Speech by Governor Bowman on building the community banking framework for the future

The strength of the U.S. banking system relies upon the diversity of its institutions, and facilitating an environment that allows each category of bank to thrive is essential to fostering a healthy financial system. For community banks, this includes building a framework that better supports the unique characteristics of these institutions. Today, my remarks will consider three foundational questions as we contemplate revising the community banking framework: (1) Given the continued evolution of the banking system, how should a community bank be defined? (2) Are we pursuing the most appropriate approach to supervision and regulation of community banks, and finally, (3) How can we build a policy framework that better supports and anticipates this evolution of the banking system now and into the future?

Of course, there are limits to this framework. And we should continue to ask if the metrics and thresholds established through regulation, and more often recently through supervisory policy decisions, are appropriate over time as conditions change.

Locking regulatory standards into a fixed asset-size threshold has its costs. Over time, these fixed thresholds fail to take into account growth attributable to broader economic growth and inflation. They are also not reflective of any changes in a particular bank’s activities or risk profile. As a result, many firms that are stable in their growth, business model, and risk profile end up unintentionally crossing regulatory thresholds. As they approach, and certainly once they cross over these asset-size lines, they must comply with additional regulatory and supervisory requirements that were specifically designed and implemented for larger and more complex firms.

While the fixed-threshold approach benefits from simplicity, it is necessary to periodically revisit the policy effect of these bright-line thresholds. There are certainly cases in which a bank with assets less than $10 billion faces risks that are disproportionate to its asset size, warranting greater supervisory scrutiny. For these firms, asset size may vastly understate their risk profile. Often, they do not operate like traditional community banks, relying instead on nontraditional services and engaging in complex activities. Therefore, it may be appropriate for a community bank to be subject to additional oversight. This is particularly relevant when a bank has un-remediated, long-standing supervisory issues that require more supervisory monitoring and oversight. In such cases, a community bank supervisory approach is likely not sufficient or appropriate.

At the same time, many banks with assets over $10 billion do operate like community banks, with a relationship-based straightforward business model, yet they are not regulated or supervised as such. Over time, the mismatch in supervisory expectations around this and other asset thresholds becomes more pronounced as economic growth and inflation effectively lower them. This results in potentially overly complex supervisory constructs for banks with a limited traditional community bank risk profile.

Is it appropriate to impose more restrictive requirements on firms when those heightened requirements are not a deliberate policy choice based on the level of risk? Is it appropriate to treat each bank below a regulatory threshold as a traditional community bank? Historically, regulators have been willing to push more complex requirements and expectations down to smaller banks—essentially bumping them into a higher risk tier—than moving larger firms into a lower risk tier when that treatment may be more appropriate.

When considering building a framework to support community banks, the definition is key—which banks will be in scope? The answer lies in the bank’s business model, activities, and risk profile.

Where we have established fixed-dollar asset thresholds, we must commit to revisit and adjust them as needed. In my view, this is a principle that extends beyond the lines defining community banks to all regulatory and supervisory thresholds. While there is need for flexibility in both directions, it is apparent that over time economic growth and inflation will result in thresholds that are inappropriately low.

The Supervision and Regulation of Community Banks

Establishing a definition for community banks leaves open the fundamental question of regulatory and supervisory approach. Before turning to that discussion, we need to take stock of supervision and regulation today. What areas of the framework require review and attention?

The Tradeoffs of Regulation

Regulation can be a powerful and effective tool to promote bank safety and soundness, and U.S. financial stability. The special privileges that are granted with a banking charter—including deposit insurance and access to the discount window—all come with the responsibility and obligation to comply with the bank regulatory framework.

A robust presence of community banks, especially those that are remote and rural, enables access to credit, banking, and payment services in underserved markets and communities. These banks support local economies by serving consumers and small- and medium-sized businesses, building an economic foundation to drive business development and growth. But community banks, like any business, face the economic reality that accompanies running a successful business. Each must manage its costs—including personnel, funding, and regulatory compliance—in light of its revenues to achieve a reasonable return on equity.

When a bank’s costs increase, there is, by necessity, a need to make changes if the bank hopes to maintain profitability and ultimately its survival. This usually involves either cutting costs or raising prices on banking services.

How do the realities of operating a business inform our current approach to regulation? The question becomes acutely relevant when regulators consider imposing new or revised regulations. Regulators should always ask (1) what problem does this new regulation solve, (2) what are costs of this approach, and (3) are there alternative approaches? Before discussing the path forward, I would like to note an example that highlights this concern.

The Hidden Cost of Supervision and Guidance

While regulation carries with it the obligation to comply with public notice and comment procedures under the Administrative Procedure Act, regulators have far more discretion in the supervisory process, and in issuing “guidance” that is technically non-binding but often operates as a de facto requirement. The development and implementation of new supervisory approaches and of guidance largely escape rigorous scrutiny due to the lack of formal procedural requirements for its development. This is true even though the expectations created by guidance can be equally or more impactful to banks than rules.

