For release on delivery

1:00 p.m. EST

Community Bank Examination and Supervision amid Economic Recovery

Remarks by

Sarah Bloom Raskin

Member

Board of Governors of the Federal Reserve System

at

Maryland Bankers Association

First Friday Economic Outlook Forum

Baltimore, Maryland

January 6, 2012
 Thank you for the opportunity to speak with you this afternoon. It is always a

pleasure to be back in Baltimore and to see so many old friends. I was here during the

most intense days of the financial crisis, and I will never forget how bankers worked

around the clock to ensure that the credit needs of Maryland residents and businesses

could continue to be met--a dedicated effort that benefited communities across the state.

That episode is behind us now, but community banks continue to face numerous

challenges, including challenges from an enhanced regulatory regime that has evolved in

the wake of the crisis. This regime includes the potential effects of the Dodd-Frank Wall

Street Reform and Consumer Protection Act (Dodd-Frank Act). From my many

conversations with you, I have a sense of the challenges that you face regarding the

changing regulatory landscape. Against that backdrop, I appreciate the opportunity to

speak at the First Friday Economic Outlook, at the start of a promising new year, and

share my thoughts with you on two vitally important topics: how the Federal Reserve’s

monetary policy aims to increase the availability of credit to foster economic growth, and

how we are tailoring our examination and supervision of community banks to ensure that

we are not inadvertently constraining lending.

I believe that examination and supervision of community banks is a timely and

important topic. Why do I say that? Because, as I will discuss shortly, lending by

community banks plays an important role in the ongoing economic recovery, especially

by providing credit to small businesses. And it is absolutely critical that examination and

supervision do not produce outcomes that are barriers to small business expansion.
 -2-

Unlike most other businesses, banks are subject to a system of examination and

supervision, developed over the past century, that has particular and deliberate

characteristics: regular on-site visits by specially trained examiners; exit meetings

between examiners and bank senior management to explain examination findings; written

examination reports with narratives and metrics describing the findings of the examiners;

and, if necessary, follow-up on action items that the bank must pursue to remedy specific

problems. The ultimate focus of examination and supervision is the safety and soundness

of the bank, as well as compliance with laws and an assessment of the bank’s ability to

withstand risks and shocks.

Community bankers are very much accustomed to opening their doors to

examiners for their on-site visits. I’m not sure if James Anthony made it here today from

his bank in Chestertown, but I want to share with you two memorable conversations I had

with James when I was the Maryland Commissioner of Financial Regulation. In one

conversation, James told me how he left the glamour and fast pace of being a

management consultant in New York City to return to the relative peace and serenity and

awesome natural beauty of the Eastern Shore to run Chesapeake Bank and Trust where,

he said, he could awaken each morning to the sights and sounds of the swallows and

geese on the bay. In the second memorable conversation, James told me that my

examiners in their dark suits were not only taking up all the spaces in the bank parking lot

and occupying all the booths in the diner, but they were also, in his words, “scaring the

bejesus” out of the same swallows and geese alighting on the bay, not to mention some

residents of Chestertown who were convinced by the arrival of the many dark suits that

the bank was on the verge of collapse. So from that point on, we implemented more
 -3-

“town-friendly” approaches to examining our banks, including less-formal dress

guidelines and more gentle parking practices for our examiners. I share this anecdote

with you because it illustrates a mindset and approach that I bring with me to Washington

every day of maintaining a focus on how what we do at the Board affects local

communities.

Lingering a moment longer on the culture of bank examination and supervision, it

may come as a surprise to some of the nonbankers in the room that community bankers

typically welcome effective and appropriate examination and supervision. They value

supervision because they know that good examiners will help them to be proactive and

identify problems early, and because a strong and durable banking system is in

everyone’s best interest. When I was appointed by Governor O’Malley as commissioner

at the onset of the financial crisis, one of my first observations was that I was going to

have a very hard time retaining and attracting good examiner talent, which was critical to

helping manage the crisis. To get the resources needed to ensure that we maintained a

strong, experienced examination staff, I faced two major hurdles: I had to deal with the

state budget folks, and I had to make the case for higher assessments from the banks.

