Supervising the Nation's Banks
This 22-minute podcast was released May 8, 2019.
“The Federal Reserve supervises all corporations that own banks, known as bank holding companies … but we also supervise small banks,” explains Julie Stackhouse, executive vice president of supervision for the Federal Reserve Bank of St. Louis. She talks with Doreen Fagan, a senior editor at the St. Louis Fed, about the Fed’s role in examining banks, the growth of fintech, and how the St. Louis Fed supports banks through education and outreach.
Doreen Fagan: Welcome to Timely Topics, a podcast series from the St. Louis Fed. I'm Doreen Fagan, your host for this episode. Our guest is Julie Stackhouse, executive vice president of supervision for the Federal Reserve Bank of St. Louis. She's joining us to talk about the important role of the Fed in supervising our nation's financial institutions. Welcome, Julie.
Julie Stackhouse: It's great to be here.
Fagan: So to start, would you tell us a bit about your role as head of supervision? What does it entail?
Stackhouse: My role as head of supervision involves some basic things such as examining the safety and soundness of financial institutions to ensure that the deposit insurance fund, the fund that protects you, the depositor, is safe based on the actions of the bank. We also examine banks for compliance with consumer laws and regulations, also really important from the standpoint of protection of you, the consumer.
Fagan: Many in our audience know that the Fed regulates and supervises banks. This awareness likely has grown since the financial crisis. Still, would you explain what this function involves and why it's so important now, 10 years later?
Stackhouse: When I look back, particularly at the fall of 2008, it's a little bit hard to articulate the frightening nature of our financial system. Financial institutions were at the brink of collapse, and actions were being taken that none of us ever envisioned would occur. Yet, we got through that crisis through some very clever supervisory activities where the Federal Reserve stress-tested the capital or shareholders’ equity levels of large banking organizations, and where a program called the Troubled Asset Relief Program or TARP stood as a backstop in case banking organizations did not have enough capital to pass those stress tests. I know some people attach a fairly negative meaning to TARP, but for us it was very important to know that there was capital backstopping the financial system if the stress tests were failed.
Over the course of time, the financial markets realized that financial institutions would remain solvent, despite the stress in the economy. And it was at that point that we began to see the financial system solidify and the Federal Reserve was then able to kick in what it needed to do in terms of the support of the economy.
Now with that story is an important outcome, and that is that the Federal Reserve—and Congress, for that matter, through the Dodd-Frank Act—recognized that large financial institutions needed a special, high quality of supervision. Something we call Enhanced Prudential Standards. In short, the nation's largest financial institutions are supervised not only for their internal quality of operations and expectations for compliance with consumer laws and regulations, they are looked at as a group to ensure that our financial system remains stable, even if we were to incur a downturn in the economy. So that financial stability perspective is quite new since the financial crisis, but also should be very satisfying and comforting to those in the public.
Fagan: And the Fed supervises all banks, correct? Big and small?
Stackhouse: So the Federal Reserve supervises all corporations that own banks, known as bank holding companies, whether they're big or small. The bank holding companies with names like Citicorp or Wells Fargo are all supervised by the Federal Reserve, and we look at them through this lens of financial stability as well as the safety and soundness of the individual institutions. But we also supervise small banks. And when we talk about small banks, these are banks in your hometown. The little bank down the street next to the hardware store that many individuals and communities view as being sort of the pillar of the community. So we see both ends.
Fagan: So not all banks are regulated and supervised in the same way, right? Could you tell us about some of those differences?
Stackhouse: The process for supervising banks can be thought of as a barbell. For our small banks, which actually some are quite large, but the smaller banks of the spectrum, they're supervised for general safety and soundness and for compliance with consumer laws and regulations. We have a training program and a process for examinations that is time tested. It ensures that that deposit insurance fund is protected. On the other hand, the large institutions are stress-tested, which means that rigorous models are applied to their operations to make sure that they can withstand economic downturns. They're stress-tested to be sure that they can pay off their depositors in a timely manner. They have to submit to regulators resolution and recovery plans, so-called living wills, to convince regulators that they can be broken apart over time should they begin to fall into very unsatisfactory financial conditions.
