The spate of bank failures this past spring has triggered more interest in how the bank supervisory process works. The Supervisory Letter (SL) is usually the most critical document coming out of the supervision of large banks. I’ve written quite a few SLs in my time and can share how the letter writing process works and what makes for an effective Supervisory Letter.
OCC issues a Report of Examination annually for Large Banks, but also conducts multiple reviews of individual areas during the year. A Target typically covers a broader business line or function and lasts three weeks. A Focused Review will cover a smaller business segment or a more specialized function and lasts two weeks. In most cases, the examiner leading the review also drafts the SL.
Fieldwork on the review drives the content of the Supervisory Letter. You want to keep the scope of the review manageable. Don’t try to boil the ocean in just two or three weeks. The same goes for requesting information from the bank. I’ve seen Request Letters with 80 or 90 items and that’s usually too much to even review. Instead focus on those items that will most likely drive your assessment. Examiners can often leverage on what they already know from ongoing supervision (OGS) activities.
I tried to schedule meetings with bank management during the first week or so of the review. That allows time for follow-ups. I usually had a good idea where the exam is headed a little past the midway point of the fieldwork. There’s a wide range of practice and I know good examiners who approach things differently. Some like to thrash things out before deciding while others decide early and look for supporting details. Even early deciders need to be flexible enough to handle surprises. Digging deeper can allay concerns – or heighten them.
Writing the Supervisory Letter
OCC’s Supervisory Letters follow a template, subject to some modification by the Examiner-in-Charge (EIC). The first paragraph starts with the exam scope and objectives. Next comes a summary of findings that can come in paragraph or bullet form. (Bullets make for easier reading.) The letter then describes any matters requiring attention (MRAs) and violations of law. The next few paragraphs provide additional detail on the examiner’s findings. A closing paragraph indicates when the response is due and provides contact information. Even with a template, there is still some art to preparing and writing an effective Supervisory Letter. I found the following approach useful.
Start with potential MRAs. When writing the Supervisory Letter itself, I usually started with potential MRAs. Begin with the big picture and take it from there. OCC uses a 5C format for MRAs: Concern, Cause, Consequences, Corrective Action, and Commitment. I’d usually draft out the Concern and the Corrective Action to find out early on if the proposed MRA would fly. I’d then run the idea by one or two of my colleagues. That might include someone on the exam or perhaps another senior examiner whose judgment I trusted. On a larger team, I’d run it by the Team Lead, who would also give a heads up to the EIC. On a smaller team, where I was both the Team Lead and the team, I would discuss with the EIC directly. Once I had a sense of where the MRA was headed, I could start to write the rest of the SL, with the concern as the starting point.
There are some other things to bear in mind with MRAs. First, think ahead. Initiating an MRA is part of a longer process. Corrective actions for an MRA may take a year to 18 months from start to finish. You should have an idea of what “satisfactory” will look like and how to monitor the bank’s progress. OCC does not include recommendations in SLs. Examiners can provide recommendations informally to the bank and note them in their Conclusion Memos, but they are no substitute for an MRA. If it’s a problem that needs to be fixed, it’s an MRA. MRAs can also be implemented more quickly than formal enforcement actions. Enforcement actions are a highly legalistic process that can take years to implement. In addition, while an individual MRA may seem like a slap on the wrist, multiple unresolved MRAs can form the basis for a ratings downgrade.
Avoid excessive jargon and regulator speak. The letter should look like it’s written by a human being for human beings. Start each paragraph with a clear, concise topic sentence. Words like “robust,” “transparent,” and “granular” have their place but they are wildly overused. For example, you can describe a statistical model as robust if it holds up across a wide range of scenarios. Don’t use robust merely as a synonym for “good” or “effective.”
Consider your audience. This objective is trickier than it sounds. Examiners at the largest banks can cover highly technical matters. Managers of the businesses and functions covered may know what you’re talking about, but the bank’s senior management and board probably won’t. You need to balance precision with simplicity. That may mean avoiding highly technical terms or at least focusing on their implications. Modeling experts throw around terms like autocorrelation, heteroskedasticity, and stationarity that may be lost on the uninitiated. Instead emphasize that these issues can affect the model’s accuracy and reliability.