Needless to say, I was rather dreading the conversation when I picked up the phone to

call Kathleen Murphy, the president and chief executive officer of the Maryland Bankers

Association. But I was pleasantly surprised to hear her say that not only did Maryland

bankers want examiners who were well trained and held a level of expertise--so much so

that they would pay for it--but that she would be willing to testify as such to the state

legislature’s finance committee. That attitude underscores how the examination and
 -4-

supervision functions are embraced and factored into the business of being an excellent

community bank.

My perspective on the examination and supervision function has only deepened

during my term as a Governor at the Federal Reserve Board. Indeed, being a Governor in

the post-financial-crisis era has made me much more sensitive to the importance of

making sure we conduct examination and supervision in a way that helps ensure we think

through potential consequences, such as unnecessarily hindering lending to creditworthy

borrowers. Access to credit, after all, is a critical factor supporting recovery in our

economy.

Monetary Policy and Credit Availability

To gain some perspective on this issue, let’s set aside for a moment the beautiful

Eastern Shore and the examiners in their new business-casual attire, taking the bus to the

banks, and approach examination and supervision from the perspective of monetary

macroeconomics and the Federal Reserve’s decisionmaking over the past several years.

As most of you know, the economy began slowing in late 2007 and early 2008

and turned sharply downward in the autumn of 2008 when the financial crisis intensified,

resulting in the worst recession in many decades. By the end of 2009, the unemployment

rate reached a horrifying 10 percent, corresponding to more than 15 million Americans

being out of work, with all of the attendant social consequences--including lost income

and wealth, mortgage foreclosures, family strains, health problems, and so on.

Officially, the recovery from the recession began in the third quarter of 2009, but

the pace of recovery has been modest. Moreover, we know that the recession was deeper

and the recovery weaker than had previously been thought. The resulting financial
 -5-

strains on many businesses and households have been severe. This consequence is

starkly evident in the recent pattern of loan delinquency rates. Delinquency rates have

been slow to return to their pre-recession levels, with some of these measures, such as

those associated with certain categories of real estate loans, staying still quite elevated

today. Against this backdrop, the Federal Reserve’s data show that after contracting for

several quarters, lending by smaller domestic banks generally resumed expanding around

the middle of last year. Although measures of community banks’ profitability have risen

from their recession lows, pressures on the banks’ profitability and credit quality remain

as a result of the lingering weak macroeconomic fundamentals, especially the stubbornly

high amount of unemployment.

In that regard, although the pace of employment growth has picked up in recent

months and the unemployment rate has fallen some, the labor market remains quite weak.

At the end of 2011, more than 13 million Americans were out of work. An additional 8

million workers were classified as “part time for economic reasons” because their hours

had been cut back or they were unable to find a full-time job. In addition, about 2-1/2

million Americans were classified as “marginally attached” to the labor force because

even though they wanted to get a job, they had not searched for one in the past four

weeks. And almost half of that group--nearly 1 million individuals--had given up

searching for employment altogether because they did not believe any jobs were available

to them. The unemployed, the underemployed, the marginally attached, and the

discouraged can speak powerfully to the slow pace of the recovery.

The economic data in this regard correspond to what I have seen firsthand since

being at the Federal Reserve. I have traveled to once-robust cities in the Midwest and in
 -6-

other parts of the country. I have walked through foreclosed homes and have seen

blighted neighborhoods. I have visited unemployment insurance offices and job training

centers, and I have met lots of people who have been out of work for more than a year or

two--out of work for so long that some of them are embarrassed to show their resumes to

potential employers.

These circumstances have called for forceful policy measures.

In normal times, the Federal Reserve adjusts the stance of monetary policy largely

through changes in the Federal Open Market Committee’s (FOMC) target for the federal

funds rate. The Federal Reserve then adjusts the supply of reserves in the banking system

through open market operations to keep the federal funds rate close to the FOMC’s target

rate. The current and anticipated level of the target federal funds rate then influences the

level of many other interest rates in the economy. For example, a reduction in the

FOMC’s target rate tends to reduce borrowing rates for households and businesses,

including auto loan rates, mortgage rates, and rates on business loans.

