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Before the Conference of State Bank Supervisors, Washington, D.C.
March 9, 1998

Bank Supervision: Lessons from the Consulting Perspective
It is my pleasure to join you today. The Federal Reserve has long enjoyed a cooperative
relationship with the Conference of State Bank Supervisors, and I expect that relationship to
As you are well aware, technological and financial innovation have become the norm in
banking and bank supervision. These innovations have accelerated the pace of transactions
and increased the complexity of transactions seen throughout the banking system. This is a
pattern we can expect to continue in the years ahead. Indeed, it is this complexity and
innovation that leads us, as supervisors, toward a more risk-focused supervisory approach
with a greater emphasis on sound management processes. Only by ensuring that a bank's
management and control processes are sound can we be confident that its risks will remain
contained throughout business and market cycles.
It is not my intention today to espouse the merits of risk-focused examinations, since I trust
we all recognize the value of that approach, especially in the case of larger, more-complex
banking institutions. I would like to focus on a challenge that we face as we move more
toward risk-focused examinations. This challenge or conundrum is captured in a comment I
heard last year at a dinner hosted by the Bank Administration Institute. A leading banker at
dinner complimented a regulator for having supervisors and examiners who provided
"consultations" at the end of examinations. Since reviewing management and control
processes is very much a "consultative" activity, I suspect such comments will become more
Being perceived as being like consultants is useful, but it is not an unalloyed blessing. As I
reflected on the compliment I heard, I wondered if the consulting metaphor was really one
we should encourage. We should all do what we can to maintain a strong and vibrant
banking system that is responsive to the needs of the public. That is part of our role as
supervisors. We should also work hard to ensure that the supervision and examination
processes are not unduly burdensome to the banks we examine. We should be supportive of
financial modernization, a process that is overdue in the banking industry. We also want to
provide guidance to banks on sound practices and to evaluate the extent to which they
conduct their activities in prudent ways. But we should be cautious in fully adopting the
label "consultants."
In my comments this morning, I would like to draw on my experience as a consultant to
banks and other financial institutions to discuss some similarities and differences, as I see
them, between the role of consultant and the role of supervisor.
I raise this topic today because the recent turmoil in Asia has some roots in poor banking

performance and poor banking supervision. I believe that the market is ultimately the best
regulator of financial services, but we will still need supervision and regulation to offset the
limitations inherent in regulation from the market. The recent turmoil in Asia serves as a
reminder of the risks that financial institutions take and the systemic impact that can emerge
if supervisors are not mindful of the important role that they continue to play in containing
that risk.
Why Do We Need Management Consultants and Supervisors
Let me begin with the basic question of why firms hire management consultants. Many large
companies that hire management consultants have substantial talent, resources and expertise
of their own. A key reason they seek outside guidance is that the employees of these
companies often lack the objectivity, the cross-company and cross-industry experience, or
the specific, technical expertise that the company needs. Companies also hire consultants
simply because they want to avoid distracting key individuals from their on-going
operational duties in order to conduct a project that an outsider can perform.
Why, on the other hand, do banks hire bank supervisors? The obvious answer is that they do
not hire them at all. Supervision is found to be necessary--not only here but also in virtually
every country abroad--to protect the public's interest in the lending and deposit-taking
process. The fact that we continue to regulate banks reflects the economic concept of
"externalities" and the need to protect the safety net that most societies extend to banks. It is
not the impact of one bank's decisions on the wealth of its owners and the job security of its
workers that worries us. Bank managers must be allowed to make managerial decisions with
a minimum amount of regulatory and supervisory interference. Bank directors and managers
have strong incentives to take care in their decisions due to a natural concern for personal
job security, personal wealth, and continuing control in the active market for bank
consolidation. Some will make wise decisions, and their institutions will thrive; others will
make decisions that prove to be incorrect and their banks will suffer.
However, we know that no single bank management team, regardless of how well
intentioned, can accurately value the cost of its decisions, good or bad, on the banking
system and economy as a whole. Therefore, supervision is a way of forcing banks,
individually and collectively, to recognize the broader impact that their risk-taking and
risk-mediation decisions might have on society at large. It also substitutes for some of the
market discipline lost, and attempts to offset the "moral hazard" that arises, due to the
existence of the safety net. It is the possibility that poor managerial decisions by one bank
will then spill over to other banks and eventually to the public at large that provides the
rationale for supervision and regulation. That possibility is also a key factor driving the
Federal Reserve's need to remain a bank supervisor. Without such active, on-site experience
supervising and evaluating bank activities, the central bank would, I believe, be less
prepared to deal with financial crises that inevitably arise. In addition, the Federal Reserve is
the operator of important parts of the nation's payment system, both wholesale and retail,
and as such has a stake in the proper functioning of banks and the banking industry.
However, we should also recognize that supervision and regulation are not without costs to
banks and, in turn, to society. Therefore, I believe that we should aspire to the minimum
amount of regulation and supervision that is consistent with maintaining safety and
soundness of the banking system and with maintaining financial stability. After all, the
marketplace is ultimately the best regulator, and we should look to the market for guidance
and feedback, wherever possible.

