FDIC: Advisory Committee on Banking Policy

Minutes
of
The Meeting of the FDIC Advisory Committee on Banking Policy
of the
Federal Deposit Insurance Corporation
Held in Meeting Room B
L. William Seidman Center
3501 Fairfax Drive
Arlington, Virginia
Open to Public Observation
April 22, 2003 - 9:00 A. M.

The meeting was called to order by the Chairman of the Board of Directors of the Federal Deposit Insurance Corporation and Chairman of the FDIC Advisory Committee on Banking Policy, Donald E. Powell.

Erica F. Cooper, Designated Federal Officer for the Committee and Deputy General Counsel of the Federal Deposit Insurance Corporation, was also present at the meeting. Committee members Jean Becker, Chief of Staff, Office of President George H.W. Bush, Houston, Texas; and Andrew B. Craig, III, Retired Chairman, NationsBank Corporation (now Bank of America), were absent from the meeting.

John M. Reich, Vice Chairman of the Corporation's Board of Directors, and the following members of the Corporation's staff were present at the meeting: John F. Bovenzi, Steven O. App, John M. Brennan, Robert W. Russell, Jodey C. Arrington, C. K. Lee, Cynthia L. Keil, Andrew B. Stirling, William F. Kroener, III, Arleas Upton Kea, Arthur J. Murton, Frederick S. Selby, Mitchell L. Glassman, D. Michael Collins, Cottrell L. Webster, Robert E. Feldman, Alice C. Goodman, James Phillip Battey, Gaston L. Gianni, Jr., Vijay G. Deshpande, Scott M. Polakoff, Stanley R. Ivie, Sandra L. Thompson, John M. Lane, Donna J. Gambrell, Miguel D. Browne, Kathy L. Moe, Richard A. Brown, Joan S. van Berg, Catherine A. Wright, G. Penny Elgas, and Daniel T. Engen.

Chairman Powell began by announcing that the meeting would begin with panel one - Regional and Field Structure - the members of which panel included Scott M. Polakoff, Regional Director, Division of Supervision and Consumer Protection, Chicago Region; Kathy Moe, Field Office Supervisor, Phoenix, Arizona, Field Office, Division of Supervision and Consumer Protection, San Francisco Region; and Stanley R. Ivie, Deputy Director, Division of Resolutions and Receiverships, Dallas Region.

After introducing the members of panel one, Mr. Polakoff reviewed the Corporation's responsibilities in fulfilling its role as the primary federal regulator for insured state nonmember banks and as the insurer of deposits made in all institutions that are members of the Federal Deposit Insurance Corporation. He noted that the Corporation performs safety and soundness examinations of FDIC-supervised insured depository institutions to assess their overall financial condition, management practices and policies, and compliance with applicable laws and regulations; to assess the adequacy of management and internal control systems to identify and control risks; and to facilitate and evaluate an institution's compliance with consumer protection/fair lending laws and the Community Reinvestment Act. Mr. Polakoff also noted that the Corporation is authorized, for deposit insurance purposes, to conduct examinations of financial institutions for which the Office of the Comptroller of the Currency, the Office of Thrift Supervision, or the Board of Governors of the Federal Reserve System is the primary Federal regulator. Continuing, he further noted that the Corporation evaluates how changes in the economy, the financial markets, the banking system, and in individual financial institutions affect the adequacy and the viability of the deposit insurance funds; identifies risks to the insurance funds by analyzing economic, financial, and banking trends; and communicates its findings to the industry and the other federal banking agencies and state authorities.

Mr. Polakoff then described for the Committee the Corporation's regional office structure. In that regard, he noted that the Corporation had divided the country into six regions - San Francisco, Kansas, Dallas, Chicago, New York, and Atlanta, with each region supported by a regional office and multiple field offices that report to the regional office. Mr. Polakoff also noted the average square feet of office space utilized by the regional and field office staff and the average number of employees in those offices. He reported that each regional office housed staff of the Division of Supervision and Consumer Protection, the Legal Division, the Division of Administration, the Division of Insurance and Research, the Division of Information Resources Management, the Office of Inspector General, and the Office of the Ombudsman. Mr. Polakoff added that the Corporation's Dallas Regional Office also housed staff from the Division of Resolutions and Receiverships.