With cheaper borrowing rates, consumers tend to increase their purchases of

houses, cars, and various other goods and services. In response, businesses ramp up their

production to meet the increased level of sales. Moreover, with lower costs of financing

for new equipment and structures, businesses may be inclined to increase their own

spending on investment projects that they might previously have seen as only marginally

profitable.

The Federal Reserve’s monetary policy has been accommodative since the onset

of the financial crisis. In particular, the federal funds rate target, which stood at
 -7-

5-1/4 percent in mid-2007, was subsequently reduced to a range of 0 to 1/4 percent by the

end of 2008, and that target range has been maintained since then.

Given the magnitude of the financial crisis and its aftermath, the Federal Reserve

clearly needed to provide additional monetary accommodation beyond simply keeping

short-term interest rates close to zero. Consequently, like a number of other major central

banks around the world, the FOMC has been deploying unconventional policy tools to

promote the economic recovery.

In particular, we have provided conditional forward guidance about the likely

future path of the federal funds rate, and we have engaged in balance sheet operations

that involve changes in the size and composition of our securities holdings. Broadly

speaking, these policy tools affect the economy through channels that are similar to those

of conventional monetary policy. Specifically, forward guidance and balance sheet

operations have been employed to put downward pressure on interest rates; lower interest

rates, in turn, reduce the costs of borrowing for households and businesses and also boost

household wealth, thereby providing economic stimulus.

In my judgment, our deployment of unconventional policy tools has been

completely appropriate to help promote the Federal Reserve’s statutory mandate of

maximum employment and price stability. Ideally, monetary policy decisions would be

informed by precise quantitative information about the effects of each tool. We do our

best in this regard, and I can certainly attest that the FOMC reviews an enormous amount

of information and analysis in reaching its decisions. That said, even in normal times,

uncertainty is intrinsic to real-world monetary policymaking. Uncertainty about the

effects of policy is particularly relevant under current circumstances where the scope for
 -8-

conventional monetary policy is constrained by the zero lower bound on the federal funds

rate, leaving unconventional tools as the only means of providing further monetary

accommodation.

However, certain factors could be constraining the channels through which

monetary policy accommodation affects the economy. In particular, many small

businesses appear to be facing unusual obstacles in obtaining credit. If times were more

typical, we would expect a smooth transmission in which lower interest rates would fuel

credit expansion that would be used to finance expanding payrolls, capital investment,

inventories, and other short-term operating expenses. Nonetheless, the latest Federal

Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices, which was

taken in October, indicated that although domestic banks continued to ease standards on

their commercial and industrial loans, the net fraction reporting easing on such loans to

smaller firms (those with annual sales of less than $50 million) remained low.1

Moreover, in recent quarters the fraction easing standards for smaller firms generally has

been below that for loans to large and middle-sized firms. In its November survey, the

National Federation of Independent Business continued to indicate a sizable proportion of

small businesses reporting that credit has become more difficult to obtain.2 These

businesses not only expect credit to become tighter in coming months but--like other

businesses--remain concerned about the broader economic outlook.

Supervision and Examination of Large and Community Banks

1
The Senior Loan Officer Opinion Survey on Bank Lending Practices is available on the Federal Reserve
Board’s website at www.federalreserve.gov/boarddocs/SnLoanSurvey.
2
See National Federation of Independent Business (2011), NFIB Small Business Economic Trends
(Nashville: NFIB, December), www.nfib.com/Portals/0/PDF/sbet/sbet201112.pdf.
 -9-

While the ability of businesses to access credit is a function of many factors, it is

my view that the examination and supervision of the lender should not hinder the ability

of creditworthy businesses to access credit. To be clear, I do not think this is occurring in

any significant way, but it is an issue that we at the Federal Reserve focus on continually.

