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Federal Reserve Bank of St. Louis. "Central Banker, Winter 2012/2013," Central Banker : News and Views for Eighth District Bankers (Winter 2012). https://fraser.stlouisfed.org/title/6284/item/603116, accessed on May 23, 2025.

Title: Central Banker, Winter 2012/2013

Date: Winter 2012
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image-container-6 among District states at 3.18 percent and 3.69 percent, respectively. 2 Policy statement and risk Management on oreo With the rise in foreclosures, the cost of maintaining and disposing of OREO property can become a significant drag on a bank’s performance. Through the third quarter of 2012, community banks across the nation incurred $1.38 billion in annualized OREO expenses, which effectively trims 6 basis points off their return on average assets. Dis- trict community banks fared slightly worse, losing $0.35 billion on an annu- alized basis on OREO, which trims 7 basis points off their return on average assets. The impact of OREO on asset quality and earnings highlights how important it is that banks appropriately market their OREO holdings to pro- spective investors. On April 5, 2012, the Federal Reserve issued a Policy Statement on Rental of Residential OREO Prop- erties (SR 12-5/CA 12-3) to clarify that banking organizations are permitted to rent OREO properties as part of an orderly disposition strategy. The move was aimed at providing more flexibil- ity in OREO marketing and improving the sales value of properties. On June 28, 2012, the Federal Reserve issued Questions and Answers for Fed- eral Reserve-Regulated Institutions Related to the Management of OREO (SR 12-10/CA 12-9) to help address questions regarding the management of OREO by institutions regulated by the Federal Reserve. Generally speaking, the Federal Reserve per- mits bank holding companies to hold an OREO asset for up to five years, with an additional five-year extension available under certain circumstances. However, the policy statement empha- sizes that bank management must have sound strategies and processes in place for the management and dis- posal of OREO properties. Long Way to Go on oreo Foreclosed properties spiked sig- nificantly during the financial cri- sis. As a result, many community banks now have significant holdings of foreclosed-upon construction and land development properties on their balance sheets. Since CLD loans proved to be one of the riskiest asset classes for community banks, naturally it holds that effectively disposing of such properties from OREO invento- ries is challenging. Despite the recent clarification from the Federal Reserve regarding the rental of OREO as part of an orderly disposition strategy, the stubbornly elevated levels of OREO on bank balance sheets suggest that com- munity banks still have a long way to go before these levels return to where they were prior to the financial crisis. Gary Corner is a senior examiner and Daigo Gubo is a policy analyst at the Federal Reserve Bank of St. Louis. ENDNOTES 1 Properties that are classified as other real estate owned (OREO) are those held by banks as the result of a foreclosure or a deed in lieu of foreclosure. 2 Problem asset ratios are nonperforming loans and OREO to total loans and OREO. 2% or more 1.50% to 1.99% 1% to 1.49% 0.50% to 0.99% 0% to 0.49% figure 4 Average OREO Concentrations by State Source: call reports > > M o r e o n L i n e Supervision and Regulation Letters SR 12-5/CA 12-3 www.federalreserve.gov/bankinforeg/srletters/ sr1205.htm SR 12-10/CA 12-9 www.federalreserve.gov/bankinforeg/srletters/sr1210.htm Central Banker winter 2012/2013 | 7
image-container-7 i n - d e p t h The Big Banks: Too Complex To Manage? T he phrase “too big to fail” re- entered common use in 2008 after Fannie Mae and Freddie Mac were put into government conservatorship on Sept. 6; the government rescued the large insurance firm AIG start- ing on Sept. 16; and nine major banks announced on Oct. 14 their intention to subscribe to the Troubled Asset Relief Program (TARP), in which the Trea- sury would purchase the banks’ pre- ferred stock. More unflattering phrases have become associated with mega- banks over the past couple of years. “Misbehaviors” connected to the big banks magnified the problems already posed by such large, complex financial organizations, which have concerned legislators and regulators for years. Have they successfully created game plans for “too-big-to-fail” firms? Are big banks needed, or do the misbe- haviors indicate that such megabanks should not even exist? These and more questions were explored during the Oct. 1 Dialogue with the Fed, part of the St. Louis Fed’s ongoing evening discus- sion series for the general public. St. Louis Fed economist William Emmons led the Dialogue, titled “Robo- signing, the London Whale and Libor Rate-Rigging: Are the Largest Banks Too Complex for Their Own Good?” Joining Emmons for the Q&A that followed were Mary Karr, senior vice president and general counsel of the St. Louis Fed; Steven Manzari, senior vice president of the New York Fed’s Complex Financial Institutions unit; and Julie Stackhouse, senior vice president of Banking Supervision and Regulation at the St. Louis Fed. See the videos and Emmons’ presentation slides at www.stlouisfed.org/dialogue. Why Were Big Banks rescued during the Crisis? The financial crisis reinvigorated the active debate on the “social good” of megabanks—whether they alone can do things smaller financial organizations can’t and whether they truly are more effective and efficient. (See “Econo- mies of Scale and Scope” on Page 10 for some details.) The primary point of contention, however, is systemic risk. Very large and complex banks are considered to have systemic risk because the failure of a megabank would hurt not just the company itself, its creditors