Observations on Community Banking Supervision in the Second District
May 14, 2015
Posted May 19, 2015
F. Christopher Calabia, Senior Vice President
Remarks at the Community Bankers’ Conference, Federal Reserve Bank of New York, New York City
As prepared for delivery

Welcome to the Federal Reserve Bank of New York.  We are pleased to continue our annual tradition of inviting community and regional bankers from across New York, northern New Jersey, southern Connecticut, and Puerto Rico to share perspectives on opportunities and challenges for smaller banks in the Second Federal Reserve District.

Community banks—which we define generally as institutions with total assets under $10 billion—remain an important focus for the Federal Reserve System and for the Federal Reserve Bank of New York, and not simply because of our statutory responsibility to ensure that state member banks and bank holding companies are managed safely and soundly and treat consumers fairly.  Community banks also help to inform one of the Federal Reserve System’s roles as our nation’s central bank. 

For me, it’s quite simply the Federal Reserve’s “dual mandate” that makes community banks an important area of focus for the Reserve Bank and the System.  As you know, the dual mandate expressed in a 1977 amendment to the Federal Reserve Act requires the central bank to promote maximum employment and price stability in the United States, commensurate with moderate long-term interest rates.  Yet it would be impossible for the Federal Reserve to promote price stability and maximum employment without understanding the demand and supply for credit across all parts of our country and all segments of our economy.  Consequently, under our dual mandate we must understand the important segment of the economy that community banks and other smaller firms serve, which generally comprises household lending, small business lending, and commercial real estate.

In my remarks today, I’d like to offer three sets of observations on community banking supervision in the Second District.  First, I’ll discuss the importance of community banking from our perspectives as both supervisors and central bankers.  Second, I’ll update you on practical initiatives we have launched in our District to tailor our supervisory approach better to our sense of the actual risks that community banks present.  Finally, I’ll share some observations on how community and larger regional banks (which we define generally as having $10 to $50 billion in assets) have performed in our District over the past two years. 

As these observations reflect my personal experiences with community and regional bank supervision, I’d like to stress that these views are my own and may not reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.1

To begin, when it comes to the importance of community banks, we know that it is because of you that more Americans are able to purchase homes for their families.  It’s because of you that more entrepreneurs are able to pursue their ideas and create small businesses—and those small businesses matter because historically small businesses have provided one of the largest sources of new jobs for our country’s economy.  We know that your competitive advantage in local markets is that you know your local business conditions and your customers better than anyone else.  We know that other, larger firms may tend to overlook the customer base you serve best.

When the Federal Reserve Bank of New York, as both a central bank and a supervisory authority, understands not just your firms’ financial health, but importantly the health of your customers as well, we develop a deeper appreciation of how the economy is faring in your part of our District.  When Reserve Banks gather similar information from community banks across the country, we can foster powerful insight for the Federal Reserve System in achieving our dual mandate.

Our chair, Janet Yellen, spoke at a conference of the Independent Community Bankers of America last year in great detail about the special role that community banks play in lending to Main Street: she said she believes that “a healthy financial system relies on institutions of different sizes performing a variety of functions and serving different needs.”2  Consequently, from the Federal Reserve’s perspective, we need diversity in the size and scope of financial institutions to ensure that all participants in our economy can be served.

Beyond the critical financial services that community banks provide to depositors and borrowers in your communities, community bankers in our District have been highly engaged in sharing perspectives with us on the economy and on business conditions outside of the supervisory process.  You do so by participating actively in this annual conference; by joining community outreach meetings that the New York Fed holds across the District; and, for some, by sharing perspectives with us through a more formal consultative body called the Community Depository Institutions Advisory Council (CDIAC).  President Dudley convenes the Second District’s CDIAC twice per year to seek insights from leaders in community banks, credit unions, and thrifts.  CDIAC members offer their views about what’s actually happening on Main Street regarding business conditions, the demand for credit, and market practices.  And yes, they share their concerns about supervisory practices, too.  Ultimately these views are reported to a national-level CDIAC body that advises Chair Yellen and other governors. 

Regardless of how you share insight with us, I know from my visits across our District with you and your staff, as well as with your firms’ directors, that you are not a silent bunch.  We welcome your candor and honesty.  We need to hear your concerns so that we can better conduct our statutory mandates and minimize the burden on your businesses, consistent with your firms’ individual risk profiles.

