When All The Examiners Left

What would happen if all the bank examiners left?

In 1983, the ninth district of the Federal Home Loan Bank lost almost all of its examiners when the office hastily relocated from Little Rock, Arkansas, to Dallas. The move was the culmination of a campaign from congressional and business efforts beginning in the 1950s, the efforts of which had previously been staved off by Arkansas’ representatives.

In response, 37 of 48 employees in the department of supervision chose not to relocate and left, according to Washington Post archival articles; the remaining 11 were mostly low-level administrators. The two remaining field agents split monitoring almost 500 savings and loans across a 550,000 square-mile area.

The move was capricious, political, expensive and, ultimately, disastrous.

The result was a rare natural experiment that explores the importance that bank supervision plays in regulation and enforcement, according to a recent fascinating paper published by Federal Reserve Bank economists John Kandrac and Bernd Schlusche.

The situation became so bad that the Federal Home Loan Bank Board in Washington implemented a supervision blitz in 1986, sending 250 supervisory and examination staffers from across the country to conduct intensive exams in the region. The number of exams conducted during the six weeks was more than three times the number performed in 1985; for many institutions, it was their first comprehensive exam in two or three years.

Here are several takeaways from the paper.

Major Setback to Supervision
The dramatic loss of expertise within the supervision division plagued the FHLB’s ninth district for at least two years. Even though Dallas is the region’s financial capital, it would take years to tutor supervision trainees to the level of the departed senior examiners. The other option the bank had was trying to poach examiners from another region or agency, which creates deficiencies of its own.

When the Cat’s Away, the Mice Will Play
The paper finds that less intensive supervision and less frequent supervision comes with some risk to the stability of institutions.

Unsupervised thrifts increased their risk-taking behaviors and appetites compared to both thrifts outside the region receiving regular examinations and commercial banks in the region. They grew “much more rapidly” by entering newly deregulated and riskier lending spaces, funded the growth with funds like brokered deposits and “readily engaged in accounting gimmicks to inflate their reported capital ratios.”

“[A]ffected institutions increased their risky real estate investments as a share of assets by about 7 percentage points. The size of the treatment effect is economically large,” the paper finds, adding later: “Our results are consistent with the hypothesis that risk taking is a function of supervisory attention.”

Some of this risk-taking led to insolvency. The paper found that the lack of supervision activity led to about 24 additional failures, which cost the insurance fund about $5.4 billion – over $10 billion in 2018 dollars.

Someone Needs to Enforce the Rules
Rules alone were insufficient for these institutions to manage their risk. The paper stresses the role that examiners play in effective enforcement of regulation – an issue that has taken on renewed relevancy given both a lengthening of the examination cycle to 18 months for some community banks and the changes in in-person visits due to the coronavirus pandemic.

Bank supervisors have many tools – formal and informal – by which they can influence a bank’s behavior. The paper notes how regular interactions and conversations, coupled with power of bank regulation itself, seem to be more effective at curbing or correcting risky behavior at banks than self-regulation alone. The six-week supervision blitz in 1986 led to a 76% increase in enforcement actions compared to the year prior, as well as management replacement actions, liquidation requests and 500 criminal referrals to the Department of Justice.

“[S]upervision and examination matter even for what many considered to be the most ineffectual supervisor in the United States. Therefore, even if the importance of supervision has diminished over time on average, we should still expect modern supervisors to meaningfully limit bank risk taking,” the paper reads.