Each depositor insured to at least $250,000 per insured bank

Minutes
of
The Meeting of the FDIC Advisory Committee on Banking Policy
of the
Federal Deposit Insurance Corporation
Held in the Board Room
Federal Deposit Insurance Corporation Building
Washington, D. C.
Open to Public Observation
November 19, 2003 - 9:00 A. M.

The members of the Committee present at the meeting were: Sheila C. Bair, Dean's Professor of Financial Regulatory Policy, Isenberg School of Management, University of Massachusetts - Amherst, Amherst, Massachusetts; Jean Becker, Chief of Staff, Office of President George H.W. Bush, Houston, Texas; Rev. Dr. Floyd H. Flake, Senior Pastor, Great Allen A.M.E. Cathedral of New York, Jamaica, New York; Richard R. Hollington, Jr., Lead Director, Sky Financial Group Inc., and Senior Partner, Baker & Hostetler, LLP, Cleveland, Ohio; Terry J. Jorde, President/Chief Executive Officer, CountryBank USA, Cando, North Dakota; John G. Medlin, Jr., Chairman Emeritus, Wachovia Corporation, Winston-Salem, North Carolina; Dennis D. Powell, Senior Vice President, Corporate Finance, Cisco Systems, Inc., San Jose, California; and John T. Sinnott, Chairman and Chief Executive Officer, Marsh, Inc., New York, New York. 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 Gray D. Lindsey, Senior Vice President, Management Services, and Chief Financial Officer, Coca-Cola North America, The Coca-Cola Company, Atlanta, Georgia; Louise M. Parent, Esq., Executive Vice President and General Counsel, American Express Company, New York, New York; Roger B. Porter, IBM Professor of Business and Government, John F. Kennedy School of Government, Harvard University, Cambridge, Massachusetts; 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 Director was present at the meeting. Also attending the meeting were: John F. Bovenzi, Steven O. App, John M. Brennan, Thomas E. Zemke, Walter B. Mason, Jr., Robert W. Russell, Jodey C. Arrington, C. K. Lee, Andrew B. Stirling, William F. Kroener, III, Michael J. Zamorski, Arleas Upton Kea, Arthur J. Murton, Frederick S. Selby, Mitchell L. Glassman, Cottrell L. Webster, Robert E. Feldman, Alice C. Goodman, Vijay G. Deshpande, David C. Cooke, Elizabeth Ford, Frederick S. Carns, William A. Stark, Ann Bridges Steely, Sandra L. Thompson, John M. Lane, Donna J. Gambrell, Richard A. Brown, David Barr, Claude Rollin, Tim Burniston, Glen Bjorklund, Patricia M. Black, George Hanc, George E. French, Beth A. Wilt, Vincent L. Johnson, Jr., Michael H. Krimminger, Sarah Junker, and W. W. Reid.

Chairman Powell presided at the meeting.

Chairman Powell opened the meeting and then Arthur J. Murton, Director, Division of Insurance and Research ("DIR"), briefed the Committee members regarding the report prepared for the Corporation by the firm McKinsey & Company on strengthening financial risk management at the Federal Deposit Insurance Corporation. Mr. Murton noted that McKinsey & Company had been asked to review the Corporation's processes for reserving for future losses; practices for anticipating risk over the long term; and overall approach to risk management. Continuing, he advised that the report contained recommendations for improving the Corporation's financial risk management practices over three overlapping time horizons: Horizon 1 -- within 3 to 6 months of the report's July 2003 issuance, recommended the quick and methodical implementation of a set of clear improvements to the Corporation's existing financial risk reporting in order to address any industry uncertainty regarding the accuracy, robustness, and transparency of the process; Horizon 2 -- within an eighteen-month period, recommended the finalization of a new generation of financial risk management models under development and the establishment of a set of supporting organizational processes; and Horizon 3 -- over the long term and continuing indefinitely after the new risk models are in place, recommended that the Corporation review its emerging risk management needs regularly and systematically to determine whether investment in a more substantial risk infrastructure was warranted. With regard to the Horizon 1 recommendations, he reported that changes had been implemented in the process for reporting the reserve for losses, which had resulted in staff's having less discretion in determining the reserve amount, in a reduction in the reserve amount reported, and in additional discipline in the process.

