I have had the pleasure of meeting the Esther George on a few occasions. My former employer, U.S. Central Federal Credit was the largest financial institution (by asset size) within the Kansas City Federal Reserve’s territory before the real estate crisis. I was very impressed with Ms. George’s intelligence, range of knowledge and matter of fact approach; she demonstrated a remarkable ability to combine deep intellectual thought with practical, common sense. Hence, I was delighted when Ms. George was announced as the new president and chief executive of the Kansas City Federal Reserve, replacing Tom Hoenig.
Barb Rehm’s interview with Ms. George for American Banker (see below – included at the end of my post – March 7, 2010 issue) clearly demonstrated the traits and approach that I had admired long before she was named president and chief executive. I particularly like what she said about the regulatory/oversight process because she articulated what I have heard repeatedly from colleagues and experienced first hand; the regulatory oversight pendulum has swung so far that it is become an impediment to the business. Unfortunately, regulators (and Congress too, but political reasons of course) tend to look in the rearview mirror and enact law or change regulation to prevent what happened in the past from recurring. Thus, there are often untended consequences resulting from that kind of approach and the Frank/Dodd legislation is living proof of what can go wrong when taking a backward looking approach. There are parts of that legislation that make compliance physically impossible for FI’s. Thankfully public comments are being sought regarding parts of the Frank/Dodd legislation, so I am hopeful that zealous, political motivated legislation will be amended to reflect the practical realities of what FI’s can and cannot do.
I also agree wholeheartedly with Ms. George’s comments regarding the restrictive oversight process in place today that does not permit, or incorporate examiner thought and judgment. The best regulatory relationships that I have experienced were ones that were collaborative, meaning that the relationship and review process was open to discussion. The issues, findings, etc., were debated openly to achieve the best outcome. Sometimes the outcome meant that additional risk mitigation techniques had to be deployed to make the payment(s) process safer and more secure. Other times the examiners learned more about the payment(s) and became comfortable with the controls and procedures already in place.
One thing is certain in my mind is if the regulatory examiners or internal FI risk and audit staff (I used to call them the “business prevention managers”) take the “got you” approach, the entire process incents the wrong behavior and ultimately hurts the value of the oversight process. Internal and external examinations are effective and beneficial when self-disclosure is encouraged and not penalized. Another hallmark of an effective examination is when findings (self-disclosed or discovered during the review) are openly discussed and debated to ensure that there is a common understanding of the issues as well as what steps need to be taken, if at all, to mitigate the finding.
The payments business comes with risk. A good payment business is built on a solid foundation where the risks are well understood and mitigated; end-to-end and take into account the business realities of payment type too. I had many discussions with regulators where I asked them not force adding on $5.00/transaction worth of security to a payment for which I charged $0.02. If every possible risk associated with a particular payment is mitigated, you will go out of business, so common sense judgment is mandatory if any payment business is to survive.
That is why I like Ms. George’s comments stating that common sense and judgment has to be part of any good oversight process. You cannot manage to theory, only policy and the policy has to reflect the underlying business fundamentals and economic realities. If examiners wish to mitigate every possible payment risk, you should just should shut the business down because it will be too expensive to operate.
Continuous risk review is necessary because of how fast technology is changing, especially the with the rapid growth in the number of channels now available to consumers and business to access to payment and financial information systems. Solid risk management is just like any effective business strategy; it gets reviewed and amended over time as the environment changes. Business strategy and risk mitigation are not static, point-in-time events.
Good strategy and risk mitigation processes are constantly scanning the environment to anticipate change so that the path forward is amended and adapted repeatedly. It is a discipline that is never finished. And the best internal and external experiences that I have had is when the examination process was approached openly and discussion was encouraged.
I have learned and grown tremendously from examiners who have taken an open approach and the payments businesses that I managed became safer and more secure as a result. I think it is fair to say that their understanding grew as well. So maybe, with time, the examination process will return to that of objective collaboration and partnership so that the payment businesses continue grow and continue to improve security, safety and soundness.
Read-to-read from AmericanBanker.com:
Kansas City Fed Chief Takes Simpler-Is-Better Approach
Ask Esther George a touchy question and she’s likely to crack a sly smile that says, “I’d love to answer that, but I won’t.”
Don’t misunderstand. The president and chief executive of the Federal Reserve Bank of Kansas City has plenty to say, but the diplomat in her knows some questions are simply better left unanswered.
Such restraint might just be the most striking difference from her predecessor, Tom Hoenig, who in his 20 years leading the Kansas City Fed bank built a reputation for doggedly speaking his mind.
Last week George marked her first five months in the top job with a trip to Washington, and in her first interview with a national publication she made it clear that she shares Hoenig’s views on the risks posed by ever larger and more complex financial institutions.
“It’s hard for me to say I think about it very differently, because Tom and I had some of the very same experiences coming through the ’80s and saw what caused banks to get into trouble,” George said. “I started [as a bank examiner] at a little bank in a strip mall in Oklahoma City called Penn Square Bank. That was my education.
“I align pretty closely with Tom in thinking about how these risks can play out. We have watched for many years the funding advantage that has come from growing consolidation in the industry, so I wouldn’t paint myself very differently in terms of how I see those issues and the concerns.”
But didn’t the Dodd-Frank Act of 2010 end “too big to fail,” and won’t its “living wills” provision nudge our largest banks to become smaller and simpler? This was George’s first opportunity in the interview to flex those diplomacy muscles.
