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Supervisory Interpretation of a Risk List

Ninth District Highlights - September 2013

September 9, 2013


Ron J. Feldman Executive Vice President and Senior Policy Advisor
Supervisory Interpretation of a Risk List

We focus this issue of Banking in the Ninth on our risk list. Some of the risks we identify may immediately resonate with readers; the risks we focus on may even match your own list. For example, we identify the tough earnings environment as a key risk. Bankers routinely highlight weaker-than-expected earnings growth as a primary challenge to overcome.

Our take on the earnings challenge, however, may differ from that of bankers. We highlight the risk that low earnings may encourage banks to take on too much risk. Most bankers I talk with are concerned with low earnings in and of themselves. We also identify the risk to banks from the agricultural sector. This may strike some as odd. The agricultural sector by many metrics shows great strength. Indeed, the extraordinary performance of agriculture itself activates our radar, as our concern arises from performance that may prove unsustainable.

This description makes us—and other supervisors who take a similar view—sound excessively focused on the downside. We can and should debate the degree to which supervisors should always identify what can go wrong. And without question supervisors should identify and recognize the effective practices that most banks routinely implement.

But the fact that supervisors should concentrate on potential future snares seems right to me. Indeed, the rationale for bank supervision links our existence to taking a contrarian view. One rationale for supervision starts with deposit insurance, which protects depositors from bearing losses that a bank failure would normally impose. This insurance works because the revenue-raising authority of the U.S. government stands behind it. Deposit insurance without government support has a relatively poor record.

Supervision can limit the potential loss that the government and those funding the government bear. It does so by working with banks to identify and limit excessive risk-taking. The role of limiting potential loss naturally leads supervisors to try to identify those risks that might ultimately generate bank weakness and even failure. The reaction to bank failure from observers often focuses on supervisors taking a too rosy view of the risk and the future. Certainly, supervisory assessments and/or responses to developments in the residential real estate market were insufficient prior to the financial crisis.

In this light, please read our risk list not as a forecast or view that supervisors are always right. It is a list of the potential problem areas that may occur or spread in the future. Indeed, the fact that we create the list and respond to it makes it less likely that the risks mentioned actually end up imposing much cost. From this viewpoint, supervisors sound like an optimistic group, although I am not sure I would go that far.

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