[Senate Hearing 113-58]
[From the U.S. Government Publishing Office]
S. Hrg. 113-58
LESSONS LEARNED FROM THE FINANCIAL CRISIS REGARDING
COMMUNITY BANKS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE MAJOR TRENDS AFFECTING COMMUNITY BANKS AND LESSONS
LEARNED FROM COMMUNITY BANK FAILURES DURING THE FINANCIAL CRISIS
__________
JUNE 13, 2013
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon MARK KIRK, Illinois
KAY HAGAN, North Carolina JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota
Charles Yi, Staff Director
Gregg Richard, Republican Staff Director
Laura Swanson, Deputy Staff Director
Glen Sears, Deputy Policy Director
Phil Rudd, Legislative Assistant
Greg Dean, Republican Chief Counsel
Jelena McWilliams, Republican Senior Counsel
Dawn Ratliff, Chief Clerk
Kelly Wismer, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, JUNE 13, 2013
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Crapo................................................ 2
WITNESSES
Richard A. Brown, Chief Economist, Federal Deposit Insurance
Corporation.................................................... 3
Prepared statement........................................... 18
Responses to written questions of:
Senator Crapo............................................ 46
Jon T. Rymer, Inspector General, Federal Deposit Insurance
Corporation.................................................... 5
Prepared statement........................................... 21
Responses to written questions of:
Senator Crapo............................................ 48
Lawrance L. Evans, Jr., Director, Financial Markets and Community
Investment, Government Accountability Office................... 6
Prepared statement........................................... 26
Responses to written questions of:
Senator Crapo............................................ 52
(iii)
LESSONS LEARNED FROM THE FINANCIAL CRISIS REGARDING COMMUNITY BANKS
----------
THURSDAY, JUNE 13, 2013
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:27 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I apologize for being a bit late, but the
vote was called. Good morning. I call this hearing to order.
Today we will discuss three recent studies on community
banks: the GAO's study, ``Causes and Consequences of Recent
Bank Failures''; the FDIC Inspector General's ``Comprehensive
Study on the Impact of the Failure of Insured Depository
Institutions''; and the ``FDIC Community Banking Study''.
Between January 2008 and December 2011, 414 insured U.S.
banks failed. Of these, 353 were depository institutions with
less than $1 billion in assets. Despite these failures, over
7,000 small financial institutions survived. We know that
community banks did not cause the financial crisis, but many
were casualties of the Great Recession that followed.
Community banks entered the crisis with strong capital and,
despite weakening earnings, most of them remained well
capitalized through the crisis. However, some banks saw an
increase in nonperforming loans and a decrease in income that
strained their capital levels.
I look forward to today's witness testimony. The FDIC, the
GAO, and FDIC IG have taken important steps to analyze the
impact of the financial crisis on community banks, and
specifically the GAO and IG studies looked at the factors that
contributed to the bank failures during this period. All three
studies have provided lessons learned from the crisis regarding
community banks and have made recommendations that would
strengthen the community bank model and improve regulation and
supervision.
Since community banks play such a vital role in so many
cities and towns of all sizes, including many in my home State
of South Dakota, it is important for this Committee to explore
major trends affecting community banks and lessons learned from
the financial crisis. It is my hope that this Committee can
find consensus and ways to strengthen community banks and the
communities they serve without undermining safety and soundness
regulation or consumer protection.
Ranking Member Crapo, do you have an opening statement?
OPENING STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Yes, Mr. Chairman, and thank you.
Today the Committee will hear about the lessons we have
learned from the financial crisis regarding community banks. I
want to thank the FDIC and the GAO for coming to testify
pursuant to a statutory requirement to brief us on bank
failures and their causes.
This is a critical issue since small banks represent the
lifeblood of many communities across America, and especially
rural communities, in Idaho and elsewhere. In fact, the FDIC's
Community Banking Study, commissioned by Chairman Marty
Gruenberg, shows that community banks hold the majority of
banking deposits in rural counties, with one in five U.S.
counties having no other banking presence.
Banking used to be a community-based enterprise, relying on
local knowledge and expertise to extend credit based on
creditworthiness of the bank's depositors. Many community banks
continue to operate that way even today.
Despite the many benefits of such relationship-based
banking, the industry has become increasingly concentrated
since the 1980s. The number of banking organizations has shrunk
by nearly one-third from 1990 to 2006, and most of this
contraction has involved small community banks whose numbers
have now fallen by more than 3,000 during that time.
The financial crisis of 2008 only exacerbated the
consolidation trend. Between January 2008 and December 2011,
414 U.S. banks failed, according to the GAO. Of those, 85
percent, or 353 banks, had less than $1 billion in assets.
Those banks often specialized in small business lending, so
their failure has had a disproportionately large impact on
small business lending and local employment.
We must carefully examine what led to such a large number
of small banks closing and the residual effect on local
communities.
We also need to be able to put this most recent crisis in
perspective and examine how it compares to past community bank
crises. While this hearing is focused on lessons learned from
the most recent financial crisis, much can be learned from the
postcrisis response as well. The regulatory framework that
emerged out of Dodd-Frank has made it increasingly difficult
for community banks to maintain and operate their business
presence in many communities. Community banks are
disproportionately affected by increased regulation because
they are less able to absorb the additional cost.
The majority of community banks today have $250 million or
less in assets, according to the GAO, which often translates
into a one- or two-person compliance department. Small
institutions simply do not have the resources necessary to
review and parse through thousands of pages of new rules. As a
result, many community and small banks have identified Dodd-
Frank as imposing overwhelming regulatory burdens on them or
serving as barriers to entry.
As Federal Reserve Governor Duke outlined in a November
2012 speech, ``If the effect of a regulation is to make a
traditional banking service so complicated or expensive that
significant numbers of community banks believe they can no
longer offer that service, it should raise red flags and spur
policy makers to reassess whether the potential benefits of the
regulation outweigh the potential loss of the community bank's
participation in that part of the market.''
I believe we have reached that point, and I look forward to
the testimony from our witnesses today.
Thank you, Mr. Chairman.
Chairman Johnson. Thank you, Senator Crapo.
Are there any other Members who wish to make a brief
opening statement?
[No response.]
Chairman Johnson. Thank you all.
I want to remind my colleagues that the record will be open
for the next 7 days for opening statements and any other
materials you would like to submit. Now I will introduce our
witnesses.
Mr. Richard Brown is Chief Economist at the FDIC.
The Honorable Jon T. Rymer is Inspector General of the
FDIC.
Mr. Lawrance L. Evans, Jr., is Director for Financial
Markets and Community Investment at the GAO.
I thank all of you for being here today. I would like to
ask the witnesses to please keep their remarks to 5 minutes.
Your full written statements will be included in the hearing
record.
Mr. Brown, you may begin your testimony.
STATEMENT OF RICHARD A. BROWN, CHIEF ECONOMIST, FEDERAL DEPOSIT
INSURANCE CORPORATION
Mr. Brown. Chairman Johnson, Ranking Member Crapo, and
Members of the Committee, I appreciate the opportunity to
testify on behalf of the FDIC regarding the FDIC Community
Banking Study. This research effort was initiated in late 2011
to better understand the changes that have taken place among
community banks over the past quarter century. This effort was
motivated by our sense of the importance of community banks to
small businesses and local economies in every part of the
country and by our understanding that community banks have
faced a number of challenges in the postcrisis financial
environment.
Our research confirms the crucial role that community banks
play in our financial system. As defined by the study,
community banks represent 95 percent of all U.S. banking
organizations. They account for just 14 percent of U.S. banking
assets but hold 46 percent of the industry's small loans to
farms and businesses.
While their share of total deposits has declined over time,
community banks still hold the majority of bank deposits in
rural and other nonmetropolitan counties. Without community
banks, many rural areas, small towns, and urban neighborhoods
would have little or no physical access to mainstream banking
services. The study identified 629 counties where the only
banking offices are those operated by community banks.
Our study examined the long-term trend of banking industry
consolidation that has reduced the number of banks and thrifts
by more than half since 1984. But the results cast doubt on the
notion that future consolidation will continue at this same
pace or that the community banking model is in any way
obsolete.
Since 1984, more than 2,500 institutions have failed, with
the vast majority failing in two crisis periods. To the extent
that future crises can be avoided or mitigated, bank failures
should contribute much less to future consolidation. About 80
percent of the consolidation that has taken place resulted from
eliminating charters within bank holding companies or from
voluntary mergers, and both of those trends were facilitated by
the relaxation of geographic restrictions on banking that took
place in the 1980s and the early 1990s.
But the pace of voluntary consolidation has slowed over the
past 15 years as the effects of these one-time changes were
realized.
The study also showed that community banks that grew
prudently and that maintained diversified portfolios or
otherwise stuck to their core lending competencies exhibited
relatively strong and stable performance over time, including
during the recent crisis. By comparison, institutions that
pursued more aggressive growth strategies underperformed.
The strongest performing lending groups across the entire
study period were community banks specializing in agricultural
lending, diversified banks with no single specialty, and
consumer lending specialists. Agricultural specialists and
diversified nonspecialists also failed at rates well below
other community banks during the study period. Other types of
institutions that pursued higher-growth strategies--frequently
through commercial real estate or construction and development
lending--encountered severe problems during real estate
downturns and generally underperformed over the long run.
Now, with regard to measuring the costs of regulatory
compliance, the study noted that the financial data collected
by regulators does not identify regulatory costs as a distinct
category of noninterest expenses. As part of our study, the
FDIC conducted interviews with a group of community banks to
try to learn more about regulatory costs. Most participants
stated that no single regulation or practice had a significant
effect on their institution. Instead, most said that the strain
on their organization came from the cumulative effects of a
number of regulatory requirements that have built up over time.
Several of those interviewed indicated that they have increased
staff over the past 10 years to support their responsibilities
in the area of regulatory compliance. Still, none of the
interview participants said that they actively track the
various costs associated with compliance, citing the
difficulties associated with breaking out those costs
separately.
In summary, despite the challenges of the current operating
environment, the study concluded that the community banking
sector will remain a viable and vital component of the overall
U.S. financial system for the foreseeable future.
Thank you for the opportunity to testify, and I look
forward to your questions.
Chairman Johnson. Thank you, Mr. Brown.
Mr. Rymer, please proceed.
STATEMENT OF JON T. RYMER, INSPECTOR GENERAL, FEDERAL DEPOSIT
INSURANCE CORPORATION
Mr. Rymer. Thank you, Chairman Johnson, Ranking Member
Crapo, Senator Warren. Thank you for the opportunity to testify
today on the lessons learned from the financial crisis. As you
requested, I will focus my remarks on the study my office
conducted on the impact of the failure of insured financial
institutions. I will summarize the study's overarching
conclusions and general observations. In addition, I will
highlight some of the work my office has completed over the
last 5 years that could contribute to the Committee's ``lessons
learned'' discussion.
