Banking regulation in the US has two separate but closely related elements: regulation and supervision. These terms are often used interchangeably, even by professionals in the field. Not all activities by regulatory agencies fall squarely in one category or another. But there are important distinctions between the two. Understanding the distinctive roles associated with each function can lead to a better understanding of banking regulation and to the U.S. financial system overall.
Regulation establishes the rules of the road when it comes to operating a federally insured bank, while supervision assesses whether and to what extent those rules are being followed. In this sense, the duties of a bank supervisor are not unlike those of, say, a USDA food inspector. The USDA establishes food safety standards while a food inspector tries to ensure that individual food processing plants meet that standard. However, a bank supervisor’s role is much broader. A food inspector focuses on how a plant addresses a specific goal (producing safe food). A bank supervisor tries to ensure not only that the bank complies with current laws and regulations, but also that it is operating in a safe and sound manner. The existence of federal deposit insurance and government-backed liquidity facilities give the government a compelling interest in preventing bank failures.
The chart below highlights some of the key differences between regulation and supervision functions. The regulatory function sets policy, which applies across banks. Tailoring rules may include or exclude certain banks based on their size and complexity. Supervision implements and enforces that policy at an individual bank level. Some examiners and more senior officials may have a caseload of banks, but the supervision occurs on a bank-by-bank basis.
Regulations are subject to public notice and comment periods. When an agency plans to issue a new regulation, it will publish a notice of proposed rulemaking (NPR) that explains in sometimes excruciating detail the rationale for the regulation and its expected effects. The NPR includes the text of the proposed new regulation. Public comments to the proposed regulation are available online. If the agency finalizes the regulation, it issues a Final Rule that highlights changes from the original proposal and provides a general response to public comments. Internal deliberations over the proposal are usually not public. With some exceptions, most guidance does not go through a notice and comment period. The guidance itself is publicly available, as are examiner handbooks.
Bank supervision activities tend to be highly confidential. Some regulatory filings, such as Call Reports and formal enforcement actions, are public, but that’s about it. Neither Reports of Examination (ROEs) nor exam ratings are public; nor are supervisory letters or MRAs. In most cases, these items never become public. We get a clearer picture if a bank fails. Material Loss Reviews include historical exam ratings and MRA counts but little or no primary source material. There are exceptions. The Financial Crisis Inquiry Commission and the Permanent Subcommittee on Investigations have published some otherwise confidential information, including exam reports and internal correspondence. The SVB postmortem included exam reports and supervisory letters.
The regulatory function is primarily staffed by attorneys and policy analysts. The supervisory function is primarily staffed by examiners, but attorneys play a key role when it comes to enforcement actions. Policy analysts may participate in exams, as do some attorneys, albeit less frequently. Supervisory staff often provide input into proposed policies, especially when it comes to guidance. They usually play a much smaller role when it comes to proposed regulations. Most regulatory staff are based in Washington, DC. Supervision staff usually sit in district or regional offices or at the banks themselves.
Gray Areas and Boundary Role Spanners
Some functions don’t fit squarely into either regulation or supervision. Supervisory guidance is one such example. Guidance fleshes out regulatory requirements. While examiners shouldn’t cite “violations” of guidance, such guidance can inform supervisory actions. Guidance isn’t supposed to be regulation lite, but some critics see it that way. Examiner handbooks describe current regulations and guidance but also more directly support the supervisory process than do regulations alone.
Boundary role spanning is a term to describe those that interface between organizations or between functions within an organization. Regulatory agencies have boundary role spanners between regulation and supervision. You can’t necessarily tell by titles. For example, at OCC the Chief National Bank Examiner is primarily a policy position that has little direct role in supervision. A better example within the OCC is the Lead Expert. These individuals can serve as a bridge between the regulation and supervision sides of the agency. They work closely with policy makers but also play a more direct role in supervision by participating in exams, conducting horizontal reviews, and providing feedback on supervisory strategies.
Tensions between Regulation and Supervision
The regulation and supervision functions are on the same team and work best in an environment of cooperation and mutual respect. That is usually the case. However, even under the best of intentions, tensions can arise between the two functions.
You’re Doing It Wrong!
Regulators make policy but have less say on its implementation. That can lead to a “you’re doing it wrong” view towards supervision. The organizational structure of banking agencies can make this problem worse. Large Bank Supervision at the OCC is quite decentralized with most examiners assigned to a single bank team throughout the year. That can lead to differences between bank teams, especially with respect to more subjective risks like interest rate risk. Most front-line supervision at the Federal Reserve occurs at the Federal Reserve Bank level, which can lead to regional differences in approaches to bank supervision.
There are both formal and informal ways to enforce consistency and compliance with policies. Agency Inspectors General (IGs) can identify noncompliance, with sanctions against individual examiners in extreme cases. Agencies quality assurance (QA) functions review policy compliance by supervisors, though their recommendations tend to be more informal in nature. These controls are more detective than preventive, however. Horizontal reviews focus more on the practices at individual banks than on supervisory processes, but can also mitigate inconsistencies across supervisors. Although horizontal reviews shed light on the range of industry practice in a particular risk area, regulators are now deemphasizing these reviews.
Who Gets Blamed?
The role of bank supervisors can be likened to that an NFL placekicker. Fans rarely notice the kicker unless he misses a critical field goal or extra point. Blame falls squarely on the kicker, even if a bad snap, a muffed hold, or a missed block all contributed to the miss. If a bank fails or gets in serious trouble, blame falls mainly on the supervisors. The impact of policy errors of omission and commission on bank failures tend to be indirect and hard to prove. Tailoring rules likely made the system more vulnerable to bank failures like SVB, Signature, and First Republic. But finding a direct causal link is more difficult. It’s more like a missed block. It might force the kicker to rush and miss the field goal attempt, but saying the missed block caused the miss is quite another matter.
This relationship may be endemic to supervisors’ role vis a vis that of regulators. But regulators can also be overly timid, especially if they expect industry opposition. Transfers of securities from available to sale (AFS) to held to maturity (HTM) provide a good case in point. Placing securities into HTM can mitigate capital volatility but can adversely affect overall liquidity risk and interest rate risk (IRR). An HTM classification makes securities less liquid since their sale is likely to trigger adverse accounting consequences. It also makes it more difficult for a bank to respond to rising interest rates.
Supervisors may understand these problems but have received little assistance from the regulatory side. The liquidity regulations do not distinguish between HTM and AFS designations. Examiner guidance is likewise thin. Examiners can discuss the additional risks posed by HTM classifications in their quarterly and annual risk assessments. (I have.) But without clear guidance from the regulatory and policy side, supervisory actions will rarely go beyond a gentle nudge.
Concluding Thoughts
The end of the Chevron deference will likely make the rulemaking process both more cumbersome and more open to second guessing by judges. This new legal framework can discourage efforts on the regulatory side to make the supervisors’ jobs easier. The actions that regulators are taking push in the opposite direction. Regulators have proposed raising the bar for even informal supervisory actions, like matters requiring attention. Meanwhile, key terms such as “likely” and “material financial harm” remain vague, providing regulators with plausible deniability that allow them to shift blame should things go wrong. Tensions between regulatory and supervisory functions are likely to get worse, at least in the near term.