I have used this column over the years to discuss the concerns that bankers express to me. The list of concerns is long, and I understand why. Regulatory and supervisory intensity has gone up—in some cases substantially—since the financial crisis. At the same time, the long-standing trends that have driven down the number of community banks show no sign of abating.
In this column I will focus on a relatively narrow but I think important comment I hear from many bankers concerning requirements for independent reviews. Often bankers express this point as “having a checker to check the checker.” This comes up, for example, in the context of interest rate risk modeling. Perhaps true to my role as a bank supervisor, I see the merits to the concern expressed while also finding value in the role that an independent check can provide. The recent confusion at the Oscars may make this point even more strongly than anything else I can offer in this article, but I will elaborate nonetheless.
The value of a second set of eyes
One of my responsibilities at the Federal Reserve is to oversee the independent validation of the empirical models used in the capital stress tests for the largest banks. Such validation is standard, and we hold our model validation program to the same requirements we set for the validation done by commercial banks. That validation experience routinely reminds me about the value of having an independent check on the information that management will use in making key decisions. An outsider can often see a conceptual or implementation error that someone working on a matter cannot. We simply get too close to our own work. I would be making a huge mistake if the first version of my column for Banking in the Ninth went out as the final version!
I do not think the idea of having formal checks on important work is controversial among bankers. However, it is fair to ask how many reviews are too many. A risk-focused approach seems the only way to answer this question.
Independent review (and frankly any other review) can improve the output we produce. But ensuring the highest level of quality has a cost and is not justified in every case. So, clearly not all work needs a second review. This logic means that the most extensive reviews, which could involve a review at the business line, an independent review, and an audit of the process, need to be focused on the most important policies and processes, particularly those involving higher-risk issues. The stress test is at the center of the Federal Reserve’s supervision of large banks. It deserves, therefore, our highest level of internal review.
But that standard cannot and should not be the norm; not all reviews require the three levels of defense noted above.
Sometimes it is more than sufficient to have someone at the bank who is generally removed from the task at hand provide the second set of eyes. I know that many of the smaller banks in the District simply are not staffed to allow any other approach. And that is typically fine for these generally less complex and lower-risk banks.
Now there are going to be cases where some level of review is mandated by either law or by regulation. Banks may not always view those reviews as having high value, but they must be done. The question in these cases is what constitutes an effective level of review. We welcome working with banks and holding companies so that they do not do more than necessary.
Measure twice, cut once
In sum, there is often good reason to measure a few times before one cuts. Measuring twice or even three times is
justified if an uneven cut would be very costly. But sometimes the returns on measuring twice or even once do not justify the cost, and supervisors should be open to that view.