The events leading to the financial crisis, and the
subsequent efforts to resolve it, involved the dynamic
interplay of laws, regulations, agency policies and practices
with the real estate and financial markets. Banks expanded
lending, fueling rapid growth in construction and real estate
development. Many of the banks that failed did so because
management relaxed underwriting standards and did not implement
adequate oversight and control.
For their part, many borrowers did not always have the
capacity to repay loans and, in some cases, pursued many
projects without considering all the risks involved.
As for the regulators, while they generally fulfilled their
responsibilities, most of the material loss reviews conducted
by the three bank regulatory IGs found that the regulators
could have provided earlier and greater supervisory attention
to troubled banks and thrifts.
Four general observations emerged from our study, and they
are as follows:
First, the FDIC's resolution methods--including the shared
loss agreements--were market driven. Often, failing banks had
poor asset quality and little or no franchise value, and as a
result did not attract sufficient interest from qualified
bidders for the FDIC to sell the banks without a loss-share
guarantee. The FDIC used these agreements to leave failed bank
assets in the financial services industry, thereby supporting
asset values and reducing losses to the Deposit Insurance Fund,
or the DIF.
Second, most community bank failures were the result of
aggressive growth, asset concentrations, poor underwriting,
deficient credit administration, and declining real estate
values.
Third, we found that examiners generally followed and
implemented longstanding policies. However, they did not always
document all of the examination steps they performed.
And, fourth, the FDIC has investment-related policies in
place to protect the DIF and to ensure the character and
fitness of potential investors.
In my remaining time, I would like to highlight some of the
other work my office has completed related to the financial
crisis.
My office has conducted over 270 reviews of failed banks to
determine the reason for the failure and, in many cases, to
assess the FDIC's supervisory performance as the primary
Federal regulator of these banks.
In addition to these reviews, we separately summarized the
major causes, trends, and common characteristics of bank
failures. In a December 2010 report, we examined the FDIC's
supervisory actions taken up to that point in the crisis and
offered recommendations geared to further enhance the FDIC's
supervisory program.
Although our focus was primarily on failed banks, we have
also looked to gain an understanding of why similarly situated
banks did not fail. Our findings from an October 2012 report
were not surprising as essentially they confirmed that
planning, risk management, and strong leadership at both the
bank management and board levels are the key ingredients to a
successful bank.
Finally, my office, along with the other two bank
regulatory IGs, looked at the use and impact of prompt
regulatory actions established in the FDI Act. In a September
2011 report, we found that prompt corrective actions occurred
too late to rescue most troubled institutions. And while
critically undercapitalized institutions were closed promptly,
the losses to the DIF were still significant.
In closing, the main lessons that should be learned from
the work we did during the crisis is for the FDIC to remain
vigilant in its supervisory activities in both good economic
times and in bad. Focusing examination attention on key
processes and risk management before an institution experiences
financial and capital decline is the supervisory key to
maintaining healthy banks.
FDIC management must ensure that the lessons learned from
the crisis become ingrained in its day-to-day operations in
order to avoid a repeat of the last 5 years. We must all
realize that these lessons will become more difficult to apply,
or sustain, as the economy improves and banks return to
profitability.
This concludes my prepared statement. Thank you for the
opportunity to be here today and join in this discussion. I
look forward to answering your questions.
Chairman Johnson. Thank you, Mr. Rymer.
Mr. Evans, please proceed.
STATEMENT OF LAWRANCE L. EVANS, JR., DIRECTOR, FINANCIAL
MARKETS AND COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY
OFFICE
Mr. Evans. Chairman Johnson, Ranking Member Crapo, and
Senator Warren, I am pleased to be here this morning to discuss
our January 2013 report on bank failures.
Between 2008 and 2011, 414 insured U.S. banks failed. Since
then, there have been 67 additional failures. Examining failed
institutions, especially in contrast to their nonfailing peers,
provides an opportunity to glean lessons learned that may be
useful for regulators and policy makers going forward. Whereas
my written statement covers a number of issues, my oral remarks
today will focus on the causes of community banks failures.
As we detailed in our report, 72 percent of the failures
were concentrated in 10 States--in the West, Midwest, and
Southeast. Almost all the failures involved small and medium-
size banks. As mentioned, 85 percent of the banks had less than
$1 billion in assets at the time of failure. Our analysis of
these failures revealed four key issues.
First, the failures were associated with high
concentrations in commercial real estate, particularly
acquisition, development, and construction loans. These loans
grew rapidly and exceeded the regulatory thresholds for
heightened scrutiny by a significant margin. ADC concentrations
at failed banks grew from roughly 100 percent of total risk-
based capital to nearly 260 percent in 2008. At the onset of
the financial crisis, ADC loans made up 30 percent of the total
loans at failed banks, roughly 20 percentage points higher than
at their open peers.
Second, ADC and CRE concentrations were often associated
with aggressive growth, poor risk management, weak credit
administration, and risky funding sources. In some cases, IG
reviews noted that failed banks engaged in lending outside of
their normal geographical trade areas where they had no
experience. We found that 28 percent of the failed banks had
been chartered for less than 10 years at the time of their
failure. According to regulators, many of these were formed to
take advantage of the commercial real estate boom but lacked
the experience necessary to manage the risks associated with
heavy concentrations.
FDIC staff noted that in many cases these young failed
banks departed sharply from the approved business plan
originally filed with the FDIC. Our econometric analysis found
that banks with higher ADC concentrations and greater use of
broker deposits were more likely to fail, while banks with
better asset quality and greater capital adequacy were less
likely to fail over the 2008-11 period.
Our model found that high concentrations of CRE loans
unrelated to acquisition, development, and construction did not
increase the likelihood of failure, of course, abstracting from
extreme concentrations.
Third, the majority of the assets held by failing banks
were not subject to fair value accounting. In fact, less than 1
percent of the assets held by failed banks were subject to fair
value accounting on a recurring basis. We found that the
biggest contributors to credit losses at failed institutions
were nonperforming loans recorded at historical costs.
Significant declines in real estate values contributed to
these losses because, as collateral-dependent loans suffered
impairment, accounting rules required that they be written down
to the value of the collateral.
Last, loan loss reserves were not adequate to absorb credit
losses, in part because the accounting model for estimating
credit losses is based on historical loss rates or incurred
losses. As a result, estimated losses were based on economic
conditions that understated default risk. As the level of
nonperforming loans began to rise during the crisis, banks were
forced to increase loan loss allowances and raise capital when
they were least able to do so.
To address this issue, accounting standard setters have
proposed a more forward-looking approach that focuses on
expected losses and would, therefore, incorporate a broader
range of credit information. If operationalized, an expected
loss model could potentially reduce the cycle of losses and
failures that emerged in the recent crisis and could also
encourage prudent risk management practices.
Federal Reserve staff noted that if management at failed
banks were forced to recognize loan losses earlier, it may
provided an incentive to limit concentrations and the types of
loans that later resulted in significant losses.
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee, this concludes my opening statement. I will be happy
to answer any questions you have.
Chairman Johnson. Thank you, Mr. Evans, and thank you very
much for your testimony.
As we begin questions, I will ask the clerk to put 5
minutes on the clock for each Member.
Mr. Evans and Mr. Rymer, with the vast majority of
community banks that survived the financial crisis, what
characteristics based on your research helped them survive?
What lessons should community banks and regulators learn from
those that failed? Mr. Rymer, let us begin with you.
Mr. Rymer. Yes, sir, thank you. I think that is a great
question to start with. We did do a study on that particular
question a couple of years ago. We looked at banks that did
have--I think all three of us have noted that concentrations in
ADC--acquisition, development, and construction lending in
commercial real estate--such concentrations, which had been a
problem at many of the failures. We identified over 400 banks
during the period of 2007 to 2011 that had concentrations of
300 percent or more of capital in ADC loans.
We looked at a particular group of those banks, 18 banks in
that group that were high-performing or well-performing banks,
either CAMELS--rated 1 or 2, and what we found in those banks
was that the common characteristics were strong and engaged
board leadership, strong management, a focus on local markets,
strong core funding or local funding, and a focus on risk
management and planning.
So, in net, it is all the things that you would expect a
well-run bank or a well-run business to do. I think the key is,
in those community banks that are actively engaged in ADC
lending, to recognize the risks associated with that business
line and invest in the controls and management to manage that
risk.
Chairman Johnson. Mr. Evans.
Mr. Evans. So I will speak on net here because our findings
were quite similar. We found that it was unhealthy
concentrations in acquisition, development, and construction
loans that were very important. And I think that underlies the
core issues, which were poor risk management and aggressive
growth. So I think, in this case--and we saw this across all
banks, even the large institutions--we saw poor risk
management, aggressive growth strategies, and weak credit
administration practices. It just materialized a bit different
for the small banks as opposed to their larger peers, and their
larger peers were, of course, concentrated in nontraditional
residential mortgage loans. And, of course, with the community
banks, it was large and unhealthy concentrations in
acquisition, development, and construction loans.
Now, to build on the October 2012 report that the IG
referred to, we also have some findings that are consistent
with those findings. We found through our rigorous econometric
analysis that CRE concentrations themselves, once you control
for capital adequacy and asset quality, did not lead to an
increased likelihood of failure. Of course, these were non-ADC
portions of commercial real estate, so your strip malls and
your gas stations and the like. That abstracts again from very
large and significant concentrations of, say, 600 percent,
something well beyond the regulatory thresholds that would
trigger additional scrutiny.
Chairman Johnson. Mr. Brown, have community banks fully
recovered from the financial crisis? And how have community
banks strengthened their balance sheets since the crisis?
Mr. Brown. Chairman Johnson, community banks have made
significant progress in overcoming the challenges they faced in
the crisis. They still have some way to go. As a group, as we
have defined them in our study, they earned a pretax return on
assets of 1.06 percent in 2012. That is an update to our study.
That is 3 times more than their profitability in 2010, so that
gives you a sense of the progress that they have made.
But as our study documented, half of the loan portfolios of
these institutions are real estate secured, and real estate is
still in a difficult situation in many parts of the country.
Problem loan levels remain elevated, and that is one of the
reasons that loan growth remains slow.
Now, the community banks were steady providers of credit
during the depths of the crisis. I think the noncommunity banks
showed much larger contractions in the credit that they
provided. But community bank loans have grown slowly recently,
largely because of the loans secured by nonfarm, nonresidential
properties, in many cases where real estate serves as
collateral for what otherwise is a commercial loans. So there
are still some challenges that they face.
Chairman Johnson. Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
Mr. Evans, in December 2012, the FDIC issued a
comprehensive report on community banks, and some of the
findings of that report suggest that bank consolidation has
very real consequences for the economy because community banks
and small banks play such a vital role in the local source of
credit. Yet some industry observers are estimating that nearly
2,000 banks will need to be acquired or to sell their assets in
the aftermath of the crisis. Others speculate that 90 percent
or more of small banks with less than $1 billion in assets are
not likely to survive.