Mr. Polakoff, noting that the Corporation had a decentralized approach to organization, with the regions operating in a somewhat autonomous manner but yet accountable to headquarters, then solicited from the Committee members their guidance and views on, and experience with, the concept of decentralization across the nation. Discussion was then centered on the extent to which best practices are shared. Mr. Polakoff advised that, in addition to constant phone contact, field supervisors are invited to the regional office four times a year to meet and discuss issues, problems, and best practices and that the Regional Directors and Deputy Regional Directors are invited to headquarters three to four times a year to elevate the concept of best practices and to discuss any problems. He added that each region audits its field operations every one to two years to ensure that practices and policies were being followed and that headquarters staff visit the regions to ensure the regional offices were conducting business as expected.

There then followed a general discussion concerning the mobility of personnel, the average tenure of examiners, pay differentials, the accessibility of staff to bankers, and the ability of staff to stay informed regarding the latest local economic conditions. During the discussion, Mr. Polakoff identified the Corporation's client base as banks, state banking departments, the other federal banking regulatory agencies, trade associations, and the Corporation's employees.

Mr. Polakoff also reviewed the Corporation's concept of vertical supervision, which he described as interaction with banks whose conditions are weak, and horizontal supervision, which he described as efforts to better understand across the industry, community, state, or region those risks or situations learned on a bank-by-bank basis. In addition, he described the Corporation's Dedicated Examiner Program for the eight largest insured depository institutions, noting that the program envisions dedicated Corporation examiners working in cooperation with primary supervisors and bank personnel to obtain real time access to information about the risk and trends in these institutions. Chairman Powell emphasized that the Corporation was not the primary regulator of the majority of the eight largest institutions and, therefore, representatives of the Corporation had met with representatives of the other federal banking regulatory agencies and had reached an agreement with them regarding the presence of Corporation examiners in the institutions for which those agencies were primarily responsible.

There then followed a discussion of various issues, including whether a customer or an investor should be informed of the CAMELS composite examination rating assigned to an institution, the confidential nature of examination reports, the clues that would indicate that a bank was experiencing financial difficulty, the peace of mind afforded bank customers through deposit insurance coverage, and the percentage of institutions associated with each composite rating.

Continuing with panel one's presentation, Ms. Moe reviewed the (1) operations and configuration of a field office territory, (2) roles of risk management and compliance field supervisors, (3) examination process, (4) risk-focused examination program, (5) compliance refocusing, (6) processing of examination reports, (7) banker outreach initiatives, and (8) development of personnel.

There then followed a discussion of the agreements that the field offices may have with the state banking departments regarding joint examinations and of other examination-related issues. Corporation staff and the Committee members also discussed examiner training and discipline and the resources available to examiners for performing their tasks.

Mr. Ivie next reviewed for the Committee the history of the Corporation's resolution/liquidation process, as well as the history of the Division of Resolutions and Receiverships' staffing and office structure. During his presentation, he noted that, in 1990, the division operated from 23 offices with over 7,000 employees and liquidated a large volume of assets acquired from failing banks; and that, in 1993, the division reduced its number of offices to headquarters and 6 regional service centers and approached the resolution process from a marketing angle, offering various inducements to encourage institutions to acquire as many assets as possible. He added that the division currently operates from headquarters and the Dallas Regional Office.

Continuing, Mr. Ivie reviewed the division's procedures for resolving failing institutions, which involves, among other things, coordinating with the regulatory community to allow for early access to information and for asset valuation review, soliciting bids and preparing for several resolution scenarios, focusing on customer service, and monitoring the various program areas so that the receiverships can be terminated as soon as possible.

There followed a discussion of related issues, during which it was noted that fraud was a major factor in recent bank failures; that the Corporation has returned, on an aggregate basis, 72 cents on the dollar of uninsured deposits; and that the Corporation determines through the bidding and resolution process, which transaction, if any, represents the least cost to the deposit insurance funds of all possible methods for meeting the Corporation's obligation to provide insurance coverage for the insured deposits in the failed bank.

Chairman Powell then announced a recess in the meeting. Accordingly, the meeting stood in recess at 10:47 a.m.

The meeting was reconvened at 11:04 a.m., at which time Chairman Powell announced that the meeting would continue with panel two - The Future of Financial Regulation - the members of which panel included Sandra L. Thompson, Deputy Director, Strategic Planning, Budget, Reporting & Special Projects, Division of Supervision and Consumer Protection; Donna J. Gambrell, Deputy Director, Compliance & Consumer Protection, Division of Supervision and Consumer Protection; John M. Lane, Deputy Director, Risk Management, Division of Supervision and Consumer Protection; and Miguel D. Browne, Associate Director, International & Large Bank Branch, Division of Supervision and Consumer Protection.

