

The Second District covers New York State, northern New Jersey, southwestern Connecticut, Puerto Rico, and the U.S. Virgin Islands.¹ The financial institutions range in size from $30 million to more than $2 trillion in total assets at the consolidated organization level.

The Federal Reserve defines community banking organizations (CBOs) as those financial institutions with total consolidated assets of less than $10 billion. As of June 30, 2019, the Second District had 197 CBOs with assets totaling $294 billion. Of those CBOs, 17 are state member banks with the Federal Reserve serving as their primary federal regulator.

The Second District state member banks had approximately $28 billion in consolidated assets as of June 30, 2019, or an average of less than $2 billion in assets per firm. Our largest state member bank has total consolidated assets of approximately $5 billion and the smallest has approximately $30 million. The majority of Second District state member banks are headquartered in upstate New York; the rest are in areas surrounding New York City.

The business models for the state member banks primarily include traditional banking activities, such as retail deposit acquisition and retail and commercial lending. Several are also engaged in, or evaluating, business activities outside of the core lending and deposit-taking activities. For example, some engage in asset wealth management and trust activities, and others are active in the cryptocurrency markets. It is notable that while Second District state member banks serve a diverse set of consumers and businesses in many industries, when compared with other Federal Reserve Districts, the Second District state member banks have a lower concentration of agricultural lending and a higher concentration of commercial real estate (CRE) lending.

Second District community state member banks are predominantly closely held private institutions. From a supervisory perspective, this type of ownership structure requires careful succession planning among family members. Issues frequently discussed with bank management include key-person risk, planning for the next generation of leadership, and remaining closely held.

Fostering a Robust Dialogue

A key strategy that informs the New York FRB’s community bank supervisory approach is an ongoing dialogue with local bankers. This dialogue supplements insights gained from supervisory activities and enables a deeper understanding of current and emerging themes impacting these banks and the communities they serve.

The New York FRB utilizes recurring and ad hoc outreach initiatives to encourage such dialogue and receive firsthand accounts from bankers in the Second District. For example, since 2002 the New York FRB has hosted its annual Community Bankers Conference. At this signature event, supervisors have the opportunity to interact with community bankers and learn about significant opportunities and challenges for their businesses and communities. The conference brings together community bank stakeholders from across the Second District and enables conversations that inform diverse views and perspectives. The two most recent conferences focused on the changing environment for community banks, with the 2018 theme of “Navigating Future Risks for Community Banks”² and the 2019 theme of “On the Horizon for Community Banks.”³ I find these conferences and related dialogue to be extremely valuable and an important part of our supervisory responsibilities.

Second District CBO Themes

These bankers conferences and recurring supervisory interactions provide insights into what is on the minds of community bank management and directors. The current state of regulation, the economy, and the evolving competitive environment are prominent macro themes in these conversations. More specifically, bankers have highlighted:

• Investment in technology. The most prominent and recurring theme in our conversations is technology and a desire to invest in the enhancement of client service delivery, administrative efficiency, and financial processes. A key consideration for CBOs regarding technology investment is the need to balance potential benefits of the investment with the costs of the technology investment relative to the size of the CBO.

• Acknowledgment that the world is rapidly changing. Changes in the banking environment are attributable to technological change, demographic change, and generational change. CBOs recognize the increased competition from banks and nonbank entities and the millennial generation’s technological preferences and proficiencies. These are key trends to consider during a CBO’s strategic planning initiatives.

• Delivery of traditional business in new and innovative ways. New York FRB supervision staff receives an increasing number of inquiries relating to mobile banking and other internet-based methodologies for enhancing client service offerings. The inquiring banks express a desire to provide value-added services to their customers but acknowledge that adding mobile and internet capabilities creates additional risks, most notably in the context of cybersecurity. The enhanced digital offerings provide an opportunity for community banks to match, or surpass, service offerings provided by out-of-region banks and nonbank entities that compete for the CBOs’ existing customers.

• Understanding of fintech and its impact on banking. Technology investment conversations often touch on fintech and how emerging or disruptive technologies present both threats and opportunities for the CBO landscape. Moreover, this mix can vary across business lines and geographies. Second District CBOs are in the early phase of evaluating fintech opportunities, including strategic partnerships.

• Exploration of nontraditional lines of business. Community bankers have noted that emerging technologies, and changing regulatory and legal environments, have created opportunities to enhance existing service offerings or develop new service offerings for clients. Recent examples of inquiries from Second District community banks have been related to providing cryptocurrency services.