This leads to my second set of observations, which concerns how we tailor our supervisory programs to your firms and our best sense of the actual risks community banks present.  One of the themes I’ve heard repeatedly from directors and senior leaders at community and regional banks in our District is the strong sense that you are struggling with the volume and weight of new regulations.  U.S. supervisory authorities and other stakeholders, including Congress and state legislatures, are still evaluating the lessons learned from the financial crisis and its aftermath.  It is indeed important to ensure that our laws and regulations reflect our best understanding of what can go wrong and how we can mitigate those risks from threatening the broader economy.

Still, we understand that community banks do not generally pose a systemic threat to the stability of the U.S. financial system.  Consequently, the Federal Reserve and other supervisory agencies have long sought to differentiate and distinguish our supervisory programs for the largest firms versus those of our smaller community banks.  To illustrate these initiatives, one of our Governors, Daniel Tarullo, gave a speech to the Independent Community Bankers of America two weeks ago.3  In his remarks, he reviewed a number of changes we have made or are making to tailor our supervisory approaches for community banks.  I’d like to share my observations on the experiences we have had in our District related to some of those changes that Governor Tarullo cited in his speech.

One of the important initiatives that Governor Tarullo mentioned concerns our conscious effort to limit the length of examinations and the period of time that community bank staff must devote to them so that we do not disrupt your businesses significantly.  Whenever I think about the amount of time that we spend onsite at community banks, I always remember Ben Franklin’s adage that fish and visitors stink in three days.  I realize that Ben Franklin’s timetable may be accelerated for bank examiners.  While I am relatively confident that we will not be able to reduce our full scope examinations to three days or less at a typical community bank in the near future, the New York Fed is undertaking several steps to reduce the time spent onsite. 

One initiative includes doing more homework in advance of arriving at your front door to evaluate your firms’ financial condition and performance with regard to capital adequacy, earnings, and liquidity.  We can then spend the time onsite asking more focused questions about the concerns we have rather than trying to update ourselves while we are onsite and then asking questions later, which could otherwise extend the duration of an onsite examination.

In addition, we’re adopting a variety of automation tools to simplify the examinations process and make it more efficient.  Increasingly, we are using a secure online platform to facilitate the electronic receipt of your responses to our requests for information in advance of our arrival onsite.  Receiving critical data and information on the firm electronically should additionally reduce both the cost to community banks of shipping boxes of information to the Reserve Bank in advance of our onsite visits and the risk of losing confidential information en route.  These secure online platforms may furthermore enable us to share information more efficiently with other responsible supervisory agencies, reducing the need for a community bank to send similar information to two or more agencies and increasing our ability to collaborate with other agencies.

On a related note, Governor Tarullo mentioned that the Federal Reserve is experimenting with the use of electronic loan files to facilitate offsite reviews of a firm’s loans.  In the New York District, we know that many community banks have not yet adopted the use themselves of digital loan files, and this is not a supervisory requirement for the time being.  Consequently, we at the New York Fed do not yet have much experience with conducting loan reviews for community banks offsite using electronic files.  Some of our fellow Reserve Banks have piloted such examinations in their Districts, and we’ve heard encouraging results about how conducting at least part of our regular loan reviews offsite has reduced the stress and burden on community bank staff.  We remain eager to talk to any community bank in our District that may be interested for its own purposes in moving to digital loan files, as we would like to pilot an examination in which we conduct at least part of our loan review process offsite.

Beyond the initiatives that Governor Tarullo mentioned, we have a massive effort underway in the Regional, Community, and Foreign Institutions Supervision and Consumer Compliance Function (RCFI) of the New York Fed to look at all of our internal processes with a fresh eye.  We are working to eliminate unnecessary steps, smooth out cumbersome internal processes, and increase efficiency so that we can conduct our examinations and share our findings with you more efficiently and effectively. 

But what does all this mean practically?  Are we able to limit the length of examinations and thereby provide community bankers with feedback sooner and reduce the burden on their daily operations?  It’s still early days for our efforts, but we have documented two pilot examinations using as many of the automation tools and business process improvements as possible.  I won’t cite the names of the firms involved, and I want to stress that the pilot examinations were conducted at firms that did not have serious supervisory issues.

