Community Banking Connections

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Board Staff Perspective on Community Bank Supervision: One Size Doesn't Fit All
by Maryann Hunter, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System

One of the recurring features of Community Banking Connections is a series of "View from the District" articles, which offer valuable perspectives from the officers in charge of supervision at the various Federal Reserve Banks across the United States. These articles provide local insights from key Federal Reserve leaders on a wide range of topics that are pertinent to community bankers. In this issue, we decided to provide a "View from Washington" to share some perspectives from the Federal Reserve Board's staff in Washington, D.C., on the Federal Reserve's community bank supervision program.

Although this article focuses on the view from Washington, I also have personal experience with the boots-on-the-ground operations of the Federal Reserve Banks. I began my career at the Federal Reserve Bank of Kansas City as a community bank examiner in 1981 and eventually became the officer in charge of bank supervision for that Reserve Bank. I also served as the branch manager in charge of bank operations at the Denver Branch of the Kansas City Reserve Bank. I joined the Federal Reserve Board's Division of Consumer and Community Affairs in 2006 and then the Board's Division of Banking Supervision and Regulation in 2010. During my 30-plus years of Federal Reserve service, I have seen just how important community banks are to their local economies and how critical it is that we supervise community banks effectively and efficiently.

Just What Do We Do at the Federal Reserve Board?

When I meet with bankers, I am often asked to describe how the role of the Federal Reserve Board compares with that of the 12 Federal Reserve Banks with regard to bank supervision.¹ Broadly speaking, while the Board and the Reserve Banks work together closely, the Board is responsible for policy and program development and program management for bank supervision, whereas the Federal Reserve Banks conduct day-to-day supervision of financial institutions on a delegated basis. The Federal Reserve Banks and the examiners who work there are the face of the Federal Reserve's supervision program, especially when it comes to community bank supervision. Each of the Reserve Banks has detailed knowledge about banking and financial conditions in its respective District. Because the Board oversees and communicates regularly with the Reserve Banks, one of our key responsibilities is to synthesize this local knowledge and provide a national perspective on banking conditions and emerging risks.

The Banking Industry Is Looking Healthier

Our staff closely monitors the overall health of the banking system. What we have seen recently is that the overall condition of community banks has improved significantly in the wake of the financial crisis, although the business model remains under strain. The number of banks on the Federal Deposit Insurance Corporation's "Problem List" fell from a peak of 884 in December 2010 to 467 at year-end 2013.²   Despite the decline, that number of problem banks compares unfavorably with historical averages of less than 100 in the years prior to the crisis.

Overall, capital levels and asset quality at small banks have improved in recent years, especially when comparing recent financial indicators with the lows that were reached during and after the financial crisis. The aggregate tier 1 risk-based capital ratio for community banks was 14.7 percent at year-end 2013, up from a low of 12.0 percent at year-end 2008, and the aggregate leverage ratio was 10.4 percent, up from a low of 9.2 percent at year-end 2009.³   Noncurrent loans represented 1.9 percent of total loans at year-end 2013, down significantly from a peak of 4.1 percent at year-end 2010, while net charge-offs as a percent of average loans were down to 0.4 percent at year-end 2013, from a high of 1.6 percent at year-end 2009. Moreover, community banks saw an uptick in lending in 2012 and 2013, with annual year-over-year loan growth of 2.5 percent at year-end 2013. This is in stark contrast to the period from 2009 through 2011 when total loans declined each year. We are hopeful that this lending is a sign of increased economic activity.

Earnings have benefited in the past couple of years from reductions in provision expenses for loan and lease losses, but this benefit has waned recently. Community banks had an aggregate return on average assets of 1.07 percent at year-end 2013, which is below precrisis levels but represents a significant improvement over relatively anemic earnings reported from 2008 to 2011. Net interest margin pressures remain an issue for all banks, but particularly for smaller banks. Finally, liquidity levels at community banks are adequate, as banks are generally well stocked with core deposits and dependence on noncore sources is relatively low.

Enhancing Community Bank Supervision

As community banks return to health and crisis management thankfully takes up much less of our time and energy, it seems appropriate to step back and take stock of our community bank supervision program. As Federal Reserve Board Chair Janet Yellen discussed recently in a speech to community bankers, it is critical that we avoid taking a one-size-fits-all approach to supervision.⁴ While the Federal Reserve has long tailored approaches relative to the size, complexity, and risk profile of the banks we supervise, we are very aware that what makes sense for large, systemically important banks does not typically make sense for community banks. With that in mind, let me share some thoughts on how we are trying to enhance our community bank supervision program.

For starters, the Federal Reserve's longstanding risk-focused consolidated supervision program provides that examination and inspection procedures should be tailored to each organization's size, complexity, risk profile, and condition. Reviews of banks and holding companies, regardless of size and complexity, entail:

• an evaluation of the adequacy of governance provided by board and senior management, including an assessment of internal policies, procedures, controls, and operations;⁵
• an assessment of the quality of the risk management and internal control processes in place to identify, measure, monitor, and control risks;
• an assessment of key financial factors such as capital, asset quality, earnings, liquidity, and sensitivity to market risk (including interest rate risk); and
• a review for compliance with applicable laws and regulations.