In the supervisory process, we should guard against being distracted by less relevant issues. The prevalence of supervisory findings related to nonfinancial metrics is in part driven by the time it may take to remediate certain issues. However, we should also scrutinize whether this trend is indicative of our supervisory focus—beyond financial risk and toward non-financial risks and internal processes—and whether that shift is appropriate. We should also be aware that due to the vast diversity in business models, size, and geographic footprint among banks, we should not expect every firm to follow the same standards and must be careful to prevent forcing uniformity through “grading on a curve.” This risk can be exacerbated through any type of horizontal-like reviews. The supervisory findings made during the examination process inform bank ratings, which can have follow-on effects like limiting options for mergers and acquisitions (M&A) activity; raising the cost of liquidity; or diverting resources away from other, more important bank management priorities.

Guidance can also impose costs on banks that are not always obvious or quantified. The purpose of guidance is to provide clarity to banks and reduce implementation uncertainty and risk. To serve this purpose, however, guidance must be clear, actionable, and account for the needs of the targeted firms, especially for community banks.

Bank Mergers, Acquisitions, and De Novo Formations

What does a healthy banking system look like? While we often espouse the virtues of a “diverse” banking system—one with many different sizes of institutions and the flexibility to shift in size over time—a healthy banking system includes opportunities for entry and exit— from de novo bank formation through merger and acquisition activity.

Fostering an environment that enables bank formation and merger transactions is vital to ensuring a future for community banking. Without viable formation and merger options for all banks, but especially for community banks, we will create a “barbell” in the banking system. If this continues, it will eventually result in a handful of very large banks, and an ever-shrinking number of community banks, with nothing left in the middle. Over time, these trends will result in a reduction in available credit and services, an increase in the number of unbanked or underbanked communities, and economic harm.

Building a Framework to Better Support Community Banks

After acknowledging the importance of community banks and effectively defining these firms, the next step is identifying principles for how these firms should be regulated and supervised. The guiding principles are relatively straightforward: the approach must be tailored to risk, transparent, and consistent across similar institutions. Together, these elements can create an opportunity to construct an enduring community bank regulatory and supervisory framework for the future.

This conference provides an ideal venue to facilitate conversations that can help spur the development of blue-sky ideas to preserve community banking well into the future. While it would be impossible to lay out a comprehensive blueprint for a community banking reform agenda in this speech, I see several opportunities that are promising and essential.

The Value of Experience

Building this framework for the future starts with personnel, the people making decisions over the long term. How do we approach our responsibilities? We should highlight examples that have been successful but also reflect on the significant work that remains to be done.

This experience, of having worked as a banker or as a state regulator, is uncommon within the Federal regulatory agencies. For example, of the current members of the Federal Reserve Board, I am the only member with experience as a banker or state regulator. In my view, we should ask how someone with this experience in the community banking system can best serve on the Board.

This experience and perspective is critical. As a former community banker at a state-chartered bank and as the State Bank Commissioner of Kansas, I have seen and directly experienced the practical effect of supervision and regulation from “both sides” of the banker’s desk. With this background, one understands and appreciates the importance of a respectful and healthy partnership between state and federal regulators and the need for setting high standards and applying strong oversight to banks of all sizes, including community banks. This background also provides perspective on how overregulation can impose disproportionate burden on a community bank, over time leading to the erosion of the viability of the community banking model.

The requirement for community banking experience does not equate to advocacy on behalf of community banks. Instead, this role provides much-needed perspective on—and calls attention to—bank regulatory and supervisory matters that affect community banks.

When I arrived at the Board, I was designated to serve as the chair of the Subcommittee on Smaller Regional and Community Banking. One of my first priorities was to make clear to examination staff the importance of their work in supervising community banks. After the 2008 financial crisis, although many community banks failed, much of the supervisory attention shifted to the very largest firms. The focus of this role provided the platform and opportunity to prioritize small regional and community banking issues, which led to a number of important successes, including:

• the creation of the Small Bank Supervision Working Group to focus on the unique issues facing small banks with Reserve Bank staff from across the system;
• the development and implementation of tools to assist community banks in complying with the Current Expected Credit Losses (“CECL”) reporting change;
• as interest rates were rising, encouraged supervisory focus to develop examination guidance to assess the risks associated with a changing interest rate environment and low tangible common equity, well before the spring 2023 banking failures;
• improved frequency and content of communication with community banks; and
• during the COVID-19 response, worked together with agency partners to implement approaches that encouraged banks to work with their borrowers, suspend exam timelines, and extend reporting deadlines for affected banks. During that time, staff also developed guidance for examiners as we emerged from the pandemic.