First of all, did you agree with this assessment that the
smaller banks still face a very serious potential of not
surviving in large numbers? And what can the FDIC do given the
causes that you have just identified and discussed with us of
so much of the failure, what can the FDIC do to ensure that
community banks, especially in rural areas, do survive?
Mr. Evans. Very important question, especially given the
importance of community banks for local communities.
I would say our work here is fairly limited that would
allow me to answer this question. But I will note that as of
the end of the first quarter of 2013, there were 612 banks on
the problem bank list. So that indicates that there are still
issues that need to be worked through.
I think some of the issues with respect to community banks,
where the examiners can play a more significant role, is
determining what it really means when concentration thresholds
are exceeded, and they say it requires additional scrutiny or
heightened scrutiny. What does that mean? Because it is really
those significant concentrations that contributed to the
problems that we saw across the board.
And, again, just regulators in general, there are a number
of issues we should be thinking about in terms of regulatory
burden and right-sizing regulations.
Senator Crapo. I know you have studied the regulatory
burden that our community banks or smaller banks have faced.
Could you give us any--just comment on what your conclusions
are with regard to whether we have too excessive a burden right
now or whether we need to fine-tune the approach that we have
taken?
Mr. Evans. Right. So, I mean, and this is an important
issue. It is important to frame it appropriately, and I think
there is a minimization problem that we are trying to solve, so
we are trying to minimize regulatory burden on institutions,
especially when some of the regulations were designed to impact
the largest, most complex and internationally active
institutions.
So, clearly, there is a minimization problem that needs to
be solved here, but there is a constraint, and that constraint
is safety and soundness. So framing the debate in that way
suggests that it is important for regulators to use their
flexibility as granted by Dodd-Frank to offer exemptions and
tier these regulations appropriately.
Again, that having been said, safety and soundness is an
important concern. Certain regulations are certainly
appropriate for banks of all sizes. And so starting to have
that dialog I think will be appropriate in determining where we
can tier and right-size some of these regulations.
Senator Crapo. Thank you.
Mr. Rymer, in the time I have got left, I would like to
talk with you about the examination process just briefly. The
FDIC has reviewed its examination rulemaking and guidance
processes during 2012, and as a result of that review, the FDIC
has implemented a number of enhancements to its supervisory and
rulemaking processes.
What feedback, if any, have you received from your
revisions from the institutions that are being supervised? How
is this working?
Mr. Rymer. Well, very little direct feedback from the
industry. Those changes to the FDIC's supervisory processes are
very recent, but many of those changes I believe were
responsive to some of the work we did in our 2009 and 2010
reports.
The FDIC, in general, is focused on community bank
examination, and I know this Committee is very interested in
that issue. I know we received a letter from Chairman Johnson,
I believe early last year, on that very topic. We have looked
at examination frequency and examination consistency. It is my
view that the FDIC is taking more of a risk-based approach to
spending more examination time, frankly, on banks that may
deserve it. There is an awareness in the agency that banks are
in the business of banking, not in the business of complying
with regulation, although regulation, as it has been noted, is
critical to the business.
Banking is a highly regulated industry. It does receive
support in the sense of insured deposits from the FDIC, so the
FDIC does have a duty to protect those deposit insurance funds.
But I think there is an acknowledgment within the FDIC through
the more risk-focused examination process and its attention to
the community banking industry through some of the work that
Rich and his staff has done and then Chairman Gruenberg's
recently forming of a community bank advisory council. There
seems to me to be a focus within the institutions, the FDIC,
and the industry as a whole about the critical importance of
the examination process.
Senator Crapo. Thank you.
Chairman Johnson. Senator Warren.
Senator Warren. Thank you, Mr. Chairman, thank you, Ranking
Member Crapo, for holding this hearing, and thank you all for
being here.
I believe we need banks of all sizes, including community
banks. Community banks are important because they increase
consumer choice, they promote competition, they counteract the
concentration that we have with too-big-to-fail banks.
But one of the principal benefits that community banks
bring us is lending to small businesses, and I think the data
show that disproportionately it is our community banks that are
out there making these loans to small businesses.
The smallest banks, those with $250 million or less in
assets, account for only 4 percent of the assets in the banking
industry. And yet they constitute 13.7 percent of all the
business loans out there. So small businesses really count on
these community banks.
When I was working on the Congressional Oversight Panel
during the crisis, we warned about the concentration in the
banking industry and about the impact it would have on small
business lending. And here we are 5 years out now, still
worrying about concentration in the industry.
So what I would like to do is just give you a chance here,
Mr. Evans, if you could talk for just a minute about the GAO's
findings in your report about the impact that concentration in
banking has on small business lending.
Mr. Evans. OK. So in this particular report, when we looked
at concentration what we were trying to get at is whether the
bank failures created the types of concentration concerns that
would trigger potential anticompetitive effects. And so in this
particular report, when we looked at it, we saw that the
acquiring banks generally stepped in and limited concentration
levels from going above that point where we would be concerned
about anticompetitive effects.
Senator Warren. Well, let me push back, though, just a
little bit on that, Mr. Evans, because part of the concern I
have is not simply whether there is physically a bank outlet
operated somewhere, but that community banks do more small
business lending, and once they are swallowed up by big banks,
whether they are swallowed up because they were failing or
whether they were just bought up, whether they were gobbled up
by the big banks, that what we see is that small businesses
have much more trouble getting access to capital.
Mr. Evans. Right, and that is one of the things we really
could not get at in the study, but we do point it out. We point
out that the patterns of lending could change because of some
of these acquisitions. And those institutions and borrowers
likely to be most hurt would be those that rely on their local
community banks for small business loans.
Senator Warren. Good. Then let me just follow up on a
question that Senator Crapo had put out on the table about how
we maintain a strong environment for our community banks,
because they are so important to the rest of our economy.
You know, after the crisis, there was just nearly a panic
about people who could not get access to credit. One of the
responses, of course, was Dodd-Frank, but one of the concerns
that I have is that in Dodd-Frank we now have a regulatory
system that, while Dodd-Frank made some distinctions between
large and small banks, small banks are still subject to many
regulations that were written for the larger financial
institutions.
And so what I am concerned about is that we now have a
regulatory system for which many parts of it are neutral on its
face, but the impact on smaller financial institutions that
cannot afford to hire an army of lawyers to go and interpret
these rules turns out to be crushing.
So the question I want to ask, and I hope we have time that
I can ask it of all of you, is whether or not we are reaching a
point where we should really think about a two-tiered
regulatory system.
Mr. Rymer, would you like to address that?
Mr. Rymer. Yes, ma'am, to the extent I can. We have not,
again, done a lot of work in that area in terms of post- Dodd-
Frank. Our focus on Dodd-Frank will be--as we have some work
planned--related to the effect of Dodd-Frank. We are planning
work later this fall to look at whether examination efforts are
coordinated between the CFPB and the primary Federal regulators
as it relates to regulatory burden, and there are clear
dividing lines between CFPB responsibilities in a bank and the
primary Federal regulator.
But I think the broader question that you are asking is
what can the regulators do and potentially the Congress do to
encourage or improve the health and sustainability of the
community bank model. Frankly, I think whatever we can do to
encourage profitability and encourage the types of positive
behaviors in a community bank that make it successful. The key
to community banking, frankly, is profitability. The majority
of banks that have evaporated from the community bank landscape
have done so through merger and acquisition, and that is
because the folks that owned those banks chose to sell those
banks, and perhaps in many cases those banks were not as
profitable as they could have been. So I think enhanced
profitability ultimately has got to be the focus.
Senator Warren. Although I am not sure we regulate that
directly here in Washington. If I can just have a few more
seconds, if that is all right, Mr. Chairman, I would really
like to hear Mr. Brown's comments on this since they are doing
this at the FDIC. Have we reached a point where it is time to
think about a two-tier regulatory system for our small banks?
Mr. Brown. Well, Senator, the issue that you bring up is a
very important one, and I think it is addressed in the
supervisory process by a risk-focused supervisory system that
tries to scale the nature of the supervisory process to the
risk and the complexity of institutions. And it is something
where it is sort of hard to write rules in advance and create
thresholds that work for all cases. I think supervisors at the
FDIC try very hard to make sure that the process is scaled to
the risk and complexity of those institutions.
I would just add that in the precrisis years there
definitely was a performance gap between the larger
noncommunity banks and community banks. The noncommunity banks
grew much faster. They earned much more money. And, of course,
they did so through----
Senator Warren. I am sorry. Can we also add to that the
noncommunity banks were the ones that took on all the risk and
crashed the economy?
Mr. Brown. Yes, I was headed in that direction.
Senator Warren. Which sort of suggests that maybe they did
not have proper oversight.
Mr. Brown. And I think the reforms in Title I and Title II
of Dodd-Frank, ending too big to fail, is a very important
element to leveling the playing field and making sure that the
community banking sector stays vibrant in the years ahead.
Senator Warren. Thank you very much.
Thank you for your indulgence, Mr. Chairman.
Chairman Johnson. Senator Moran.
Senator Moran. Chairman, thank you. I appreciate the
opportunity to visit with individuals from the FDIC.
Most of my time in the Senate, which is short, certainly in
the Banking Committee we have raised the topic of regulations
of community banks, and I have raised that not just with the
FDIC but other regulators. There is a pretty standard response
to those questions about how we understand the value of
community banks. We treat them differently. We have an advisory
committee that we get input from. And yet the statistics and
trends continue with additional consolidation. I see it in the
numbers in Kansas. The number of banks is less than it was a
year ago. And I heard it anecdotally, the continual
conversation, and it makes sense to me that the increasing cost
of regulation means that a bank has to be larger in order to
cover the costs of those regulations. Fixed costs matter.
I remember a banker telling me that an examiner was in the
bank and suggested that they hire two more people in the bank
to comply with rules and regulations. The bank employs eight
people. Two people is a significant increase in the number of
people working there. Increasing employment would be a good
thing, but not if you cannot afford to do that.
And so our bankers' options, particularly as the economy
becomes more difficult, their options generally are find some
other bank interested in buying them. And I think there is a
significant consequence to rural America in the absence of
community financial institutions, the ability to--the
relationship banking remains important to my farmers, ranchers,
small business men and women. And my concern or complaint is
that--I do not want to be pejorative and say we continue to
provide lip service to this issue, but I cannot ever find any
evidence that we are really doing anything differently in
regard to the regulatory environment that community financial
institutions face.
Maybe you could satisfy me with the suggestion that we have
a different examining standard, we have different criteria when
our examiners are in the bank, we have a different set--we have
eliminated--give me an example of regulations that we have
eliminated or modified because of the size and scope of the
bank. And, again, I would portray this, at least in my view,
that all of this is in the context of financial institutions
that are not too big to fail and that have little consequence--
significant consequence in a community or to shareholders, but
little consequence systemically to the economy.