In short, the nation's largest financial institutions have the most rigorous level of supervision that is tailored and applied based on the risks that they present to the financial system.
Fagan: In speaking about smaller banks, you often hear that small business is the engine of the economy. Yet, some small banks can face some pretty big compliance hurdles. Have you found that, relatively speaking, it's more expensive for smaller banks to stay compliant?
Stackhouse: We have seen through the data collected by the state bank commissioners, the offices that state banking departments run, that there are what are called economies of scale in banking. In other words, the cost of compliance, which includes things such as anti-money laundering and Bank Secrecy Act procedures, consumer compliance laws and regulations, things that in and of themselves are good and important, involve a fixed cost that if you are small will be relatively higher for the small banks. So that's a reality, and part of the reason that a number of small banks are choosing to sell to larger organizations.
Fagan: And are regulatory costs also one reason why the Fed is looking at ways to tailor regulations, as you say, to the size and risk exposure of banks to lessen some of this burden?
Stackhouse: When we talk about tailoring, that generally is thought of in terms of the nation's largest financial institutions. Recently, the Federal Reserve talked about a proposal to better align supervisory processes with the risk of the institution, and that was presented as a tailoring proposal. For smaller institutions, many of the laws and regulations apply evenly to those institutions regardless of their size. So in short, what the institution must invest in anti-money laundering efforts or consumer compliance requirements will be the same, regardless of the institution. That causes institutions to sometimes say, “Can I afford the cost of regulation?” or to express concern about the cost of regulation. We're sensitive to it, but we also realize that we must ensure that we follow the laws and regulations that are in place.
Fagan: Correct me if I'm wrong, but the 2018 National Survey of Community Banks put out by the Federal Reserve and the Conference of State Bank Supervisors did show compliance cost as coming down. I believe inferred compliance cost for the community banking industry, which had been increasing in previous years, actually declined in 2017. So, good news?
Stackhouse: Well, always good news. There tend to be some bubble costs when new laws and regulations come into place. And for a few years, we were probably seeing the effects of new mortgage regulations that were mandated by the Dodd-Frank Act, which was a result of the financial crisis. Going forward, we're probably going to see a few more bubble costs related to a new accounting standard called the Current Expected Credit Loss model. So, it wouldn't be surprising in future surveys to see that come back up a little bit.
One thing that we know about community banks is that the hardest thing for a community bank is to implement new regulations or accounting standards. Once they're implemented, they tend to be in a much better position.
Fagan: So you mentioned before consolidation. We are seeing more consolidation among community banks. Are economies of scale driving this, or competition, or something else?
Stackhouse: There are probably many things driving the consolidation we see in banking. As we look at our rural communities, for example, we see declining populations. In the last decade, over 75 percent of counties designated as rural experienced population declines. It's hard to be successful as a bank if you're losing population. There are also the challenges of nonbank competitors. And when I say nonbank competitors, that could be something as simple as online lenders, mortgage lenders for example, or small business or consumer lenders. So that's in play.
Fagan: Would you talk about the growth in fintech companies? Names like PayPal and Venmo are probably most familiar to our audience. Would you explain their role in the payments system alongside the Fed?
Stackhouse: So financial technology, or fintech, is definitely a topic of interest to many consumers, because consumers want convenience and, honestly, most consumers don't want to go into a bank anymore. So if you think of it this way, new technology such as the Cloud environment have allowed more and more data or information to be brought together in one place. And computing power, the simple ability of computers to run their so-called algorithms in a very quick manner, has improved. What that has meant is that we're seeing a new wave of financial services. To you, as the consumer, you're going to see that in things such as online lending options. Just to give you a sense of what that might be, my son recently purchased a house. They applied online, they got their mortgage online, it closed very conveniently and they never had to go into a physical facility to do that. Wow, what a contrast to my first purchase of a home where I went into an office of an institution. So that's one example of lending through financial technology, but it doesn't stop there.
