- Key insight: While the banking industry has largely applauded the FFIEC's attempt to make examinations more transparent and objective, the lack of specificity is a concern, especially for smaller banks.
- Expert quote: "I strongly believe [management] is the most important factor of the CAMELS rating to ensure the safety and soundness of a bank and should continue to be heavily emphasized in safety and soundness examinations." —David Herndon, State Bank Commissioner of Kansas
- Forward look: The FFIEC will review the comments and incorporate them into a final rulemaking.
Bankers say they appreciate the Trump administration's new cross-agency supervisory shift toward prioritizing issues that present "material financial risk" over more trivial box-checking exercises. But there's just one problem: they don't know what "material financial risk" means.
The Federal Financial Institutions Examination Council's
Even so, across the more than 60 comment letters submitted in response to the proposal before this week's deadline, a common theme from advocates and opponents alike was that the proposal's central thesis — that examiners should emphasize "material financial risks" — was too ambiguous for such an important change.
"The entire reform turns on the concept of 'material financial risk, yet the proposal does not define the term," wrote William Mellin, president and CEO of the New York Credit Union Association, who called for clear guidelines or illustrative examples of what might constitute such risks. "Without such guidance, the undefined term risks preserving the very examiner discretion the proposal seeks to constrain."
The FFIEC is a collective body that includes officials from the Federal Reserve Board, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, National Credit Union Administration, the Consumer Financial Protection Bureau and representatives from five state banking supervisors. In May, it issued its reform proposal with an eye toward curbing subjectivity in bank oversight.
The Uniform Financial Institutions Rating System was created in 1979, laying out a five-point rubric for scoring bank safety and soundness: Capital adequacy, Asset quality, Management, Earnings and Liquidity. It was last reformed in 1996, a process that added a Sensitivity to market risk component, resulting in the acronym CAMELS.
The 1996 reform also placed a greater emphasis on the management component of the rating system, a shift that banks and bank policy analysts say resulted in the category being overweighted by examiners. As a result, banks have argued, they were more frequently downgraded because of operational issues that carried no immediate threat to safety or soundness, and with little transparency into the issues that might trigger a downgrade.
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The FFIEC proposal
Some commenters said these proposals would not do enough to remove the issues related to management-based examination. Tabitha Edgens, executive vice president and co-head of regulatory affairs for the Bank Policy Institute, argued that the component should be removed from the framework entirely.
"Given the continued subjectivity and redundancy inherent in the management component as currently applied and its overlap with other components, the simplest fix would be to eliminate it," Edgens wrote. "Eliminating the standalone management component would promote the proposal's goals by ensuring that supervisory judgments about governance, controls, and compliance affect ratings only through their demonstrated effect on material financial risk."
Others warned that the move to de-emphasize management would be a mistake. Kansas State Banking Commissioner David Herndon urged the FFIEC in his letter to reconsider the change, noting that it could have disproportionately large impacts on the oversight of smaller, state-chartered banks.
"I strongly believe [management] is the most important factor of the CAMELS rating to ensure the safety and soundness of a bank and should continue to be heavily emphasized in safety and soundness examinations," Herndon wrote. "I specifically disagree with removing the review of management succession, the willingness of the board to address minor auditor or examiner recommendations and not discussing specialty reviews while reviewing management."
A common critique of the proposal's treatment of management is that the focus on measurable risks inherently makes the examination process more backward-looking, thus reducing the odds of supervisors addressing issues early enough for banks to remedy them.
"Internal Audit and other control functions frequently identify governance and risk-management weaknesses before financial losses occur," wrote James Hunsanger, chief strategic enablement officer at Michigan State University Federal Credit Union. "The framework should therefore recognize objective evidence that a weakness is reasonably likely to create material financial risk if left unaddressed, rather than requiring realized financial deterioration."
Other commenters say the issues with the CAMELS system run deeper than the treatment of management issues. Peter Sullivan, general counsel for Flagstar Bank, said the FFIEC examination process has been operating out of compliance with Administrative Procedures Act and urged the council to remedy that fact during its reform effort.
In his letter, Sullivan noted that when the rating system was created, it was intended to be an internal system to identify issues and better allocate supervisory resources. But he said that over time the ratings have accumulated a variety of legal and financial implications for banks. Because of this, the standards that undergird the rating system have never been through an official notice and comment process. He urged the agencies to either go through that process or return the rating system to an internal agency tool.
"What the agencies may not lawfully do is preserve the status quo, in which binding monetary and authority consequences flow automatically from an uncodified, unpromulgated, and standardless framework that the FFIEC simultaneously disclaims as 'not a rule,'" Sullivan wrote.
Comments to the proposal also highlighted an apparent schism between large and small banks. While institutions from both sides expressed support for the spirit of the changes and requested certain clarifications, community bankers and their representatives noted that the proposal's unintended consequences would be felt more acutely by their constituents.
Amy Ledig and Joseph Chaves, top safety and soundness regulatory officials for the Independent Community Bankers Association, warned that "frequent changes to the regulatory regime" can result in new expenses that weigh heaviest on resource-constrained community banks. They urged the agencies to ensure that however material financial risks are defined, that they reflect the underlying size of the institutions being examined.
"It is critical that revisions to the CAMELS rating system not become a means of reducing scrutiny of the large institutions that pose the greatest risk to financial stability," Ledig and Chaves wrote. "The FFIEC should ensure that any materiality-based standard is applied on a tiered basis that accounts for an institution's size, complexity, business model, interconnectedness, and systemic footprint."