Can you assure me that the conversations that I have had
with individuals who regulate banks and are responsible for
those regulations over the last 2\1/2\ years have done more
than tell me they understand my problem and have done something
about it?
Mr. Brown. Senator, your question on consolidation is a
very good one, and I do want to put it in perspective, that
after----
Senator Moran. My other questions are not?
[Laughter.]
Mr. Brown. They are all very useful.
After two-and-a-half decades of consolidation that we
followed in our study, 95 percent of banking organizations in
2011 were community banks, and we saw the biggest decline among
very small community banks. The number under $25 million
actually declined by 96 percent, much less consolidation at
slightly larger size groups.
In fact, the number of charters with assets between $100
million and $1 billion increased by 19 percent over the study
period, and that is where 65 percent of community banks
currently operate.
We did studies of economies of scale. How much do average
costs fall as asset size increases? For some lines of business,
like commercial real estate lending, there were some economies
of scale, but most of them are realized at an asset size of
$100 to $300 million. So, you know, the idea that you have to
be a $2 or $3 billion bank to do business, I am not sure that
the numbers square up with that.
That said, we also understand that the overhead expenses of
community banks are very sensitive to regulatory costs and
staffing for regulatory purposes. The FDIC has undertaken a
number of steps--you described them--to try to mitigate those
costs, provide services that are valuable to the banks in terms
of meeting those regulatory requirements.
Senator Moran. That answer is different than the other
answers I have received over the last 2\1/2\ years. What are
the specific examples of modifications that the FDIC has made
to accommodate--and I guess let me further indicate to you that
I understand--if this was a matter of bank consolidation
because of normal free market economic principles about size of
scale economies, that to me is a different issue for us than
one that is driven by the regulatory environment and the fixed
costs or the costs associated with meeting those requirements.
I do not know whether your study demonstrates what--is
there an explanation for why those costs increase and the
economies of scale--I guess to further indicate that a $25
million bank is important to me and to a community in Kansas,
and when you assure me that things get better at $100 million
and above, I mean, I am pleased to know that, but there are a
lot of banks in Kansas that fall between that $25 million and
that $100 million that are very important certainly to the
people who work there, who own that bank, but more importantly,
to the community that they serve.
Mr. Brown. Well, understood, and I think those economies of
scale that I referred to, the decline in average cost includes
both regulatory and nonregulatory costs. The fact is we do not
have the data to break down overhead expenses between those two
categories, so we can only look at overall overhead costs. But
for the community banking sector the last 3 years, those
overhead costs as a percent of assets have been stable at 2.9
percent of average assets. And so we are not seeing large
increases in overall overhead expenses.
We do understand, though, the need on the part of the FDIC
to provide technical assistance. We have created a Web-based
pre-exam tool to make sure that information requests are
synchronized and very clear with the bank being examined. We
have created a regulatory calendar that reminds institutions of
when the comment periods and what the compliance periods are.
And we have created a series of videos on our Directors
Resource Center that provide very detailed technical
information about how to comply with the various standards
coming down the pike so consultants are not needed to explain
that. So we think those can be helpful in terms of helping to
navigate.
Senator Moran. Thank you very much. My time has expired. I
would only point out that what the FDIC does is critical in
this arena. You are at least one of the few, if not the one
regulator that the bank cannot escape. As we have seen in our
State and elsewhere in the country, as banks have rechartered
to become State institutions to alter this regulatory
environment, they are never going to get away from you. And
what you do matters to the success not just of my banks, but
the communities that they serve.
Thank you.
Chairman Johnson. Senator Heitkamp.
Senator Heitkamp. You are going to hear a recurring theme
here. Thank you, Mr. Chairman, and thank you for this hearing.
You are going to hear a recurring theme in all of this. We are
deeply concerned in a very nonpartisan way with the viability
and the continuing operation of small community banks. And our
overall concern is that we are now in an era where we create an
atmosphere too big to fail and what the net result is too small
to succeed.
And I would suggest, Mr. Evans--and without having any
dialog behind this--that, in fact, when you say you look at
overall overhead costs and they have not increased, I would
suggest to you that is because banks are doing things that--are
not doing things that they have done in the past because they
do not want to get in trouble. And one of those issues that is
very critical in North Dakota is housing. Our small community
banks have always been a huge part of financing residential
development, and we are seeing a huge retraction from that
responsibility to the community, not as a matter of choice but
as a matter of--we do not know that we can comply. We do not
know that we have the capacity to comply with what is coming at
us.
And so where I listened to the discussion that you had
today about, you know, we are listening, we are moving, I had a
conversation with the Chairman and suggested that he needs to
listen directly to the small community banks. And I am grateful
to report that he, in fact, will be coming out to North Dakota
to do roundtables with our small community banks in North
Dakota to address these issues.
But I want to take this in a little different direction.
You know, there is postcrisis research regarding community
banks showing that public benefits provided in the crisis and
in the recovery stages after the crisis actually minimized the
direct effect. Having a good relationship with your bank gave
you the ability to continue to get the capital that you needed,
the operating loans that you needed.
You know, their central role--and, you know, I know you
guys deal with numbers, but a lot of this in little towns in
North Dakota, in Hankinson, North Dakota, it is about
relationships. They have a generation-generation-generation
relationship with their depositors. They have done operating
loans for years, and now they are terrified to do them. And,
you know, that may be drive, in fact, by reality or it may be
driven by just the fear of what is coming down.
And so I cannot impress upon this panel enough that we are
deeply concerned about consolidation. We think it is being
driven by regulation--I do think it is being driven by
regulation. And we want to know whether this will reach the top
runs in terms of evaluating what we can do to stop
consolidation on the lower level and continue the viability of
small community banks. I will start with you, Mr. Evans.
Mr. Evans. So the re-occurring theme here I think is
important because it speaks to the need to minimize, where
appropriate, burdens on community banks. And so I would take
this time to plug some of the work we have done on Dodd-Frank
where we have made recommendations to the regulators to
strengthen their prospective analysis before they write these
rules, as well as the retrospective analysis, because we have
heard from community bankers that it is the cumulative burden
of these regulations--``death by a thousand cuts,'' as it is
often referred to--that raises the most significant concern.
And so retrospective analysis there would be extremely
important because this will allow us to really assess the
impact of various regulations.
And we have also asked the regulators to start to plan and
think about the data they need to collect in order to do this
assessment, because we do need to understand the impact of
regulations and exemptions on stability, efficiency, and
competitiveness.
Mr. Brown. I think one thing to keep in mind is that the
forces of consolidation include, potentially, regulation going
forward, but in the past they also have included bank failures.
We had more than 2,500 bank failures during the study period
that led to consolidation. And I think that the safety and
soundness of the industry is one of the important factors,
obviously, in determining the future pace of consolidation.
I think one of the other things that we have observed is
that the banks that came through the crisis in pretty good
shape are generally pretty conservatively run. They generally
have high supervisory ratings. They have the types of
governance qualities that Mr. Rymer described in his statement
and generally comply with the regulatory requirements as they
are.
And so I know that the cost of the change in regulation is
disconcerting for many. We are trying to help them work through
that. We think that communication is absolutely critical to
making sure there are no surprises and making sure that there
is an agreement between supervisors and banks as to how the
regulations are going to work going forward.
Senator Heitkamp. Mr. Chairman, if I could just take--just
make one more point, which is enforcement versus regulation.
There is not a kid that you grew up with who does not like
being lumped in when their older siblings do something wrong
and they all get punished, right? And so, you know, we are in
an atmosphere--in North Dakota, no bank failures, but yet my
banks are suffering the consequences of what happened. And I
would suggest to you that the lack of enforcement of existing
regulations before Dodd-Frank is a critical component to bank
failures, and the reaction has been to regulate, and some would
argue excessively, in response to that, which is one-size-fits-
all, we are going to punish you all equally regardless of your
appropriate conservative management of your financial
institution.
And so be very careful, because I am going to judge things
very carefully on regulatory versus enforcement, and what I
would suggest to you may have failed is enforcement, but what
we got was regulation.
Chairman Johnson. Senator Crapo will make a statement.
Senator Crapo. Thank you, Mr. Chairman. Before we wrap up,
I just wanted to make a very brief summary statement, and to
the panel, again, thank you for coming and for the work you are
doing on this critical issue. I think every Senator who has
been at the hearing here today has raised the same issue set
with you. We are concerned about whether we have it right in
law and in regulation and implementation in terms of the
regulatory system that we are applying to our smaller and
community banks, whether it is a question of whether we need to
move to a two-tier system or whether we need to do other
reforms at the congressional level, at the policy level, or
whether we need to be more aggressive at making the appropriate
distinctions in the regulatory, implementation, and the
examination process, or what have you.
I would just encourage you to help us answer this question
correctly, to do the kind of analysis and studies that gets to
the answers to some of the questions that we do not have
answers to yet, and to work with us to help identify the proper
structure and system that we need to have in place to create
the best safety and soundness and the best profitability for
our strong community bank system.
Thank you.
Chairman Johnson. I want to thank our witnesses for their
testimony today as well as their continued focus on efforts to
strengthen the community bank system.
This hearing is adjourned.
[Whereupon, at 11:24 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF RICHARD A. BROWN
Chief Economist, Federal Deposit Insurance Corporation
June 13, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee, we appreciate the opportunity to testify on behalf of the
Federal Deposit Insurance Corporation (FDIC) regarding the state of
community banking and to describe the findings of the FDIC Community
Banking Study (the Study), a comprehensive review based on 27 years of
data on community banks. \1\
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\1\ FDIC Community Banking Study, December 2012, http://
www.fdic.gov/regulations/resources/cbi/study.html.
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As the Committee is well aware, the recent financial crisis has
proved challenging for all financial institutions. The FDIC's problem
bank list peaked at 888 institutions in 2011. Since January 2008, 481
insured depository institutions have failed, with banks under $1
billion making up 419 of those failures. Fortunately, the pace of
failures has declined significantly since 2010, a trend we expect to
continue.
Given the challenges that community banks, in particular, have
faced in recent years, the FDIC launched a ``Community Banking
Initiative'' (Initiative) last year to refocus our efforts to
communicate with community banks and to better understand their
concerns. The knowledge gathered through this Initiative will help to
ensure that our supervisory actions are grounded in the recognition of
the important role that community banks play in our economy. A key
product of the Initiative was our FDIC Community Banking Study,
published last December, which is discussed in more detail below.
In my testimony, I describe some key lessons from the failures of
certain community banks during the recent crisis identified by the FDIC
Community Banking Study. Consistent with the studies performed under
P.L. 112-88 by the FDIC Office of Inspector General (OIG) and
Government Accountability Office (GAO), the Study found three primary
factors that contributed to bank failures in the recent crisis, namely:
(1) rapid growth; (2) excessive concentrations in commercial real
estate lending (especially acquisition and development lending); and
(3) funding through highly volatile deposits. By contrast, community
banks that followed a traditional, conservative business plan of
prudent growth, careful underwriting, and stable deposit funding
overwhelmingly were able to survive the recent crisis.
