Economy Matters podcast series

Lali Shaffer: Welcome to another episode of the Economy Matters podcast. I'm Lali Shaffer, senior financial specialist in our Supervision, Regulation, and Credit Division, and also your host for today. I'm joined by our executive vice president, Mike Johnson—hello, Mike.

Michael Johnson: Hi, Lali—thanks for having me.

Shaffer: Good to have you—and also Jennifer Duprow, who is a director in our division. Hello, Jennifer.

Jennifer Duprow: Hi, Lali.

Shaffer: I wanted to thank Tom Heintjes, who normally hosts these, for allowing Supervision to record this particular episode today. So I wanted to say: Jennifer, this is your first time with us. How are you feeling?

Duprow: I'm very excited. Thank you for having me.

Shaffer: Okay, good!

Johnson: We're excited as well, Jennifer.

Duprow: Thank you.

Shaffer: Yes, we wanted to also thank all of those listeners out there. And before we begin, I need to say that the views expressed here are of the presenters and may not reflect the views of the Federal Reserve Bank of Atlanta, or System. Speaking of "system," Mike, can you give a brief overview of the role of supervision within the Federal Reserve System?

Johnson: Yes, I sure can. Thanks, Lali, for that—that's always a good place to start, especially when not all of our listeners tend to be bankers sometimes. The Federal Reserve plays a really important role in the supervision of banks operating in our financial system. In fact, it's core to the overall mission of the Federal Reserve. You typically think of that mission related to monetary policy and price stability, as well as economic growth and employment. Those factors are really obviously critical to the overall economy, but a key part of supporting that is a healthy financial system, and the Federal Reserve plays a key role in that through the supervision of financial institutions.

We supervise all companies that own banks—we refer to those as "bank holding companies"—and we also supervise a subset of the direct banking population. They're called "state member banks." That's an important piece of our supervisory program, and in addition to those we supervise a number of foreign banks. So we have a wide supervisory footprint that we think gives us a great lens into the performance of the financial system, great information as it relates to our daily interactions with bankers, and is part of—and informs—our broader mission of financial stability for the country.

Shaffer: Great, thank you for that explanation. Next, Mike will also give an update on our current banking landscape, and after that we will discuss a new enhancement to our supervisory exam process. Mike, take it away.

Johnson: Okay, thanks, Lali. So with that as a lead-in about why this is so important, let's talk about the condition of the financial institutions that we do in fact supervise. So I'm primarily talking from a Sixth District lens—that's the Atlanta Federal Reserve district—but many of the comments I think can be extrapolated nationally as well. If you've been following the economy, you know that it continues to perform pretty well, but there are a number of headwinds. And I would basically say that that's a good way to describe banking conditions as well.

Banks in the Sixth District have continued to grow. Early third quarter data shows that loan growth, especially at community banks, is slowing a little bit, but again—still overall pretty healthy. We think of our banks, from a performance standpoint, in terms of asset quality—basically, the loans that they make, what's the quality of those loans? High quality loans of course is what we're striving for—a healthy industry, of course, always has strong returns and earnings, and you always want that buffer for bad times, which is the capitalization of the industry. So I thought I'd make a couple of quick comments across that spectrum.

So this has been a long, positive, expansive credit cycle, and asset quality for banks in the Sixth District continue to reflect that. In other words, strong, really good. Other real estate owned, nonperforming assets—basically, problems are at some of the lowest levels since the financial crisis, and continue to be operating at a low level. On the flip side of that, the amounts of reserves against those problems that banks have set aside are at some of the highest levels in a decade. That's a really good picture. To be honest with you, we're starting to see some pockets of cracks in that, but the thing that I want to really reinforce is the strong positive base that we're starting from there.

With that good asset quality profile, that lends itself to an industry that is very profitable and has once again a stable and steady income stream. So second quarter earnings for Sixth District banks continued to be positive. Changes in loan cycles—as well as changes in the interest rate environment—are, however, stressing net interest margins. They've been relatively stable, but we are starting to see pockets of decline—and net interest margin essentially is the spread between how much you earn on a loan to a customer versus how much you pay as a bank for deposits from your customers. So that positive spread is the way most banks make the bulk of their profits. And with the low interest rate environment, that's starting to squeeze a little bit. But overall earnings remain strong. All regulators talk in terms of capital, and we tend to like more, [laughter] so more is better. And thanks for that chuckle, Jennifer—you can really relate to that comment.