These accomplishments highlight how prioritizing community banking issues at the highest level can improve the outcomes and experiences for community banks. We need a balanced approach to regulation and supervision of community banks. This approach should prioritize the key risks facing the banking system, acknowledge the costs of regulation and supervision, and consider alternatives that may be more efficient than simply adding additional requirements and expectations for smaller institutions.

While I am proud of these accomplishments and our work together, a more formal structure for this seat’s responsibilities—one that includes dedicated responsibility over the supervision and regulation of community banks, and to play an active role in interagency coordinating bodies like the Federal Financial Institutions Examination Council (FFIEC)—would go a long way toward building and preserving an enduring framework that supports community banks in the future.

There are other opportunities to expand coordination with states, both through formal coordination bodies and when engaged in rule making efforts that are intended to impact state-chartered institutions. These coordination bodies include (1) the FFIEC—which is tasked with prescribing uniform principles, standards, and reporting forms for the federal examination of financial institutions, and making recommendations to promote consistency in the supervision of financial institutions—and (2) the Financial and Banking Information Infrastructure Committee—which is tasked with promoting information sharing and enhancing incident response planning, in addition to identifying cybersecurity best practices.

Coordination is only effective if we are committed to work in an open, collaborative, and balanced way with other agencies and policymakers. There are unmet opportunities on this front. For example, the FFIEC is the venue in which regulators coordinate on examination standards and discuss and agree on reporting requirements that apply to smaller banks. With a growing divergence in the approach of state and federal regulators to the examination process, we need to ask how the FFIEC can better accomplish its goals.

We also need to ask whether the other important work of the FFIEC, like establishing reporting requirements, is being conducted in an appropriate way. The opportunities for input, review, and oversight of this important work are very limited, with only the Board representative on the FFIEC participating. Notwithstanding these structural impediments, I have prioritized rationalizing the Call Report, an effort that I revived when I joined the Board.

These types of overly broad requirements pose their own risks to community banks, and we should remember to focus on the unglamorous work of making sure we are not collecting more data than is necessary and appropriate for supervisory purposes, and that we are efficient in the collection of that data, for example, by leveraging data previously collected instead of requiring further collection of the same data.

Regulators also tend to be very proprietary about the development of regulatory and supervisory proposals. Often, policies are far along in the development process before they are published for public comment in the rulemaking process, and state banking regulators rarely provide feedback on proposals before or after they are put out for comment.

While regulators tasked with implementing regulations, supervision, and guidance bear the ultimate responsibility for those policy choices, this process can greatly benefit from more interaction among federal regulators and our state bank regulatory counterparts. More extensive dialogue with state regulators can improve proposals in the formulation stage by sharing practical, real-world perspectives, including observations on the impacts of intended and unintended consequences. While it is challenging to anticipate the unintended consequences of reforms, casting a wide net for views can lead to better, less disruptive, and better-informed policy choices.

The importance of enhancing coordination between state regulators and the Federal Reserve cannot be overstated. At a recent meeting of the Board’s Subcommittee on Smaller Regional and Community Banking, my colleagues and I were delighted to welcome representatives of the Conference of State Bank Supervisors and four of their State Bank Commissioner members. We learned firsthand about the successes, frustrations, concerns, and areas for improvement in the coordination between state and federal regulators. There is simply no substitute for these direct conversations and building upon and improving these important intergovernmental relationships.

Collaborative Approach to Reform

Historically, one of the many virtues of the Federal Reserve Board is the structural incentive to work together to achieve compromise. Governors serve extended, staggered terms intended to insulate them from political considerations. The Board consists of seven independent governors who often bring their unique voices to a range of policy matters. While instances of dissent tend to attract the most attention, the Fed has a long history and tradition of engaging in thoughtful debate, exchange of views, and reaching more durable compromises on rulemaking matters. The history of consensus on bank regulatory matters is not surprising because we work toward common goals of safety and soundness and financial stability.

Consensus is a powerful tool. When there is broad policy agreement, there tends to be moderation in approach, acting as a check on wild swings of the regulatory pendulum and providing banks and holding companies with an important degree of stability in their regulatory and supervisory expectations. While it is important for regulators to adapt to changing conditions, and to evolve in the face of new and emerging risks, this incremental approach tends to produce better policy and better outcomes in the banking system.

The antithesis of this policymaking approach is one that involves the close guarding of information, limiting the airing of competing views, and failing to engage in meaningful discussion and debate about policy. When contrasting these two ends of the policymaking spectrum, the virtues of consensus-building are even more apparent. Regulatory reform should not be a “shock” to the banking system, and meaningful discussion and consensus act as a check on dramatic swings of the regulatory pendulum.

