OCC and FDIC recently finalized regulations that significantly narrowed the scope of matters requiring attention (MRAs). The Federal Reserve has also scaled back MRAs. Regulators not only narrowed the scope but also changed their approach to closing MRAs. They have even decided to close hundreds of MRAs, not because the bank addressed the concern but because the MRA no longer fits the current, more stringent criteria. How have bank supervisors historically approached the closure of MRAs? How is the new approach likely to affect bank supervision?
The Final Rule
The Final Rule sought to define unsafe and unsound practices and establish thresholds for the issuance of MRAs. The unsafe and unsound definition rests on two vague terms: “likely” and “material financial harm.” The agencies decided against defining either “likely” or “material” in quantitative terms. Merriam-Webster defines “likely” as “having a high probability of occurring or being true; very probable.” At the very least, the unsafe and unsound definition would seem to preclude exposure to any kind of low probability, high impact tail event.
Regulators set a lower threshold for MRAs. The new standard requires imprudent practices that materially harm the institution “under current or reasonably foreseeable conditions.” This focus on “reasonably foreseeable” falls into the plausibility trap I discussed in an earlier post.
Regulators claim that the new MRA standard “would have been capable of proactively addressing the risks that precipitated the failure of Silicon Valley Bank.” Oh, please. Interest rate risk deals primarily with exposure to unexpected changes to interest rates, not reasonably foreseeable ones. Mortgage rates experienced the sharpest rise in more than 40 years. A rate rise of that magnitude only became reasonably foreseeable after it already happened. Did this would-be MRA include time travel?
Decisions to open new MRAs will rely on the new rules. But how will supervisors decide to close MRAs? Actions to date show a significant change in approach but the specifics vary by agency, as shown below.
Closing Time at the FDIC
When the Final Rule came out, the FDIC announced completion of a “lookback” review of all outstanding MRAs to assess which meet the MRA standard under the final rule and which should be closed out. The FDIC concluded “that a large majority of outstanding supervisory criticisms do not meet the standard under the final rule and thus will be … closed out.”
This look-back approach has a very top-down flavor and raises some important questions. There were literally hundreds of outstanding MRAs. Who performed this review? If the FDIC assigned this to field examiners, wouldn’t there be issues of inconsistency since the rule is new and “reasonably foreseeable” is in the eye of the beholder? Perhaps some attorneys led the effort. From my experience, agency attorneys rarely get involved in MRAs and play little direct role in bank supervision. And wouldn’t all this effort on look-back reviews leave supervisors with little time to focus on, ahem, material financial risk?
MRAs usually are part of a broader supervisory letter that provides additional context and color to the MRA. My supervisory letters typically used potential MRAs as a starting point. Is the FDIC also going to rescind or rewrite these supervisory letters? One other point worth remembering is that MRAs have relatively short time horizons. Banks are usually expected to remediate the concern within 18 months. Longer-term fixes usually require more formal enforcement actions. Most of the MRAs issued under the old criteria will roll off fairly soon anyway. Are these look-back reviews even necessary?
Closing Time at the Federal Reserve
The Federal Reserve didn’t join in on the Final Rule but is taking a similar approach to MRAs. The Fed didn’t bother with the formal rulemaking process but instead implemented the Vice-Chair’s Statement of Supervisory Operating Principles (SSOP). The Bank Policy Institute didn’t scream about the Administrative Procedures Act this time around because these “principles” give the large banks exactly what they want. As with the FDIC, the Fed initiated a review of existing MRAs and MRIAs for conformance with the SSOP. Any MR(I)As “not consistent with the SSOP will be downgraded to an observation or closed.”
The Fed also will reduce the role examiners play in determining whether an MRA should be closed. It will instead rely on the bank’s internal processes and no longer consider whether the bank’s corrective actions are sustainable. The OCC is adopting a similar approach, discussed in more detail below. Beyond the look-back review, the FDIC has not publicly commented on the MRA closure process.
Closing Time at the OCC
The OCC has not announced any look-back review for the current crop of MRAs. (Significant though less fundamental changes to MRA processes in 2014 did not result in a lookback review.) OCC has, however, revised its approach to closing MRAs. The OCC told a reporter at the Financial Times that “it would make its policies and procedural manual public for the first time in a bid to foster transparency and accountability.” In fact, the Comptroller’s Handbook serves as the primary policy and procedures manual for the OCC and has been publicly available on the OCC website since the last century. The OCC had already incorporated its internal guidance on MRAs in the Comptroller’s Handbook (under Bank Supervision Process), but not the MRA procedure as a standalone document. OCC has now publicly released its revised internal procedures for MRAs.
Are examiners too reluctant to close MRAs, even after the bank has taken the necessary corrective action? Well, sometimes. No one wants to be second-guessed. That can make people overly cautious about closing MRAs. But incentives can run in the other direction as well. Bank supervisors love to notch “wins,” and an MRA closure is one way to declare victory. Monitoring open MRAs can also be an administrative hassle.
The new guidance diminishes the role of examiners in determining whether to close an MRA. Instead, the banks themselves will make that determination through their Internal Audit (IA) function. The guidance only requires a “satisfactory” rating for IA. These ratings come from the OCC’s non-public Risk Assessment System. From my experience, however, “satisfactory” ratings were ubiquitous, with “insufficient” or “weak” ratings for any risk management area quite rare.
I’m reminded of an old commercial for the Mars candy bar featuring actor Jamie Farr. The commercial suggestion you celebrate even your smallest accomplishment with a Mars bar, as Farr proceeded to reward himself for tying his shoes. Getting a “satisfactory” rating is a Mars bar level accomplishment.
It certainly makes sense for examiners to leverage off IA’s work. IA often asks the right questions and performs enough testing to give us confidence that the bank took the necessary corrective action. But not always. In some cases, IA didn’t fully understand the underlying concern or failed to perform sufficient testing. Examiners should have at least some discretion in determining whether the bank has adequately addressed the concern.
The other change involves sustainability. It’s one thing to verify that the bank taken corrective actions, but quite another to determine whether those actions are effective and sustainable. Sustainability was especially important for more systemic changes, such as those related to modelling, data accuracy, and internal controls. Now, however, OCC states that examiners “must not review a corrective action for sustained performance prior to closing an MRA.” (Emphasis added.) Don’t look up.
Checking the Box?
Current leaders at the key banking agencies have decried a supposed “check the box” approach to bank supervision. But the new approach to closing MRAs looks like a classic check the box exercise. Has the bank satisfactorily addressed the concerns that led to the MRA? Well, they said they did and checked all the boxes. Are these corrective actions effective and sustainable? We’ll worry about that later.
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