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.

A Former Regulator Shares His Advice for Boards


regulator-6-13-19.pngDeveloping a positive relationship with regulators is important for any bank. How can banks foster this?

There’s no one better to answer this question than a former regulator.

Charles Yi served as general counsel of the Federal Deposit Insurance Corp. from 2015 to 2019, where he focused on policy initiatives and legislation, as well as the implementation of related rulemaking. He also served on the FDIC’s fintech steering committee.

In this interview, Yi talks about today’s deregulatory environment and shares his advice for banks looking to improve this critical relationship. He also explains the importance of a strong compliance culture and what boards should know about key technology-related risks.

Yi, now a partner at the law firm Arnold & Porter, in Washington, D.C., spoke to these issues at Bank Director’s Bank Audit & Risk Committees Conference. You can access event materials here.

BD: You worked at the FDIC during a time of significant change, given a new administration and the passage of regulatory relief for the industry. In your view, what do bank boards need to know about the changes underway in today’s regulatory environment?
CY: While it is true that we are in a deregulatory environment in the short term, bank boards should focus on prudent risk management, and safe and sound banking practices for the long term. Good fundamentals are good fundamentals, whether the environment is deregulatory or otherwise.

BD: What hasn’t changed?
CY: What has not changed is the cyclical nature of both the economy and the regulatory environment. Just as housing prices will not always go up, [a] deregulatory environment will not last forever.

BD: From your perspective, what issues are top of mind for bank examiners today?
CY: It seems likely that we are at, or near, the peak of the current economic cycle. The banking industry as a whole has been setting new records recently in terms of profitability, as reported by the FDIC in its quarterly banking profiles. If I [were] a bank examiner, I would be thinking through and examining for how the next phase of the economic cycle would impact a bank’s operations going forward.

BD: Do you have any advice for boards that seek to improve their bank’s relationship with their examiners?
CY: [The] same thing I would say to an examiner, which is to put yourself in the shoes of the other person. Try to understand that person’s incentives, pressures—both internal and external—and objectives. Always be cordial, and keep discussions civil, even if there is disagreement.

BD: What are some of the biggest mistakes you see banks make when it comes to their relationship with their examiner?
CY: Even if there is disagreement with an examiner, it should never become personal. The examiner is simply there to do a job, which is to review a bank’s policies and practices with the goal of promoting safety and soundness as well as consumer protection. If you disagree with an examiner, simply make your case in a cordial manner, and document the disagreement if it cannot be resolved.

BD: In your presentation at the Bank Audit & Risk Committees Conference, you talked about the importance of projecting a culture of compliance. How should boards ensure their bank is building this type of culture?
CY: Culture of compliance must be a focus of the board and the management, and that focus has to be communicated to the employees throughout the organization. The incentive structure also has to be aligned with this type of culture.

Strong compliance culture starts at the top. The board has to set the tone for the management, and the management has to be the example for all employees to follow. Everyone in the organization has to understand and buy into the principle that we do not sacrifice long-term fundamentals for short-term gain—which in some cases could end up being [a] long-term loss.

(Editor’s note: You can learn more about building a strong culture through Bank Director’s Online Training Series, Unit 16: Building a Strong Compliance Culture.)

BD: You served on the FDIC’s fintech steering committee, which—in a broad sense—examined technology trends and risks, and evaluated the potential impact to the banking system. Banks are working more frequently with technology partners to enhance their products, services and capabilities. What’s important for boards to know about the opportunities and risks here?
CY: Fintech is the next frontier for banking, and banks are rightly focused on incorporating technology into their mix of products and services. One thing to keep in mind as banks increasingly partner with technology service providers is that the regulators will hold the bank responsible for what the technology service provider does or fails to do with regard to banking functions that have been outsourced.

BD: On a final note: In your view, what are the top risks facing the industry today?
CY: I mentioned already the risks facing the industry as we contemplate the downhill side of the current economic cycle. One other issue that I know the regulators are and have been spending quite a lot of time thinking about is cybersecurity. What is often said is that a cyber event is not a question of if, but when. We can devote volumes of literature [to] talking about this issue, but suffice for now to say that it is and will continue to be a focus of the regulators.

Arnold & Porter was a sponsor of Bank Director’s Bank Audit & Risk Committees Conference.