Of course, banks are far more likely to be able to lend when they are in sound

financial condition. In that regard, I am encouraged that community banks are faring

better in the current environment. There is still considerable uncertainty about the health

of residential and commercial real estate markets in many parts of the country, and many

community banks’ balance sheets remain weighed down with nonperforming real estate

loans. At the same time, the competitive landscape is being shaped by increasing

consolidation in the industry. Having said that, despite the tough road that many

community banks still must navigate, there are promising signs that conditions seem to be

stabilizing. While profitability remains below long-run historical norms, returns on

equity and assets have reached their highest post-crisis levels.3 Earnings have steadily

improved in recent quarters despite compressed net interest margins. Although

nonperforming asset ratios remain high, they have continued to decline for community

banks broadly speaking, and small community banks (those with total assets of less than

$1 billion) in recent quarters have registered their first overall decreases in this ratio since

the crisis began.

Nonetheless, we must continue to think about how we can improve the

examination and supervision of community banks. One issue that we constantly must

evaluate is the appropriate balance in the allocation of responsibilities between banks and

3
Observations about recent financial developments generally are based on Call Report data filed by banks
as of September 30, 2011.
 - 10 -

examiners.4 In addition, we must always think about whether the allocation of

responsibilities should be different depending on whether the supervision is of a

community bank rather than a large bank, especially one whose failure could

significantly disrupt the broader financial system.5 Specifically, there are key differences

between these two sets of institutions, and these differences have implications for our

supervisory framework.

The way the banking industry has evolved over at least the past decade indicates

a trend toward greater concentration. Ninety-nine percent of banks in the United States

are community banks, with most of these holding less than $1 billion in total assets. The

remaining 1 percent of banks together hold more than 80 percent of the assets in the

banking system, with much of this concentrated at a handful of the very largest banks.

The four largest commercial banks, each of which has more than $1 trillion in

consolidated assets, collectively hold just under half of all U.S. banking assets.6

The largest commercial banks are characterized not only by their size, but also by

their scope of operations and complexity. Their legal and business line structures,

balance sheets, and product offerings often are extraordinarily complex. For example,

4
See Sarah Bloom Raskin (2011), “Community Bankers and Supervisors: Seeking Balance,” speech
delivered at the Federal Reserve Bank of New York Community Bankers Conference, New York, N.Y.,
April 7, www.federalreserve.gov/newsevents/speech/raskin20110407a.htm.
5
For the purposes of these remarks and for the Federal Reserve’s supervisory programs, the largest banking
organizations are generally considered to be those banks and bank holding companies with total
consolidated assets of $50 billion or greater. Oversight of approximately a dozen of the largest and most
complex organizations is conducted by the Federal Reserve’s Large Institution Supervision Coordinating
Committee; see Ben S. Bernanke (2011), “Implementing a Macroprudential Approach to Supervision and
Regulation,” speech delivered at the Federal Reserve Bank of Chicago’s 47th Annual Conference on Bank
Structure and Competition, Chicago, Ill., May 5,
www.federalreserve.gov/newsevents/speech/bernanke20110505a.htm.
6
Of course, there are still banking organizations that are at neither end of the spectrum, which our
supervisory program reflects. Regional banking organizations, for example, which are generally
considered to be those banks and bank holding companies with total consolidated assets between
$10 billion and $50 billion, share characteristics of both larger and smaller institutions, and we have a
tailored supervisory program for those organizations. For the purposes of today’s discussion, however, I
would like to focus my remarks on the institutions at opposite ends of the spectrum.
 - 11 -

they have extensive trading and capital markets activities, and make significant use of

over-the-counter derivative instruments and other complex financial products. They are

relatively diversified, but also tend to be more highly leveraged than smaller institutions,

and often rely on more volatile wholesale funding. These organizations often are tightly

interconnected, raising the prospect that the failure of one institution could rapidly

destabilize the wider financial system, giving rise to the “too-big-to-fail” problem.7

The characteristics of the largest commercial banks stand in contrast with those of

community banks. To be clear, community banks are not immune from taking on

excessive risk. But there are reasons why risks at community banks are likely to be less

dangerous to the financial system. First, community banks generally are less complex

and more easily understood. Second, community banks tend to be more traditional in

approach. What is often referred to as “financial engineering” is less likely to become the

norm in community banks because such engineering, by definition, may pose hidden

risks that could reflect poorly on community bankers’ judgment and negatively affect

their image in the community if these risks are realized. Third, community banks are less

interconnected, so when a community bank fails, the effects are less widespread.

