The Federal Reserve System is investing more time and resources into educating bank executives and directors.
While enforcement and supervision are critical parts of its job, efforts are underway to be more transparent and provide better guidance to member banks.
That was the big takeaway from interviews with Julie Stackhouse, managing officer of supervision, credit, community development and learning innovation at the Federal Reserve Bank of St. Louis, and Lisa White, who oversees supervision, regulation and credit at the Federal Reserve Bank of Richmond.
Cybersecurity risk is perhaps the top concern, and the Fed is putting together educational materials for directors that it hopes to issue early next year. Liquidity risk is another area being emphasized in meetings between bankers and Fed officials.
The Fed system is also investing more time educating examiners in areas such as cybersecurity and fintech.
“We have raised the bar for the need of bankers and boards to understand information technology and cyber risk,” Stackhouse said. “The Federal Reserve is going to do its part to promote that education.”
Stackhouse and White also discussed their views on updating the Community Reinvestment Act, increased de novo activity and credit quality. Here is an edited transcript of those conversations.
What’s your view on the underlying health of banks in your region?
JULIE STACKHOUSE: Banking conditions are really good right now. That’s of course when regulators wonder what can go wrong. Then we worry about whether our staff is getting all the experience they need for the next downturn.
But I do think we have to recognize that there are some fundamental changes going on at community banks. … They are less liquid than they have been in the recent past. We know competition from larger banks is a factor. They can do that because it is easy to go to the internet to place a deposit. We also know that issues that are very demographic are occurring. In the Midwest, we talk about the outmigration in rural communities. Sometimes the deposits leave with that outmigration. Sometimes they leave when the parents who stayed pass away.
We’re doing some banker education on this. Not to be scary but stating that we all have to remember that liquidity is there until you need it. … We just need to keep an eye on that.
LISA WHITE: We’re still seeing solid economic trends that are constantly impacting the banking system overall. We talked a little bit about the financial resiliency of our firms. We’re not seeing anything that’s overly alarming at this point. It’s just monitoring our institutions and making sure that they’re continuing to hold adequate levels of capital and liquidity.
What types of discussions are you having with bankers now?
STACKHOUSE: There’s a lot of talk about cyber risk, but I have a hard time separating that from the financial technology because the pieces you add on increase your cyber risk. … We have raised the bar for the need of bankers and boards to understand information technology and cyber risk. The Federal Reserve is going to do its part to promote that education.
Credit risk is also important, but the domino effect of technology risk is something that we don’t fully appreciate or know if and how it might happen. So we need to keep that high on our list. Our community bank examiners, when they go through training, are getting 40 hours on information technology risk in their curriculum.
WHITE: As far as what we’re focusing on, it is mostly more of the things that fall under the label of operational risk and operational resiliency. That’s where we’ve been having the most discussions with our firms. Those are the supervisory issues we’re citing with the greatest frequency.
Operational risk covers a broad swath. It would be information technology, cybersecurity, fintech, vendor management. Obviously a lot falls within that category. So generally, with any size institution, first and foremost we’re looking at the risk appetite and what are the risk management and internal controls and processes. When we are identifying issues, it is usually with regard to the core risk identification process at the firm, or possibly instances where they are taking increased risk but it has not been properly reflected. Also looking at risk articulation and what has been approved by the board of directors.
What are your thoughts on board engagement?
WHITE: That’s still very important to us, but at the same time that is an aspect of our supervision program … where we are trying to be very rational and careful about what we’re asking boards of directors to do. … One of the things we’re doing in our supervisory programs is really stepping back to say what are the things that are truly the most important for us to expect the boards to take a look at and approve.
STACKHOUSE: We believe it is so critical that we are working on some educational material for boards on cyber risk basics. Not to be overwhelming but to say that, in your governance role, you have to understand that. In our role as regulators, we will be setting out some expectations for you. … We hope to roll that out in the next six months.
What are your thoughts on updating the Community Reinvestment Act?