The measure of efficiency that we are monitoring is the number of days from the start of the examination at a community bank—namely, the first day our examiners arrive onsite at your firms—to the close of the onsite portion of the examination.  At one firm, our adoption of new automated tools and our own internal business process improvement efforts reduced the time spent onsite at the firm from 32 days in 2011 to 18 days in 2013.  That represents just over a 40% reduction in time spent onsite over just a two-year period.  But it’s even more dramatic if we look back further to a period before we were implementing these new automated tools and process improvements.  In 2009, it took us 81 days from the start of the onsite examination to conclude all of our onsite work at that same firm, compared to just 18 days in 2013.  Now admittedly 2009 represented a difficult time in our nation’s and region’s economic history, so it may not be the best baseline of comparison.

But we found similarly material reductions in time spent onsite at a second firm: in 2012, we had spent 39 days onsite at the second firm, and after adopting these improvements, spent just 31 days onsite in 2014.  I would remind you that we conducted the two pilot examinations at community banks that were generally in sound condition.  The efficiencies we gain may depend greatly on the underlying condition and performance of the firm we are examining.  Consequently, I cannot predict how much time we’ll be able to save at future examinations as more of the tools become available.  Still, the improvement in efficiency reflects our efforts to bring community bank supervision into the twenty-first century and transform what had been a highly manual process for decades into a more automated and risk-focused process.

I should also note that some community banks don’t want us to conduct all of our work offsite.  They don’t want our examiners to reduce their firms to a data set that we process in an offsite supervisory model.  That’s certainly not how community banks do business, as it is not how you treat your customers.  So the onsite portion of examinations will remain an important supervisory tradition: we simply want to have a better strategy for our time spent onsite so that our discussions will be more focused and meaningful for both the examiners and the bankers. 

Governor Tarullo similarly mentioned in his remarks the Federal Reserve System’s adoption of a new risk-focused supervision program with regard to our consumer compliance work.4  I’d like to share our experiences in the Second District with adopting this approach. 

From my perspective, our consumer compliance examinations fit in well with our role as both a supervisory authority and a central bank: if consumers feel that banks do not treat them fairly, the Federal Reserve will not be able to foster public confidence in the banking system, no matter how much capital banks have.  Still, we’re working hard to adjust our supervisory programs for consumer compliance matters so that they make sense for the scale and risk profiles of community banks.  Please allow me to mention just two examples.

First, in years past, we usually included all lending areas and some deposit areas in our reviews of consumer protection matters.  By adjusting our scope to focus on the higher risk lending and deposit areas, we’ve found efficiencies in terms of the numbers of examiners sent onsite and the number of weeks spent onsite.  In one case, we sent eight examiners for four weeks to a community bank under our former approach, yet more recently we were able to scale that back to about half the number of examiners and one week less onsite at that particular firm.  We’re still developing experience with the new approach, and I want to emphasize, as always, that when risks are higher or problems have been identified, we will devote the appropriate time and resources to understand those challenges.

As a second example, the Federal Reserve System is currently testing an automated tool to help us analyze institutional risk factors from a consumer compliance perspective.  The tool helps us to look across many firms in our District simultaneously to identify potential outliers and new products that should draw more of our examiners’ attention.  This tool and others should put us in a better position to focus our consumer reviews appropriately and in a more risk-sensitive way.

So far, I’ve discussed some observations about why community banks matter to us as supervisors and central bankers, and I’ve also discussed some of the practical efforts underway to tailor our supervision to the general lower risks that community banks pose to the economy.  Now I’ll move on to my third set of observations, namely what we’ve observed in community banks’ performance in our District; I’ll broaden this group to include regional banks ($10 to $50 billion in total assets), as they present similar stories overall. 

With regard to the financial condition of community and regional banks in our District, it’s been our sense that many have experienced gradual stabilization in their financial health over the past two years.  Challenges do remain in the District, as evidenced by the fact that some firms continue to have somewhat lower capital ratios.  Interestingly, capital ratios on average for our community and regional banks remain slightly below those of national peer group averages; the good news is that we’ve seen few signs of deterioration in the solvency of supervised firms in our District over the past two years.  This more stable performance contrasts with a more volatile period prior to two years ago.

The key business for most community and many regional banks has historically been lending, and consequently credit risk is typically the most significant risk for such firms.  Over the past two years, we have found that indicators of credit risk as evidenced in the quality of assets on the balance sheets of regional and community banks in our District (such as weighted classification ratios of troubled loans to total lending, various measures of the ratio of the allowance for loan and lease losses related to loans, etc.) tend to compare slightly more favorably than those of peer banks nationwide.  This slightly stronger risk profile may explain why some Second District regional and community banks hold a little less capital.  To some degree, asset quality in the Second District may reflect the somewhat greater stability experienced in real estate values in our District, especially in the metropolitan area surrounding New York City, compared to other markets of the country where values fell precipitously—such as Florida, Las Vegas, Phoenix, or Atlanta—and for a prolonged period of time during the financial crisis.  However, we have to temper even that statement, as some individual communities in our District did experience worse shocks in housing or real estate prices during the crisis, including some that were more akin to some of the most troubled real estate markets in the country. 