All of these characteristics have implications for how large and complex banks

should be supervised, as compared with community banks. Notably, our supervision of

large banks reflects the scope and complexity of their activities as well as their

interactions with other firms and possible effects on financial markets, and incorporates

7
When the Basel Committee on Banking Supervision recently issued rules for global banks that are
systemically important, the methodology for determining system importance was based on five criteria:
size, interconnectedness, lack of available substitutes, global/cross-jurisdictional activity, and complexity.
See Basel Committee on Banking Supervision (2011), Global Systemically Important Banks: Assessment
Methodology and the Additional Loss Absorbency Requirement (Basel, Switzerland: Bank for International
Settlements, November), www.bis.org/publ/bcbs207.htm.
 - 12 -

systemic risk considerations that could arise from the failure of these banks. This

circumstance requires regulators to make capital, liquidity, and risk-management

standards more stringent for large banks than for community banks. These standards not

only are being established internationally, but also are required for the largest institutions

under the Dodd-Frank Act. A critical part of this supervisory process is rigorous capital

planning and stress testing to ensure that the largest institutions are capable of absorbing

unforeseen shocks. The Federal Reserve, for example, requires the largest top-tier bank

holding companies to submit annual capital plans and conduct rigorous stress tests as part

of the Comprehensive Capital Analysis and Review exercise.8 In recognition of their

systemic importance, the largest firms also are required to plan for their own orderly

resolution in the event that they should fail.

Because of their complexity and risk characteristics, these firms require intensive

and continuous on-site supervision; the Federal Reserve has dozens of full-time

examiners on site at the largest banks to monitor their risk-management systems,

strategies, and operations on an ongoing basis. In the years since the crisis began, our

supervision of these firms has become arguably much more intensive, which I believe is

perfectly appropriate given the effect that problems at the largest firms had on the

financial system and the broader economy.

You may be asking, What does this have to do with community banks? Not very

much--which is precisely my point. The community banking model is very different

from that of the largest banks. Community banks are local by their very nature. They

have deep roots in their communities. Their value proposition is that they are able and

8
See Board of Governors of the Federal Reserve System (2011), “Federal Reserve Board Issues Final Rule
on Annual Capital Plans, Launches 2012 Review,” press release, November 22,
www.federalreserve.gov/newsevents/press/bcreg/20111122a.htm.
 - 13 -

willing to take the time and effort to know and work with their customers in a way that

may not be possible for a larger, more distant institution. This trait is particularly

important when it comes to small business lending, where a local community bank may

understand things about a prospective customer that cannot be captured in a more

quantitative credit-scoring model that might be used by a larger institution. Risks at

community banks tend to arise from their lending activities, whether in the form of credit

or interest rate risk, and a lack of diversification can exacerbate these risks. Unlike large,

complex banks, community banks typically do not rely on their investment portfolios or

diversified business lines to offset low profits.

All of these characteristics call for a very different model of examination and

supervision than what is required for the largest banks. Just as community banks have a

deep understanding of their local communities, it is important that examiners also

understand local market conditions to be able to put the bank’s management and credit

decisions in the proper context. For example, when I was commissioner here, there was

an old joke among state examiners that you never dared set foot in a bank on the Eastern

Shore if you didn’t know the latest monthly count of blue crabs.