and its employees but potentially the entire financial indus- try and the economy. In other words, they are “too big to fail” without creat- ing dire consequences for the economy. “Sometimes institutions need to fail. That is essentially what capitalism is about: that when a firm is no longer viable it should be able to leave the market (e.g., fail),” Emmons said. “But we were caught flat-footed in 2008 when the financial system almost col- lapsed and we had no safe, effective way to wind down failing megabanks.” Consequently, the federal government propped up many large and complex financial institutions—including AIG, Fannie Mae and Freddie Mac—to avoid the damage of chaotic collapses. The lack of a structure to deal with a megabank failure has troubled many policymakers and lawmakers who, as discussed later, are attempting to craft such a mechanism. Misbehaviors: a Failure of discipline? The revelations of recent contro- versies such as robo-signing, the London Whale and Libor rate-rigging— explored in “Big Bank Misbehaviors” in the online version of this article at www.stlouisfed.org/cb—as well as other problems not mentioned here indicate figure 1 Which Forms of Governance Appear To Be Effective for Complex Banks? Corporate governance Mechanisms internal governance mechanisms in the best corporations Among u.s. megabanks corporate culture Board oversight Managerial self-interest external governance mechanisms Product-market discipline Shareholder discipline Depositor/bondholder/ counterparty discipline Supervision and regulation overall effectiveness of governance 8 | Central Banker www.stlouisfed.org
image-container-8 dealing with Large, Complex Banks But why didn’t federal regulators catch the misbehaviors and other issues before they became major problems? Complexity. For example, Manzari, responding to a Dialogue audience question, said that super- vising a handful of megabanks is definitely more complicated than supervising hundreds or thousands of smaller institutions. • Numerous regulators for one megabank – “Every jurisdiction has some sort of prudential super- visory agencies. A firm that does business in the United States, the U.K., Europe and Asia will have a range of different entities involved in the supervision of that firm. That puts a big premium on communica- tion and collaboration of those dif- ferent agencies.” • No uniform set of rules across agencies – A nationally chartered bank in the U.S. faces a uniform set of rules, and you don’t have state- to-state differences. However, there is no globally unified regulatory framework for all international firms. “There is an effort to harmonize capital standards (and) liquidity stan- dards, but still you get different rules in different regimes,” Manzari said. Illustrating Emmons’ prior exposi- tion on megabank discipline, Manzari added that “The very complexity of megabanks often creates relationships inside the firm that become apparent only after the problem manifests itself.” Addressing supervision of smaller banks, Stackhouse noted that while the supervisory process is easier, there is also a very clear resolution mechanism. Since the financial crisis, more than 400 small banking organizations have continued on Page 10 that something critical was lacking in the discipline of large, complex banks. “Discipline” is a combination of an institution’s internal and external gov- ernance. Internal governance includes corporate culture, oversight by the bank’s board and managerial self-inter- est, while external governance comes via supervision and regulation, as well as discipline by product markets, shareholders, depositors, bondholders and counterparties. Was the internal discipline effective? Not really, Emmons explained: “Some of those misbehaviors point in this direction, that the internal corporate cultures at the largest banks are not an effective mechanism for keeping the banks on the straight and narrow.” As indicated in Figure 1 on Page 8, inter- nal discipline generally appears to work well in the best corporations but not as well among the U.S. megabanks, while external governance generally seems to have worked better for megabanks, Emmons said. “The basic message is that there are some real weaknesses on the internal side, and to the extent that we can be effective as supervisors and regulators, we can probably provide fairly effective external sources of discipline,” he said. “I think it’s also true that board over- sight is often lacking,” Emmons said. It’s a perennial issue at small banks and a bigger issue for midsized banks but seems especially challenging for megabanks, as their board members are nonexperts recruited from other economic sectors yet are expected to provide effective oversight of very large and complex organizations. “It’s true that the megabanks operate in very competitive product and labor markets, which pushes them to be more efficient. But the other internal governance weaknesses noted above and their overwhelming complexity appear to make them ‘too big to manage effec- tively,’” he said. Both Emmons and Manzari addressed shareholders in response to a question from the Dialogue audience. They noted that small shareholders are exerting some discipline through selling their stock but that there are restrictions on what large shareholders can do and that the type of governing influence that shareholders can have on firms has yet to play out in this changing regulatory environment. “We were caught flat-footed in 2008 when the financial system almost collapsed and we had no safe, effective way to wind down failing megabanks.” Economist William Emmons Central Banker winter 2012/2013 | 9
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Date: Winter 2012
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  • Authors: Corner, Gary S., Gubo, Daigo
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