Bank supervision is a longstanding practice intended to ensure we have a safe and sound banking system. Experienced bank supervisors can provide informed and focused feedback to banks, supporting banks’ efforts to operate successfully in a dynamic economy. The benefit of appropriate supervision is clear: a safely-run bank delivers for its customers and communities. What if, however, supervision becomes broken, unfocused, and excessive? Like incorrect or excessive medication, there is an increased risk of adverse side effects. In recent years, the signs of those effects have become increasingly clear and pervasive. Bank supervision has strayed from its core objectives, and banks of all sizes are experiencing those side effects. The results are not good, and they ironically may be reducing safety and soundness. Given the critical importance of the banking system to our nation’s shared prosperity and growth, we need to get back to a rigorous but sensible approach to bank supervision and we must not wait.
Four broad changes must be vigorously pursued to bring supervision back to its core mission: focus on material risks, respect the boundary between supervision and regulation, provide for effective challenge, and improve efficiency in supervision.
Getting Back to the Core Mission: Restore Focus on What Matters
Fundamentally, the objective of supervision is to ensure that banks operate in a safe and sound manner. Supervisors review the activities of banks and assess whether the firms are complying with laws, a raft of regulation and other guidance. They also assess whether firms are properly managing risks associated with proper funding (e.g., capital and liquidity), operations (e.g., cyber resilience), and financial crime (e.g., money laundering) to name a few. Outsized risks, if poorly managed, can imperil a bank’s safety and soundness. To be effective, bank regulators must focus their resources on those bank practices that have a clear and material bearing on a bank’s financial risks and soundness.
The recent failure of Silicon Valley Bank (SVB), and the resulting reports that detail the failures leading up to its collapse, clearly demonstrates the costs of losing supervisory focus. The Federal Reserve’s report on SVB details 31 distinct issues that were flagged by supervisors for remediation prior to its failure. Of those 31 issues, a significant majority – 20 out of 31 – fell under the rubric of “Governance and Controls”. Governance and Controls covers a range of largely process-driven issues that, while not irrelevant, do not relate to the core banking function that drives safety and soundness. A review of the SVB report shows that the Governance and Controls issues identified by supervisors included “data governance,” “vendor management,” and “IT asset management.” Unfortunately, only a relatively small share of supervisory findings related to the core capital and liquidity issues that were at the heart of SVB’s collapse.
The lesson learned from SVB cannot be overstated, must not be forgotten, and must inform near-term supervisory reform efforts. Bank supervisors do not have limitless resources. The resources stewarded by bank supervisors must be focused on activities and practices that go directly to a bank’s safety and soundness. In his recent Congressional testimony, Chair Powell reflected on the key problem at SVB. In response to a direct question about SVB, he offered that “what happened was, I would say a lot of focus on process and on governance and controls and not enough focus on basic bread and butter banking, credit risk, liquidity, risk, interest rate risk, things like that.” Bank supervision can be significantly improved and made more efficient by heeding these words and re-focusing supervision on what truly matters.
Finally, in fixing one mistake and re-focusing supervision on materiality, it is important not to make another, even more costly mistake. Supervisors should not engage in “Monday morning quarterbacking” of bank decisions. Supervisors should ask questions and seek to understand why bank management makes certain, material risk decisions, but a drive to understand should never be allowed to morph into a drive to supplant bank management. It can indeed be tempting for supervisors to inject their own views considering all the context and information that is being provided as part of the supervisory process, but that temptation must be actively avoided. Supervisors are not bankers and are not in the business of providing “consulting advice” to bankers. Rather, bankers and supervisors must respect the relevant expertise and role of the other party as they work together in the supervisory process.
Stick to Your Knitting: Respecting the Boundaries Between Supervision and Regulation
Bank supervisors have an important job to do; they are charged with the critical task of assessing whether banks comply with existing regulations supporting bank safety and soundness. Bank supervisors are not charged with making new regulations or otherwise adjusting or tweaking existing regulations based on their views of bank practices. Regulatory staff have a different charge: they devote significant time, attention, and resources to the policy formation process. Their work is subject to public review and comment before implementation. For good reason, regulation is a distinct and separate function from the supervision function and their boundaries must be respected. Supervisory findings may, when subject to appropriate public transparency standards, inform the regulatory process, but supervisory judgement should not replace the existing, open, and transparent policy process. Private guidance or other directions by supervisors that results in a de-facto regulatory change runs counter to long-standing, good public policy and risks reducing the effectiveness of supervision.
Much of supervision occurs through observation of practices across a set of banks followed by suggestion and comment. Such “horizontal reviews” of bank practices, when well executed, can be a useful input to the supervisory process. At the same time, using the findings of those reviews to require or vigorously “suggest” policy changes in bank practices provides no opportunity for public review and comment and breaches the boundary between supervision and regulation.
Let’s Go to the Replay Center: Providing for Effective and Non-Contentious Challenge
Professional sports have been transformed over the past 25 years by the introduction of video review. The use of video review reflects the fact that referees are human and make mistakes that they cannot self-identify in real-time by dint of the fact that they are… human.
