Much of bank supervision operates outside the public eye. Recent critiques of supposed regulatory overreach note the secretive nature of bank supervision but then make claims of their own that are hard to either verify or falsify. This can lead to an “unreliable narrator” problem. One area where this is readily apparent is in the supervisory appeals process, which some critics claim is “broken.” But do these claims stand up to scrutiny?
The concept of an “unreliable narrator” is a literary device where the story’s narrator makes inaccurate statements or leaves out key information. This feature can lead to a dramatic twist. Those who have seen the films “The Usual Suspects” or “Gone Girl” get the idea. Bank managers, attorneys, consultants and their political allies will also weave self-interested narratives regarding their supposed unfair treatment by regulators, often providing little supporting evidence.
How Supervisory Appeals Work
Back in 1994, Congress required banking regulators to establish a process for appealing supervisory decisions. There is some variation across regulators. For OCC, appeals are primarily decided by its Ombudsman. For the FDIC, appeals first go to the applicable District Director and then to the Supervisory Appeals Review Committee (SARC). The three-person committee consists of an FDIC Board Member and Special Assistants for the remaining two Board members. The FDIC District Director “will make his or her own supervisory determination without deferring to the judgments of either party.” Once the appeal reaches the SARC level, however, the burden of proof rests with the appealing bank. OCC guidelines are less explicit in that respect. Both agencies have established anti-retaliatory procedures.
Criticisms of the Process
Critics of the supervisory appeals process make both a qualitative and quantitative case for its supposed weaknesses. The qualitative case rests on the presumption of regulatory overreach by banking regulators. Examiners are supposedly giving undue weight to subjective assessments of management, which in turn focus on “minutia” rather than true financial risks. Congress recently held a hearing on “regulatory overreach” in banking. I listened for nearly three hours and did not hear any specific evidence that this was the case. This is a good example of an a priori fallacy, which boils down to assuming something is true without evaluating the evidence.
The confidential nature of bank supervision provides the ideal environment for unreliable narrators to flourish. Statements are hard to either prove or disprove. Unreliable narrators may well be sincere. Bankers may believe they are doing an awesome job running their banks and examiner criticism is unwarranted. There is ample evidence from the field of cognitive psychology to support this notion. More than 80% of people surveyed believed they were better-than-average drivers. Researchers found similar results for creativity, intelligence, athleticism, and honesty. We also have the Dunning-Kruger effect, where less able people are most likely to overstate their abilities. My experience in bank supervision was somewhat of a mixed bag in this regard. Some arrogant people are also quite competent. But there were also plenty of cases of often wrong, but never in doubt.
The Quantitative Case
The quantitative case focuses on the small number of formal appeals. The FDIC decided on five formal appeals in 2024 and on 15 over the past eight years. That total excludes four appeals on assessments. OCC decided on 11 appeals in 2024 and 41 over the past eight years. Over the same period, OCC also decided on 65 Shared National Credit appeals, which follow a separate process. Critics contrast these amounts with the thousands of bank exams that occurred over the same period. Treasury Secretary Scott Bessent has claimed the appeals process is more theoretical than real. But is this the right denominator? A better understanding of examination ratings is a good place to start.
Examination Ratings
Supervisors rate banks on a scale of 1 (best) to 5 (worst). The composite rating consists of six components, Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk, which go by the acronym CAMELS. The composite rating does not necessarily reflect an arithmetic average of these components since one or two may have more impact on a bank’s overall condition. A rating of “3” doesn’t mean average, but rather, needing improvement. Supervision of “3” rated banks is especially important, since supervisors can intervene as problems emerge but before the bank is too far gone.
Most banks are rated “1” or “2.” For example, OCC has established a performance goal that at least 90% of its supervised banks receive a composite CAMELS rating of “1” or “2.” The actual percentage of 1 and 2 rated banks has ranged from 92% to 99% in recent years. (See table below.) OCC supervises roughly 1,000 banks and thrifts. That means during the during FY 2021, only about ten banks were rated “3” or worse. Ten. The total has climbed a bit more recently but still represents very few banks.
Supervisory appeals aren’t limited to adverse ratings. Banks can and do appeal composite ratings of “2.” But seriously, why? There is little practical difference between the two ratings. A “2” rated bank receives much of the same light touch supervision as a “1” rated bank. Changes to assessments and FDIC premiums don’t kick in until the bank is downgraded to a “3.”
Some appeals focus on individual components. Examiners informally describe some “2” rated banks as “clean” or a “dirty.” With a dirty “2”, the bank’s overall rating is satisfactory, but there are weaknesses in some key areas, say, liquidity or asset quality. Anchoring can occur and it’s easier to downgrade a dirty 2 than a clean 2 the next time around. While examiners can make mistakes, it’s important to remember that appeals are inevitably one-sided. No one is going to complain that the examiners rated them too easily. There just aren’t that many adverse supervisory findings out there to appeal.
Results of the Appeals
Critics also point out that banks lose most of their appeals. Of 18 appeals since 2017, FDIC denied 15. Two were granted with a third receiving a mixed verdict. Of 40 appeals, OCC denied 26, with most of the remaining split decisions. Partial wins by the banks were often on less substantive matters, like revising language in the Supervisory Letter, though there were exceptions. The presidential administration in power or the FDIC Chair had little if any effect on either the frequency or result of appeals.