Similarities between Consultants and Supervisors
Given these fundamentally different incentives for banks to have consultants and
supervisors, why would an obviously intelligent CEO of a major bank compliment us on
providing "consultations"? The answer is that a good examiner brings some of the same
strengths to an examination that a good consultant brings to a consulting assignment, namely
objectivity, cross-firm experience and critical technical expertise. Like consultants, the
independent assessments that examiners make are becoming more dependent on statistical
sampling and on the accuracy of a bank's internal information systems. Requiring banks to
have, on an on-going basis, sound internal procedures should reduce risks to the financial
system and lead to fewer surprises overall.
Reviewing procedures, though, entails a more subjective approach than reviewing credits.
Although analyzing credits can be complex, the potential resolutions are few. The examiner
reaches a conclusion about individual credits and the overall quality of the loan portfolio,
and his findings are communicated to the bank. Some loans are charged-off, others are
written down, and the results are clear. Addressing procedural problems, however, is rarely
so decisive because we get into judgmental areas and into a range of potentially
acceptable--and unacceptable--resolutions. In this, supervision and consulting are very
One approach consultants use to resolve the challenge of dealing with more subjective
judgments is to maintain open lines of communication between consultant and top
management. The results of a consulting assignment are rarely a surprise when the final
report is presented, and management has had an opportunity to respond to early findings and
present their perspectives. Similarly, the results of a bank examination should not come as a
surprise to bank leadership. Clear and frequent communication of supervisory guidance on
sound practice is of critical importance. Particularly in new or innovative activities, bankers
need to hear clearly which arrangements the supervisor will accept.
Another technique consultants use to analyze a subjective topic, such as bank processes, in
which several practices might be acceptable, is to have open lines of communication within
the consulting team. All team members have a chance to add their perspectives to the
potential solution. Similarly, examiners from different agencies examining a single banking
entity should be able to share perspectives and findings.
While both consultants and examiners may be forced to make judgments regarding
management processes, it is essential that such judgments be made only after reviewing the
relevant facts. For consultants, those facts may encompass a wide array of market or
company data. For examiners, those facts may be gleaned from a credit analysis and the
review of credit files. Despite all the innovation and structural changes we have witnessed
throughout the financial system, extending credit and limiting the volume of bad loans
remain the primary business of banks. Examiners will continue to need to evaluate whether a
bank's own internal assessment of its exposures is sound, which will by necessity involve a
review of a sample of loans.
In another, less appealing, way consultants and bank examiners are quite similar. In both
cases the process can be obtrusive, with outsiders asking for scarce time and attention from
bank employees. Consultants and examiners alike must learn to adjust their professional
approach to minimize the degree of disruption to the institution being served. In this regard,
the move toward more off-site work and preparatory work is to be commended, and I am
certain that it is appreciated by banks.