Strong lines of communication between examiners and community banks are

vitally important. Examiners are only on site periodically at most community banks, so it

is essential that when they are on site, they communicate clearly with management about

supervisory concerns in order to help bankers make improvements as appropriate.9

Examiners need to listen carefully to management to understand their perspective where

9
Full-scope, on-site examinations of state member banks typically are required at least once during each
12-month period, although this may vary depending on, among other things, the size and condition of the
bank. See Board of Governors of the Federal Reserve System (2000), Commercial Bank Examination
Manual, section 1000.1 (Washington: Board of Governors, May),
www.federalreserve.gov/boarddocs/supmanual/cbem/0005cbem.pdf.
 - 14 -

views may differ. I also believe it is critically important for federal examiners to work

closely with their state colleagues, especially since we have joint supervisory

responsibility for state-chartered banks that are members of the Federal Reserve System.

When these working relationships are strong, the banks we jointly oversee receive

supervisory messages that are consistent.

The need for effective communication and feedback goes beyond the examination

period. Examiners and other supervisory staff are often key sources of information on

regulatory developments between examinations. We encourage our examiners to be

responsive to questions from bankers and help banks understand new regulatory

requirements, and they take this responsibility seriously.

One of the analogies that I began to use years ago--and that I’ve shared with many

of you--is that the risk-management system of a healthy bank can be pictured as a series

of concentric circles. The inner circles consist of the systems and functions that keep the

bank healthy and allow it to meet the credit needs of its community while remaining

financially sound and compliant with its legal and regulatory obligations. Moving

outward, additional circles include processes and checks such as internal audit, executive

management committees, risk-management and internal controls, and appropriate

governance by the board of directors. The outermost circle is effective supervision. The

critical element of this model is that problem identification is first and foremost the

responsibility of the bank, while banking supervisors kick the tires of the bank’s risk-

management and internal control systems. The examiners are, in this sense, a last line of

defense and do not substitute for a bank’s own processes for risk identification and

mitigation. They are not a guarantee of the bank’s ultimate success or failure.
 - 15 -

While I think this model of concentric circles generally holds true for banks of all

sizes, the complexity of the largest institutions requires far more complex inner circles.

Arguably, the financial crisis revealed that at many of the largest firms, the sophistication

of these banks’ governance, controls, and risk management did not keep pace with the

rapid growth of risk. Moreover, because the potential cost of a breakdown at the largest

firms includes losses that are external to the financial institution, it is essential that a

strong outer circle of effective supervision be in place as an extra buffer to insulate other

firms and taxpayers from systemic risk. I would suggest that the outer circle that is

necessary at a systemically important bank should be far more layered than what is

needed at a small community bank.

Community Bank Supervision at the Federal Reserve

One way we at the Federal Reserve are working to ensure that our supervisory

program is properly tailored to the wide array of institutions we supervise is to review

policies that are under development with an eye toward considering the effect that these

policies might have on smaller institutions. In this regard, along with my colleague

Governor Betsy Duke, I serve on a subcommittee of the Board that oversees the

supervision of community and small regional banking organizations. Among other

things, we consider not only whether specific policies are appropriate for community

banks, but also whether these policies could have the effect of reducing the availability of

credit to sound borrowers. We are actively involved in providing greater clarity and

specificity regarding the applicability of supervisory policies to community banks. One

of the things that I try to do whenever I review policies is to draw on my experience of

working with community banks in Maryland and think about the effects these policies are
 - 16 -

likely to have on community banks and the areas they serve. Ideally, our supervisory

policies result in stronger community banks that are able to lend and promote sustainable

economic growth in their communities.

Let me conclude my remarks by again thanking you for the opportunity to share

my thoughts today. I certainly don’t claim to have all the answers when it comes to

supervising community banks, but I hope my remarks will at least continue our

conversation about how best to structure a regulatory and supervisory framework for the

banking system that effectively supports the real economy and encourages sound and

sustained lending to creditworthy borrowers. In order to sustain the economic recovery,

we need strong, well-run community banks that operate in a framework of smart and

effective supervision. I commend you for the work that you are doing every day in your

communities, and I look forward to continuing the dialogue.