FDIC Community Banking Study
In December 2012, the FDIC released the FDIC Community Banking
Study, a comprehensive review of the U.S. community banking sector
covering 27 years of data. The Study set out to explore some of the
important trends that have shaped the operating environment for
community banks over this period, including: long-term industry
consolidation; the geographic footprint of community banks; their
comparative financial performance overall and by lending specialty
group; efficiency and economies of scale; and access to capital. This
research was based on a new definition of community bank that goes
beyond the asset size of institutions to also account for the types of
lending and deposit gathering activities and the limited geographic
scope that are characteristic of community banks.
Specifically, where most previous studies have defined community
banks strictly in terms of asset size (typically including banks with
assets less than $1 billion), our study introduced a definition that
takes into account a focus on lending, reliance on core deposit
funding, and a limited geographic scope of operations. Applying these
criteria for the baseline year of 2010 had the effect of excluding 92
banking organizations with assets less than $1 billion while including
330 banking organizations with assets greater than $1 billion.
Importantly, the 330 community banks over $1 billion in size held $623
billion in total assets--approximately one-third of the community bank
total. While these institutions would have been excluded under many
size-based definitions, we found that they operated in a similar
fashion to smaller community banks. It is important to note that the
purpose of this definition is research and analysis; it is not intended
to substitute for size-based thresholds that are currently embedded in
statute, regulation, and supervisory practice.
Our research confirms the crucial role that community banks play in
the American financial system. As defined by the Study, community banks
represented 95 percent of all U.S. banking organizations in 2011. These
institutions accounted for just 14 percent of the U.S. banking assets
in our Nation, but held 46 percent of all the small loans to businesses
and farms made by FDIC-insured institutions. While their share of total
deposits has declined over time, community banks still hold the
majority of bank deposits in rural and micropolitan counties. \2\ The
Study showed that in 629 U.S. counties (or almost one-fifth of all U.S.
counties), the only banking offices operated by FDIC-insured
institutions at year-end 2011 were those operated by community banks.
Without community banks, many rural areas, small towns and urban
neighborhoods would have little or no physical access to mainstream
banking services.
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\2\ The 3,238 U.S. counties in 2010 included 694 micropolitan
counties centered on an urban core with population between 10,000 and
50,000 people, and 1,376 rural counties with populations less than
10,000 people.
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Our Study took an in-depth look at the long-term trend of banking
industry consolidation that has reduced the number of federally insured
banks and thrifts from 17,901 in 1984 to 7,357 in 2011. All of this net
consolidation can be accounted for by an even larger decline in the
number of institutions with assets less than $100 million. But a closer
look casts significant doubt on the notion that future consolidation
will continue at this same pace, or that the community banking model is
in any way obsolete.
More than 2,500 institutions have failed since 1984, with the vast
majority failing in the crisis periods of the 1980s, early 1990s, and
the period since 2007. To the extent that future crises can be avoided
or mitigated, bank failures should contribute much less to future
consolidation. In addition, about one third of the consolidation that
has taken place since 1984 is the result of charter consolidation
within bank holding companies, while just under half is the result of
voluntary mergers. But both of these trends were greatly facilitated by
the gradual relaxation of restrictions on intrastate branching at the
State level in the 1980s and early 1990s, as well as the rising trend
of interstate branching that followed enactment of the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994. The pace of
voluntary consolidation has indeed slowed over the past 15 years as the
effects of these one-time changes were realized. Finally, the Study
questions whether the rapid precrisis growth of some of the Nation's
largest banks, which occurred largely as a result of mergers and
acquisitions and growth in retail lending, can continue at the same
pace going forward. Some of the precrisis cost savings realized by
large banks have proven to be unsustainable in the postcrisis period,
and a return to precrisis rates of growth in consumer and mortgage
lending appears, for now anyway, to be a questionable assumption.
The Study finds that community banks that grew prudently and that
maintained diversified portfolios or otherwise stuck to their core
lending competencies during the Study period exhibited relatively
strong and stable performance over time. The strongest performing
lending groups across the entire Study period were community banks
specializing in agricultural lending, diversified banks with no single
specialty, and consumer lending specialists, although the latter group
had shrunk to fewer than one percent of community banks by 2011.
Agricultural specialists and diversified nonspecialists also failed at
rates well below other community banks during the Study period. Other
types of institutions that pursued higher-growth strategies--frequently
through commercial real estate or construction and development
lending--encountered severe problems during real estate downturns and
generally underperformed over the long run.
Moreover, the Study finds that economies of scale play a limited
role in the viability of community banks. While average costs are found
to be higher for very small community banks, most economies of scale
are largely realized by the time an institution reaches $100 million to
$300 million in size, depending on the lending specialty. These results
comport well with the experience of banking industry consolidation
during our Study period (1984-2011), in which the number of bank and
thrift charters with assets less than $25 million declined by 96
percent, while the number of charters with assets between $100 million
and $1 billion grew by 19 percent.
With regard to measuring the costs associated with regulatory
compliance, the Study noted that the financial data collected by
regulators does not identify regulatory costs as a distinct category of
expenses. In light of the limitations of the data and the importance of
this topic in our discussions with community bankers, as part of our
Study the FDIC conducted interviews with a group of community banks to
try to learn more about regulatory costs. As described in Appendix B of
the Study, most interview participants stated that no single regulation
or practice had a significant effect on their institution. Instead,
most stated that the strain on their organization came from the
cumulative effects of all the regulatory requirements that have built
up over time. Many of the interview participants indicated that they
have increased staff over the past 10 years to support the enhanced
responsibility associated with regulatory compliance. Still, none of
the interview participants indicated that they actively track the
various costs associated with regulatory compliance, because it is too
time-consuming, too costly, and so interwoven into their operations
that it would be difficult to break out these specific costs. These
responses point to the challenges of achieving a greater degree of
quantification in studying this important topic.
In summary, the Study finds that, despite the challenges of the
current operating environment, the community banking sector remains a
viable and vital component of the overall U.S. financial system. It
identifies a number of issues for future research, including the role
of commercial real estate lending at community banks, their use of new
technologies, and how additional information might be obtained on
regulatory compliance costs.
Examination and Rulemaking Review
In addition to the comprehensive study on community banks, the FDIC
also reviewed its examination, rulemaking, and guidance processes
during 2012 with a goal of identifying ways to make the supervisory
process more efficient, consistent, and transparent, while maintaining
safe and sound banking practices. This review was informed by a
February 2012 FDIC conference on the challenges and opportunities
facing community banks, a series of six roundtable discussions with
community bankers around the Nation, and by ongoing discussions with
the FDIC's Advisory Committee on Community Banking.
Based on concerns raised in these discussions, the FDIC has
implemented a number of enhancements to our supervisory and rulemaking
processes. First, the FDIC has restructured the pre-exam process to
better scope examinations, define expectations, and improve efficiency.
Second, the FDIC is taking steps to improve communication with banks
under our supervision. Using Web-based tools, the FDIC created a
regulatory calendar that alerts stakeholders to critical information as
well as comment and compliance deadlines relating to new or amended
Federal banking laws, regulations, and supervisory guidance. The
calendar includes notices of proposed, interim, and final rulemakings,
and provides information about banker teleconferences and other
important events related to changes in laws, regulations, and
supervisory guidance. The FDIC also is actively taking steps to provide
bankers with additional insights on proposed or changing rules,
regulations, and guidance through regional meetings and outreach.
Further, we clarify and communicate whether specific rules,
regulations, and guidance apply to the operations of community banks
through the use of statements of applicability in our Financial
Institution Letters.
Finally, the FDIC has instituted a number of outreach and technical
assistance efforts, including increased direct communication between
examinations, increased opportunities to attend training workshops and
symposiums, and conference calls and training videos on complex topics
of interest to community bankers. In April, the FDIC issued six videos
designed to provide new bank directors with information to prepare them
for their fiduciary role in overseeing the bank. A second installment,
to be released very soon, is a virtual version of the FDIC's Directors'
College Program that regional offices deliver throughout the year. A
third installment, expected to be released by year-end will provide
more in-depth coverage of important supervisory topics and focus on
management's responsibilities. The FDIC plans to continue its review of
examination and rulemaking processes, and continues to explore new
initiatives to provide technical assistance to community banks.
Conclusion
The recent financial crisis has proved challenging for financial
institutions in general and for community banks in particular. Analyses
of bank failures during the crisis by the FDIC, the FDIC OIG, and the
GAO point to some common risk factors for institutions that failed
during the recent crisis, including rapid growth, concentrations in
high-risk loans, and funding through volatile deposits. In contrast,
community banks that followed traditional, conservative business models
overwhelmingly survived the recent crisis. The FDIC's extensive study
of community banking over a 27-year period shows that while these
institutions face a number of challenges, they will remain a viable and
vital component of the overall U.S. financial system in the years
ahead.
PREPARED STATEMENT OF JON T. RYMER
Inspector General, Federal Deposit Insurance Corporation
June 13, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee: Thank you for the opportunity to testify in today's hearing
on the lessons learned from the financial crisis related to community
banks. As you requested, I will focus on the broad and comprehensive
study, required by Public Law 112-88, that the Federal Deposit
Insurance Corporation (FDIC) Office of Inspector General (OIG)
conducted on the impact of the failure of insured depository
institutions during the recent financial crisis. Specifically, I will
summarize the study's general observations, findings, conclusions, and
recommendations contained in the report, Comprehensive Study on the
Impact of the Failure of Insured Depository Institutions (Report No.
EVAL-13-002, dated January 3, 2013). In addition, I will highlight some
of the work my office has completed over the last 5 years that could
contribute to the Committee's ``lessons learned'' discussion.
The OIG is an independent office within the FDIC, established to
conduct audits, investigations, and other reviews to prevent and detect
waste, fraud, and abuse relating to the programs and operations of the
FDIC, and to improve the efficiency and effectiveness of those programs
and operations. I was appointed as the Inspector General of the FDIC by
President Bush, and confirmed by the Senate in June 2006.
Through its audits, evaluations, and other reviews, my office
provides oversight of FDIC programs and operations. Our work is either
required by law or self-initiated based on our assessment of various
risks confronting the FDIC. Our audits, evaluations, and other reviews
assess such areas as program effectiveness, adequacy of internal
controls, and compliance with statutory requirements and corporate
policies and procedures. We perform our work using internally available
resources, supplemented by contracts with independent public accounting
firms when expertise in a particular area is needed or when internal
resources are not available. Our work, as well as that of our
contractors, is performed in accordance with standards applicable to
Federal audit, evaluation, and investigative entities.
Before I discuss the study's high-level observations and resulting
recommendations, and to provide helpful context, I will briefly
describe the regulatory framework and the individual regulator
responsibilities for overseeing insured depository institutions and
resolving those institutions when they fail.
