SRC Insights: Second Quarter 2006

SVP Commentary on...Efficient, Effective Regulation and Supervision of Financial Institutions

by Michael E. Collins, Senior Vice President & Lending Officer

Banking organizations play an important role in the U.S. financial markets through their deposit-taking, lending, and other activities. Our banking system also plays a central role in allocating resources, pooling capital, and funding and fostering economic growth both in local markets and for the national economy. Banking organizations also enjoy special benefits, such as access to the discount window, payment systems, and deposit insurance protection, collectively referred to as the safety net.

Because of the importance of a well functioning banking system, it is imperative that there be prudent supervision and regulation of the industry. As regulators, we should continuously strive to ascertain which regulations and supervisory practices are associated with financial stability, economic growth, and better banking organization performance, and we should promote these regulations and practices to better the banking environment.

The purpose of bank regulation is to both protect the public and promote an efficient, competitive banking system. Bank regulators subject banks to certain requirements, restrictions, and guidelines with the goal of upholding the soundness and integrity of the banking system. However, bank regulation is often the subject of public policy debate and discussion around regulatory burden. It is critical that a balance is achieved so that regulation helps limit systemic risk for the banking system without stifling growth and innovation.

Historical approaches to bank regulation center around capital adequacy. Capital serves as a buffer against losses and impacts the risk appetite of banking organizations. Together with other elements of the safety net, capital aligns the incentives of bank owners with depositors and other creditors. Recent efforts in capital adequacy are designed to more closely align bank performance and risk taking with market interests.

While capital remains at the core of bank supervision, the rapid evolution of the banking industry, new technologies, and changing business processes are placing a premium on effective risk management practices. In recent years, financial innovations have occurred at an accelerated pace, new financial products and services are continually being introduced, and banking organizations are expanding their roles in the financial markets. Interdependencies in the market place and the increased scale and scope of banking operations require effective and flexible frameworks in which banks can operate.

At the same time, the need to restore investor confidence in the financial markets (in the aftermath of corporate scandals) has resulted in very detailed regulation and placed a premium on corporate governance. The need to eliminate terrorist and illicit financing of activities has also resulted in detailed legislation. This combination has had a significant impact on smaller banking organizations in particular.

History provides us with many examples where some banks have taken imprudent risks in fulfilling their responsibilities, resulting in adverse impacts on the economy. Periods of fraud and abuse, together with technological and social change, typically result in the creation of specific regulations in response to specific problems.

So what is the best way to proceed in responding to ongoing industry innovation and diversification and potential future negative events? Some would say the best way is to have a limited response, letting market participants provide the necessary stability and efficiency. On the opposite end of the spectrum is a response of strict regulation and supervisory oversight that could potentially curtail, even silence, industry innovations and limit growth and expansion.

The most effective response is probably somewhere in between, and there are things that regulators can do to achieve a balance and to help prevent increased regulatory burden. Understanding and evaluating industry innovation—new products and services, technological advances, and market expansions—will help regulators determine whether a new policy is warranted or whether changes to an existing policy may be needed. In addition, the acquired knowledge can be shared with banking organizations to assist them with understanding and managing any potential risks.

An effective policy response also involves ensuring that there are proper incentives surrounding ongoing industry innovation and that banking organizations acquire sufficient information and research before embarking on any new strategic initiatives. The board of directors and management should be fully aware of the risks from new initiatives, and there should be effective risk management policies and practices in place to monitor and manage the risks.

If there is strong evidence that the risks are effectively managed in such cases, regulators may not need to create any significant new regulation, but instead they may stress the application of existing supervisory guidance. This was the case with the home equity lending guidance that was issued in May 2005 and the current proposed guidance for both commercial real estate concentrations and nontraditional mortgage loan products.

Ongoing dialogue between regulators and banking organizations is also very important. Regular interaction will help to promote a cooperative effort among bankers and their supervisors. Regulators will be better able to identify any emerging risks, and bankers are provided an outlet to express their views on bank regulation and supervisory oversight.

Here in the Third District, we sponsor several Bankers’ Forums each year to share information and to provide the institutions we supervise with an opportunity to voice their concerns. We can then factor this information into our comments on proposed regulatory policies and also share the information with staff from the Board of Governors in Washington.

Finally, ongoing monitoring of emerging risks in the banking systems and of industry innovation is important for efficient, effective supervision and regulation. Identifying and responding to emerging risks on an ongoing basis helps to limit potential systemic risk and potential bank failures. Industry innovation can lead to revised or new regulation. The advancement of banks’ ability to measure and manage their risks has resulted in a proposed new capital framework. The proposed Basel II capital framework provides for greater risk sensitivity than its predecessor and is intended to allow capital regulation to better reflect continued industry innovation.

It is clear that we need a supervisory and regulatory scheme to ensure both public confidence and financial stability. The goal of regulators should be to construct and operate under supervisory and regulatory policies that are economically efficient and that will lead to economic growth. There is also an ongoing need to evaluate the cost, benefit, and impact of regulatory policies and compliance on banking organizations. The debate over the benefits versus the costs of banking regulation is ongoing, and regulatory burden relief efforts continue. Currently, there are efforts underway in Congress to pass a regulatory relief bill this year.

Whatever the outcome of the regulatory relief efforts, a continued focus must remain on the basic objectives of bank regulation, on managing systemic risk while promoting industry growth and innovation, and on determining how existing and proposed regulations will affect the financial system in the future.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

SRC Insights: Second Quarter 2006

SVP Commentary on...Efficient, Effective Regulation and Supervision of Financial Institutions

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