Ms. Thompson began by advising that panel two would discuss some of the risk management and consumer protection activities taking place at headquarters. She noted that the nature of the current financial environment was more complex than ever before, that new developments presented increased challenges to the Corporation, and that market evolution and innovation had resulted in unprecedented convergence and consolidation in the financial services industry. In that regard, she referred to the disappearance of barriers to interstate ownership and branching and of separation of the banking and securities industries. She added that, while the number of financial institutions had decreased, the largest entities continued to increase in asset size, with the eight largest of the 9,000 insured institutions holding nearly 50 percent of the industry's total assets; and that these institutions had turned to a variety of nonlending activities to diversify their revenue such as insurance, commercial banking, securities underwriting, off-balance sheet contracts, derivatives, and investments. She advised the Committee that, in response to the new financial environment, the Corporation had implemented a number of initiatives to monitor and manage risks, including the establishment of a risk analysis center. With respect to the Corporation's consumer-related activities, Ms. Thompson reported that a financial literacy program entitled, "Money Smart" had been developed and implemented and that she and others taught the program in local communities; and that a national consumer response center had been established to receive information, complaints, and inquiries directly from consumers.

In describing the integrated risk analysis process, Mr. Lane reported that a number of mechanisms were being employed by the Corporation in analyzing the risks associated with the changing environment of banking. He noted that the National Risk Committee, the members of which were the Corporation's senior managers, identifies and evaluates the most significant external business risks facing the Corporation and the banking industry and, where necessary, develops a coordinated response to these risks, including appropriate policies and operating strategies with regards to FDIC-supervised and insured institutions.

Continuing, he then noted that the regional risk committees identify and prioritize existing and emerging macroeconomic and banking trends and risks that may affect insured institutions; develop follow-up strategies and actions to address the identified issues; allocate resources, when necessary, to meet changing strategies and actions; convey information regarding identified trends and risks to the national risk committee at headquarters and to other regions, to field examiners, and to other federal and state regulators; and incorporate information and recommendations from the national risk committee in regional risk committee strategies.

Mr. Lane also noted that the policy development committee was tasked with handling comprehensive policy issues and determining the best course of action for the Corporation to manage and address risk-related issues; and that the financial risk committee was responsible for addressing risk exposure to the insurance funds.

Mr. Lane then advised that, in identifying a need for more real-time information and a rapid response to certain emerging risks, the Corporation had opened a state-of-the-art risk analysis center, which provides for a real-time physical location to receive information on the financial market activities on a daily basis and to monitor and discuss risks to the insured funds and strategic issues that institutions represent.

The Committee members and the Corporation staff then discussed in general the means by which the Corporation might improve its process of identifying and understanding risk. During the discussion, staff mentioned that it had engaged the services of a consulting firm for the purpose of reviewing the risk analysis process and identifying ways to improve the process.

Ms. Gambrell then presented an overview of the Corporation's compliance examination program, consumer affairs function, and community affairs function. She noted that the Corporation had conducted a review of its compliance examination process for the purpose of developing a more effective and efficient approach and, as a result, expects to launch its Compliance Refocusing Project soon. Ms. Gambrell advised that, under this new project, the Corporation would conduct a risk-based review of an institution's compliance program and discuss with the financial institution's personnel the methods by which the institution identifies emerging risks, keeps informed of changes to the laws and regulations, and ensures that its employees understand their responsibilities in fulfilling the compliance assignments and tasks. She added that a pilot test of the program had produced positive feedback from the banking industry and that staff was optimistic that the program would also be viewed favorably.

Continuing, Ms. Gambrell mentioned two other programs - the community affairs program which facilitates relationships between financial institutions, community organizations, government agencies, and others; and the consumer affairs program which addresses written complaints and inquiries and phone calls from consumers.

There then followed a discussion among the Committee members and Corporation staff of consumer-related issues.

Next, Mr. Browne discussed the importance of a financial institution's level of capital, noting that capital absorbs losses, promotes public confidence, restricts excessive asset growth, and protects the interests of depositors and the deposit insurance funds. He then continued with a review of the history of capital regulation in the banking industry, noting, among other things, that during the 1980s, capital regulation progressed from an agreement between the regulators and the bankers to an international agreement on risk-based capital set forth in the first Basel Capital Accord adopted by the Basel Committee on Banking Supervision, which is comprised of representatives of the central banks and supervisory authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States), and Spain and Luxembourg, and which meets at the Bank for International Settlements in Basel, Switzerland). In that regard, Mr. Browne noted that the first Basel Accord provides systematic procedures for factoring both on and off-balance-sheet risks into the supervisory assessment of capital adequacy, reducing disincentives to holding liquid, low risk assets, and fostering coordination among supervisory authorities from major industrialized countries; that, under the 1988 Accord, as implemented in the United States, assets and off-balance-sheet items are "risk-weighted" based on their perceived credit risk using four broad categories which forces banks to hold more capital if they choose riskier assets, and does not penalize them for holding less risky portfolios; that institutions subject to the Accord are required to maintain a minimum ratio of regulatory capital-to-total risk-weighted assets of at least 8 percent; and that, in addition to the risk-based capital requirements, all United States institutions must comply with minimum leverage ratio requirements of Tier 1 capital-to-average total consolidated on-balance-sheet assets.