So in many ways, while the goals of the consultant and examiner are different, the
techniques used may be quite similar. One can imagine an effective examination process
resembling a good consulting process. Both rely, in part, on internal data. Both should be
characterized by frequent and candid conversations between bank leadership and the
leadership of the examination team. Both should help bank leadership to understand what is
considered sound practice. Both consultants and supervisors must at some level analyze the
tangible results of the management processes, be that loan quality or some other measure of
corporate performance. Finally, to be successful both consulting and examination must be
carried out with the minimum of on-site disruption after careful off-site planning.
Sharing Knowledge among Examiners
Another similarity between consultants and examiners is that there is much practical
experience gained by the professionals that must be shared with their co-workers or team
members or even more broadly among the community of professionals. For the community
of supervisors, these insights are the results of many years of first-hand experience with
banks. Consultants have developed the fancy phrase of "knowledge management" for the
process of building individual insights, sharing them with others, and finally applying the
collective knowledge through an individual professional working with a client. The
challenge, of course, is how to complete this cycle of "build-share-apply" when the
community spans several thousand people, across multiple locations and, possibly, multiple
agencies. This gathering is an example of one possible solution to this challenge. Technology,
through group software and the creation of more common, interagency tools, might prove to
be another solution. I shall return to the need for broadly shared common technology
Distinctions between Consultants and Supervisors
Now let me turn to the numerous differences between consultants and supervisors. In adding
value to the banking industry, supervisors have a major advantage over consultants in that
we have the standing and authority to influence actions industry-wide. That ability to
influence state or national policies is an important aspect of our work and one that helps to
motivate and retain our key people.
This fact ties directly to the sound practice papers we provide. As supervisors, we need to
share what we learn to help the industry manage and control its risk. To develop industry
guidance, we do well in looking to leaders within the industry, and to institutions that know
their business best. The knowledge we gain from our associations with so many banks also
accommodates the development of new regulatory paradigms. The recently adopted rule for
market risk that is based on the internal models of banks is a good example. Without the
in-depth access to virtually all of the world's leading trading banks and to their experiences
and observations, supervisors collectively could not have developed their own understanding
and the willingness to pursue this approach.
This new approach highlights a series of significant differences between consultants and
First, consultants often find themselves acting as "change leaders," attempting to get their
clients to take greater business risk based on consulting judgment. Supervisors recognize that
banks are in the business of taking risk, but our goal is not to encourage or to discourage
risk-taking by individual banks. Our goal is to have banks recognize and manage well the
risk they are taking, price the risk appropriately and avoid undue concentrations of risk. In
that way we hope to reduce systemic risk.

A second difference between consultants and supervisors is in the need for consistency
across banks. Consultants generally place little value on consistency across clients. The best
consultants tailor solutions to each individual client. Therefore, two clients served by the
same consulting firm on the same topic may receive different sets of recommendations.
Supervisors, by comparison, properly put a premium on consistency across banks and over
time. We do not want to create an unstable market by giving inconsistent examination
A third difference that emerges is an appetite for novel professional approaches. Senior
consultants reward younger professionals who develop new approaches. Within the
fraternity of supervisors we want to maintain modern approaches to examination and
supervision, but should only adopt them widely once we are sure they lead to the desired
Finally, you may recall that earlier I referred to the communication and feedback required in
order for an examination to have the impact of a good consultative process. The challenge in
providing this feedback is in knowing just how far to go. As supervisors, we need to
communicate our views, but we must avoid making operating decisions for banks.
Supervisors, unlike consultants, must let banks make independent judgments. The
responsibility for sound banking is with the banks, and it is they who must, ultimately,
develop and take full responsibility for their decisions. Supervisors must be free to criticize
conditions that, if not corrected, may lead to heightened risk in the future. Unlike
consultants, supervisors have in their arsenal the power to effect change not only through
examination of findings but also through moral suasion, a strong bully pulpit and ultimately,
supervisory guidance, regulations and enforcement actions.
One critical area where currently we are exercising the power of moral suasion is in
connection with the possible decline in credit underwriting standards that may be becoming
widespread. For more than two years now, we have heard persistent reports of declines in
lending terms, conditions, and standards. It is not just isolated reports from some examiners.
Leading bankers, such as John Medlin of Wachovia, and survey data, also support these
The question then becomes "what should we do?" We can certainly expect that in the next
economic downturn credit problems will rise and weaker lending standards, if they exist, will
only make matters worse. While the lending decision is ultimately that of the banks, this is
an important area in which we can offer advice and general counsel. We should not create
an artificial credit crunch, and I do not think that we are at risk of doing that, but we can and
should urge caution that is based simply on our long experience in watching business cycles.
We can continue to make sure that bankers, themselves, understand their own procedures
and the risks that they face. We all seem to be taking a more aggressive approach on this
issue, and I expect that we will remain vigilant to sound the alarm when necessary.
Interagency Coordination Efforts
Throughout my comments I have noted a number of points that bear directly on initiatives of
state and federal supervisors to work together toward a stronger supervisory process. As the
U.S. banking system becomes more entwined through interstate banking and branching, it
becomes ever more critical that we all coordinate our efforts in maintaining a healthy, viable,
and attractive dual banking system. It is also important for states to work to minimize
unnecessary distinctions that slow the progress of interstate banking.

