Commentary: Regulating or Managing Banks? The Line Grows Thin

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During my tenure at the Federal Reserve Bank of Minneapolis, it was very clear that as a bank regulator, I was to "regulate and supervise" but not "manage" banks. The line between "supervision and regulation" and "management" was not always spelled out, but there was a stated rule and recognition that the goal was to not cross that line.

In my experience, the attitude on this has changed significantly in the past five years. There may not have been a conscious decision on the part of regulators to redraw the line, but the most recent financial crisis (just like the ones before it) certainly generated a feeling in Washington that the banking agencies should have been more proactive.

We need to step back and reassess where the line between regulating and managing is and where it should be.

A thoughtful, pre-crisis interpretation can be found in Kenneth Spong's book, "Banking Regulation: Its Purposes, Implementation, and Effects," which was first published in 1983 and updated in 2000 by the Federal Reserve Bank of Kansas City (with a foreword by now FDIC Vice Chairman Thomas Hoenig). As Spong notes, regulation and supervision is meant to protect depositors and consumer interests, provide monetary and financial stability, maintain a framework that encourages efficiency and competition and ensure an adequate level of banking services throughout the economy.

Signficantly, Spong observes: "Because bank regulation has been extended to cover a range of goals, there is always the possibility that it might be extended to areas that are not of proper concern for public policy. Thus, the limits of bank regulation can best be understood in terms of the things it should not try to do." Spong says bank regulation should not try to substitute "a banker's decisions in operating a bank." When bank examiners identify problems, they may offer advice, he says, but should not determine policy or establish particular lending and investment practices.

Following the savings and loan debacle and the farm crisis of the 1980s, Congress enacted the FDIC Improvement Act of 1991, which created the concept of prompt corrective action. Under PCA, banks could be subjected to ever-increasing levels of regulatory oversight and restrictions when capital declined to worrisome levels.

At the same time, the regulators' power to pursue cease-and-desist orders and other enforcement actions has expanded.

Over time, the bank regulatory agencies have incorporated provisions into their enforcement actions that arguably place regulators in the position of making management decisions about strategic planning or the products and services that a bank offers-or even when a bank will be put up for sale.

Even for banks that are not subject to PCA restrictions and not under enforcement actions, there appears to be an expectation by Congress and a willingness by regulators to go beyond the offering of findings and advice, and to require that banks follow regulators' decisions on certain business matters. Indeed, failures to follow regulatory comments are increasingly leading to downgrades of the management component of a bank's CAMELS rating.

This raises a fundamental question: Are we on a slippery slope toward regulators managing banks?

In my view, this would be dangerous from a public policy perspective. Just as bank directors should provide oversight and not manage, bank regulators should regulate and supervise, and not manage.

Like bank directors, regulators are not in the bank on a day-to-day basis; usually they can only judge actions after the fact and without all of the relevant information and considerations. It's blatantly unfair to put them in the position of having to manage the bank. And a failure to be mindful of the appropriate roles for the various players could inadvertently hinder banks as they strive to serve the needs of their customers and the overall economy.

Karen Grandstrand chairs the bank and finance group at the law firm Fredrikson & Byron in Minneapolis. She previously spent 14 years at the Federal Reserve Bank of Minneapolis, where she was senior vice president of the banking supervision and risk management departments.

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