Regulatory Framework and Regulator Responsibilities
In the wake of the savings and loan and banking crisis of the
1980s, the Congress passed two laws that drove the closure and
resolution decisions we witnessed in this most recent crisis. These
laws were the Financial Institutions Reform, Recovery, and Enforcement
Act of 1989 and the FDIC Improvement Act of 1991. Taken together, these
laws amended the Federal Deposit Insurance (FDI) Act to require, among
other things, that (1) institutions maintain minimum capital levels and
the chartering regulator promptly close critically undercapitalized
institutions through prompt corrective action provisions, (2) the FDIC
resolve banks in the least costly manner, and (3) the FDIC maximize
recoveries from failed institutions. The FDI Act also placed
requirements on how the regulators examine institutions, including
establishing minimum examination frequency requirements, requiring the
agencies to establish standards for safety and soundness, and requiring
the agencies to establish appraisal standards. In response, the FDIC
and the other regulators issued implementing regulations and policy
statements pertaining to many of the topics discussed in our report.
The Office of the Comptroller of the Currency (OCC), the Board of
Governors of the Federal Reserve System (FRB), and the FDIC oversee the
Nation's insured depository institutions to ensure they operate in a
safe and sound manner. The OCC supervises national banks, the FRB
supervises State-chartered banks that are members of the Federal
Reserve System and bank holding companies, and the FDIC supervises
State-chartered banks that are not members of the Federal Reserve
System (State nonmember banks). The FDIC has additional
responsibilities for insuring deposits, effectively resolving failed
institutions, and maximizing the recovery of receivership assets.
In examining insured depository institutions, the regulators assess
the condition of institutions through off-site monitoring and on-site
examinations, and have longstanding policies for reviewing an
institution's lending and loan review functions, assessing capital
adequacy, and recommending improvements, if needed. When regulators
determine that an institution's condition is less than satisfactory,
they may take a variety of supervisory actions, including informal and
formal enforcement actions, to address identified deficiencies. Each
regulator has somewhat different approaches to enforcement actions.
Should an institution's condition decline to a point that it
becomes Critically Undercapitalized, the chartering regulator (a State
banking authority or the OCC) is generally required by law to promptly
close institutions that cannot be recapitalized. The FDIC is required
by law to resolve failing institutions in the least costly manner.
Study Results--Observations, Findings, and Conclusions
The financial crisis had devastating impacts on the banking
industry, businesses, communities, and consumers. At the time of our
review, over 400 institutions had failed and some of the country's
largest institutions had required Government intervention to remain
solvent. Commercial real estate (CRE) collateral values had fallen by
more than 42 percent. Construction starts remained partially complete
and continued to detract from the quality of neighborhoods and home
values. Trillions of dollars of household wealth had vanished, and
almost 18 million loans had faced foreclosure since 2007. Unemployment
peaked at 10 percent in October 2009 and remained stubbornly high at
the time of our study.
Events leading to the financial crisis and subsequent efforts to
resolve it involved the dynamic interrelationship of laws passed by the
Congress, regulatory rules, and agency-specific policies and practices
with the real estate and financial markets in ways that are continuing
to play out. In that regard, our study indicated the following:
The markets drove behaviors that were not always prudent.
Banks expanded lending to keep pace with rapid growth in
construction and real estate development, rising mortgage
demands, and increased competition. Many of the banks that
failed did so because management relaxed underwriting standards
and did not implement adequate oversight and controls. For
their part, many borrowers who engaged in commercial or
residential lending arrangements did not always have the
capacity to repay loans and pursued many construction projects
without properly considering the risks involved. Ultimately,
these loans created significant losses for the institutions
involved and often left the FDIC with the challenge of managing
and disposing of troubled assets.
In response to unprecedented circumstances, the regulators
generally fulfilled their supervisory and resolution
responsibilities as defined by statutes, regulations,
accounting standards, and interagency guidance in place at the
time. In addition, the regulators reacted to a rapidly changing
economic and financial landscape by establishing and revising
supervisory policies and procedures to address key risks facing
the industry. While not a focus of this study, our report does
acknowledge, however, material loss review findings that showed
the FRB, OCC, and FDIC could have provided earlier and greater
supervisory attention to troubled institutions that ultimately
failed. For its part, among other initiatives associated with
resolutions, the FDIC reinstituted the use of shared loss
agreements (SLA) with acquiring institutions and took steps to
promote private capital investments in failing institutions.
In our report, we provided a detailed presentation of our findings
and conclusions for each of the topics under the law's eight matters.
These matters include (1) SLAs, (2) significance of losses at
institutions that failed, (3) examiner implementation of appraisal
guidelines, (4) examiner assessment of capital adequacy and private
capital investment in failing institutions, (5) examiner implementation
of loan workout guidance, (6) application and impact of formal
enforcement orders, (7) impact of FDIC policies on investments in
institutions, and (8) the FDIC's handling of private equity company
investments in institutions. In addressing these matters, we also made
the following observations:
The FDIC's resolution methods--including the SLAs that we
studied--were market driven. Often, failing banks with little
or no franchise value and poor asset quality did not attract
sufficient interest from viable bidders to enable the FDIC to
sell the banks without a loss-share guarantee. The FDIC used
SLAs to keep failed bank assets in the banking sector, support
failed bank asset values, and preserve the solvency of the
Deposit Insurance Fund (DIF). The FDIC has established controls
over its SLA monitoring program, which help protect the FDIC's
interests, promote loan modifications, and require equal
treatment of SLA and legacy loans. We did find, however, that
the FDIC should place additional emphasis on monitoring
commercial loan extension decisions to ensure that acquiring
institutions do not inappropriately reject loan modification
requests as SLAs approach termination. In addition, we
concluded that the FDIC needed to formulate a better strategy
for mitigating the impact of impending portfolio sales and SLA
terminations on the DIF so that the FDIC will be prepared to
address the potentially significant volume of asset sale
requests.
The majority of community banks failed as a result of
aggressive growth, asset concentrations, poor underwriting, and
deficient credit administration coupled with declining real
estate values. These factors led to write-downs and charge-offs
on delinquent and nonperforming real estate loans as opposed to
examiner-required write-downs or fair value accounting losses.
The regulators have longstanding policies for classifying
problem assets, monitoring appraisal programs, assessing
capital adequacy, evaluating CRE loan workouts, and
administering enforcement actions, when warranted. The
regulators also have processes and controls, training programs,
and job aids to help ensure examiner compliance and
consistency. We found that examiners generally followed
relevant policies and implemented them appropriately. For
example, examiners usually did not classify as loss loans that
the institution claimed were paying as agreed without
justification, nor did they question or reduce the appraised
values of assets securing such loans. However, examiners did
not always document the procedures and steps that they
performed to assess institutions' appraisal and workout
programs. We also noted that the regulators had different
approaches to enforcement actions, particularly related to
nonproblem banks.
The FDIC has investment-related policies in place to
protect the DIF and to ensure the character and fitness of
potential investors. These policies are largely based in
statute. By their nature, such policies are going to have an
impact on investments in institutions. The FDIC approved most
change-in-control and merger applications, although approval
rates were lower for States such as California, Florida, and
Nevada that were heavily impacted by the financial crisis. The
FDIC has policies and procedures for certain aspects of the
review of private capital investors, and the FDIC generally
followed those policies. Purchases of failed institutions by
private capital investors accounted for 10 percent of total
failed bank assets acquired. Finally, we identified instances
where the FDIC did not accept proposed open bank investments
and instead closed an institution. However, in each case, we
found that the FDIC identified concerns with the proposed
investment related to safety and soundness issues, proposed
management, or proposed business plans, or determined that the
proposed transaction would not present the least loss option to
the DIF.
Recommendations
While the regulators generally implemented their policies
appropriately, our study identified certain areas for improvement and
issues warranting management attention. In the interest of
strengthening the effectiveness of certain supervisory activities and
helping ensure the success of the FDIC's ongoing resolution efforts, we
made seven recommendations. Five were addressed specifically to the
FDIC and two were directed to the three regulators. These
recommendations, which the regulators concurred with and proposed
actions that adequately addressed the recommendations' intent, involved
the following areas:
SLA Program. We made recommendations related to developing
additional controls for monitoring acquiring institutions'
commercial loan modification efforts and developing a more
formal strategy for mitigating the impact of impending
portfolio sales and SLA terminations on the DIF.
Appraisals and Workouts. We made several recommendations
related to clarifying how examiners should review institutions'
appraisal programs and strengthening examiner documentation
requirements to more clearly define examination methodologies
and procedures performed to assess institutions' appraisal and
workout programs. These recommendations should help to assure
agency management that examiners are consistently applying
relevant guidance.
Enforcement Orders. We recommended that the regulators
study differences between the types of enforcement actions that
are used by the regulators and the timing of such actions to
determine whether there are certain approaches that have proven
to be more effective in mitigating risk and correcting
deficiencies that should be implemented by all three
regulators.
Study Approach
Signed into law on January 3, 2012, Public Law 112-88 required my
office to conduct this study and submit a report to the Congress not
later than 1 year after the date of enactment. The legislation required
my office to conduct work at the FDIC, OCC, and FRB, and as required,
our scope included open and failed State member, State nonmember, and
national banks. Our scope did not include institutions formerly
regulated by the Office of Thrift Supervision. Our review time frames
generally covered a 4-year period (i.e., 2008 through 2011).
My office performed work at three FDIC regions, three OCC regions,
eight reserve bank districts, and selected State banking agencies. In
conducting our work, we
Interviewed agency officials and bank examiners,
representatives at open banks, investment bankers, and
compliance contractors;
Reviewed relevant policies and guidance;
Reviewed examination reports, working papers, material loss
review reports, and documentation supporting loan workouts and
enforcements orders;
Analyzed institution financial data and agency enforcement
action statistics; and
Surveyed borrowers of failed institutions.
We conducted our work from January 2012 through October 2012, in
accordance with the Council of the Inspectors General on Integrity and
Efficiency's Quality Standards for Inspection and Evaluation. KPMG LLP
assisted us with several areas of review. We also coordinated with the
U.S. Government Accountability Office as that office conducted its work
pursuant to Public Law 112-88.
Other OIG Work
As the Committee continues the discussion of the financial crisis
and possible ``lessons learned,'' I wanted to highlight some of the
other work my office has completed. Over the last 5 years, my office
was heavily involved in the efforts to explain what happened during the
financial crisis. The following is a brief snapshot of this work.
During the financial crisis, my audit and evaluation staff was
dedicated to conducting reviews of the FDIC-supervised banks that
failed, and providing feedback to the FDIC to assist the Corporation in
improving its bank supervision program. As required by section 38(k) of
the FDI Act, and amended by the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act), my office, along with our
fellow financial regulatory OIGs, was required, at some level, to
review the 484 institutions that failed during the crisis. To date, we
have issued 107 reports that take a comprehensive look at why the
failed bank caused a material loss to the DIF and provide an assessment
of the FDIC's supervision of that bank. Since the Dodd-Frank Act
amended the FDI Act, my office has also performed 166 failed bank
reviews, where the failure was below a certain loss threshold and no
unusual circumstances existed to warrant a more in-depth review of the
loss.
