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8 :15 AJ4 •/ EST
April 1 | 1985________


Presentation by
Preston Martin
Vice Chairnan
Board of Governors of the Federal Reserve System
to the
American Bankers Association
Conference on Safety and Soundness
Mayflower Hotel
Washington, D.C.
April 11, 1985

Supervising the Nation's Financial Institutions Challenges and Responses
Presentation by Preston Martin
to the
American Bankers Association
Conference on Safety and Soundness
at the Mayflower Hotel
Washington, D.C.
April 11, 1985

Deregulation of banks, thrifts, and other financial institu­
tions has brought a cornucopia of services for corporate and individual
consumers and a bushel basket of challenges and headaches for bankers
and for government officials who are charged with supervising banks and
bank holding companies. Business now has cash management services,
camiercial paper, and even some aspects of investment banking; govern­
ment has electronic payments, bookentry, and other services; and house­
holds have insurance, discount brokerage, an impressive array of sav­
ings instruments, and credit availability once only the prerogative of
the wealthy.

The entry into banking of retailers, Wall Street, and

insurance firms fran outside the banking industry has blurred industry
lines and affected gross margins.

The public benefits when pricing for

services more nearly reflects market forces, but the responsible gov­
ernmental officials should be alert to the altered profitability of
carpeting institutions and what that portends for adequacy of capital
and of liquidity.
Narrower margins in financial services have pushed management
to seek volume on the one hand and, on the other, riskier assets, which
have the appearance or the potential of filling the profitability gap.
Take discount brokerage.

Is this service likely to develop an adequate

return on needed investment or is it rather a low return or no return


means to hold or expand market share?

Or take a non-bank bank.


it is difficult to make a marginal, but full service branch profitable,
hew do you earn on a costly to establish limited facility?

Limited in

service to squeeze through the loophole, and expensive to establish in
another state, the non-bank bank is as costly as a World War II beach­
head on an enemy island.

It may take a touch of genius to make a non­

bank bank profitable on a cost accounting basis.
And, management cannot lose sight of its most basic objec­
tive, long-run profitability, in its effort to diversify its "products"
or its willingness to undergo short-term operating losses to achieve
limited interstate banking.
Moreover, bankers and thrift institution managers have to
seek profitability and growth in an economy in which disinflation
appears here to stay for the foreseeable future.

Just as some U.S.

manufacturers are virtually drowning in a flood of inports, U.S.
bankers find their markets undercut by the price competition from
foreign-based lenders.

Technological change is also increasing at an

apparently increasing rate, forcing financiers to invest very substan­
tial funds into systems for which the return on investment is uncer­
One effect of disinflation, deposit deregulation, diversifi­
cation, and even deflation— in commodities, energy assets, housing
values, foreign assets, and farm land— is on perceptions of asset

Old views are challenged.

In addition, today's economic


expansion has bypassed whole regions and industries here and abroad.
Foreign competition has driven seme U.S. industries and certain U.S.
agriculture down to depression levels.

Maintaining loan portfolio

quality is thus complicated not only by internal factors to the banking
industry but also by forces exogeneous to the lending process.
It is therefore not hyperbole to characterize these tines as
revolutionary for banking.

Success, even survival, depends upon adher­

ence to the classic virtues, upon quality assurance structures and upon
the integrity of the management by objective process.

Beware the

executive who says, "I'm not a banker anymore, I'm a manager!"

Or even

worse, "I'm an information manager!"
Unqualified growth as management by objective, "M.B.O.",
overemphasized by any institution is the leading indicator of future

Obsession with growth as virtually the sole objective

expressed at all levels of management is impossible to reconcile with
high quality assurance.
down the line inpossible.

Grcwthmanship makes monitoring and control
Management must focus on the vital documen­

tation of policies and controls in credit extension and asset acquisi­
tion, and on the "three Rs"— review, review, and review.

I observe

with satisfaction changed thinking in commercial bank management with
regard to the need for a more senior executive, for a senior management
group, and for board connittees to control the review of credit deci­

This particular function is so inportant that we, and you, must

more carefully analyze those controls.

Your internal auditor and your


CPA firm are in a strategic position to do that, on a periodic basis,
by the evaluation of procedures, policies, and objectives which lead to
quality of assets.
These are a few of the challenges to management. Let me turn
now to the governmental examiners and supervisors who, on the other
side, cannot afford to reduce their consideration of the safety and
soundness of the financial system and of the integrity of each institu­

A subset of governmental objectives, an important one, is the

responsibility of the banking agencies, particularly the Federal
Reserve, for the integrity of the whole of "banking" or of payments
system institutions.

Forms of organizations are growing

with affiliates and subsidiaries and joint ventures.

more complex

As the institu­

tional asset structure becomes more diversified, it is imperative that
the examination process allocate more resources toward measuring and
analyzing the quality of assets and somewhat less toward the most tech­
nical aspects of compliance. This is not to abandon the review of
potential conflicts of interest, tendencies toward market concentra­
tion, financial disclosure, consumer protection, and other public con­
cerns, but rather to suggest additions to the review process.
Today's dynamic environment demands greater focus upon con­

We see increased roles to be played by senior management,

internal auditors, and CPAs.

How will these supervisory roles be

First, there must be an increase in the number of quali­

fied, experienced bank auditors and supervisory examiners, and an

accentuation of the use of information management techniques to delimit
the scope of examinations and to flush out those areas of particular
risk in the institution being examined.

