By Jeff Bater
March 18 — A vocal regulatory official is pressing for a new approach to the supervision of banks amid concerns about credit risk in the lending industry.
In an address to a Federal Reserve New York bank conference, Thomas Hoenig, the vice chairman of the Federal Deposit Insurance Corporation (FDIC), said banks should be subject to full-scope examinations and required to disclose important supervisory findings to shed light on their financial condition.
In addition, supervisors must insist firms hold sufficient capital to act as a backstop against management mistakes and bad luck.
Hoenig said supervisors must show “the responsibility and courage to convey their findings to bank management — even in an environment of growth, when it is often easier to accept the prevailing view.
“Within reasonable bounds, it is the supervisors' responsibility to swim against the tide of enthusiasm,” he added.
Regulators came under fire as not doing enough to prevent the financial crisis . In his speech, Hoenig recalled that in 2006 and 2007, during the run-up to the crisis, there were clear signs problems were surfacing, and yet supervisors “were slow to act.”
“Even when guidance was issued about commercial real estate, the agencies quickly backed down after the industry raised objections,” he said. “In hindsight, the regulators were correct in their projections, and the only mistake was in backing down.”
With the banking sector having strengthened over the years since the crisis, other regulatory officials have been warning about credit risk. Thomas Curry, who is comptroller of the currency and a fellow FDIC board member, called attention during a speech in October to growing exposures in commercial real estate loans and warning about subprime automobile lending .
Historically, following a period of economic recovery, banks relax loan underwriting standards and develop larger loan concentrations without concurrent increases in reserves. The “natural by-product of competition among banks for yield” mean supervisors and bank risk officers need to practice vigilance, Curry said. In one anecdote buried in the Federal Reserve's latest “Beige Book” report on economic conditions in the U.S., the Fed's Cleveland district reported consumers have been increasingly turning to nonbank competitors for auto lending.
Hoenig's appeal for sufficient capital isn't a first. He has told banks and regulators before that the tangible leverage ratio is a superior alternative to risk-weighting schemes .
The tangible leverage ratio compares equity capital to total assets, deducting goodwill, other intangibles and deferred tax assets from both equity and total assets. It is based on International Financial Reporting Standards (IFRS), and data as of mid-2015 show that U.S. banks seen as systemically important on a global basis (G-SIBs) have a tangible capital ratio of 5.73 percent.
Hoenig said conservative estimates of bank losses in the 2008 crisis show the industry lost around 7 percent of assets. Leverage ratios currently around 5 percent might boost return on equity to individual firms and facilitate growth of economies during boom times — but provide virtually no sustainability during downturns nor enough margin for inevitable errors by even the best bank managers or simply from bad luck, he said.
“The largest banking firms insist that they are well capitalized, but data and evidence suggest that this is not the case,” Hoenig said. “In an apples-to-apples comparison, it is striking that the largest firms are the least well capitalized of any group of banks operating in the United States.
“From a supervision program perspective, moving away from risk-based capital measures toward an assessment of adequacy based on tangible equity would generate more reliable information from which to make supervisory judgments and would free up billions of dollars from supervision budgets currently spent waiting for, understanding and implementing risk-based measures,” he added.
Hoenig also pushed for more transparency among the largest banks. He said regulators should consider requiring banks to publicly disclose significant or material findings, which could include examiner concerns about weak control systems or credit review.
“Such disclosures would impose market discipline at an earlier stage, which would likely make banks more accountable for their risk choices and help limit the severity of problems identified by examiners,” he said. “Additionally, enhanced disclosures would hold supervisors accountable and inhibit their being captured by firms.”
Hoenig called disclosure the best cure for unanticipated crises, especially when it is early on. “It seems that the market already recognizes the absence of full disclosure by the largest firms, as evidenced by the fact that many are trading below their book values,” he said.
Supervisors of large banks have become overly reliant on bank models and stress tests in judging the condition of a firm, Hoenig said. In his address, he expressed support for full-scope examinations, which delve into the quality of portfolios and their implications for long-term resilience.
“A full-scope exam is a point-in-time analysis of a bank's full balance-sheet quality and management competence,” Hoenig said. “It includes the models and material provided by the banks that currently are used in exams, but a full-scope exam also involves reviewing and testing asset quality using accepted examination standards.”
Jaret Seiberg, an analyst at Guggenheim Securities, said Hoenig's speech has political ramifications in this presidential election year, particularly his argument that risk-weighted assets are misleading and banks should be judged against their leverage capital.
Seiberg wrote in market commentary that “in more normal times, we would not take such a radical shift in policy that seriously. But these are far from normal times. Both parties are very populist and the biggest banks remain unpopular.”
He expressed concern populists on the left and right could embrace Hoenig's call for a tougher leverage ratio and more intrusive big bank supervision.
“The odds remain against this type of radical change, in our view, but the political environment is so chaotic that one has to acknowledge that the vice chairman’s approach could appeal to the leading presidential candidates in both parties,” Seiberg wrote, labeling Hoenig “a maverick.”
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The Hoenig remarks are available at http://src.bna.com/dqt.
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