WHITE: Even though the OCC went ahead and came out with its advance notice of proposed rulemaking, counterparts from our organization, FDIC and OCC have worked closely together along the way. What we’re hearing on our end that there was a lot of input that our colleagues provided that was included in the version that came out in the form of the ANPR. I think that bodes well as a good starting point to lead to whatever the final proposed rule is.
The organizations have been working on this for quite a while. There’s a lot of thinking that just because we weren’t joined at the hip … we’ll still end up in a good place. We’re of the mindset that the OCC going out and gathering comments is a good first step because those comments will be valuable to all organizations.
STACKHOUSE: I am close to the issues because I have individuals in my responsibility area, including examiners and community development folks, and I attend a lot of those meetings. … I don’t think there’s any question that there is frustration with the regulations. And there is no question that there are people who are just frustrated with the law itself, particularly since it is applied only to depository institutions. So I think we all agree that it should be changed.
I’m not sure there will be a consensus on how it should be changed. And maybe that is due in part that, when you look at low- to moderate-income communities, the access to credit and fairness of credit can be addressed. But it still doesn’t mean that the individual who is low-income can get a loan when they need it. … There will probably be some disagreement on the change that needs to occur. I think the best rulemaking will be where the most parties can agree on the best outcome.
What are your views on fintech?
STACKHOUSE: If we had talked five years ago about fintech, few of us would have had an idea of what we were talking about. Fast forward to 2018. The Federal Reserve is actively looking at putting together educational materials for our staff so that everybody will have a foundation in fintech. That way it is woven into the culture of who we are as regulators. And obviously it is working into the culture of banking organizations.
I don’t know if I see massive changes occurring in law or regulation. But I do see that anytime you grow and have a much deeper understanding of what the product is … you can have the regulation align with the technology. How can the regulators help? Stay informed and educated.
When I look at fintech longer term, I wonder how does all this work in an economic downturn? There is so much promise, particularly for reaching the underserved, but I think there is a reasonable risk that if the algorithms or the mechanisms are not set up to continue to serve those customers in a downturn, it will be a challenge for the traditional community banks to step into that role given the consolidation we’re seeing.
WHITE: Following all the developments with the other agencies … this is definitely a place where the Federal Reserve has deliberately chosen to take more of a passive approach in the beginning, versus coming out of the gate with a stance one way or another. My personal opinion is that’s the right approach. There are still so many moving parts and things to better understand at this point. It is not a bad move or strategy for us to take a look at how the financial firms react to the options that they have available now.
Any thoughts on de novo activity?
WHITE: It is definitely encouraging. We’ve been seeing more of that, especially in North Carolina. It is something we’re paying attention to. When I was in Virginia recently for an exam, we spoke with one of the bankers who is involved with the [Virginia Bankers Association], and there was some talk about whether that group could do more to make de novo formation a little easier. I’ll be interested in seeing how that plays out.
STACKHOUSE: I’ve been surprised there have been as many de novo applications as there have been. It is reasonably inexpensive to buy a bank and move its charter, particularly if it is in the same state. As long as there are banks for sale it seems reasonable that those charters would be prime targets. Once those are gone, de novo banks would presumably become more popular.
What loan categories are you watching for credit cracks?
STACKHOUSE: Of course we always start with commercial real estate and upper-end multifamily housing because it is so big and prominent in the Midwest. Will we end up with too much upper-end multifamily housing? If history proves true, yes. Is the amount of equity investment high enough so that we won’t feel a great deal of pain? That’s my hope. It doesn’t mean that some banks won’t be hurt … but I don’t think we’re going to see 2006 or 2007 all over again.
We always talk about ag. As we talk today about concentrations, in the Midwest it is the banks that are engaging in agricultural lending that are often concentrated … so any downturn has a magnifying effect. There will inevitably at some point be some correction. The question is will it be a big deal, or a systemic deal? I don’t see that yet.
WHITE: I think we’re still really focused on CRE overall and the trends there. At larger organizations, one thing the Fed has really been focused on the shadow banking sector. We were very focused on leveraged lending, and now we’re looking at the second-order effects of that. What institutions that we supervise have been lending to large firms who have in turn lent to companies now that are highly leveraged? That is something that is brewing at the moment.