Earnings levels for regional and community banks in the District have tended to remain positive and show some recent signs of greater stability, possibly reflecting the somewhat better quality assets underwritten and held in many firms’ portfolios.

If we look to the other side of the balance sheet, we see that core deposits continue to fund the majority of assets for many Second District regional and community banks.  That’s a healthy sign, as one independent study5 suggests that community banks that were more dependent on this traditionally sticky and usually well-priced sources of funding fared better than those that relied more on wholesale funding sources during the financial crisis. 

So I’ve shared with you why we view community banks as important to informing our work as supervisors and central bankers; I’ve talked about how we are tailoring our supervisory approach to reflect the actual risks that community banks present to the economy, which generally are lower compared to that of larger firms; and I’ve shared some observations that community and regional banks in our District are showing signs of stabilization over the past few years, though the story remains mixed.

What does all of this mean?

It means that those of you who have been leading community and regional banking organizations in our District have steered your firms through one of the toughest financial crises in generations.  Moreover, you are still navigating well the fog-covered waters of continued economic challenges.

Your accomplishments remind me of one of the observations that Will Rogers, the cowboy humorist of the 1920’s and 30’s, once said.  For those who may not be familiar with him, Will Rogers was an actual cowboy who gained fame for his lasso and rope tricks in vaudeville circuses.  But he was also a largely self-educated man who took a great interest in the events of the day and quickly became known for his witty and folksy observations on politics, business, international affairs, and culture.  He was once asked how it was that he could be so funny, all the time, when discussing current events.  His answer was that “There's no trick to being a humorist when you have the whole government working for you."  I should stress that I’m quoting his view rather than my own. 

Despite his wry and witty daily commentary, Will Rogers was a keen observer of people and famously said that he never met a man he didn’t like.  There’s one observation from Will Rogers that I think is most appropriate today. He said once, “There are basically two types of people. People who accomplish things and people who claim to have accomplished things.  The first group is less crowded.”

So, looking around this room, you count yourselves among that smaller group of people who have actually accomplished something.  Critically, you’ve accomplished something important.  By steering your firms through the challenges of recent years, you continued to safeguard the hard-earned savings of consumers and businesses alike in your communities.  You provided credit and other financial services to them when other, larger firms might have otherwise overlooked them.  You can be proud of that accomplishment and of the impact that you have had on your communities.

But the message I want to leave you with is that your work is not finished.  We need community bankers to continue to demonstrate sound judgment and prudent business sense in your communities.  We need you to continue to provide credit and other services to businesses and consumers alike.  We need you to offer your services in a manner that is safe, prudent, and fair.  We need you to continue to maintain close ties to your neighbors and neighboring businesses so that you can leverage your special ability to understand and build sound business relationships with community members. 

The Federal Reserve and other regulatory agencies at the state and federal levels will still be there to encourage you to maintain safe and sound operations.  We’ll be especially active in doing so when things may appear to be going wrong. 

But ultimately only you can ensure that your firms thrive, even when times get tough.  And when you manage your firms prudently, you can continue to play a vital role in serving the banking needs of those businesses and families who call your communities their home towns.  When you thrive, you can help your communities to thrive as well.

I hope that you find our conference to be useful and informative.  Thank you for joining us today. 

1 Deborah Arndell, Jacqueline Fenton, Jordan Light, and Wilma Sabado provided input and advice for these remarks.

2 See Tailored Supervision of Community Banks. Remarks by Janet Yellen at the Independent Community Bankers of America 2014 Washington Policy Summit, Washington, D.C., May 1, 2014.

3 See Tailoring Community Bank Regulation and Supervision. Remarks by Daniel Tarullo at the Independent Community Bankers of America 2015 Washington Policy Summit, Washington, D.C., April 30, 2015.

4 See Consumer Affairs Letter 13-19, Community Bank Risk-Focused Consumer Compliance Supervision Program, Board of Governors of the Federal Reserve System, November 18, 2013.

5 See Financial Institutions: Causes and Consequences of Recent Bank Failures, United States Government Accountability Office, January 2013.

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