Mr. Browne noted that certain limitations of the 1988 Accord had become both more apparent and important over time; that although the 1988 Accord was more risk-sensitive than earlier capital guidelines, it was nevertheless a blunt instrument with respect to credit-risk differentiation and allowed securitizing banks significant latitude for capital arbitrage; and that the increasing size and complexity of the largest banks had made it more important for bank supervisors to enhance their ability to enforce capital adequacy by harnessing two key tools, market discipline and the risk metrics employed by banks themselves. He added that revisions to the 1988 Accord proposed the use of internal risk measures to set capital requirements to credit risk and comprised three mutually reinforcing "Pillars" - Pillar 1 would set out minimum capital requirements, with three options (approaches) for calculating credit risk and three others for calculating operational risk; Pillar 2 (supervisory review) is based on a series of guiding principles, all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks and for supervisors to review and take appropriate actions in response to those assessments; and Pillar 3 (market discipline) is a set of disclosure requirements that allow market participants to assess key information about a bank's risk profile and level of capitalization.

He added that representatives from the Corporation were currently at Basel and he anticipated that that committee would soon vote on whether to release the latest draft of the Accord for public comment.

Mr. Browne continued with a review of the capital adequacy framework of the new accord, after which Chairman Powell announced that the meeting would stand in recess. Accordingly, at 12:45 p.m. the meeting stood in recess.

The meeting was reconvened at 2:22 p.m. that same day at which time Chairman Powell announced that the meeting would continue with panel three - The Future of Banking: Emerging Issues, Emerging Risks, and Effective Policy Development - the members of which panel included Arthur J. Murton, Director, Division of Insurance and Research; Alice C. Goodman, Director, Office of Legislative Affairs; and Richard A. Brown, Associate Director/Chief Economist, Risk Analysis Branch, Division of Insurance and Research.

After Mr. Murton had provided a brief background of the Division of Insurance and Research, Mr. Brown outlined the Division's roles and responsibilities, which included, among other things, performing macro risk analyses and providing the results to the Board of Directors and to the public. Continuing, he noted a number of issues being examined which related to the economic outlook, banking lines of credit, credit risk, commercial lending, commercial real estate, consumer and mortgage lending, operational/market risks, interest rates, derivatives, and securitizations. Mr. Brown reported that staff viewed commercial real estate lending and sub-prime lending as emerging risks.

With regard to the economic outlook, Mr. Brown noted a number of factors affecting the economy such as corporate restructuring, governance issues, the potential for war and terrorism, and deflationary pressures on the global economy. He added that, while there has been some monetary and fiscal stimulus, there continued to be some concern over whether the country was out of recession.

Mr. Brown noted that, while there had been no improvement in job growth, consumer spending led the economy by way of tax cuts, unemployment benefits, a reduced inflation rate, and refinancing opportunities, but that there was some concern with regard to the financial vulnerability of consumers. He further noted that capital investments declined to the lowest in 25 years; that equipment and software investments increased modestly; that investments in fixed nonresidential real estate continued to decline; and that corporate executives had appeared to be focused inward, not taking advantage of opportunities possibly due to the pending war, corporate restructuring, and weak global demand. The Committee members and staff discussed at length other factors that could impact the economy, underlying problems with pension underfunding, and events occurring in the equity markets for the last three years. During the presentation and discussion, Mr. Medlin cautioned regulators to not let down their guard on asset quality and expressed the view that the economy would recover at a slow rate. Mr. Powell added that he expected the employment level to improve at a slower than normal pace, and Mr. Porter noted that lower oil prices would contribute to a healthier economy.

Mr. Murton pointed out that the banking industry was in a good financial position and it was unlikely that the slower economic growth recovery would be detrimental to the banking industry and the insurance funds.

