In remarks last week, Secretary Bessent drew attention to a new OCC and FDIC proposal that, among other things, defines what will be considered “unsafe” and “unsound” when it comes to bank examination and enforcement. As Mr. Bessent said, “While simply defining a term might seem like a small thing, …, a clear focus on material financial risk will put an end to this nonsense.” By which he meant the egregious supervisory lapses that led to four costly bank failures in 2023. He’s right, but the banking agencies must also match these new words with far faster, tougher, and transparent supervisory deeds.
There’s no question that supervisory policy has long forced banks to think at least as much about papering decisions as making them. This is a particular problem for community banks without teams of compliance specialists, adding all too much cost to the technology and product innovations essential to banks that aren’t just safe, but also sound competitors that serve their communities. Much in the post-2008 rulebook needs a rewrite and almost everything proposed after the 2023 crash is badly designed.
But ripping out too many pages in righteous rage could spark yet another of the downward spirals in lax rules and irresponsible banking that occur every other decade or so. I thus worry about a few aspects of this new proposal.
For example, the proposal bars supervisory sanction unless or until a material loss is foreseeable or has actually occurred. Violations of banking or consumer law cannot spark intervention unless the violation could pose a material financial risk. Past violations that come to light are off limits.
As drafted, these provisions mean that supervisors can only step in when material financial risk is imminent, indisputable, an – perhaps – irreversible. Violations of law or rule could grievously harm depositors, consumers, or competitors, but only get dinged if the offending bank is forced to cut a big check.
Under the proposal, supervisory sanction is also possible only if a material financial loss is due to imprudence. This is a useful constraint to the extent it keeps supervisors from sanctioning business judgments that don’t work out, thereby punishing banks for taking the kind of chances essential to success in a dynamic marketplace. However, supervisors under the proposal also could not hold banks accountable if loss is due to externalities such as an interest-rate hike or macroeconomic slowdown. This is like allowing banks to go out without a raincoat even though forecasts are ominous, skies are darkening, and the sound of thunder is clear in the distance.
Supervisors should absolutely not try to exercise business judgment, but they must also ensure that business judgment is not so driven by short-term incentives that it jeopardizes long-term franchise resilience. Been there, done that.
We’ve learned the hard way that three prongs are essential to effective supervisory policy. The first is indeed to constraining supervisors from backroom bank management, 20-20 hindsight, and endless demands for largely irrelevant documentation. But this can go too far if bank latitude and supervisory lassitude are not paired with tough, transparent ratings along with rapid supervisory intervention at the earliest sign of credible, demonstrable material financial loss or of bank behavior so abusive to consumers, depositors, or taxpayers as to warrant not just a note to the file or a bleat to the board, but also express and unavoidable remedy.
However, more tightly-honed supervision and far better enforcement will not prevent costly bank failures if the FDIC still can’t resolve faltering banks. It must be rapid and ruthless when a bank fails be it small, big, or even gigantic. Bankers can and should exercise business judgment and investors can and should exert market discipline, but none of them will do so if failure remains essentially cost-free to malefactors.
The law gives the banking agencies all the tools they need to get supervision and enforcement right and the FDIC is mandated by Congress to back this up with ready-resolution capabilities. The agencies thus can and should match supervisory relief with structural enforcement and resolution reform. The new proposal is a good start, but it must be just a start on the way to a thorough overhaul that equips banks to compete with nonbanks even as it protects vital public interests.