You as the consumer, or if you're my generation, maybe it's your children, no longer really care about carrying cash. They want to use technology to make payments to other people, and there are many options to do that that are out there. We can give more and more examples, but the short summary is this: Technology is being applied on top of traditional banking services, and as consumers, it is critically important that we understand what that is doing, because each of these services is different. As you opt into these services, you need to understand what data is being collected and how it will be used. Once you understand that, you make that choice, you make that decision, then the services are fabulous.
Fagan: So walk us through what happens behind the scene, so to speak, or the curtain, with these online money transfer transactions. Do banks play a role?
Stackhouse: So each service is a little different, but in every situation, unless the service is in itself a bank, a bank is involved. So I'm going to give you a personal example. My family uses a lot of products produced through the Apple family. So we have iPads, and we have Apple computers, and I have my Apple watch. That made it very convenient for me when it was announced to adopt something called Apple Pay, which is a payment service. So if you have an account, I can set up a mechanism to transfer money to you so I don't have to give you cash. Great for my kettlebell class. When I need to pay my instructor and he'd take cash, but that's not convenient for me, so I can make that Apple Pay payment to him—or I can go into the store, click my watch and make a payment for my purchases. Very convenient for me. I don't have to pull out my card. So that's great. What happens behind the scenes?
Behind the scenes, Apple is transmitting that data through very normal banking channels using very traditional banking organizations. To you, it looks like Apple. To me as a regulator, it looks like it is working through the banking system. So it works smoothly, but as I said earlier, each of these services are different and as consumers, it is increasingly important that we understand whether the service is actually making a transfer of our money or if the service is putting the money into an account where we have to take it out later. Each is different.
I know your next question will be, “How do I understand all this?” Here's the really good news: Traditional organizations like Consumer Reports are starting to review these products and lay out matrices of how the products work and what you as consumers should know. I'm very confident that as consumers, if you go out to the internet and just do a teeny little bit of homework, you really will understand how the product works and feel probably pretty comfortable with many of these products.
Fagan: And as a consumer who might be familiar with having FDIC-insured checking deposits, for instance, could you talk about what guarantees stay in place along the entire path to settlement?
Stackhouse: So I'm glad you raised Federal Deposit Insurance. When we hit the height of the financial crisis, we realized that many individuals with traditional banking accounts did not understand what Federal Deposit Insurance meant, but it became very important when you thought your money was at risk or your institution might fail. I hope there's never another financial crisis like we saw particularly in 2008, but if there is, you as a consumer want to know, is your money insured by the Federal Deposit Insurance Corporation? As you use these financial technology services, you have to read the fine print. There are always disclosures that tell you how the money is moving and will give you options to make changes to that. So for example, one very popular product that is associated with a company called PayPal will aggregate funds in an uninsured account until you otherwise move them. That's not necessarily bad, but that may not be optimal for you. By reading the disclosures, you'll understand how it works, and as a consumer you can then make choices to adapt the product to your preferences. You may say, “Move money the very next day. I don't want it sitting in that aggregated account.” I do think it has made it a little more difficult for consumers. I do expect that these products will continue to improve in terms of real-time consumer disclosures, but we're in the infancy right now.
Fagan: So understanding what monies are insured and what personal data you may be disclosing along the way really sound like key takeaways.
Stackhouse: Very important takeaways, particularly the data. Data is precious, and as we give away our data we ideally should do so knowingly, not because we failed to read what the disclosures told us when we first signed up for the product.
Fagan: So tell us about the different ways that the St. Louis Fed supports the banking industry through education and outreach. You're actively involved in an annual community banking conference. What are some of the topics you've explored?
