WASHINGTON - Globalization and convergence have pushed bank managements to reconsider some of their basic assumptions about how best to compete in an increasingly competitive environment.

That's nothing compared to what has been happening to the regulators.

For Federal Reserve Board Governor Laurence H. Meyer, supervising large, complex banking companies is "the challenge of the decade."

Part of the problem for examiners stems from the simple fact that they are forced to play follower, without necessarily knowing where the banks are going to lead them next. "Banks should decide what range of financial services they want to engage in," he explained in a recent interview. "Banks should make the decision about how large is desirable and efficient."

Once banks make those decisions, he added, "the supervisors should adapt."

Their ability to adapt is being tested almost constantly.

Both the Fed and the Office of the Comptroller of the Currency have made huge changes in the way they oversee the nation's largest banks. The trend dates to the mid-1980s, when the Comptroller's Office singled out roughly 10 institutions for special attention, including dedicated teams of examiners who worked at the banks on a permanent basis.

But the agencies quickly realized that an on-site presence was not enough. Bank operations became so sophisticated that examiners found themselves trying to oversee things they could not understand.

So in 1997 both agencies launched separate efforts to improve supervision of large banks.

AT HOLDING COMPANIESThe Fed targets about 30 holding companies, including 10 foreign institutions, which it terms "large, complex banking organizations," or LCBOs.

Teams of examiners, headed by one individual, are assigned to these institutions and gain intimate knowledge of their operations. "You can't do a risk-focused exam unless you understand the specific strategic direction of the banking organization," Mr. Meyer explained.

Unlike a once-a-year snapshot-type exams, these large firms are reviewed continuously. Rather than spending time searching for problems by tracking randomly-selected transactions, these examiners focus on validating higher-level processes, such as the bank's method for assuring that all loans are reviewed periodically.

Transaction testing is still important, Mr. Meyer said, but only as a way "to ensure that the internal controls and the risk management processes that they tell you are in place, are actually in place."

In addition to these teams of examiners, the Fed has developed a core of specialists who assist the examiners on particular issues.

The Fed currently employs 367 of these specialists in areas of expertise such as capital markets and credit risk management. They average eight years of Fed experience and more than half hold advanced degrees or certifications.

"The career development is different for the specialist than it is for the ordinary, traditional bank examiner," Mr. Meyer said. "They have to be able to understand the risk management systems and the nature of the risk a bank is facing in order to talk to senior management, credibly tell them that they are not getting the job done, and to give them some guidance in terms of where they need to go."

The Fed provides continuing education programs for these specialists to keep them abreast of the latest innovations in their areas of expertise.

AT NATIONAL BANKSIn 1997, the Comptroller's Office expanded its large bank program to about 35 institutions, and formally separated its examination force into two groups: one focused on large banks and one on small banks.

"Prior to that we used our examiners somewhat interchangeably," Senior Deputy Comptroller Leann G. Britton said in an interview. "But we were finding that the skills were changing so much that we were giving better supervision if we could specialize."

Largely due to mergers, the original 35 banks in the program have been reduced to 25. Each of these banks has an examiner-in-charge with a staff that varies from several examiners to more than a dozen, depending on the institution's size and complexity.

In all, the large bank division has about 365 employees, with an average of 15 years at the OCC, making it the most experienced segment of the agency's supervision staff. About one out of every four employees is a certified public accountant, chartered financial analyst, certified fraud examiner, or other credentialed member of a professional association.

In addition to rotating individuals with specialized knowledge in and out of banks for targeted exams, the Comptroller's Office hired a stable of 20 PhD economists - referred to within the agency as "the rocket scientists" - who work directly with examiners on particularly tough issues.

"They report to the economics department, but they spend 80% to 90% of their time in the field, working in our banks," Ms. Britton said.

They are able to augment the effectiveness of bank exams, she said, because criticism of a bank's procedures and systems is more easily delivered "when you have PhDs matched off with PhDs."

FED/OCC COORDINATIONBecause the majority of the holding companies that the Fed classifies as large and complex have lead banks supervised by the Comptroller's Office, the agencies must coordinate their efforts.

The Fed's lead examiner for a given company meets quarterly with the comptroller's head examiner for that firm's bank subsidiary.

"They discuss planned exam activities and perceived risks," Ms. Britton said. "In some cases, we might have a Fed examiner join us on a targeted exam in a specific area."

Mr. Meyer described the cooperation as a common-sense way of sharing resources and avoiding duplication.

"If we fail to do that, all we do is increase regulatory burden," he said. "I don't think any of us want to increase the burden associated with supervision by failing to get our job done."

WATCHING TALENT WALK OUT THE DOORThe downside of keeping their examiners on the cutting edge in areas of vital interest to banks, such as risk management, is that agencies have created their own retention problem.

Ms. Britton says turnover "keeps me awake at night." The majority of examiners who leave the OCC for positions in the private sector are snapped up by bank risk management and regulatory compliance departments, she said.

"In today's job environment it is difficult to attract people, so what concerns us is maintaining a pipeline of skill sets," she said. And because the agency sees 15 to 21 candidates for every specialist they hire, and invests $30,000 to $40,000 in training courses in first five years, it requires a lot of advance planning to do so.

Unlike the competition, the agencies can't offer stock options, bonuses, and other incentives that are common in the private sector.

"[We] try to find compensation packages that get the job done, but it is a continuing challenge," Mr. Meyer said. "What you find is that you can compete on the basic salary component, but it becomes very difficult to compete in terms of the higher-order variable pay, like stock options. That creates problems."

The Fed's pay scale for its specialists varies, depending on which of the 12 Reserve banks they work for, but a general range for its senior specialists is between $103,000 and $143,000 a year. At the Comptroller's Office, salaries of the PhD economists working with examiners range from $65,000 to $110,000.

HELP FROM THE MARKETBut even a staff of highly skilled regulators, sufficiently protected from private-sector temptations, will need help as the business of banking continues to expand, Mr. Meyer said.

The best risk manager in a market economy, he said in a speech last month, is the market.

As much as the regulators focus on maintaining a skilled staff, they will increasingly need the help of market discipline.

A revision of the Basel Capital Accords, due out late this year or early in 2001, is expected to require new disclosures of banks' financial information, so that market participants will have the information to assess their riskiness on their own. The Fed, independent of the Basel Committee, recently released a staff study outlining the form that some of those disclosures should take.

"I am quite optimistic that we are going to make some significant progress in market discipline," he said.

Banks had better hope he is right.

In Chicago last month, he painted a grim picture of a future in which market discipline does not work: "Our failure to use market discipline or the failure of market discipline to work as advertised will lead, I fear, to re-regulation, a return to more-invasive supervision, and a general reversal of the freeing of banking markets."

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