With regard to the Horizon 2 recommendations, he advised that staff was working with members of the academic community to produce a credit risk model foundation for use in assessing risk exposures. Mr. Murton added that, in early 2003, the Corporation had created the National Risk Committee ("NRC") (a cross-divisional body of senior managers established to identify and evaluate major business risks facing the banking industry and the insurance funds) to provide coordinated policy guidance, including on the development of appropriate strategies and operating policies; that a network of similar committees in the Corporation's regions delivers regular regional risk reports to the NRC; that a state-of-the-art Risk Analysis Center ("RAC") was created to monitor emerging macro and micro risks on a daily basis and to recommend responses to the NRC; and that the NRC and the RAC complement a third cross-divisional risk committee, the Financial Risk Committee, the mission of which is to quantify risks to the deposit insurance system for financial reporting and fund management purposes.

Mr. Murton then advised of a new initiative by the Corporation to draw on the resources available in the academic community. In that regard, he reported that plans included the sponsoring of research, the holding of conferences, and arranging for staff to work with individuals from the academic community. Mr. Murton further advised that one such conference was scheduled for early December. In conclusion, he noted that staff was eagerly anticipating the benefits that will be derived from these efforts.

With regard to other outreach activities, Mitchell Glassman, Director, Division of Resolutions and Receiverships ("DRR"), reported that DRR had recently held a symposium in Dallas, Texas, on the question of why banks failed; that the attendees included bankers, members of the academic community, and bank regulators; and that staff had found the symposium to be very informative.

Michael J. Zamorski, Director, Division of Supervision and Consumer Protection ("DSC"), next discussed the Basel II Accords and the process to revise the international capital standards for internationally active banks from the standards initially developed in 1988 by the Basel Committee on Banking Supervision and endorsed by the Group of Ten countries (current member countries include Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States). With regard to regulatory capital, he noted that banking organizations or institutions in the United States must maintain a minimum leverage ratio and two minimum risk-based ratios. He further noted that the Basel Committee had developed a new regulatory capital framework that would recognize new developments in financial products, incorporate advances in risk measurement and management practices, and more precisely assess capital charges in relation to risk; and that, in 2003, the Basel Committee had released for public consultation The New Basel Capital Accord which sets forth proposed revisions to the 1988 Accord.

Continuing, he advised that representatives of the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Board of Governors of the Federal Reserve System, and the Corporation had jointly developed an interagency advance notice of proposed rulemaking ("ANPR") explaining how the United States banking and thrift regulatory agencies would propose to adopt the advanced internal ratings-based approaches to assessing credit risk capital charges and the advanced measurement approaches to assessing operational risk capital charges. Mr. Zamorski further advised that staff believed that more analysis was needed of the potential competitive effects of the new accord, its impact on the risk-based capital requirements for specific activities, and its effects on the supervisory process before a final determination could be reached about the desirability of adopting the proposals described in the ANPR; and that publication of the ANPR elicited substantial comments that should prove helpful to the Agencies in formulating their final views on these proposals.

With regard to the current status of the ANPR, Mr. Zamorski reported that staff was in the process of analyzing the comments that had been received, which comments concern issues relating to the adequacy of capital in the banking system, and level playing fields between smaller and larger institutions and between United States banks and foreign banks (unintended consequences, disparities, and competitive impacts).

George E. French, Deputy Director (Policy and Examination Oversight), Division of Supervision and Consumer Protection, added that the comments from the largest banks in the country indicate that the capital proposal is viewed favorably, although those same institutions also believe that the capital framework developed over the years is too conservative, that competitive impact is not a concern because economic capital is the factor that drives pricing, and that regulatory capital is not relevant. Mr. French also noted that comments from the United States institutions indicate their belief that the regulatory capital framework in the United States needs to be rationalized and made more scientific and more sensitive to risk.

Mr. French noted that staff was studying very closely the potential for a significant reduction in risk-based capital ratios under the formulas established by the Basel Committee. He also noted the possibility of a serious issue developing within the United States regarding the minimum capital philosophy - the well-capitalized standard of 5 percent of total assets. At this point, Mr. Medlin noted that minimum capital ratios are a legislative requirement and that there must be some minimum cost of admission to the safety net. He also indicated that he did not believe a minimum capital ratio of 5 percent was unreasonable.

Next, Mr. French noted that staff was conducting a study of loss history data on all insured banks going back into the 1980s in an attempt to determine the average loss rates for different types of lending and to determine capital requirements on a business-cycle basis; that the study had found that capital requirements vary over the course of the business cycle, especially for certain types of lending, and that capital requirements for mortgages and other retail loans were low compared to current requirements.