The way these reviews are conducted, however, differs significantly across portfolios of banking organizations.⁶

Tailoring Supervisory Policies

There are distinct differences between the supervision programs for large and small banks. For one, large banks are under a continuous supervision model, whereas small banks receive point-in-time examinations. Large banks generally have a dedicated supervisory team that may reside at that bank. By contrast, small banks may meet with an examination team only every 18 months, depending on their condition. Large banks are also subject to more stringent regulatory requirements, as seen with the recent rulemakings implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Federal Reserve Board continually strives to make sure supervisory policies are appropriate and calibrated in a way that makes sense for community banks.

We recognize that regulatory burden tends to fall disproportionately on smaller banks; therefore, we are being careful to write rules and guidance so as not to subject community banks to requirements that would be unnecessary or too difficult to implement. To give just one example, the Federal Reserve and the other banking agencies have made clear that the stress testing requirements for large banks do not apply to community banks.⁷ Moreover, to make it easier for community bankers to navigate the lengthy regulatory capital rules and the Volcker rule, the Federal Reserve, along with the other federal banking agencies, has developed guides outlining the specific provisions of these rules that are most relevant to community banks.⁸

The Board is also providing additional clarity on the applicability of supervisory policies to community banks. When we are developing new policies, we always ask ourselves explicitly whether they should apply to community banks. For Supervision and Regulation (SR) letters, which are the primary way in which the Board issues supervisory guidance to bankers and examiners, we include an applicability statement at the beginning of these letters to clarify which banks are subject to the guidance, with a special focus on community banks (see box below). This additional clarity not only allows community bankers to focus their efforts on the supervisory policies that are applicable to their banks but it also helps to reduce the chance that examiners will inadvertently subject community banks to large bank expectations.

The Future of Community Bank Supervision

In addition to these enhancements to the supervisory policy development process, the Federal Reserve is taking additional steps to review and enhance our community bank supervision program. For one, the Federal Reserve is conducting what we are calling a "zero-based review" of the community bank supervision program to make sure this program and related supervisory guidance are appropriately aligned with current banking practices and risks. This project consists primarily of a review of all existing supervisory guidance, such as SR letters, that apply to community banks to determine whether the guidance is still relevant and effective. As a result of this review, we are likely to eliminate some guidance that is no longer relevant and to revise other guidance to bring it in line with current supervisory and banking industry practices.

Second, we are using bank regulatory reporting data more effectively to enhance off-site surveillance, identify emerging risks, and tailor on-site examination procedures. Third, we are developing and implementing common technology tools across the Federal Reserve System for use in our community bank supervision program that will improve efficiency and reduce the burden on supervised banks. Finally, we are investigating the possibility of conducting more off-site examination activities, including loan review work for banks that have invested in technology that would allow us to do so. This effort is discussed in more detail in the article titled "Federal Reserve Seeks to Conduct More Loan Reviews Off-Site," which also appears in this issue.

Examples of Applicability Statements

SR Letter 14-4, "Examiner Loan Sampling Requirements for State Member Bank and Credit Extending Nonbank Subsidiaries of Banking Organizations with $10-$50 Billion in Total Consolidated Assets"
Applicability: This letter does not apply to institutions supervised by the Federal Reserve with $10 billion or less in total consolidated assets.

SR Letter 13-25, "Interagency Statement Regarding the Treatment of Certain Collateralized Debt Obligations Backed by Trust Preferred Securities Under the Volcker Rule"
Applicability: This guidance applies to all institutions regulated by the Federal Reserve, including those with $10 billion or less in total consolidated assets.

As we develop supervisory policies and examination practices, we are mindful of community bank concerns that new requirements for large banks could be viewed as "best practices" and trickle down to community banks in a way that is inappropriate.⁹ To address this concern, the Board is enhancing its communications with examination staff about expectations for community banks versus large banks to ensure that expectations are calibrated appropriately. Along this line, we also routinely conduct horizontal reviews of Reserve Bank practices to promote consistency and to clarify expectations with respect to the examination process.

Concluding Thoughts

In closing, we at the Board have a keen understanding of the important role that community banks play in the economy and the financial system. We are well aware that supervisory expectations for the largest, most complex firms are often inappropriate for community banks, and we are committed to ensuring that large bank expectations are not applied to community banks when it does not make sense to do so. Rigorous supervision is still critically important, but I believe that we must also take a balanced approach that fosters stable, sound, and vigorous community banks.

The author would like to thank Jinai M. Holmes, senior supervisory financial analyst, Policy Implementation and Effectiveness, Division of Banking Supervision and Regulation, Board of Governors, and T. Kirk Odegard, assistant director, Policy Implementation and Effectiveness, Division of Banking Supervision and Regulation, Board of Governors, for their contributions to this article.