The Dodd-Frank Act did something brilliant, but it only did it halfway.
The reform law laid out a plan for applying different and separate supervision for the largest, most complex financial companies. Congress ought to go back and do the same thing for the simplest and the smallest.
Calibrating regulatory resources to the risk posed by an institution is not a new or novel idea, but it is an idea that is finally taking root and is likely to fundamentally change the nature of supervision.
"The definition of community bank as a different animal never took hold until Dodd-Frank. Everyone said a bank is a bank is a bank," said Jeff Gerrish, a regulator turned consultant based in Memphis who counts hundreds of community banks among his clients. "But that has changed. … The time is certainly ripe for some sort of tiered regulation."
The tiered regulation mandated by Dodd-Frank requires greater scrutiny as well as higher capital, liquidity and operational costs for the large, complex firms that present the greatest risk to the financial system.
But the law does not address the small, less systemic part of the industry or those companies that fall somewhere in between. That is likely to change as regulatory resources are stretched thin and the smallest banks make a convincing case that they are being overregulated.
"I think the crisis we just lived through created the critical mass to really look at a tiered structure of regulation," said Cam Fine, the president and chief executive of the Independent Community Bankers of America.
"There just has to be a recognition in national policy that there are two systems of banks now," Fine said. "The regulatory apparatus needs to catch up with that evolution."
In some ways it has.
The notion of risk-based supervision has been around for 20-plus years but has never been spelled out in broad legislation that the agencies could implement in uniform ways.
Tiered regulation would actually take risk-based supervision a step further, moving beyond segregating banks by size and complexity to adjusting which rules are applied to which banks and how.
Officials at the Federal Reserve Bank of Cleveland have been working on a supervisory plan they call "tiered parity," which envisions the same rules applied the same way to different classes of banks.
"Risk-based supervision is alive and well. What we are suggesting is addressing it beyond just the supervisory programs to the rules and regs themselves," said Stephen Ong, a vice president in the supervision department of the Cleveland Fed. "We think about it not just in terms of supervision, but even ahead of supervision there has to be the appropriate rules and regulations. They need to be right-sized to the different tiers of firms."
In a joint interview with Ong, James Thomson, an economist in the Cleveland Fed's research department, stressed the "parity" aspect of the plan, applying the same rules and scrutiny to groups of banks with similar risk profiles.
"That is the essence of tiered parity. You don't treat institutions the same along the scale, but you would treat institutions horizontally the same," Thomson said, adding, "We shouldn't be expending resources to avoid something that is a very, very low probability at the small-bank end."
A few examples of tiered regulation already exist. For instance, a 2006 law allowed the agencies to lengthen the exam cycle to 18 months for banks with assets of less than $500 million and a Camels rating of 1 or 2. Community Reinvestment Act exams are also tiered depending on size and past performance.
And Dodd-Frank did make one nod to smaller banks. It exempted all banks with assets of less than $10 billion from enforcement by the new Consumer Financial Protection Bureau. The bureau will write consumer protection rules and enforce them against banks with assets of more than $10 billion, but primary bank supervisors will provide the enforcement for small banks.
The ICBA fought hard against that provision, and it is looking to build on its victory. Fine said the group is rounding up sponsors for its "Communities First Act," which has provisions affecting the oversight, taxation and reporting requirements facing small banks.
"The foundation of the Communities First Act is tiered regulation," Fine said. "Banks need to be regulated according to scale."
Changes the ICBA is seeking from Congress include restoring dividend payments on preferred GSE stock, forcing a cost-benefit analysis before any changes are made to accounting standards and reducing origination and program fees for rural and small-business borrowers.
"We've succeeded in getting into the minds of policymakers that community banks do have a place in our financial structure and they need to be helped out because they have been disadvantaged," Fine said. "The phenomenon of too big to fail, which we all just witnessed in its full, tragic glory, has put new emphasis behind the idea that you should not be treating a $100 million bank the same way as a megabank.
"That just buries that local bank."
Plenty of community bankers have been relaying that message to their congressmen and Republicans who took control of the House this year are listening. House Financial Services Committee Chairman Spencer Bachus has repeatedly said he wants to find a way to lighten the regulatory burden on small banks, mainly as a way of stimulating lending to small businesses, which could then use that financing to grow and create more jobs.
No one is suggesting that examiners look the other way when a small bank does something stupid. This idea of tiered regulation would apply only to healthy banks, ones the regulators have already judged to have sound management, solid credit quality and plenty of capital. For those banks, off-site monitoring could be used to track risk-taking. Any bank experiencing some sort of departure from normal operations — a big growth spurt, for example — could be flagged for quick attention by examiners.
But there is no need to send teams of examiners into well-run banks for weeks at a time and then leave the bank wondering for months about its rating, which is a common complaint these days.
Those examiner resources could be put to better use.
Former Comptroller of the Currency Bob Clarke works with a lot of community bankers as a lawyer based in Houston. He says "the relationship between the regulators and the banks is about as bad as I have ever seen it."
He points to commercial real estate lending as an example where tiered oversight could make a difference. Regulatory guidance instructs banks not to let CRE lending exceed 300% of capital but many small banks are way over that limit. Clarke says that's largely because so many of their borrowers pledge real estate for loans to finance their businesses.
"When you make a loan, the collateral is the building. Those are the kinds of loans that community banks make," Clarke said, adding that CRE portfolios are typically more diverse and less risky than examiners may presume.
"They don't do enough thinking. They just look at the numbers," Clarke said of these examiners. "If the number is above 300%, they nail them and require all this extra capital and it is killing community banks."
To Clarke, tiered regulation just makes sense.
"It really goes back to a style of regulation that is more tailored to a small bank, where the risks are pretty straightforward and the remedies for problems are straightforward as well," he said. "You just don't have to go at it with the same vigor" that's applied to larger, more complex banks.