Duprow: I can.

Johnson: So capital is at some of the highest levels in history. Median Tier 1 common capital levels are well over 15 percent for community banks in our district. We're really happy to see that. And over 99 percent of the banks in our district, we consider to be well-capitalized. So this is a positive story—we're in good shape.

One of the things that I do want to mention, though, that we're keeping our eye on: I did earlier say "some cracks on the asset quality side, and some tightening of the net interest margin." So essentially what that means is if both of those continue to worsen, meaning we see higher nonperforming loans, which means higher costs out from our banks, and then a continued squeezing of that net interest margin, which means lower margin for profits—so those two pressures, we're keeping an eye on that because those could pressure overall earnings for the industry on a "go forward" basis. But bottom line, we're in really good shape. So let's leave it with that positive statement: banking conditions, two thumbs up right now.

Shaffer: All right, excellent. It's always good to hear what's going on in the banking landscape. And for this particular episode, we wanted to bring awareness to something that many community and regional banks out there will find interesting, since it is about making your exam process better. Now, I know what you're thinking: It can only be better if we no longer had to do them, right? Well, remember we exist to support a safe and sound financial services system. However, we did want to make that process more efficient, so we're calling the actual process BETR—or "better"—which is an acronym that stands for Bank Exams Tailored to Risk. This means that banks involved in low-to-moderate risk activities may potentially have less burden. Jennifer, you're working closely on this implementation. Can you give us some background on this enhancement of tailoring supervision, and who does it apply to?

Duprow: Absolutely. The letter was issued on June 3, 2019, and it applies to state member banks with assets less than $100 billion. And so the Federal Reserve recognizes that there are differences in risk among community banks, and so we further tailored our supervisory approach. We've designed an exam process that is both forward-looking and risk-focused, and it combines surveillance metrics along with examiner judgment to classify levels of risk at a bank within individual risk dimensions. The process classifies each risk category into one of three risk tiers—as you mentioned, low, moderate, or high. So far, it's been deployed for six financial risks: credit, capital, earnings, liquidity, interest rate, and securities—really, all the risks that Mike just talked about. And we are currently working to develop metrics for the nonfinancial risk.

Shaffer: That is a great overview, Jennifer. Can you talk more about the primary objectives of this new process?

Duprow: Yes, the primary objective of the process is to tailor a bank's examination to reflect the levels of risk present so we can appropriately streamline—or expand—exam procedures commensurate with the risk. So for low-risk activities, we apply streamlined exam work programs to those areas, thereby reducing regulatory burden or minimizing regulatory burden. Conversely, for high-risk activities, we target those for enhanced supervisory attention so we can direct our supervisory resources to where they're needed most. And for moderate-risk activities, it really falls somewhere in between the two.

Shaffer: Thanks, Jennifer. Mike, you are head of Supervision. If I'm a state member bank and I want to know what risk level I am, how can I find out? Can I text you? Can I send you a tweet? [laughter]

Johnson: Well, you can always text me but I don't tweet. [laughter]

Shaffer: Well said, well said.

Johnson: Yes, I can go into a whole other topic on that. But yes, feel free to text me. More to the point, the best way is to get in contact with your specific portfolio manager. So one of the things that I'd like to mention: at the Federal Reserve, we very much value our individual relationships with the banks that we supervise. We have a common objective, which, again, is a safe and sound and healthy and robust banking system. We have different roles to play in that, but we also have to recognize that we have these common objectives. We think the best way to achieve those objectives is to have direct, transparent, open, and honest—and very professional—lines of communication. So part of what we do then is we assign specific individuals to be that point of contact and that central point of communication with the banks that we supervise. So you can always send me a text. But I would encourage you, if you're a state member bank, you know who your primary contact is already, so get in touch with those individuals. You can always direct a tweet my way, but that will be unanswered. [laughter]

Shaffer: Very good. Let's dig a little bit deeper. Jennifer, can you describe how surveillance metrics may assist examiners in classifying levels of risk, and what are some of those design features?