• Compliance with regulatory and accounting standard changes. Community bankers are concerned about meeting expectations relating to current expected credit loss (CECL) implementation.⁴ The Federal Reserve conducted outreach events such as “Ask the Fed” webinars and other mechanisms to support the implementation of CECL. Importantly, the Federal Reserve Board has also implemented a three-year phase-in for CECL implementation, which will allow for monitoring as the new accounting standard from the Financial Accounting Standards Board (FASB) goes into effect. On October 16, 2019, the FASB voted to extend the CECL implementation timeline for smaller reporting companies to fiscal years beginning after December 15, 2022. The Federal Reserve will continue to provide Q&A support on this topic for bankers.

We will continue to engage with bank management and directors to stay informed on emerging themes relevant to the communities they serve and the Second District. These themes help us identify key areas of supervisory focus when planning examinations.

Risk-Based Supervision

The diversity of Second District community banks can be observed across many dimensions: asset size, earnings, number of branches, and many other financial, strategic, and geographic factors. As a result, we use a tailored supervisory approach for each bank based on its risk profile.

The Economic Growth, Regulatory Relief, and Consumer Protection Act, also known as S.2155, became law on May 24, 2018. The Federal Reserve Board has implemented provisions of the legislation that affect community banks, including:

• raising the total asset size threshold for banks to qualify for an 18-month examination cycle from $1 billion to $3 billion;⁵
• streamlining the regulatory reporting requirements for firms with less than $5 billion in assets by introducing the FFIEC 051 short form Call Report;⁶
• excluding community banks from the Volcker rule;⁷
• raising the asset threshold for the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement to $3 billion in total consolidated assets;⁸ and
• adopting the community bank leverage ratio that will enable banks meeting certain criteria to qualify to utilize a simplified capital adequacy framework.⁹

The Federal Reserve has also introduced the Bank Exams Tailored to Risk (BETR) program¹⁰ to tailor state member bank examinations to reflect the level of risk present at the supervised institution. BETR is a risk-focused program aimed at streamlining supervisory work programs for low-risk activities while providing more supervisory focus on high-risk activities. Our expectation in the Second District and throughout the Federal Reserve System is that BETR will ease the examination process for well-managed banks with appropriate risk management processes and allow us to use a tailored approach that is better suited to the unique characteristics of each bank. The recent changes align the supervisory approach with the conclusion that there is not a one-size-fits-all approach.

We strive to achieve the balance between regulatory efficiency while being vigilant to bank-specific and System-wide risks. As part of our supervisory work, we are closely monitoring the following risk themes:

• Continued growth in CRE lending. CRE lending for all Second District community banks has increased from $58 billion as of the fourth quarter of 2015 to nearly $80 billion as of the fourth quarter of 2018. That is an aggregate growth rate of 37 percent. Second District state member banks have exhibited a similar growth rate of 35 percent, increasing from $6 billion as of the fourth quarter of 2015 to more than $8 billion as of the fourth quarter of 2018.

• Improved risk management over CRE concentrations. The demographics of the Second District, particularly the New York City metropolitan area and associated population density, are such that there is a high demand for multifamily housing and office space. As the aggregate CRE levels have increased, examiners have observed risk management practices that are commensurate with the growing concentration risks.

• Diversified lines of business. Second District CBOs are exploring new service offerings with the primary goal of supplementing income with fee-based revenue sources. One of the noted offerings is asset wealth management services; state member banks are now managing and administering more than $14 billion in assets related to these services.

• Liquidity risk. Second District CBO deposit balances have shown signs of competitive pressure with a shift away from more traditional deposits, as savings account balances have decreased and reliance on time deposits has increased.

• Vendor management. CBOs continue to rely on third-party service providers for support in specialty areas such as audit, loan review, and core processing. Prudent oversight of these relationships should include a clear understanding of the contractual arrangement, the roles and responsibilities of each party, and a contingency plan addressing service providers’ inability to meet contractual obligations.

Conclusion

Our supervisory and outreach approach for Second District community banks encourages dialogue and an appreciation of the unique profile of each firm.

The depth of knowledge gained by Reserve Bank staff from discussions with local bankers is invaluable. Our team accomplishes this through bank-specific discussions during examinations and periodic on-site visits, and at broader events such as our Community Bankers Conferences. My onsite visits and ongoing updates from the examination team provide excellent opportunities to better understand the market dynamics of the local community and the issues faced by bankers serving the financial needs of their communities. I look forward to opportunities to visit Second District community bankers and to learn about the unique attributes of each bank.

Our efforts to engage with Second District community banks are aligned with the following principles:

• Every Second District CBO is unique.
• The Federal Reserve System — including the New York FRB — supports tailored, risk-focused supervision for CBOs.
• The New York FRB is committed to providing forums for community bank education and collaboration.
• We support measured and controlled risk-taking at community banks.
• Community banks fill a need in today’s economy, and our supervisory efforts are intended to ensure their safety and soundness so that they can continue to play a vital role in the local economies.