In the discussion that followed, Ms. Jorde commented that risk-based capital requirements impact negatively on the efforts of community banks to remain competitive, successful, and viable. Vice Chairman Reich voiced his concern that implementation of the new Basel capital accord would result in incentives for larger banks to acquire other institutions and thereby increase the rate of consolidation in the banking industry. Ms. Bair noted that, due to the subjectivity and complexity of the risk-based standards, regulators may need to address examination staffing resource issues.

Next, Steven O. App, Deputy to the Chairman and Chief Financial Officer, discussed the Corporation's 2004 budget process. He noted that, as suggested at an earlier Advisory Committee meeting, for this past year, divisions and offices had been asked to consider, in preparing their budget submissions, whether they could operate with a budget which was 10 percent less than the previous year, which effort resulted in savings in certain areas thereby enabling the funding of new initiatives. He noted that the Corporation had largely concluded its downsizing efforts, having reduced staff numbers from 23,000 to 5,400 over a ten-year period, with approximately two-thirds of the proposed 2004 budget allocated to salary and compensation expenses; and that further budget savings may be realized going forward through additional outsourcing in the information technology ("IT") area.

In response to a question from Chairman Powell, Mr. App advised that IT security remains a matter of concern and that staff had addressed the General Accounting Office's ("GAO") criticisms in its 2001 audit but, given the nature of the technology, there may be other risks that could present issues. Vice Chairman Reich, who is also chairman of the Corporation's Audit Committee, commented that significant progress had been made over the course of the year with respect to IT security issues.

At this point, Arleas Upton Kea, Director, Division of Administration, mentioned various personnel issues including, but not limited to, staffing size, pay and corporate performance standards, and union negotiation of pay and benefits.

Next, Vice Chairman Reich reported on the Corporation's efforts, in conjunction with the other banking regulatory agencies, in reviewing all regulations and eliminating those that are outdated, duplicative, unduly burdensome, or no longer necessary to the industry.

Chairman Powell then announced that the meeting would recess. Accordingly, the meeting stood in recess at 10:04 a.m.

* * * * * * * * * *

Donna J. Gambrell, Deputy Director (Compliance and Consumer Protection), Division of Supervision and Consumer Protection reviewed for the Committee members DSC's Money Smart Program. She noted that the purpose of the program was to help consumers understand the basics of banking and thereby enhance their money skills and assist in positive banking relationships; that the program had been extremely successful, with more than 100,000 persons having completed at least one module of the curriculum and more than 14,000 banking relationships having been formed as a result thereof; and that the program and the staff team had been awarded a Service to America Medal by the Partnership for Public Service in recognition of their achievement. Ms. Gambrell advised that staff was working with the White House on several projects; that other government agencies (the Internal Revenue Service and the Department of Housing and Urban Development) had adopted the Money Smart Program curriculum as part of their national initiatives; that, in November, staff had hosted a symposium for the purpose of discussing the "best practices" for educating consumers about banking; and that staff expected to release the information gleaned during the symposium. She further advised that, during 2004, staff anticipated conducting an evaluation survey with the Gallup organization which will focus on the "before" and "after" of individuals who had participated in the program; continuing to explore national partnerships with organizations such as financial institutions; reaching out to the Hispanic community; establishing an employer-based financial education model; and working on remittance programs involving immigrant populations and their transferring of monies to home countries.

Ms. Gambrell also noted that Spanish, Chinese, and Korean language versions of the Money Smart curriculum were available; that a Vietnamese language version was in the process of being produced and was anticipated to be released in the first quarter of 2004; and that interactive English and Spanish language versions of Money Smart would be available on CD-ROM in early 2004.

There followed a discussion of issues related to predatory, payday, and subprime lending. During the discussion, Mr. French noted that certain banks had engaged in partnerships with payday lenders in other states to circumvent state usury laws; that staff had concluded that such activities were a risky business for a bank from a safety and soundness perspective, from a consumer protection standpoint, and in terms of legal and reputational concerns; and that guidance had been issued to the examiner staff and the banking industry outlining the Corporation's concerns regarding such activities and supervisory expectations.

Ms. Bair, confirming with Mr. French that it was the Corporation's practice in examining banks engaging in payday lending to also examine the payday lending affiliate, expressed confidence that the Corporation's examination staff would scrutinize such relationships in its examination process. In addition to cracking down on abusive lending, she suggested that the staff explore the regulatory approach necessary for offering the under-served population similar services or other alternatives at reasonable rates.