Strike the right tone. The tone will depend on the bank and the findings. Don’t treat every weakness as catastrophic. You lose credibility that way. However, a sharper tone can be appropriate, especially if the bank has been slow and ineffective in correcting longstanding issues. Also avoid being too effusive following a clean exam. It’s sufficient to say that the review did not identify any significant concerns. Don’t say this is the most wonderful bank in history. Remember that these conclusions are based on a two- or three-week review. Banks are rarely either universally strong or universally weak. Acknowledging that balance can demonstrate objectivity. But try to avoid adding favorable comments solely for the sake of apparent balance.
Be careful about making broader assessments. The OCC uses a risk assessment system that categorizes the quantity of risk (high, moderate, low) and quality of risk management (strong, satisfactory, insufficient, weak) for broad risk categories. Some examiners make a similar assessment following a target or a focused review. Use with caution. That assessment is fine for an end-to-end review of a broad area like liquidity or interest rate risk. It makes less sense when you are covering a specific business, like commodities trading or indirect auto lending. While individually that business may be too small to break the bank, rating the risk as “low” may be misleading. Consider that megabanks may have many other similar business and correlation approaches 100% in a crisis.
Remember that you are a ghostwriter. The EIC signs the Supervisory Letter. Don’t take too much umbrage if the EIC wants to set a different tone or take it in a different direction. That’s the EIC’s prerogative. The CM is a little different since it’s under the name of the lead examiner and not the EIC. The CM includes a section on potential MRAs that didn’t make it to the Supervisory Letter. This represents a relatively new addition and it’s not yet clear whether examiners will use this section to highlight differences between the draft and final Supervisory Letters.
What Was Wrong (and right) with the Fed’s Supervisory Letters for SVB
The Fed’s review of the SVB failure includes not just a narrative analysis but also primary source material, including exam reports and SLs. The FDIC’s review of the Signature Bank failure did not include primary sources. I reviewed the Fed’s Supervisory Letters but also tried to avoid two fallacies common in such reviews. The first is the “we do it differently” fallacy. Just because the Fed’s SLs look a little different from the OCC’s doesn’t make their approach wrong. The other is the idea that because SVB failed, its supervision must have been botched from start to finish. Supervisory failures are more often a combination of bad decisions and bad luck.
I reviewed two SLs. The first, an asset quality and credit risk management target completed in 2021, is a bit of a mess. The letter runs seven pages (longish for an SL) and includes two MRAs. The first 16 paragraphs make no more than passing reference to the two new MRAs. This is a classic case of what journalists call burying the lede. Even when the letter gets around to discussing the MRAs, the “issue” (concern) paragraph starts with the statement that “risk ratings are timely, accurate, and generally supported” before getting to the “however.” This is a good example of balance for the sake of balance. This approach may be trying to make the point that processes that may have been satisfactory for a small bank no longer cut it as the bank gets larger. There are, however, more direct ways to communicate this “welcome to the NFL” message.
The second, a November 2021 liquidity planning target, is much better. The target resulted in four MRAs and two matters requiring immediate attention (MRIAs). The letter starts with a clear, unambiguous summary of the bank’s weaknesses in liquidity risk management. It doesn’t waste a lot of space with extraneous information and summarizes the key issues in the first two pages. Some have asserted that “the [SVB] examiners were far too focused on risk management processes and procedures, and not on actual risk.” This criticism trivializes serious risk management weaknesses related to stress testing, risk limits, and contingency funding plans. However, a more effective SL would have also emphasized the bank’s high concentration risk to add needed context to these risk management weaknesses.
Supervisory actions (or inaction) after issuing the SL presented a bigger problem. At the time of the 2021 target, liquidity was rated “1.” The Fed did not downgrade liquidity until August 2022 and, even then, to a still satisfactory “2.” The risk management weaknesses alone should merit a rating no better than “3,” and possibly a “4” given extreme funding concentrations. The Liquidity rating remained at “2” until the bank failed in March of 2023. A clear, authoritative Supervisory Letter is a necessary but not sufficient condition for effective supervision. Regular monitoring and decisive follow-up are just as important.