Mr. Murton then noted that, that section 7(b) of the Federal Deposit Insurance Act governs the authority of the Board of Directors to set assessment rates for the Bank Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF") and directs the Board to (1) establish a risk-based assessment system for BIF- and SAIF-insured depository institutions; and (2) set assessments when necessary and only to the extent necessary to maintain the Designated Reserve Ratio ("DRR") of the BIF and of the SAIF at 1.25 percent. He further noted that most of the industry had not been assessed deposit insurance premiums since 1996 because the DRR had been above 1.25 percent for both funds; that, while the current DRR for the SAIF was well above 1.25 percent, there was a possibility that the DRR for the BIF could fall below 1.25 percent; and that the factors affecting the fund balances and the DRR included the reserve set aside to address the increased number of problem banks and the lower yields being realized on fund investments.

Mr. Murton then turned the presentation over to Ms. Goodman to discuss deposit insurance reform.

Ms. Goodman reported that several legislative proposals had been introduced in Congress over the past several years which contemplated increasing the deposit insurance coverage from $100,000 to $200,000; that while the focus of the debate was primarily on the need to increase coverage, the Corporation believed there were other aspects of deposit insurance that needed to be examined; and that, as a result of an FDIC study conducted in 2001, a number of recommendations were forwarded to Congress which contemplated (1) merging the SAIF and the BIF; (2) eliminating the requirement for the statutory DRR; (3) indexing the deposit insurance coverage limit to the Consumer Price Index, with five-year adjustments; and (4) pricing deposit insurance according to risk, with the Corporation having the flexibility to manage the fund size in periods of stability as well as in crisis. The Corporation recommended that it have the discretion to: set the target size for the fund ratio, determine the speed of adjustment toward the target, charge appropriately for risk at all times, and grant banks a credit toward future assessments in proportion to assessments paid in the past.

Continuing, Ms. Goodman reported that the House of Representatives had recently passed legislation that would (1) merge the two insurance funds; (2) establish a reserve ratio of 1.15 percent to 1.40 percent per hundred dollars of deposits; (3) provide the Corporation the ability to charge steady risk-based premiums, with a cap for best-rated institutions; (4) provide for assessment credits and for rebates when certain triggering events occur; (5) increase basic deposit insurance coverage to $130,000 with coverage for Individual Retirement Accounts and Keogh Accounts to be double the amount of basic coverage; and (6) substantially increase the coverage of municipal deposits up to $2 million and beyond.

Ms. Goodman advised that the Corporation had a number of concerns with the bill passed by the House, specifically the loss of flexibility to determine the appropriate time for providing rebates and credits, the substantial increase in coverage for municipal deposits, and the cap on premiums for well-rated institutions. She noted that the Senate, however, had been more reserved in its drafting of the legislation and had asked the United States Department of the Treasury to develop a document that would reflect a consensus among the different agencies. She added that the agencies were close to reaching a consensus on the issues and it was expected that the requested document would be forthcoming in the near future.

Ms. Goodman then reported on two other issues which the Corporation was following -- payday lending and industrial loan companies. She noted that payday lending was characterized by small-dollar, short-term, unsecured lending that borrowers promise to repay out of their next paycheck or regular income payment; that such loans were usually priced at a fixed-dollar fee, which represented the finance charge to the borrower; and that, while the payday lending business presents banks with new growth opportunities, it also presents significant risks. Ms. Goodman further noted that industrial loan companies were considered non-bank banks, exempt from the provisions of the Bank Holding Company Act and, therefore, their parent companies were not regulated by the Board of Governors of the Federal Reserve System; and that Congress was currently contemplating expanding the powers of the industrial loan companies. The Committee then discussed briefly some other issues that related to the interaction of banking and commerce.

At that point, the discussion turned to the future of banking. Mr. Murton noted that several years ago, the Corporation had conducted a study of the banking industry entitled "Mandate for Change"; that, in that study, the Corporation had argued that the most important aspect for a healthy deposit insurance system was a healthy banking system and that banks should be allowed to explore new profitable opportunities; and, as long as there were proper safeguards and controls in place around the insured bank, that banks should be allowed to affiliate with, or be owned by, entities other than holding companies including securities and insurance firms. Mr. Murton added, however, that the Corporation recognized there were concerns about the intermingling of banking and commerce. The Committee then discussed the need for a consistent policy on the intermingling of banking and commerce, the need for flexibility by regulators in allowing banks to compete with other entities in meeting market demands; and the need to examine the effect of intermingling of banking and commerce on the financial system and the deposit insurance funds.

At the conclusion of the discussion, Chairman Powell expressed his appreciation to the members of the panel and to those individuals who had assisted in the preparation of the Committee's activities and, on behalf of the Corporation, appreciation to each of the members of the Advisory Committee for their time and input.