The same issue arises in the case of supervision. Often, there are differing views on complex financial and regulatory issues. For example, did he swat the basketball away before or after it reached its maximum height? In such cases, supervisors should be accepting of and even invite effective challenge. An effective challenge of an existing view requires one to rigorously re-evaluate their position and ultimately improves the quality of the viewpoint and any decision tied to it.
Moreover, supervisors often simultaneously play the role of “judge, jury, and executioner”. The supervisory agency is responsible for establishing the rules, supervisors judge adherence to those rules, and the supervisory agency will mete out any penalties or other consequences for any violation of those rules. As a result, it is all the more important that supervisors institute and actively encourage the ability of a firm to challenge a supervisory finding.
An effective challenge mechanism would allow firms to seek a third-party review of a supervisory finding or interpretation that it believes to be made in error. To be clear, a third party may be a representative of the supervisory agency but should not be anyone that is directly connected to the issue being challenged. Such reviews must be received in good faith by supervisors and must not come with the fear – real or perceived – of reprisal. The challenge mechanism must be predictable and efficient. The process to escalate and resolve a challenge must be clear to all parties, not subject to change on a whim, and should be concluded within a reasonable timeframe so that things don’t linger interminably.
Making the Trains Run on Time: Elevating the Importance of Efficiency in Supervision
Beyond focusing too much on immaterial matters, the case of SVB also demonstrated that a lack of efficiency and overly cumbersome bureaucracy in supervision can have tragic consequences. In the case of SVB, supervisors did identify the key lack of liquidity risk management that ultimately led to its downfall. Tragically, however, supervisors did not act decisively or deliberately to get ahead of the problem before it was too late. Rather, untold rounds of meetings and briefings were held without providing specific and actionable feedback to SVB management. By the time the liquidity risk crystallized, it was too late to address the long festering problem, and the firm collapsed.
This incident should serve as a parable to illustrate a broader truth. Efficiency matters. Sitting on the right answer until it is too late is worse than having no answer at all. More broadly, supervision should be designed at the outset to be effective. Effectiveness means providing feedback in a reasonable time frame and then laying out clear, transparent, and actionable steps that can be taken to address the issue.
The supervisory process must be designed to be as efficient as possible. As an example, supervisory communication can often be long and drawn out. Supervisors may conduct an exam and then take several months formulating and processing the results before any feedback is provided to firms. Finally, supervisory findings may not come with clear, actionable steps that can be taken to address the identified issue. Rather, supervisory communication may be too “high-level” or “principles-based” to be of much practical use.
A move to greater efficiency in supervisory communication would promote a frank and healthy exchange of views. In the vein of “if you see something, say something”, a quick and direct communication shortly following identification of a supervisory issue is likely to elicit an informed and genuine response as the issue will likely still be top of mind for management. Shrouding each and every communication in an overly elaborate, formal and formulaic response deadens the senses and limits the scope for productive engagement.
A re-invigoration of the supervisory process with a drive for greater efficiency will improve the quality and quantity of supervision and firm engagement. With clearer and more transparent communication, signposts, and remediation action steps, firms will realize that they have greater agency and will be incentivized to productively and collaboratively contribute to the supervisory process.
The Road Ahead: How Do We Get Where We Need to Go?
We have laid out four key supervisory reform areas:
Refocus supervision to focus on issues of significant materiality to safety and soundness.
Respect the boundary between supervision and regulation.
Provide for effective challenge of supervisory determinations.
Elevate the importance of efficiency in the supervisory process.
Each of these changes is critical to reforming bank supervision. Together, these changes amount to a real cultural shift in supervision. Culture change is both notoriously difficult and spectacularly rewarding when achieved. Manifesting a real culture change will require an “all of the above strategy” that seeks to change both informal, internal processes and executive organization of supervision, as well as changes to the regulatory framework that governs how supervision is conducted.
In some cases, new regulations are called for to enact the needed changes. Durable changes to a policy regime require formal changes to the “rules of the road” to establish and publicly signal a permanent shift in thinking and behavior. As an example, establishing an effective challenge system is one example where changes to regulations are likely required.
But culture does not change by fiat alone. Put differently, you can’t regulate people into thinking differently. To affect a durable and genuine change in supervisory culture, the internal, and necessarily informal, organization and administration of supervision must change. The organization and number of supervisory committees, standards of practice around supervisory examination and communication, and expectations around how supervisors engage with bankers on a day-to-day basis will most efficiently and effectively be reformed by changing internal processes and procedures that reset the cultural baseline that determines “how supervision is done”.
Getting Started: No Time Like the Present
Effective and efficient supervision is critical to the safety and soundness of our banking system, along with the growth and American competitiveness it supports. Our members are committed to working with supervisors to support a safe and sound banking system that works for everyone. The areas of reform detailed above represent common sense changes that would bring focus and efficiency. They are supported by the collective experience of our members as well as the recent example of Silicon Valley Bank. As the collapse of SVB made clear, the conduct of supervision can have a first order impact on bank safety and soundness. Our expectation is that supervisors will immediately begin the process of implementing reforms that will have a durable and positive impact on the banking system and our economy.