Secondly, the accounting pro­

fession is compelled to assume a more "examinational" role, one which
emphasizes high relative risks within an audited institution.
Yet the control augmentations I have enumerated may not suf­

I want to raise the radical notion that it is time for the

industry and regulatory bodies, both federal and state, to investigate
with seriousness the feasibility of seme kind of "peer review" or self

It is time that all of us consider hew the known short-run

trends in risk taking— known, that is, to the management within the
banking industry and within the thrift industry— can be sourced, delved
into in the examination and the CPA auditing process, to accomplish a
new quality of supervision.

As a first step, let us today look at peer

review techniques in two of the most highly controversial business

peer review in the accounting profession, and peer review in

the nuclear power industry.
In the accounting profession, the American Institute of Cer­
tified Public Accountants, in its SBC Practice Section, has designated
a Public Oversight Board (POB). Its board members are drawn from
industry leadership— for exanple, Arthur M. Wood, former chairman and
CEO of Sears— from government and from academic accountancy; the SEC
Practice Section's Executive Committee has membership from a wide
variety of firms in the accounting profession, and it utilizes a small
permanent staff.


Between 100 and 200 firms are reviewed each year, on a threeyear cycle.

The imposition of sanctions by one or another of the POB

has been notable by its absence, and the Congressional hearings before
the Dingell Subcommittee have recently reviewed this amission at sane

Nevertheless, the accounting profession should be caimended

for its voluntary effort conducted by a professional organization and
aimed at improving the quality of the auditing process.

The methodolo­

gy includes establishing professional standards for quality control and
testing each firm's ccnpliance with those standards.

The strength of

peer review lies in its reach, at one time or another touching every
major accounting firm.

The tests must include review of the supervi­

sion and review of an audit engagement.

What asset tests were performed?

How did the CPA conduct its
The exit conference following

a peer review provides the opportunity for the firm under scrutiny and
the PC©

reviewer to exchange ideas, particularly those storming from

the successful auditing done by carpeting firms.
Despite the failures in auditing which have been widely dis­
cussed, I believe that peer review in the accounting profession has had
a widespread salutary effect upon practices and upon quality control in
that profession; that is, the more numerous audit "successes."


question naturally springs to tr mind as to hew such a process might be
applicable to banking.
Admittedly, the answer is not clear.

Wbuld the banking in­

dustry voluntarily set up a board to do its own reviews, limited, say,


to quality control in the lending process or asset acquisition of a
given banking institution?

Would any commercial bank voluntarily

submit itself to the review of any of its practices or results by a
group made up in the fashion of the POB ?

Obviously, the intrusion of

competitive factors and the confidentiality of information roust be
considered, as must qualitative differences between quality control in
bank lending as compared to quality control in accounting procedures.
But, could a board be set up voluntarily which would serve as a source
of information to governmental supervisors when they set up of the
scope of their own examinations of banking firms?
However, banking is an art, a management process, not a pro­

Let us turn, therefore, to a controversial management operat­

ing area, one which has been subject to the extremes of criticism and
praise over the past six years; namely, the nuclear electric utility

This industry maintains the Institute of Nuclear Power

Operations (INPO) to promote inproved safety and reliability in the
operation of controversial nuclear plants.

INPO does not aspire to

the governmental review and oversight of the U.S. Nuclear Regulatory
Cctimission (NRC). However, INPO has a record of accomplishment as a
self-regulatory, virtually a peer review, process.

Indeed, INPO has

gone a step further in receiving the endowment of the industry of
authority to bring pressure for change upon individual members at indi­
vidual plants.

The eight members of the INPO steering ccranittee repre­

sent nuclear electric utilities from each region of the country.



board of directors is likewise composed of utility executives, as is
the president of the Institute.

An advisory council of professionals

from outside the industry draws from academe, science, industry, and
the health professions.

INPO's objectives embrace items which are, of

course, not strictly comparable to the banking industry, but its mis­
sion encourages excellence, promotes the exchange of information and
good practices among its members and, indeed, provides guidance for
members' use in training and operations.

The emphasis is to "assist

member utilities in implementing their own improvements rather than
attempting to preempt their management responsibility."*
A further activity is the Institute's analysis of nuclear
power plant events, whether those occur in the construction, testing,
or operation of nuclear plants.

The information and conclusions de­

rived from such an analysis are disseminated to members and partici­

Perhaps more interesting is that onsite reviews of member

institution plants are conducted and, in those reviews, corrective
actions are stimulated as part of an ongoing evaluation program.
Vihile such details of the POB

and the Institute of Nuclear

Power Operations peer review would have to be studied, I think that the
necessity of better, more effective supervision in today's high-risk,
high-exposure financial world demands serious consideration of ways to
draw on industry knowledge in measuring the quality of assets in
corrmercial banking and in the thrift industry through an approach
similar to the POB.


Institutional Plan for the Institute of Nuclear Power Operations,
May 1983, page 4.


I have cited two instances of favorable experience in self­
regulation among the many with which we are all familiar in order to
suggest sane methods by which the present state of supervision of bank­
ing could be improved through efforts of the industry itself— the bank­
ing and the thrift industry— and of the several professional organiza­
tions which serve them.
We have arrived at a crossroads in the banking business,
which faces a future considerably different fran the past.

New tech­

niques are therefore required to insure stability on the path to 21st
century banking.

The challenges and opportunities confronting banks

will continue to increase, and bankers will be expected to step up to
greater leadership roles in maintaining safety and soundness in the
changing banking industry.
approaches by the examiners.

Today's high-risk banking requires new
Industry self-interest, I would submit,

also necessitates your involvement in self-regulatory and other