Collaborative reform is more effective when we have both a widespread sharing of information, analysis, and policy perspectives, and when a range of views is brought to bear on important regulatory questions. One way that we can accomplish this goal is through representation of those with banking or state regulatory experience representing the Federal Reserve in bodies that are influential in the shaping of policy approaches, like the FFIEC, and by embracing a culture of freely sharing information among policymakers both within and across regulatory agencies.

Assessing the Costs and Benefits of Existing Approaches and Reform

Too often when regulators impose requirements on banks, the temptation is to overestimate the benefits and underestimate the costs. Requiring banks to report additional data allows us to better understand the operations of banks. Limiting the fees that may be charged to consumers may result in a short-run reduction in consumer costs. But in the long run, regulation carries with it many costs, ranging from the direct costs of compliance and capital to indirect costs like the reduction in product offerings or increased prices for consumers. Regulators must anticipate, assess, and balance these costs in the rulemaking process and accept that, at times, the right policy is not to impose additional regulations but rather to take actions to reduce the burden of existing regulatory requirements.

One of the key challenges to pursuing this balancing is how to effectively complete the analysis. The incremental burden of any single regulatory reform may be challenging to measure—its costs may seem minor when weighed against the benefits. But this approach ignores the additional cost of cumulative burdens, a concern that is particularly acute among community banks faced with an onslaught of changes.

The cumulative burden of regulation is rarely acknowledged in the rulemaking process. While we assess burden with respect to discrete rule changes, there is no obligation to “refresh” that analysis due to changes in underlying conditions or new information about impact absent a further rule change. And the analysis of a rule focuses on the incremental impact of the specific regulation, ignoring the likely aggregate effect of requirements.

While the minimum legal process required under the Administrative Procedure Act should be the “floor” for rulemaking, in my view it is insufficient. Likewise, while policymakers have even greater discretion in pursuing changes to supervision, we need not do so in a vacuum without opportunities for—and a receptiveness to—feedback. We can and should expand the lens through which we consider proposals, in a way that considers the cumulative effects of regulation and supervision on banks and their ultimate customers, in a way that identifies redundancies and excessive burdens, and in a way that considers multiple alternatives and the tradeoffs of different approaches.

Tailoring

Finally, I would be remiss to discuss the future of community banking without noting one of the critical mechanisms to build a sensible framework for the future—tailoring. Tailoring helps us calibrate regulation and supervision to the activities and risks at every tier within our oversight framework, but it is particularly important when we think about the application of prudential tools to community banks. Tailoring our approach helps with the allocation of finite resources—among both banks and regulators. It enables us to right-size the approach to regulation and supervision to the complexity of banks, acknowledging that community banks that pose manageable risks in the event of their failure, and no real risk to financial stability, simply do not warrant the same treatment as larger, more complex, and more systemically interconnected banking institutions.

While in some cases, policymakers have made efforts to promote appropriate tailoring, often the end result has been lacking. As I noted earlier, in my view the 2023 CRA reforms represent a missed opportunity to rationalize and right-size CRA requirements for community banks. Instead, the rule applied the same essential framework to all institutions above $2 billion in assets, scoping in community banks with the very largest global systemically important banks. Even where supervisory approaches take into account the needs of community banks, the end result requires reviewing and incorporating ever-increasing guidance into their risk management activities. This was certainly the case with regulatory guidance on third-party risk management.

Often, our guidance has a “cumulative” or “compounding” effect—a bank cannot go to a single source or compendium to understand supervisory expectations or requirements for a particular activity. Instead, a banker must parse through multiple regulations and guidance before understanding how regulators expect an activity to be conducted. A community banking regulatory framework that enables small banks to thrive must prioritize tailoring.

Closing Thoughts

Thank you for your commitment to community banking, and conducting the important research that can inform the regulatory policy agenda. Community banks may be small but their contributions to local communities are mighty. The importance of their role in providing credit to a broad range of customers and businesses that in their absence would have far fewer banking options cannot be overstated.

There simply is no alternative or replacement for community banks and the relationship banking model. If regulators believe in a dynamic banking system, if we support financial inclusion and extending the availability of banking access, we must acknowledge the importance of community banks and ensure that our regulatory framework preserves their role for the future. To function effectively, the banking system requires the presence of banks of all sizes—larger, regional, and community banks. This diversity of our financial institutions is the greatest strength of our banking system, and it can easily be imperiled by insufficiently targeted regulation, supervision, and guidance.

The discussions we will have over the next two days will include steps to further preserve and enhance the future of community banking. The presentations will enhance our understanding of the dynamics and pressures that shape the banking system, identify issues and concerns that may threaten different bank business models and activities, and develop policy approaches that consider the tradeoffs in our regulatory and supervisory approach.