Banking in the Ninth

Improved Risk-Focusing: A Federal Reserve Effort to Reduce Supervisory Burden

Ninth District Highlights - March 2016

Published March 14, 2016  | March 2016 issue

Bank supervisors try to ensure that banks receive the appropriate level of supervisory scrutiny by risk-focusing their exams. Lower-risk banks, all else equal, should receive less intense scrutiny. Improving risk-focusing is one way supervisors can reduce supervisory burden, which is a high-priority effort for the Federal Reserve. The Federal Reserve already risk-focuses its supervision. But we can improve. And the Federal Reserve is in the midst of a major national effort precisely to enhance our supervisory risk-focusing. We want to make sure that the riskiest banks face the most intense supervision, while safer, lower-risk banks face the least. I will explain the key features of one of our current efforts in the rest of this article.

Better Scoping, More Risk-Focused Exams

Getting the scope of an exam right is key to ensuring appropriate risk-focusing of Federal Reserve exams. As a result, the effort to better risk-focus Fed community bank exams has been geared toward targeting the scope of an exam to the risk profile of the bank. Our efforts target risk within each individual risk area, rather than at the bank overall. A bank could, for example, have low risk in the investment portfolio but have a high degree of earnings risk. In such a case, relatively more scrutiny should be provided to earnings than to investments.

Improving Identification of Bank Risk Profiles

The first step in our effort is to improve the empirical support for determining if a bank’s risk profile in each risk area is, roughly speaking, high, medium, or low. This analytical exercise is itself multistep. Staff have to identify a good measure of the riskiness for a given type of risk. For example, we have to find a good marker for a bank with high credit or interest rate risk that also identifies a bank with lower credit or interest rate risk. This process involves identifying several potential markers for risk and testing their accuracy using relevant historical data. We are seeking to identify those markers that are able to predict future risk, in addition to identifying those banks currently facing elevated risk. A desired measure of interest rate risk, for example, would differentiate banks by the losses they would incur now and in the future, when interest rates move. Choosing any particular measure of risk involves trade-offs, of course. Ideally, one would find a metric that minimizes the number of false negatives (banks that really are risky but are not identified) and false positives (banks that are not risky but which are identified as risky). But no measure is perfect. The key is picking a measure of risk that sorts banks into high, medium, and low groups of risk better than our current practice. And we are meeting that objective; we have identified ways of improving the Fed’s ability to identify which banks pose the most risk and which do not.

Linking Scope Intensity to Risk Profile

Simply identifying banks’ risk profile will not change the supervisory experience of banks if the follow-up exam work does not differ between banks. We ensure that this outcome occurs by preparing a different scope of exams for a given risk that depends on the risk that bank poses. A bank that our measures show poses a high level of risk in a particular risk area will face a more comprehensive exam scope in that area than a bank that poses a low level of risk. There is field testing of the new scopes before they go into production to make sure that we have gauged their likely effect correctly. The final step is to move the new scopes into the automated systems that examiners use to support their work. This system ensures that the riskiness of the bank is accurately assessed and that the proper initial draft scope is selected.

To be clear, Federal Reserve scoping of exams includes both empirical and qualitative factors. Exam staff must have discretion to incorporate factors that are not captured by the empirical measure of risk, to make the scope more intensive or less intensive. We will monitor the implementation of the new scopes to determine if and how they could be modified going forward. We have created a continuous process by which to risk-focus exams.

Status of Improved Risk-Focusing Efforts

The first step I described of identifying key metrics of risk has been nearly completed for almost all the key risks that an exam would review, such as interest rate and liquidity risk. New scopes have been completed for a smaller number of the risks, and only interest rate risk has gone through the complete process. We anticipate completing the full process for risks like credit and earnings over the next several months.

By the end of the process, we think the Federal Reserve will have completed a major effort to further risk-focus our exams. Perhaps more importantly, we will have established a program to continually ensure that we target our supervisory resources to the highest-risk banks while reducing the burden on the least risky.