As the discussion continued, Ms. Gambrell noted that the reasons for enrolling in the Money Smart course varied from audience to audience -- individual development accounts; job field training; an increased awareness of personal finance issues; and assistance with credit card management. Chairman Powell added that complex and cultural issues engendered in many families a general distrust of banking institutions. Regarding efforts to educate the public nationwide, Ms. Gambrell reported that the State of Arkansas had agreed to make the Money Smart curriculum available to all 11th and 12th graders in the state; and that staff was in the final stages of preparing a website version of the curriculum program, expecting to launch it in early 2004. She added that staff was also working on a plan to market the website.

At this point, John M. Lane, Deputy Director (Risk Management), Division of Supervision and Consumer Protection, added further detail regarding the staff's examination procedures with respect to institutions engaged in payday lending and to the payday lending affiliates, noting, among other things that, at the present time, there were 12 institutions engaged in payday lending throughout the country; and that such institutions could be required, given the circumstances, to maintain certain capital levels to address the payday loans or may be required to sever their relationships with the payday lenders.

Next, Ms. Gambrell briefly reviewed staff's efforts in conducting compliance examinations for purposes of the Community Reinvestment Act ("CRA"), noting that staff would be conducting focus group meetings with the examined institutions to solicit input regarding the process.

Mr. Zamorski then reported that the Kansas City Regional Office had conducted a pilot "call-in" program which had enabled 1,500 bankers from over 400 banks to call in and engage in dialogues with staff regarding interest rate risk, consumer debt, commercial real estate lending, and agricultural lending. He added that, under this call-in program, bankers were also able to send in emails to staff.

Mr. Zamorski noted that the examiners had developed a streamlined examination process which preserved the integrity of the examination process and allowed time for examiners to look at other areas of risk. He added that the streamlined process had also enabled management to conduct workforce planning.

Ms. Jorde expressed the view that, although examiners were spending less time in the banks conducting examinations, the examination process itself, whether for purposes of safety and soundness, CRA, or compliance, continued to be extremely burdensome for the banker.

Next, Mr. Murton gave a presentation on the future of banking - structure and policy considerations for the Corporation. He noted that the operating environment for banks had undergone rapid and continual change over the past 25 years as a result of market forces, higher competitive pressures, changing consumer preferences, financial innovation, public policy, and legislative reforms; and that over that same time period financial activity had increased significantly relative to the overall economy, with the ratio of debt relative to the size of the economy growing by 50 percent (from 1.3 percent to 2.0 percent). In that regard he also noted that the banking industry's share of this expanding financial activity had not kept pace, but had remained stable, with banks remaining the lead providers of credit to small businesses.

Continuing, Mr. Murton noted that the banking industry had also been affected by consolidation, with the number of community banks declining from 14,000 to 7,500 over a 15-year period, which resulted in the 10 largest banks now controlling a 44 percent share of the industry's assets. He added that staff was presently studying the issue of whether the industry was becoming too concentrated, and what that would mean for the Corporation and the safety net, as well as the future of community banking.

Mr. Murton commented that bank failures and relaxation of branching restrictions had directly affected the rate of consolidation in the banking industry over time; that the consolidation rate was tapering off; but that another external force, such as regulatory burden and/or the implementation of the new Basel capital accord, could result in further consolidation.

At that point, Ms. Becker questioned the importance of protecting the existence of community banks and asked where the responsibility for such would rest. In response, Mr. Murton commented that the Corporation had traditionally taken the view that deposit insurance plays a very important role in stabilizing the financial system; that the market should be allowed to evolve naturally; and that the Corporation was not in the business of making sure one group was favored over another. He noted, however, that the Corporation needed to remain aware that its decisions could affect one group differently than another.

C.K. Lee, Special Advisor to the Chairman, commented that bank customers and the marketplace would ultimately decide the fate of community banks.

Mr. Murton then added that a significant portion of the decline in the number of community banks could be attributed to acquisitions, but demographics also contributed to the decline. In that regard, he noted that staff was also studying the effects on economic activity of depopulation in rural areas and increased population in metropolitan areas.

Ms. Jorde noted that, although community banks controlled only a 15 percent share of assets in the industry, they originate over 40 percent of small business loans; and that the ability of community bankers to establish a personal relationship with its customers facilitates the launching of new business.

