Current Legal Issues Affecting Central Banks, Volume IV.

11C. Report from the Office of the Comptroller of the Currency: The Future of Bank Supervision

Robert Effros
Published Date:
April 1997
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This paper addresses how bank supervision must change and how the Office of the Comptroller of the Currency (OCC) is engaged in changing it. Supervision is not a new interest to the OCC, which has been supervising banks for 130 years,1

Evolution of Bank Supervision

Because society and the economy evolve, banking and bank supervision must also evolve in tandem. Just as the failure to evolve makes banking less relevant to the needs of the economy, so does the failure to evolve make bank supervision less efficient in assuring financial intermediation in the economy. Bank supervision must therefore be a dynamic process—not just a static structure applying rigid laws and rules. There can never be a single answer as to what is the best way to regulate banks. The answer changes as circumstances change.

For the past several decades, the economy and the financial services sector have been in constant change, both in the United States and globally. Although the banking industry in the United States is closely regulated, it has also been partially deregulated by fits and starts. Bank supervisors have had to work hard and think hard to keep abreast of these changes. It is fair to say that, since the end of the 1970s, banking has experienced something of a deregulatory revolution. First, there has been interest rate deregulation. This deregulation addressed money market deposit accounts, which developed in response to the securities industry. Even before the recent legislation,2 there was actual, de facto interstate banking through regional banking compacts. Usury ceilings were eliminated for certain loans. Discount securities brokerage has emerged. The list of innovations—which are remarkable—can go on for quite a while.

As a result of these changes, banks can engage in a far wider range of activities than were possible 20 years ago. This expanding range of activities has placed new and substantial demands on bank supervisors—demands that the supervisory system has not always found easy to meet. For example, supervisors have had difficulties in accurately measuring the extent of bank diversification and the effect of diversification on risk. Moreover, the task of monitoring and assessing off-balance-sheet activities—a somewhat new exercise for supervisors—has proved to be quite challenging. Supervisors have also struggled to come to grips with accurately measuring an institution’s overall risk in a cost-efficient manner. The newest wrinkle is the identification of risk by distinguishing between true hedging and plain, old-fashioned speculation in some of the new instruments.

It is probably fair to say that the biggest challenge in public policy is to restore and maintain a dynamic balance among the business of banking, bank supervision, and the demands of a market economy. To meet the demands of the economy, banks must remain competitive; however, the lesson of recent history is that regulatory and statutory developments that enhance bank powers must proceed hand in hand with supervisory reform. Without adequate supervision, including effectively monitoring bank activities, enforcing regulations, closing institutions, and attending to possible sources of systemic risk, expansion of the banking franchise carries with it implications for the deposit insurer and for the economy as a whole that are potentially unacceptable.

How best to supervise a banking industry whose activities continue to expand has been the subject of much recent debate, with opinions sometimes clustering around two extremes. On one extreme, advocates argue that supervisors can structure the corporate form of financial institutions in a way that insulates not only its banking component but also, as in the U.S. system, the Bank Insurance Fund and even, to some extent, the economy. Advocates on the other extreme argue that only a highly developed supervisory system is appropriate, where supervisors monitor all risks with a view to limiting them effectively. In the real world, supervisory practices fall between these two extremes, and the business of making supervisory policy centers very much on where to draw that line.

The constant change in banking calls into question the effectiveness of any regulatory scheme based primarily on the idea of corporate separation. The illusion of insulating a bank against risk through corporate structure is arguably a concept of theoretical simplicity and elegance, as well as of regulatory minimalism. However, while corporate separation may be a necessary condition of risk management, it is, standing alone, usually not sufficient. In the long run, markets will erode the barriers anyway, and, in the short run, expedience may lead bankers simply to ignore them until something comes along that forces them to take notice.

OCC’s Approach

While the OCC certainly agrees that the close monitoring of risk on a daily basis is important, it does not believe that the “hands-on” approach means that supervisory processes should replace bank management. Rather, the OCC would like to add two refinements that factor bank management into the supervisory equation. The first refinement raises four questions. The initial question is: Is the new activity legal? The next three questions come only after the lawyers have given their opinion on the first question. These three questions are concerned with supervision: Can the risk of new activity be adequately monitored? If so, can monitoring be verified by the supervisors, management, and directors? Finally, can the risk be managed? If the answer to any one of these questions is no, supervisors should take a hard look at the new activity before allowing banks to get involved with it in a larger way.

The second refinement that the OCC has injected into the analysis is the suggestion that bank supervisors should concentrate their attention and their resources on risks with greater potential implications for the economy and the Bank Insurance Fund. These risks usually fall into two categories: the sudden, usually unexpected, collapse of confidence in a significant portion of the banking or financial system; and new product trends and other developments that may affect large portions of the industry and carry substantial safety and soundness implications for the banking industry. Todate, the approach of bank supervisors has been primarily ad hoc and crisis driven. The OCC is striving to change that approach. It is engaged in a variety of initiatives to refocus its supervisory effort to address these risks more consistently and in a more timely manner.

One practical implication for daily examination procedures is to focus on risks depending on the size of a bank. In supervising large banks, the complexity and types of activities of these banks obviously pose greater systemic risk than do the activities of smaller banks. For each of the largest banks, the OCC now develops an individual risk profile, based on all the risks that the bank undertakes. The OCC then tries to determine whether the risks are appropriate for that institution, given its resources, and whether the controls that the institution has in place are appropriate to control those risks. Stable banks in small communities that are engaged in traditional banking activities also tend to have a common risk profile. For these reasons, the OCC will soon begin examining these small banks against a common standard of performance, rather than against the more intensive and intrusive managerial standards that have been used so far.

What does the future hold for banking? The OCC wants to ensure that it holds a system of bank supervision that addresses the growing complexity and technical sophistication of the industry.

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