In a separate report, Follow-Up Audit of FDIC Supervision Program
Enhancements (Report No. MLR-11-010), issued in December 2010, we
examined the supervisory actions the FDIC had taken in response to an
internal memorandum we issued in May 2009, which outlined major causes,
trends, and common characteristics of the eight bank failures we had
reviewed to date, and identified new trends and issues that emerged
from our reviews of subsequent failures. Our January 2013 study further
supported the existence of these trends and issues, which included
concentrated assets in the CRE and acquisition, development, and
construction (ADC) loan portfolios, inadequate risk management
practices for loan underwriting and credit administration, and reliance
on volatile funding sources to support growth.
In October 2012, my office issued a report, Acquisition,
Development, and Construction Loan Concentration Study (Report No.
EVAL-13-001), detailing our evaluation of FDIC-supervised institutions
with significant ADC loan concentrations that did not fail during the
economic downturn. We studied the characteristics and supervisory
approaches for these institutions and identified the factors that
helped them mitigate the risks associated with ADC concentrations
during periods of economic stress. Our findings were not surprising, in
that they confirmed what regulators have been saying are the
ingredients for a strong bank--a well-informed Board, strong
management, controlled growth, sound credit administration and
underwriting, and adequate capital. We also observed that surviving
banks were responsive to supervisory actions and guidance and
maintained or secured capital needed to absorb losses in response to
regulatory demands.
My office also teamed up with the other bank regulatory OIGs and
evaluated prompt regulatory action, as described in sections 38 and 39
of the FDI Act. The OIGs from the FDIC, FRB, and Department of the
Treasury issued a comprehensive joint report in September 2011,
Evaluation of Prompt Regulatory Action Implementation (Report No. EVAL-
11-006), which discussed the use and impact of prompt corrective action
(PCA) and the safety and soundness standards during the crisis. We
found that PCA occurred too late to rehabilitate most troubled
institutions and while critically undercapitalize institutions were
closed promptly, failure losses were still significant. We recommended
the regulators consider several options for strengthening the prompt
regulatory action provisions.
The reports noted above are available on our Web site,
www.fdicig.gov.
This concludes my prepared statement. Thank you for the opportunity
to discuss the work of the FDIC OIG. I will be pleased to answer any
questions that you may have.
PREPARED STATEMENT OF LAWRANCE L. EVANS, JR.
Director, Financial Markets and Community Investment, Government
Accountability Office
June 13, 2013
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM RICHARD A. BROWN
Q.1. Academic researchers estimate that when Dodd-Frank is
fully implemented, there will be more than 13,000 new
regulatory restrictions in the Code of Federal Regulations.
Over 10,000 pages of regulations have already been proposed,
requiring more than 24 million compliance hours each year. As
FDIC's Chief Economist, how are you trying to track the total
compliance costs for community banks? Please share specific
details.
A.1. Quantifying Costs--The costs of regulatory compliance and
their effect on profitability and competitiveness are frequent
topics of discussion among community bankers. While our ability
to quantify the costs of regulatory compliance is somewhat
limited, the FDIC has undertaken a number of initiatives
designed to make those costs as small as possible.
This topic was repeatedly addressed in the six Roundtable
discussions hosted by the FDIC in 2012 as part of the Community
Banking Initiative, and also has been a frequent topic of
discussion in meetings of the FDIC's Community Bank Advisory
Committee.
Notwithstanding the high degree in interest in this topic
by all concerned parties, regulatory data reported through the
quarterly Call Reports provide only a limited picture of bank
overhead expenses. While all FDIC-insured institutions report
total noninterest expenses each quarter, these expenses are not
broken down into regulatory and nonregulatory components.
Expressed as a percent of total assets, noninterest expenses
for community banks have been flat for three consecutive years
(2010-12) at 3.0 percent.
In view of the data limitations, FDIC researchers conducted
interviews with nine community bankers as part of our 2012
Community Banking Study to try to better understand what drives
the cost of regulatory compliance and, where possible, obtain
actual financial data to better understand how regulation and
supervision affects bank performance.
Most participants stated that no single regulation or
practice had a significant effect on their institution.
Instead, most cited the cumulative strain imposed by a number
of regulatory requirements over time. Several indicated that
they have increased staff over the past 10 years to support
regulatory compliance. Yet none indicated that they actively
track compliance costs, citing the difficulties of breaking out
these costs separately.
These responses from community bankers speak to the careful
balance regulators must achieve when trying to measure
regulatory costs. While community bankers themselves are
certainly in the best position to understand their cost
structure, requiring that they report more detailed data about
the nature of those costs would itself impose a new regulatory
burden.
Supervisory Approach--As the primary Federal regulator for
the majority of smaller, community institutions (those with
less than $1 billion in total assets), the FDIC is keenly aware
of the challenges facing community banks and we already tailor
our supervisory approach to consider the size, complexity, and
risk profile of the institutions we oversee.
In addition, the FDIC has implemented a number of
initiatives to mitigate the compliance costs associated with
new regulations, based on feedback we received from community
banks during our Examination and Rulemaking Review undertaken
in 2012. This effort was informed by a national conference to
examine the unique role of community banks in our Nation's
economy and the challenges and opportunities they face and a
series of roundtable discussions conducted in each of the
FDIC's six supervisory regions that focused on the financial
and operational challenges and opportunities facing community
banks, and the regulatory interaction process.
First, as a result of comments we received, we developed a
Web-based tool (e-Prep) that generates a preexamination
document and information request list tailored to a specific
institution's operations and business lines.
Second, we instituted a new Regulatory Calendar that alerts
stakeholders to critical information as well as comment and
compliance deadlines relating to changes in Federal banking
laws and regulations.
Third, to enhance the ability of community banks to comply
with regulatory requirements without the need for outside
consultants, the FDIC recently made available new online
resources. A new Director's Resource Center provides links to
more than a dozen new instructional videos, including a new
Virtual Director's College, designed to provide valuable
information and advice to bank managers and directors. (In an
effort to help reduce banks' compliance training costs, we have
been conducting director and banker colleges in each region for
some time now.) In addition to these efforts, the FDIC includes
in all Financial Institution Letters a Statement of
Applicability that clarifies whether the specific rules,
regulations, and guidance will apply to community banks.
The FDIC continues to conduct outreach sessions, training
workshops, and symposia to provide technical training and
opportunities for discussion on subjects of interest to
community bankers.
Q.2. Do you agree with Federal Reserve Chairman Bernanke's
statement at a recent hearing that the burden of Dodd-Frank
regulations falls disproportionately on small and community
banks? If so, what can be done to reduce that burden?
A.2. As demonstrated in the crisis of 2008, the economic costs
of financial instability are enormous. Prudential regulation
and supervision of depository institutions have been instituted
under the Federal Deposit Insurance Act and other statutory
mandates to promote financial stability and to reduce the
frequency and severity of such crises.
The costs of complying with these regulatory requirements
on the part of FDIC-insured institutions are not insignificant.
Moreover, these costs include some that vary a great deal with
the size and complexity of the institution, and some that are
relatively fixed. With regard to the latter category of fixed
regulatory costs, it is true to say that they fall
disproportionately on smaller institutions, which employ fewer
people and have fewer financial resources that can be devoted
to complying with regulatory requirements.
At the same time, there are many examples of regulatory
costs and requirements that have been designed to vary with the
size and complexity of the institution, and therefore, do not
necessarily impose a higher cost on smaller institutions. Among
these are the premiums charged by the FDIC for deposit
insurance, which are based on both the size and the risk of
each institution. It is worth noting that an important
requirement of the Dodd-Frank Act was to broaden the assessment
base for deposit insurance premiums from domestic deposits to
total liabilities minus net worth. This shift, implemented by
the FDIC in 2010, served to reduce the annual premiums paid by
small banks (with assets under $1 billion) by about 30 percent.
In addition, accommodations were made for smaller institutions
when the Dodd-Frank mortgage rules were implemented. Special
exemptions reduced the regulatory requirements and lowered
compliance costs for smaller institutions. These exemptions
were included in several key regulations, including those
related to servicing, the ability-to-repay, and qualified
mortgage regulations.
Nonetheless, the FDIC continues to pursue initiatives that
will help to further reduce the costs of regulatory compliance
on community banks, as described in the response to Question 1.
These efforts recognize the potential for regulatory compliance
costs to fall disproportionately on smaller institutions and
include specific steps designed to help smaller institutions to
minimizethose costs.
Q.3. In light of FDIC's thorough report on community banks and
their failures, is there a single element that we should
monitor in the event of future crises?
A.3. The FDIC Community Banking Study and the Material Loss
Reviews conducted by the FDIC Office of Inspector General (OIG)
both identified a collection of business strategies that proved
to be especially problematic in the recent crisis and are now
subject to close supervisory attention by the FDIC.
The Community Banking Study showed that institutions
pursuing high-growth strategies--frequently through commercial
real estate or construction and development lending--
encountered severe problems during real estate downturns and
generally underperformed over the long run. In contrast,
community banks that grew prudently and that maintained
diversified portfolios or otherwise stuck to their core lending
competencies during the study period exhibited relatively
strong and stable performance over time.
According to Material Loss Reviews conducted by the OIG in
the aftermath of bank failures, losses at community banks
during the crisis were most often caused by management
strategies of aggressive growth and concentrations in
commercial real estate loans, including notably, concentrations
in acquisition, development and construction loans, coupled
with inadequate risk management practices in an environment of
falling real estate values that led to impairment losses on
delinquent and nonperforming loans. Another common
characteristic of failed banks was reliance on volatile
brokered deposits as a funding source.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM JON T. RYMER
Q.1. Public Law 112-88 requires that the FDIC OIG conduct a
study on the impact of the failure of insured depository
institutions during the recent financial crisis. One of the
findings in your study is that the FRB, OCC, and FDIC could
have provided earlier and greater supervisory attention to
troubled institutions that ultimately failed. In your view,
what have the regulators done to address such deficiencies?
What else should they do?
A.1. While not a focus of the review called for in Public Law
112-88, we noted in our report that material loss reviews (MLR)
performed by our office and the Inspectors General (IG) of the
Board of Governors of the Federal Reserve System (FRB) and
Department of the Treasury showed that the FRB, Office of the
Comptroller of the Currency (OCC), and Federal Deposit
Insurance Corporation (FDIC) could have provided earlier and
greater supervisory attention to troubled institutions that
failed. As noted in our report, the regulators generally
fulfilled their supervisory responsibilities as defined by
statutes, regulations, accounting standards, and interagency
guidance in place at the time. Our report also pointed out that
the regulators reacted to a rapidly changing economic and
financial landscape by establishing and revising supervisory
policies and procedures to address key risks facing the
industry.