Duprow: Sure. The metrics gauge the potential for a bank to experience adverse outcomes, such as highly unfavorable financial trends, severe losses or rating downgrades, over a one- to two-year period (and under unfavorable market conditions). So low-risk activities pose the least potential for adverse outcomes, and as you would expect, high-risk activities entail the greatest chance of unfavorable results. And as you mentioned, the metrics have certain design features. First of all, they are data-driven, and they're primarily based on call report data. So the content or predictive capability has been confirmed via data analysis, and this feature involves the estimation and back-testing of the metrics using data from previous banking cycles. They are forward-looking, as I mentioned, and they gauge a bank's exposure to severe losses or substantial underperformance, and this feature is supported by estimating the relationship between the risk indicators at a given point in time and a bank's performance a year or two later, particularly under those unfavorable market conditions. Lastly, they are granular by individual risk dimension, so it's not "one size fits all," and the process does not generate an overall risk tier, so when you're calling your portfolio manager, there's not one risk tier that you're going to get, just FYI.

Johnson: Good point.

Duprow: So far we've talked a lot about the metrics, and that they derive an initial risk tier of low, moderate or high. But one key point I want to bring out is that this is just a starting point of the process for determining the scope of work to be performed during examinations. The next step is to apply examiner judgment to confirm or adjust the model-driven risk tiers. So we have a tool, but it's just a tool. We do adjust the risk tiers both up and down based on our specific knowledge of the institution, and based on discussions with bank management. In my mind, this is really the most important part of the process, and I wanted to make sure I stress that point.

Johnson: Jennifer, if I could add—because I just want to stress that point as well—I completely agree with you. The one thing that we know about models is that they are helpful, but they are wrong. They're not an exact science, so overlaying judgment is a key feature—not a bug—of the approach.

Duprow: Absolutely.

Shaffer: Excellent point. So now that we have determined the risk level of an institution, what happens next, as far as planning the actual exam work?

Duprow: Once the final risk tier is confirmed, the examination is then designed to reflect the levels of risk, and we have developed exam procedures that are tailored to the low-, moderate-, or high-risk levels for each risk dimension. So for low-risk activities, examiners perform limited transaction testing. In contrast, for high-risk activities examiners apply the full extent of examination procedures. And again, the moderate risk is somewhere in between the two. We've also tailored our exam request lists to the tiers, so the request lists for low-risk activities should have fewer items than moderate- or high-risk activities. And one thing I do want to stress here is that all examination work continues to include review and verification of corrective action taken to address any outstanding matters requiring immediate attention or matters requiring attention—and that's regardless of the risk tier levels.

Shaffer: Mike, another bonus of this process is to create efficiency in how the Reserve Banks deploy their resources. Can you describe how this enhancement will assist us in that process?

Johnson: Thanks, Lali—that's a great question. One of the things that I really want to emphasize is how you asked that question, which is focused on efficiency. So this is actually not about doing less, it's about being more efficient—and I would say "directive"—in the resources that we use to supervise our institutions. I hope our bankers, as well as the public at large, would agree that it makes a lot more sense for us to focus our resources on high-risk and high-priority areas, or at least focus the bulk of our resources there. And this program allows us to do that better than we have in the past, so I think that's very much a positive element of the program.

A couple of other comments, though, that I would like to make on the efficiency piece that we think both continues to serve our broader supervisory mission but also reduces the burden for the banks that we supervise, is doing more of our work what we refer to as "offsite." From our perspective, it's a little perverse kind of language, so when we say "offsite," we mean in-house here at the Federal Reserve Bank, and not onsite at the bank's location. So some of the things that we can do now by leveraging technology is do most all of our financial analysis, for example, here in the office. Another piece that is vital to the success of any exam is looking at assets in detail. I talked earlier about asset quality, basically the quality of loans—that's a core element of any exam. We're going to use the BETR program to help us scale that, but we also can now do a lot of that work by leveraging technology here in the Reserve Bank by tapping either directly into the bank's systems, or at least getting that information electronically from the bank that we can use. So part of this we view very much as a win-win: we preserve our supervisory mission and objective, while also reducing the burden on the banks that we supervise. And we're going to continue to look for ways to maximize that trade-off.