Stackhouse: The community bank conference was started back in 2013, and we really did it as a way to focus attention on the issues facing community bank. At the time, that was largely focused on what we called regulatory burden. We had the support not just here at the Federal Reserve Bank of St. Louis, but we had support at the Board of Governors, the governors themselves were really interested in this conference.
What we found as we began the conference, though, is we had a great opportunity not only to bring academic researchers to the table to look at the issues facing banking—whether it's regulatory burden or the impact of financial technology on banks—we also had an opportunity to do a few other things, such as work with the state bank commissioners to collect data that could be used for future research, to introduce a college case study competition where college students partnered with banking organizations to look at the issue of the day facing banks. That alone has been incredibly powerful. We've now had literally hundreds of students who have a new image of banking and who are being hired by some of the banks with which they partnered.
We've also done videos about community banking and the power in the community. One that I think is so powerful was a St. Louis area bank that made a loan to a local health care company that provided health care services to individuals in low- to moderate-income communities. This particular nonprofit had previously banked at a large bank, and with changes in the health care law were concerned that they might lose the loan from the large banking organization. To see the power of what that community bank meant for that organization, how they stepped in and they kept medical services going without interruption for individuals in that low- to moderate-income community was absolutely powerful. There are so many stories about what community banks do for communities, and we're just thrilled that we've been able to capture some of them.
Fagan: So if interested in learning more about that, listeners can go to communitybanking.org. Is that right?
Stackhouse: That's right. There is great information out there and also information on our event for 2019 as we begin work for that one.
Fagan: Terrific. You also contribute to the St. Louis Fed's On the Economy blog with your special series Supervising Our Nation's Financial Institutions. Tell us about some of the interesting topics you've explored and what you might be writing about next.
Stackhouse: The reason that I started the blog was partially just to get information out there that might be helpful for those that were reading newspaper stories. So I started with topics like why are banks regulated, and did the Dodd-Frank Act make the financial system safer? But I also then moved to focus on some things that are actually kind of hard to talk about, such as the Community Reinvestment Act, what is its purpose? How well does it work? Or looking at things like reports that banks submit on their home mortgage lending, what those reports mean, and what they don't mean. So the goal was simply to put out unbiased information that might be helpful in understanding the basics of banking.
Our recent series has been on the bank rating system, the so-called CAMELS rating system. If nothing else, just to demystify that rating system. If, at the end of the day, we're able to answer a question or just simply service a source of high-quality information on the banking system, then I will have really met my goal with that blog.
Fagan: So, fast-forward 10 years. What do you see yourself writing about then?
Stackhouse: Well, it's always a little bit hard to get that crystal ball out, but I think we're going to have a smaller banking system than we have today. I think consolidation will continue. So we'll still be talking about that. But I also think this array of products and services that are available because of technology will have exploded. And I'm not so sure we'll even be thinking of banks the way we do today. Now, that's not to say banks will go away. I think there's a group of people who like traditional banks and traditional banks will continue to meet that need. But for my millennials or for their kids, I do think we'll have a different array of services accessed through the internet that may or may not provide the same affinity to a banking organization as existed during my early days of association with banking. That will pose some challenges to traditional banking organizations, but for those who are strategic, who plan ahead, who ensure they offer the services at the right time to their customers, I also think they will provide opportunities. So maybe a little bit smaller system, but maybe a system that is also a little more efficient and offers more services than we see today.
Fagan: Very informative, Julie. Thanks so much for joining us.
Stackhouse: It was my pleasure.
Fagan: For more of Julie's insights, go to stlouisfed.org and select the blogs and publications tab. You can search for Julie's series, Supervising Our Nation's Financial Institutions, as part of the On The Economy Blog. To listen to more Timely Topics podcasts, go to stlouisfed.org/timelytopics.
Economists and experts talk about their research, topics in the news and issues related to the Fed. Views expressed are not necessarily those of the St. Louis Fed or the Federal Reserve System.