First the smile, then: “I can be hopeful. I am an optimist at heart, but I don’t see any evidence of that.”
Hoenig was rarely that subtle. His replies to such questions had more of a “hell, no” flair to them, and he didn’t hesitate to detail his plans to protect commercial banking from riskier forms of finance.
Hoenig turned the Kansas City Fed over to George in October after he reached the mandatory retirement age of 65. (He was nominated by President Obama to a seat on the Federal Deposit Insurance Corp. on Oct. 20, and his confirmation is pending in the Senate.)
George, 54, is the latest career regulator to take over as a Federal Reserve bank president. Of the 12 sitting presidents, seven have worked in the central bank system for more than 15 years. Only Sandy Pianalto, who leads the Cleveland Fed, has a longer Fed resume than George, who joined the Kansas City Fed in 1982.
Hoenig, who was at the Kansas City Fed for 38 years, promoted George to head of supervision and risk management in 2001 and then to chief operating officer in August 2009. The Fed board in Washington borrowed George during the crisis when it found itself without a chief of supervision.
A Missouri native, George is warm, down to earth and authentic. She calls things as she sees them and generally takes a simpler-is-better approach. She’s been married for 30 years and her two children attend college in Missouri. She still keeps the books for her parents’ farm.
George thinks regulation has grown too burdensome and too complicated, and that oversight is suffering from a by-the-book mentality.
While she realizes regulatory tactics and strategies must evolve as banks balloon in size and scope, George insists boots-on-the-ground supervision is crucial. She worries complex approaches are overshadowing common-sense judgments.
A case in point is the current fascination with stress testing.
Stress testing is a “useful tool to gauge potential losses from different economic scenarios. It is no substitute for supervisory judgment and examination,” she said.
“Stress testing helps calibrate capital,” she continued, “but to really know a bank’s condition, you have to go in and examine those credits.”
(Coincidentally, just after the interview an executive with one of the largest banks volunteered that he too was worried that basic safety and soundness checks were being overshadowed by the obsession with stress testing.)
While the central bank has taken many steps in recent years to open its monetary policy decisions to more scrutiny by outsiders, its regulatory policy making has grown more opaque. Gone are the days when Fed governors debated policy decisions in open meetings. George would reverse that trend.
“I think we have to apply the transparency pledge to everything we do,” she said. “Part of what we have succumbed to is a sense of urgency. Things are moving fast.”
She would prefer a more considered approach that includes time to “ponder the unintended consequences.”
“These rules have big import,” she said. “Whether it’s the interchange rule, whether it’s the Volcker Rule, whether it’s capital rules coming down the pike, it’s all going to affect a lot of people.”
I asked about the Volcker Rule, which has been lambasted by nearly everyone as too complicated to ever work. George supports the rule’s goals but isn’t involved in writing it and wasn’t about to criticize those who are.
But her reply revealed her philosophy on regulation.
“You can make any rule as complicated or as simple as you want. The more complicated you make it, and I learned this watching Basel II get crafted, I don’t think you ensure any chance of success.”
Because Dodd-Frank forbids banks from doing proprietary trading, why not write a rule that just says that and then let examiners police it? Without saying so explicitly, George agreed.
“I would like to see us go back to a time when examiners were required to use judgment. You gave them simple, clear rules and they had to make judgments.”
To illustrate the oft-cited pendulum that swings from regulatory laxity in good times to regulatory crackdown in tough times, I swung my arm and asked George to stop me when I got to the place where she thinks the pendulum sits today. She just stared, and smiled as my arm climbed above my shoulder.
“I worry about the burden on small banks,” she said. “I have watched over the years. It is an accumulation of compliance, and community banks do not have the scale to spread those costs, so they bear them disproportionately.”
Consumer compliance issues seem to cause the most friction among bankers and their examiners, she said.
“That’s due to prescriptive rules that tell the examiner that you don’t get to apply judgment here. If it meets this, this and this test, then it’s a problem. That’s the frustration of bankers.”
Don’t mistake George for a pushover, however. She’s still a tough examiner at heart.
“Forbearance drags things out,” she said. “I think about it pretty simplistically. Anytime you have an asset, a loan, that gets into trouble, somebody has to take the loss. The sooner you take the losses,” the better.
George belongs to a growing cohort of folks who question some of the conventional wisdom growing up around community banks, namely that a massive wave of consolidation is coming and the average size must increase.
“I don’t think they all have to be $1 billion” in assets, she said. “I don’t think there has to be a wave of consolidation.”
But she is worried about credit risk at community banks. She fears both margin pressure and competition from larger banks that can use lower funding costs to undercut smaller rivals.
“The concern I have in this policy environment is they [banks] need more yield so they will go out for more risk,” she said. “And when they do that in a low interest rate environment it can look OK. But those borrowers start looking worse when rates start ticking up.
“I hear bankers saying, ‘I am going to have to start making some credits that I wouldn’t normally make because I have to generate earnings.’ “
George said community banks also are telling her about losing business to large banks.
“They say I am trying to compete with the big bank in my market,” she said, “but that big bank is coming in and pricing a loan in a way that I cannot and would not.”
Community banks that survive will be the ones that hold the line on risk but continue to adapt, she said.
“At the end of the day community banks are core to the payments system and core to lending in these markets. I don’t see that model being outdated. It’s always got to be tweaked, but I worry the thing that is going to drag them down is regulation. That seems like something we could address and should address.”