There is good reason to expect banks to lose most appeals. Adverse exam findings go through an extensive vetting process. To downgrade the rating of an individual component rating (say Liquidity), we needed to write a detailed memo mapping each element of that rating to existing guidance. That analysis then required concurrence by not just the Examiner-in-Charge (EIC) but also by higher-ups in Washington. I don’t recall there being a similar process for upgrading a component or composite rating. Before sending out a Supervisory Letter, we would run our findings by bank personnel to weed out any factual inaccuracies. Banks also had an ample opportunity to challenge our findings both during and after an exam.
Looking at the Record
FDIC and OCC post anonymized summaries of each appeal on their websites. There is some variation in quality. For example, FDIC Case 2018-05 involved the appeal of a Liquidity Rating. After four throat-clearing paragraphs, the SARC concluded:
“An affirmative vote of a majority of all members present is required to overturn an RMS decision. In this case, the two voting members of the Committee would have needed to agree that the Bank had met its burden of proof. Given the applicable standard of review, the Committee is unable to reverse the RMS decision in this matter”
Well, that tells you nothing. But such terse reviews are the exception. SARC 2018-07 involved the appeal of composite and component ratings. The SARC provided considerable detail in upholding the examiner’s findings, noting poor earnings, operating outside of interest rate risk limits, reliance on wholesale funding, and failure to sufficiently address problems. OCC appeals summaries cite the guidance used to render the decision, complete with hyperlinks.
Banks have won some significant cases. In SARC-2024-05, the FDIC overturned a bank’s Asset Quality, Liquidity, and Composite ratings. In Q3 2018, the OCC Ombudsman reversed a bank’s Management rating. The SARC summary made a fairly strong case that some of the ratings appeared overly harsh based on existing guidance. That was less the case with the OCC’s finding, which concluded that “the MRAs and violations cited in the ROE were valid criticisms of bank processes, but the Ombudsman found that the issues were within management’s capability to address in the normal course of business.” That strikes me as a highly subjective assessment to make from a distance, since onsite examiners are usually more familiar with a bank’s day-to-day operations.
Transparency vs. Confidentiality
One pre-2010 SARC summary provided some very specific details about the bank including its total assets in millions, number of branches, and date of FDIC insurance. That’s way too much identifying information. More often, however, the appeals summaries avoid providing specific numbers that could support the overall findings. For example, this OCC review from Q2 2017 provides a strong rationale overall for upholding supervisory findings. However, it includes the following statement: “While problem loans and net loan losses have declined, the overall levels remain high relative to the bank’s critically deficient capital and earnings and pose an imminent threat to the bank’s viability.” It would be helpful to know what “high” means in this context, such as “problem loans represent more than X% of capital.”
More transparency is appropriate, but we should temper expectations. Even when supervisors provide primary source data like exam reports (SVB) and supervisory letters (concerning “debanking” of crypto firms), few review these primary sources and even fewer have sufficient background in bank supervision to make judgments based solely on that information. More often, an interested party spins the information to promote a preferred narrative. During the regulatory overreach hearing noted above, Rep. Bill Huizenga (at 58:34) stated that regulators “did not effectively use the [management rating] metric when supervising SVB and Signature.” Sarah Flowers of the Bank Policy Institute concurred. Neither pointed out is that in 2022, the Federal Reserve rated Management as “deficient.” Every other ratings factor was rated as “broadly” or “conditionally” meeting expectations. The problem at SVB’s supervision wasn’t its Management rating.
De Novo Reviews
Some advocate a “de novo” approach to supervisory appeals. This concept is open to interpretation. Reviews of appeals look for conformance with existing supervisory guidelines and whether supervisory findings are adequately supported. Some might go further and attempt to replace the judgment of the examiners on the ground with that of the SARC or Ombudsman. In other words, they want a do-over.
It’s also a terrible idea. Consider the following. I’ve written a few Matters Requiring Attention (MRA) involving deposit modeling. I spent decades covering that area and was viewed as a go-to person within my agency. We would also usually have one or two quants from our Washington office participate in the review. We combed through highly technical model development and validation documents and had extensive question and answer sessions with bank management. Any supervisory actions needed to go through our normal vetting process, with included EIC signoff. Reviewers in the Ombudsman office often have exam experience, but is it reasonable to expect them to perform a similarly thorough and informed de novo review?
Solution to a largely imaginary problem
Congress has proposed reforms to the supervisory appeals process. Apparently, the country has too few real problems that Congress needs to find solutions to imaginary ones. The bill, called the Fair Audits and Inspections for Regulators (FAIR) Act would establish protections against retaliation (which already exist under current practice) and establish a type of Super Ombudsman within the FFIEC. It also appears to endorse the de novo standard and to allow appealing banks (not just the Ombudsman) to access some examiner workpapers. Under current practice, this information is rarely shared with other regulators or even with examiners at the same agency assigned to other banks.
Looking Forward
Supervisory actions should be fair, consistent with existing standards, and adequately documented. The current supervisory and appeals framework has established protections in each of these areas. There is room for some further improvements. However, the pendulum can swing too far in the other direction. A recurring theme of recent bank failures is the supervisory process can be too deliberative. Supervisors of SVB identified many of that bank’s weaknesses but the Fed’s extensive vetting process prevented them from taking prompt action. Expanding the appeals process and weighting it more in favor of the bank is likely to further slow things down. In addition, while documenting supervisory findings is important, that can be overdone as well. Examiners shouldn’t spend the bulk of their time documenting findings rather than …examining.
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