I mentioned, for example, the need to modernize U.S. banking laws, share practical
supervisory experiences, maintain consistency, reduce intrusion during the bank examination
process and, in general, improve the overall efficiency of our staffs. These are not new
challenges and, indeed, are goals that we collectively have been working toward successfully
for some time through the State-Federal Working Group and other forums. As we all know,
state banking authorities have done much to advance interstate banking and branching and
to work together and with federal authorities toward a seamless oversight process. The statefederal protocol has helped greatly to bring about that seamless approach and is a crucial
element in maintaining the viability of the state banking charter.
Individual states and the state charter, in turn, have provided the industry with important
flexibility to experiment in developing new banking products and delivery systems. In this
and in many other ways, the state charter and the dual banking system have served the
country well. Fortunately, the dual banking system seems healthy. Consider, for example,
that of the 207 new banking institutions chartered last year, 146 were state chartered.
Adapting available technology to examinations and to sharing insights among examiners is
another area in which significant progress has been made through our joint efforts to
produce more efficient examinations. As you may know, the FDIC's ALERT system now
permits examiners to download bank data onto their own PCs in order to analyze exposures
and prepare for upcoming examinations. It is being used widely by many states and by a
number of Federal Reserve Banks; more are likely to learn about and use it in the months
ahead. The Fed's own ELVIS program is another important advance that assists examiners
through the risk-focused process for community banks that is being used by the Fed and
FDIC and by most states.
Looking forward, examiners should soon be able to use the "GENESYS" system to access a
broad range of automated information contained in supervisory databases and download it
into their examination reports. Together, these and other initiatives--including greater use of
analyst and examiner electronic desktops, new web pages, and expanded data access
techniques between state and federal supervisors--have helped significantly to improve the
efficiency of our examiners and to create a less intrusive supervisory process. We should all
be pleased with these results and should expect the process to become even better in the
months and years to come.
In closing, I see many challenges ahead for us all, as we adapt the supervisory process to
keep pace with events in financial markets. In some respects consultants and bank
supervisors have much to share and can learn from one another:
1. Consultants and supervisors must have open, trust-based channels of communication
with bank management and among their peers. Both must add value by analyzing both
processes and the outcomes of those processes. They are both well advised to limit
their intrusiveness while not foregoing a thorough and professional inquiry.
2. Both consultants and supervisors face the challenge of building, sharing and applying
professional knowledge and skills in a rapidly changing business environment. The
failure to manage our knowledge within teams, within agencies and even across
agencies will certainly result in wasted effort and may even result in a caliber of
supervision that does not keep pace with changing financial technology and increased
sophistication by banks. The Federal-state coordination efforts that I mentioned are an

example of this needed cooperation.
However, while it might be quite appealing to speak of supervisors as acting more like
consultants, in many critical ways the consulting metaphor does not work very well for
supervisors. There are at least three factors that make consulting an inappropriate model for
supervisors to follow:
1. Consultants are hired by management and work to add value to the shareholders that
management represents. Supervisors, in contrast, ultimately work for the public at
large. Rather than adding shareholder value, supervisors seek to reduce or eliminate
excessive risks to the financial system and the federal safety net.
2. Supervisors have much more impact in the banking industry than even the most savvy
or articulate consultant. We must be willing to exercise that moral and legal authority
to forestall as best we can practices that we know might become harmful even before
the full results of such practices become evident. In this we may not always be
3. Finally, consultants can be wrong with only relatively limited consequences. The
caliber of their advice is rarely subject to after-the-fact scrutiny. When a consulting
firm makes a mistake, it may lose a client and that company may lose some money.
When a banking agency fails to act, the consequences can be widespread for the
economy and the public at large.
To keep the public's trust, we need to be ever mindful of whose interests we serve. We do
want to minimize the burden of supervision. We do want to foster modernization. We must
stay current with the latest financial techniques. We can assist institutions by identifying
weaknesses and, at times, we can offer views toward resolution. Ultimately, however, we are
forced to supervise and regulate banks in the interest of the public.
Thank you.

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