Duprow: What I've heard is very positive feedback on the offsite work that's being done, so if a bank is interested they should contact their portfolio director—especially for the loan review piece.

Shaffer: Excellent. Jennifer, where can our audience get additional information about this and other supervisory topics?

Duprow: If you go to federalreserve.gov, under the Supervision & Regulation tab, there's a section called Supervision & Regulation Letters, and it is by year or topic, and as I mentioned, this letter was published in 2019. Alternatively, if you want the information pushed to you, in the upper left-hand corner on each page, there's a section called Stay Connected. You can choose your communication preference, and you can select the items you'd like to subscribe to: the letters, press releases, testimonies, speeches—there are all kinds of information that can be pushed to you, so it's a great way to get information from the Federal Reserve.

Johnson: And no tweeting is involved in that? [laughter]

Duprow: There is a Twitter link, I think, and to their Facebook page. There are all kinds of communication options, whatever you may prefer.

Shaffer: That's right. You pick your platform—how about that? Thanks Jennifer. Mike, this was a great discussion of how the Fed is making efforts to risk-focus supervision and to create efficiency. What other efforts do you want listeners to know about?

Johnson: Yes, there's a lot going on these days at the Federal Reserve. We're busy like everybody else, and we're trying to continue to improve. One of the things that I would like to highlight, since you asked the question, is what we're referring to as "strategic themes." Every organization has a strategic plan, and we do as well. But we have some themes that are driving the direction of supervision. We have four of those: one is agility, and I'll give you an example. The BETR program fits very much within that agility framework, meaning, how do we deploy our assets and our people? We need to make sure that we have the agility to shift gears when priorities shift, to shift gears when topics become higher risk, and things of that nature. So the agility theme fits right within the program that Jennifer talked about. Also we want to be more innovative, and—once again—the BETR program fits within that. Some of the comments that I made earlier about doing more loan review on an electronic basis offsite fit within that, and we're continuing to work on how to use new technologies in the supervisory space.

And then another cornerstone of this—the third strategic theme that I would mention—is transparency. It's part of why we're doing this podcast. We want to make sure that the public at large—but also our state member banks, the banks that we have primary responsibility for supervising—actually understand what we're doing, what we're expecting, and how we go about it, well in advance. Because we think that by being agile and innovative, and enhancing the transparency of the overall process (and our expectations), it will lead to a more optimized approach relative to our collective goals and our overall mission.

The fourth one is that optimization piece: agility, innovation, and transparency all leading to a more optimized, and a better overall framework that supports our broader mission. I thought I would—since I'm talking, I thought I would also mention a couple of other things that we're doing around the transparency front. In many ways, we've been trying to reach out and have ongoing dialogues with the institutions that we supervise directly, even outside of the supervisory process. But we also want to take advantage of the collective wisdom of our various portfolios. So, for example, we recently hosted the directors of some of the largest banks in the country for a day and a half event here at the Atlanta Fed. We also recently hosted regional bank senior executives and directors in an inaugural nationwide conference here at the Atlanta Fed. We regularly meet with all of our state member banks' CEOs, primarily with a focus on our community and regional banks, to talk about risks, issues and things that are on our radar screen—in addition to programs like the BETR program that we discussed here—and we had one of those events just a couple of weeks ago. And if that wasn't enough, in Miami we partnered with the Florida International Bankers Association to host another outreach event, primarily focused on anti-money laundering activities in that portfolio. So our goal is no surprises, and hopefully this podcast is a step in the right direction with that goal in mind.

Shaffer: Thank you so much for sharing those activities. We are definitely busy here at the Atlanta Fed. Do either of you have any closing comments or thoughts?

Johnson: If you have any questions at all about our supervisory program, about state member bank membership, or any questions in general that we can help with, please contact any one of us.

Shaffer: Thank you for joining us for this episode of Economy Matters. Please join us again next month when we'll sit down with Atlanta Fed research economist Veronika Penciakova, who will discuss her recent research into venture capital and its impact on firms' success and growth. Tom will be back, and we hope you can tune in. Have a good day.