There followed a lengthy discussion of issues related to various factors impacting the ability of community bankers to compete in today's market.

At the conclusion of the discussion, Chairman Powell announced that the meeting would recess. Accordingly, at 11:47 a.m., the meeting stood in recess.

* * * * * * * * * *

Mr. Lee next reviewed the policy issues relating to regulatory burden, consumer privacy, capital regulation, and the mixing of banking and commerce, and there followed a lengthy discussion of the same among the Committee members and staff.

During the discussion, Vice Chairman Reich stressed the importance of preserving the future of community banks and noted that perhaps a two-tier system of regulation might prove beneficial. Staff advised that such a system had not as yet been considered.

The discussion continued on other topics, including the increased use of Internet banking, competition between community banks and credit unions, and capital related issues. Ms. Bair raised the issue about the extremely low capital requirements for government-sponsored enterprises such as Fannie Mae and Freddie Mac that is of concern to Congress and the Administration, and that if the Basel II accords are to lower effective capital requirements, such as mortgage assets, what impact this would have from a supervisory standpoint. She also advised that she had been researching the increased activities of Federal Home Loan Banks ("FHLBs") with respect to mortgage acquisitions and the question of whether that system had the expertise and infrastructure to be managing risks associated with such. Through her research, she advised, she was fascinated to learn about the FHLBs' "super lien" against the assets of banks to which they make advances. These rights, she added, including prepayment fees, are provided by statute and are superior to the rights of depositors and even to the FDIC after an institution fails. In response to her request for an explanation as to how the super lien works, Michael Krimminger, Manager (Policy), Division of Resolutions and Receiverships, noted that, when an insured institution fails, creditors of the institution have a set priority of claims, similar to priority in bankruptcies; that there were two classes of claimants, secured and unsecured, with secured claims being paid in full up to the value of the pledged collateral (principal and interest to date of closure) but no post-closing investment losses paid, and with unsecured claimants being paid in the following order: administrative claims, deposit liabilities, general creditors, subordinated obligations, and finally, shareholders; that, in a typical failure, the Corporation is appointed receiver of the bank and provides coverage for insured depositors; that, after paying or covering insured depositors, the Corporation, as insurer, is subrogated for the depositors' claims and receives dividends from the proceeds of the sale of assets along with uninsured depositors; that, over the closing weekend, the Corporation either sells the whole bank, parts of the bank, or decides to pay off the insured depositors and liquidate the assets of the bank; and that, if there were FHLB advances in the institution at failure (FHLB advances are secured by pledges of high-quality collateral, such as 1-4 family mortgages), the Corporation as receiver would promptly pay off the principal and interest to date, the FHLB would then demand a prepayment fee. Ms. Bair noted that the cost and potential exposure to the Corporation increases as more community and other banks rely on advances of the funding source, and she questioned why one government agency was paying prepayment penalties to another government agency.

There then followed discussion regarding the foregoing, after which David C. Cooke, Chief Learning Officer, Corporate University, reviewed the progress, strategy, and vision of the FDIC's Corporate University. He noted that the Corporate University ("CU") was the training and employee development arm of the Corporation, supporting the Corporation's mission and business objectives through high quality, cost effective continuous learning and development; that the CU provides opportunities for employees to enhance their sense of corporate identity while learning more about Corporation's major program areas of supervision, compliance, resolutions and insurance; and that the CU manages five schools -- the School of Supervision and Consumer Protection (which supports core examiner training programs), the School of Resolutions and Receiverships (which provides blended training in receivership management and resolutions, franchise marketing, and loan management), the School of Insurance (which provides technology and classroom-based learning opportunities that support the Division of Insurance and Research), the School of Leadership Development (which provides programs and resources to enhance the leadership skills and capabilities of Corporation employees with a curriculum that includes a series of core leadership courses, as well as computer-based instruction and skill-based classroom sessions focusing on effective management), the School of Corporate Operations (which provides cross-divisional learning opportunities to keep employees abreast of current business practices and partners with non-business line divisions and offices to develop training opportunities) -- and a number of innovative development programs.

There followed a discussion of the level of experience of newly-hired employees, the training process, instilling Corporation "culture", opportunities for advancement, and workforce planning.

At the conclusion of that discussion, and there being no further business, the meeting was adjourned.

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Executive Secretary
Federal Deposit Insurance Corporation
and
Committee Management Officer
FDIC Advisory Committee on Banking Policy