The Federal Reserve Board in November issued a statement outlining supervisory operating principles. It's a short, three-page document, but it made an impact when released, and the language the board uses is what's interesting — it's not the traditional "Fed speak" to which we in bank regulatory land have become accustomed.
A Significant Shift in Operating Practices
The statement comes on the heels of an announcement in August related to Vice Chair for Supervision Michelle Bowman's priorities and operating principles wherein she outlined a new approach for supervisory principles to strengthen supervision by focusing on identifying and taking timely, proportionate action as early as possible to eliminate the most important risks threatening the safety and soundness of banking organizations.
This is obviously a worthy cause and not all that different from the way that the banking bar currently thinks; however, the last sentence of the first paragraph of the supervisory statement at issue says, "These changes represent a significant shift from past operating practices."
The statement provides what it calls "directional guidance" on the changes that Bowman expects the Fed to undertake and outlines a shift in priorities and focus on the supervisory context.
As the statement indicates, "staff should not assume that [the Fed's] current or past operating practices should continue going forward," and that "staff should continually consider whether their work conclusions, messaging, and other actions are aligned with the specific changes outlined in this statement and, more broadly, with this overall shift in direction and posture."
This is fascinating — and clear — language addressing the shift in the Fed's direction on supervisory matters. Indeed, expectations are changing for examiners in which they are to prioritize attention on a banking organization's material financial risks.
Fed examiners are instructed to avoid getting "distracted" by "devoting excessive attention to processes, procedures, and documentation that do not pose material risk to a firm's safety and soundness."
One forthcoming initiative mentioned is that the Fed will be amending Supervisory Letter SR 13-13 to "reverse its directive to eliminate supervisory observations."
Again, the approach will be enhancing supervision to focus on the material financial risks — a very clear shift in the way that things have been done in the past with respect to the supervision of banks and bank holding companies by the Fed.
Leveraging Sister Federal and State Banking Agencies, Unless That's "Impossible"
Another slight directional shift, though seemingly not as dramatic, is the desire to leverage the language of the Gramm-Leach-Bliley Act. It directs examination functions at the federal banking agencies to rely to the maximum extent possible on the exams and other supervisory work by the primary state or federal banking supervisor of bank subsidiaries, other than the state member banks, which of course are primarily supervised by the Fed.
To this point, the statement does not mince words on this expectation, stating that Fed "supervisory staff should not conduct their own examination of such depository institution subsidiaries unless it is impossible for the Federal Reserve to rely on the exam of that bank's primary state or federal supervisor."
"Impossible" is a strong term and sets a very high bar in this context.
This impossibility standard, the statement continues, might be met if such a bank's supervisor "does not share sufficient information about the depository institution for the Federal Reserve to rely on their examinations or supervisory work." It should not be considered impossible just because the Fed's exam work is different than another federal banking agency's exam work or a state bank supervisor's exam work.
The result of this is that exam teams should be tailoring supervision based on the size, complexity and systemic importance of the banking organization and focusing more substantial resources on larger banking organizations.
Changes in Enforcement Expectations
Beyond the supervisory function, the shift in operating practices also address the use of matters requiring attention, matters requiring immediate attention, and other requirements in enforcement actions, indicating that staff need to change the way they decide whether to issue an MRA, MRIA or other requirements in an enforcement action.
Additionally, staff is directed not to delay "the termination of an MRA, MRIA, or a requirement in an enforcement action if the underlying deficiency has been fully remediated."
This is certainly a welcome perspective from the Fed to address MRAs more effectively and efficiently, and where issues are fully remediated the statement is clear about removing the enforcement action or other requirement immediately.
Indeed, staff are instructed not to conduct additional reviews or what are referred to as "capstones" on issues that are not directly related to any of the deficiencies identified in an enforcement action. What this means is that the enforcement actions should be specific and targeted, if they're needed.
This also means that when the surgical remediation is completed, enforcement actions should be removed immediately and without giving supervisors some kind of ability to look into issues that are ancillary or not directly related to the issues that led to the enforcement matters.
Again, this reflects a targeted approach with a greater focus on material issues, specifically material financial issues.
Going forward, exam ratings should "accurately reflect an institution's financial condition and material financial risks," and the "management and risk management components of both the [capital adequacy, assets, management capability, earnings, iquidity and sensitivity] and RFI/C(D) ratings should not be given more weight than the other components in determining a firm's composite rating," per the statement.
Instead, the statement indicated that all ratings "should be considered and weighed based on their materiality to the institution," i.e., a tailored approach to each banking organization.
This is clearly a departure from the past, where there seems to have been a significant focus on the management component when considering the composite rating of an organization.
Additionally, the standard for issuing MRAs and MRIAs based on threats to safety and soundness will be changing such that MRAs and MRIAs should "[p]rioritize deficiencies that could have a material impact on a firm's financial condition."
In another interesting departure from "Fed speak," the statement directs examiners and supervisory staff "to communicate MRAs and MRIAs with sufficient specificity so that a person of ordinary intelligence can readily know what the deficiency is underlying an MRA or MRIA and what a nondeficient state would be.
It also tells examiners to engage in meaningful dialogue with banking organization management to offer clarity when it's requested and "invite feedback from an institution as to whether a particular MRA or MRIA is justified" or whether there's some lack of clarity around the expectations or what the remediation expectations ultimately look like.
This is absolute Mozart to bankers' ears after years of frustration and fear of retaliation with this very issue.
Finally, the last bullet of the statement delivers yet another gem for bank management, stating that the Fed's "interpretation of the statutory standard for issuing enforcement actions based on an unsafe or unsound practice will also be changing." Work is underway to clarify this standard.
Going forward, the result is that the Fed's examination and enforcement focus will be directed to material financial risks and issuing enforcement actions that are much more surgical than in the past. This is welcome news for banking organizations under the purview of the Fed, even though it may take some time to penetrate long-standing examiner training and expectations.
Regardless, this statement is a critical piece of examiner guidance for banking organizations to deconstruct.
Joseph E. Silvia is a partner at Duane Morris LLP. He previously served as counsel to the Federal Reserve Bank of Chicago.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
Reprinted with permission of Law360.