The three reports summarized below describe the efforts the
FDIC has made to strengthen its supervision program in light of
the issues we identified in the nearly 100 MLR reports our
office issued and other related work our office performed since
the crisis began in 2008. Although one of the reports also
comments on the efforts the FRB and OCC have made to strengthen
their supervision programs, we are not the IG for the OCC or
FRB and, accordingly, have not assessed the efforts or progress
they may have made to strengthen their respective supervision
programs.
Follow-up Audit of FDIC Supervision Program Enhancements
(Report Number MLR-11-010, December 2010). In this audit, we
discussed the efforts that the FDIC had taken to strengthen its
supervision program in response to the financial crisis. We
noted that the FDIC had implemented a comprehensive review and
analysis of its approach to supervision and had implemented or
planned actions that substantially addressed our reported MLR
trends and issues. In particular, we reported that the FDIC
had:
emphasized a forward-looking supervisory approach,
consisting of a comprehensive training program and
various financial institution and examiner guidance,
including guidance related to de novo banks;
implemented other cross-cutting initiatives, such
as establishing relevant Corporate Performance Goals in
2009 and 2010 related to some MLR issues;
implemented a post-MLR assessment process to
identify lessons learned from the bank failures and
conclusions included in our MLR final reports and
solicited input from its examination staff regarding
suggested changes to policies and procedures. This
process also resulted in the identification of
potential best practices related to the FDIC's
examinations;
enhanced offsite monitoring activities;
enhanced coordination between its risk management
and compliance examination functions;
improved interagency coordination for charter
conversions; and
worked with the other Federal regulatory agencies
to implement a new agreement associated with the FDIC's
backup examination authority.
Evaluation of Prompt Regulatory Action Implementation
(Report Number EVAL-11-006, September 2011). In this
evaluation, conducted jointly with the FRB and Department of
the Treasury Offices of Inspector General (OIG), we reported
that the regulators had begun to incorporate a number of
lessons learned from the financial crisis into their regulatory
processes, including those resulting from their respective IGs'
MLR reports. We reported that the regulators had recognized the
need to re-emphasize a supervisory approach that encompassed
consideration of an institution's risk profile in all facets of
the examination process. As it relates to the FDIC, we noted
that the purpose of its supervisory enhancement initiative was
to build upon the strengths of the supervision program,
emphasize balanced and timely response to weak management
practices and identified risks, and emphasize a more proactive
approach to examination analysis and ratings based upon the
lessons learned from recent failures. Importantly, we reported
that although the new emphasis was a step in the right
direction, sustaining long-term improvement depended on not
forgetting the lessons learned once the economy and banking
industry improve.
Acquisition, Development, and Construction Loan
Concentration Study (Report Number EVAL-13-001, October 2012).
In this evaluation, we looked more specifically at a particular
area of concern contributing to the crisis--the excessive
concentration of acquisition, development, and construction
lending on the balance sheets of many financial institutions.
In our report, we noted that the FDIC, in response to MLR
findings and other issues, had issued specific examiner and
financial institution guidance and taken actions, including:
Recognizing factors that are indicative of elevated
risk associated with management, which included high-
risk appetite and degree of responsiveness to examiner
recommendations;
Issuing additional guidance regarding the
inappropriate use of interest reserves;
Emphasizing to examiners the risks that the use of
noncore funding can present to a financial institution;
Issuing guidance regarding consideration of
brokered deposits in the deposit insurance risk
assessment process, use of such funding sources for
institutions that are in a weakened condition,
processing requests for brokered deposit waivers, and
interest rate restrictions for banks that are less than
Well Capitalized; and
Issuing guidance to emphasize the importance of
monitoring institutions subject to enforcement actions,
including the need to clarify expectations for
quarterly progress reports, meet with an institution's
Board at the beginning of a corrective program, and
conduct on-site supervisory activities between
examinations.
With regard to the question as to what else can be done, we
believe, as we note in each of the reports described above,
that sustaining long-term improvement will depend on the
regulators remaining vigilant in their supervisory activities
and not forgetting the lessons learned once the economy and
banking industry begin to improve. In particular, early
regulatory intervention (i.e., before an institution
experiences financial and capital decline) is key to
maintaining healthy banks. When examiners identify practices,
conditions, or violations of law that could result in losses to
a financial institution, they must aggressively address them
and ensure that management takes prompt and effective
corrective action. We acknowledge that these lessons may become
more difficult to apply, or sustain, as the banks return to
profitability. We also believe that the regulators should
pursue interagency efforts to jointly address some of the more
systemic MLR trends, such as capital definitions, capital
levels, and liquidity.
Q.2. Your study also found that examiners did not always
document the procedures and steps that they performed to assess
institutions' appraisal and workout programs, and that the
regulators had different approaches to enforcement actions,
particularly related to nonproblem banks. How much progress
have the regulators made to address such deficiencies? What
else should the regulators do?
A.2. Provided below is how each of the three agencies responded
to the findings detailed in our study related to documentation
concerns.
The OCC responded that while the agency believed
its supervisory examination strategy and core
assessment processes satisfied this recommendation, the
OCC had plans to improve its guidance by including a
section specific to appraisals in the commercial real
estate and mortgage handbooks that are currently being
revised.
The FRB responded that it is continually looking
for ways to improve its examination processes,
including ways to improve documentation procedures.
The FDIC agreed to coordinate with the FRB and OCC
to review the interagency Appraisal and Evaluation
Guidelines and determine the most appropriate way to
strengthen examination documentation requirements.
As we do not oversee the OCC or FRB, we have not made an
assessment of the internal progress that these regulators may
have made to respond to our recommendations. As for the FDIC,
we have been provided information through our audit follow-up
process regarding the Corporation's efforts. Specifically, FDIC
officials indicated that the FDIC, OCC, and FRB staff consulted
in January and February 2013, and these officials continue to
discuss with the OCC and FRB whether documentation requirements
need to be strengthened going forward. At a February 2013
Federal Financial Institutions Examination Council (FFIEC) Task
Force on Supervision meeting, the FDIC also discussed its plans
to strengthen documentation, which include reiterating the
FDIC's existing working paper documentation guidance to
examiners and monitoring examiner compliance as part of the
FDIC's internal control function. Finally, in February 2013,
the FDIC clarified how examiners should approach and document
their review of appraisal and workout programs during a policy
conference call with regional FDIC representatives. The FDIC
OIG will continue to monitor progress of these efforts until
such time the FDIC takes sufficient action to close the
recommendation.
Regarding the question as to what else regulators should
do, our office believes that the FDIC should continue to
identify efficient ways to document procedures that were
performed during an examination.
The second part of the question related to the different
approaches that regulators employ regarding enforcement actions
and the progress that has been made to address such
deficiencies. We do not view the regulators having different
approaches to enforcement actions to be a deficiency on any
regulator's part. In our report, we pointed out the differences
and recommended that the regulators study them to determine
whether there are common approaches that should be implemented
by all three agencies. All three regulators concurred on this
recommendation. At the abovementioned February 19, 2013, FFIEC
meeting, representatives of the FDIC, FRB, and OCC agreed to
research this recommendation as part of a joint Task Force on
Supervision project.
As previously noted, as we do not oversee the OCC or FRB,
we have not made an assessment of any internal initiatives
these regulators may be pursuing. As noted in the comments on
our study's report, the FDIC agreed to conduct an internal
study in 2013 on its approach for using informal and formal
enforcement actions to determine whether an alternative
approach to mitigate risk and correct deficiencies may be more
effective. We understand that the FDIC has begun an internal
review of the scope and effectiveness of enforcement actions
and will complete the study in 2013.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM LAWRENCE L. EVANS, JR.
Q.1. As Director for Financial Markets at the GAO, you have to
analyze historical data. How does the most recent financial
crisis compare to past crises with regard to community banks?
A.1. While we did not review the failure of community banks in
past crises as part of our recent bank failures study, prior
GAO work has addressed failures that occurred during the
banking crisis of the 1980s and early 1990s. Between 1990 and
1994, more than 1,600 banks insured by FDIC were closed or
received FDIC financial assistance. In our May 1989 report,
``Bank Failures: Independent Audits Needed To Strengthen
Internal Control and Bank Management'' (GAO/AFMD-89-25), we
reviewed the 184 bank failures that occurred during 1987. The
vast majority of these failed banks were small institutions.
\1\ Common to the failures we studied in both crises were
internal weaknesses in bank management and board oversight that
led to weak underwriting, aggressive growth strategies fueled
by riskier funding sources, and high loan concentrations.
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\1\ Ninety-two percent (172) of the banks that failed in 1987 had
assets under $100 million. At that time, banks were considered
community banks if they had assets under $250 million.
Q.2. Did you recognize any of the underlying causes of past
crises in this crisis that caused community banks to fail? If
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so, please describe such shared causes.
A.2. As indicated above, we found several similarities in the
underlying causes of the bank failures we studied in the
banking crisis of the 1980s and early 1990s and the most recent
crisis, in particular internal weaknesses in bank management
and board oversight that led to weak underwriting, aggressive
growth strategies fueled by riskier funding sources, and high
loan concentrations.
The objectives of the 1989 review were in part to summarize
data on internal weaknesses that Federal banking examiners
cited in examinations of these banks prior to their failure. Of
the internal control weaknesses Federal banking regulators
identified, those that contributed most significantly to the
184 bank failures were lack of general lending policies (79
percent), inadequate supervision by the bank's board of
directors (49 percent), weak loan administration (42 percent),
and poor loan documentation and inadequate credit analysis (41
percent). Other internal weaknesses regulators cited related to
an overreliance on volatile funding sources such as brokered
deposits (32 percent), unwarranted loan concentrations (24
percent), excessive out-of-area lending (16 percent),
excessively growth-oriented policies (26 percent), and a
failure to establish adequate loan loss allowances (29
percent). We found that Federal regulators cited neither a
single weakness nor a specific combination of weaknesses as the
sole contributing factor to a bank's failure. Rather, each bank
demonstrated a unique combination of weaknesses.
As we noted in our recent report, inadequate management of
risks associated with high concentrations of CRE loans, and in
particular, ADC loans were a primary cause of failure in small
banks. Other internal control weaknesses we reported included
weak underwriting and credit administration practices. In
addition, these failed banks had often pursued aggressive
growth strategies using nontraditional, riskier funding
sources--particularly brokered deposits. Similar to the past
crisis, failed banks often did not maintain an adequate loan
loss allowance and some had engaged in out-of-territory lending
through loan participations.
Q.3. If you had to single out one dominant cause for banks'
failure in this past crisis, what would that be?
A.3. As our econometric analysis showed, banks with high
concentrations of ADC loans and a greater use of brokered
deposits were more likely to fail between 2008 and 2011.
However, the build-up of such high concentrations of risky
loans via a reliance on nontraditional funding sources is
ultimately a reflection of aggressive growth strategies and
poor risk management at these banks.