Annual Report 1997 - St. Louis Fed

A Shrinking Universe

The MultiDimensional Examiner

St. Louis Initiative: Technology

For several years now, the entire banking industry has faced the challenge of responding to technological changes and financial innovation. Technology has both lowered the costs and time needed to bring new products to market and increased the efficiency with which information is collected and transactions are processed. As a result, bank customers can now get loan approvals over the phone or at automated loan machines; investors can buy and sell stocks at home over their PCs; and consumers can shop on the Internet.

The nature of competition in the banking industry also has been altered through an unprecedented number of bank consolidations. Computers and the Internet are removing geographic barriers that have traditionally separated many domestic and international markets. And artificial barriers -- such as the laws that have restricted bank growth across state lines -- are coming down as well.

Supervising banks in this environment is a challenge. The risks inherent in rapidly changing markets are often difficult to pinpoint. When financial markets evolved more slowly, and the composition of a bank's asset and liability structure was relatively static, a periodic snapshot of a bank's condition, obtained through an on-site examination, was an effective means of overseeing an institution's stability.

Today, however, evaluating a bank's condition at a single point in time -- using only traditional accounting techniques and balance sheet analysis -- is no longer effective. For this reason, the Federal Reserve developed a new framework known as risk-based supervision.

Shifting the Focus to Risk
Risk-based supervision presumes that a bank's own management is in the best position to monitor the institution's exposure to risk. To verify management's capability in this regard, the Fed's bank examiners must address several issues: Does the bank's management have the expertise to effectively oversee its business strategy? Does management have the internal controls to adequately monitor the bank's activity? Is there a contingency plan to mitigate loss in a worst-case scenario? Risk-based supervision attempts to identify weak banking practices early on so that emerging problems can be contained and remedied, and losses minimized.

The same advances in technology that have changed banking services and competition have enhanced the Fed's ability to conduct risk-based exams. Risk-based supervision enables examiners to shape each review to fit the institution. The examiner may identify areas requiring analysis during a planning period so that on-site examination resources match the areas requiring review. Further, examination data from each bank can be provided to the examiner electronically so that review areas can be analyzed and targeted before the examiner ever enters the institution. New technology also permits particular areas of the bank -- such as a securities portfolio -- to be assessed entirely off-site.

Once on-site, the examiners continue to evaluate aspects of a bank's operations, like the credit quality of the loan portfolio, as they have traditionally. However, the overall emphasis of the examination is very different. Where the primary means of determining the institution's financial and operating condition used to rely heavily on transaction testing, the assessment is now focused largely on assessing ongoing risk management processes, such as how well these processes address banking risks.

The bottom line is whether the institution's ability to manage risk is commensurate with the level of risk it has taken on in its business practices. This assessment is accomplished in a much less disruptive manner than ever before. Examiners are able to reduce the time they spend reviewing low-risk activities and emphasize instead those areas with higher risk. Examinations no longer employ a one-size-fits-all approach; they are tailored to the institution's business lines, risk profile, operating philosophy and size.

A Shrinking Universe
Bank consolidations also have forced the Fed to restructure the examination process. Banks today face intense competitive pressures, not only from other banking firms but also from nonbanks, such as insurance companies and securities firms. As banks look for ways to lower costs and expand services, they have increasingly chosen to merge with other banks. Technology has played an important role by enabling banking organizations to integrate systems faster and on a broader scale than was possible a few years ago.

Since 1980, this merger pace has reduced the number of independent commercial banks by 40 percent, resulting in a landscape increasingly divided between large multiregional and money-center banks, and small community-based banks. Examination planning and procedures have evolved to accommodate these changes in the industry's structure and complexity. The resulting supervisory structure needs to be both flexible enough to adjust to a rapidly changing financial environment and rational enough to address the inherent differences and risk exposures in large and small banking organizations.

Increasing Cooperation among Regulators
The Fed applies federal banking law to bank holding companies and member state chartered banks -- financial institutions with a wide range of sizes, business activities, sophistication and markets. Complicating this task is the recent passage of interstate branching legislation. The legislation eliminated laws that, for generations, prevented banks from branching across state lines and has prompted bank expansion and reorganizations. As a regulator with supervision responsibility on both sides of the dual (federal and state) banking system, the Fed has led initiatives to broaden cooperative agreements with other regulators. While achieving a more consistent partnership with state authorities and other federal regulators, this cooperation also controls the regulatory burden placed on banking organizations. The goal is to make these supervisory efforts seamless by conducting coordinated examinations with more joint resources and expertise, and providing consistent direction to banking organizations that are overseen by multiple regulators.

The Fed's concern for banking safety and soundness extends beyond its domestic borders, too. As a central bank, the Fed is concerned with systemic risk in banking and economic systems -- that is, the risk that a banking failure or financial crisis will spread through financial markets, causing widespread failures. In this regard, the Fed has worked with international regulators to build strategies that promote sound banking practices worldwide. For example, the Basle Committee on Bank Supervision, an organization of supervisory authorities and central banks from around the world, has adopted the Fed's model for risk-based supervision.

New challenges, as always, are in the offing. Two of note are the current debates in Congress on how to dismantle Depression-era laws that have separated commercial banking from the securities industry, and on the expansion of banking powers so that banks can better compete with the growing number of nonbank financial service providers.

A perennial challenge for bank regulators, however, concerns how to strike the appropriate balance of regulatory oversight without overly interfering with market innovation -- since the former ensures prudent industry practices and the latter serves the public's demand for financial services. The Fed is working continually to achieve this balance by ensuring that its supervisory framework remains flexible, comprehensive and efficient, and that it continues to respond to the realities of an industry in transition.

The MultiDimensional Examiner
At the heart of the new risk-focused examination process is a skilled examiner. And, just as the supervision process has been revamped to address the realities of today's banking environment, so have examiners' skills. In a previous era, the typical examiner was well grounded in the principles of accounting. Today, examiners must bring a host of broad financial and business skills to the table. They are expected to be multidimensional professionals -- problem solvers, mediators, communicators and negotiators -- and must complete a five-year training program at the Fed before gaining a commission as a certified bank examiner. Armed with laptops instead of adding machines, examiners must employ the same technology that is transforming the industry they're supervising. Today, for example, they must be prepared to evaluate strategies that may be as cutting-edge as establishing a "virtual" bank on the Internet, or as complex as creating an interest rate risk management program that employs derivatives.


	The St. Louis Fed led two major technology initiatives for the Federal Reserve System's Banking Supervision and Regulation area. The St. Louis staff provided leadership for the development of the National Examination Database (NED). Implemented in late 1997, NED is the System's principle source of supervisory information and is utilized by all Fed Districts, the Board of Governors and numerous State Banking Departments. St. Louis also significantly enhanced the Home Mortgage Disclosure Act (HMDA) and Community Reinvestment Act (CRA) software used by some 10,000 financial institutions nationally to report their compliance with the HMDA and CRA regulations.

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