Credit risk management update: Contributions from the NinthAmy Kytonen, Vice President

Credit risk arises from the potential that a borrower or counterparty will fail to

perform on an obligation. For most banks, loans are the largest and most obvious source of credit risk. However, there are other sources of credit risk that arise when adverse developments disrupt the orderly operation or stability of the banking system or money and capital markets, or the viability of key market players. Examples of adverse developments range

from banking panics, stock market crashes, security breaches, and financial bubbles to currency crises and sovereign defaults. In such situations, financial institutions may experience difficulties in obtaining orderly final settlement of transactions in their accounts or in obtaining funds more generally. These difficulties can spread rapidly to other institutions and markets, ultimately leading to major disruptions to the financial system.

So what is the Fed doing to mitigate such disruptions? I’m pleased to report that there’s a lot of activity concerning credit risk, and I’m proud of the Ninth District’s lead role. In 2017, the Minneapolis Fed began leading the Subcommittee on Credit Risk Management

(SCRM). SCRM assists Reserve Bank presidents in developing and implementing policies for managing discount window credit, condition

SEPTEMBER 2019

Banking IN THE NINTH

REGULATORY UPDATE

continued on page 2

continued on page 2

NINTH DISTRICT HIGHLIGHTS

Community Bank Conference

This is the seventh year that the Federal Reserve System has partnered with the

Conference of State Banking Supervisors (CSBS) to host a research conference focused on community banks, called Community Banking in the 21st Century. Last year, the Federal Deposit Insurance Corporation (FDIC) also joined as a co-sponsor and will continue to be one. The event is planned by a

volunteer committee, which I joined this year, and it will be hosted by the Federal Reserve Bank of St. Louis on October 1–2. The attendees typically include academics, regulators, and community bankers, among others. There are three main parts to this event: research paper presentations and discussions, the emerging scholars program, and the community bank case study competition.

In this article, I will highlight these elements as well as other features of the conference. I will also provide details on where you can find more information on this conference and how you can livestream the event.

Research papersGiven that the main focus of the conference is for academics and others to present research papers on real-life industry issues related to community banks, the conference planning committee starts organizing the event by putting out a call for papers several months before the event. Over the years, an increasing number of papers have been submitted from researchers all over the world. The event sponsors select experts to read and review every paper that is submitted, and they ultimately choose the papers whose authors will be invited to present at the conference. This year, 12 papers were

Christine Gaffney

SCRM assists Reserve Bank

presidents in developing and

implementing policies for

managing discount window

credit, condition monitoring,

and payment system risk.

chosen for presentation. You can see past papers at the following link: https://www.communitybanking.org/research.

Emerging scholars programThe second element of this conference is the emerging scholars program, which is targeted to Ph.D. students who are focusing on banking-related topics. To apply for the program, students submit a brief application to the conference organizers. Applications are typically due in mid-June, and the scholars are announced in late July. The scholars who are selected are invited to attend the conference, with their travel-related expenses paid. They also have the opportunity to network with attendees. More information on the program and the scholars selected for 2019 is at: https://www.communitybanking.org/news/2019-emerging-scholars-program-applications-due-june-14. If you know Ph.D. students with a banking focus, encourage them to apply for the 2020 program!

Community bank case study competitionThe third element of the conference is the CSBS-sponsored community bank case study competition. This year, 58 teams from 44 colleges and universities competed. The CSBS partners with the conference planners and state banking agencies to serve as judges for this competition. I have served as a judge for the past two years and continue to be impressed by the ambition and knowledge of these young students, who partner with local

community banks to explore issues on a predetermined topic. The students produce a paper on the topic and a 10-minute video. This year’s first place team comes from Juniata College in Pennsylvania. Each of the students on the team will receive a $1,000 scholarship. The winning team and their faculty adviser will also attend the conference and present their study. Like the scholars, they will have the opportunity to network with other attendees. Details about the 2019 competition winners, as well as historical details on the case study competition, are available at: http://www.cvent.com/events/csbs-community-bank-case-study-competition/event-summary-15d1377af2114ab4a9f8112ec45aed30.aspx.

Other conference featuresIn addition to the conference elements already discussed, this event features keynote speakers throughout the two days. Among those speaking this year will be Governor Michelle Bowman of the Federal Reserve System, President Patrick Harker of the Federal Reserve Bank of Philadelphia, and Chairman Jelena McWilliams of the FDIC.

Although attendance at the conference is by invitation and is limited, you can livestream it from the comfort of your office. I strongly encourage you to review the website, which outlines the agenda and provides more details on everything discussed here. If you are interested in parts of the event, or all of it, you are welcome to join in by livestream. The conference website is https://www.communitybanking.org/.

REGULATORY UPDATE continued from page 1

monitoring, and payment system risk. The discount window officer of the Minneapolis Fed chairs SCRM and, in this role, her principal activities include encouraging collaboration among the discount window officers of Reserve Banks across the country, with the goal of ensuring consistent application of policies throughout the Federal Reserve System. In a nutshell, SCRM ensures that all things related to managing credit risk are considered nationwide, and the Minneapolis Fed plays a key role.

While SCRM provides a forum for discussing and influencing policy, this group is also very focused on developing and implementing tangible solutions that seek to reduce credit risk. For example, in October 2017, Reserve Banks implemented a voluntary, no-cost pilot program that monitors Fedwire funds transfers in real time for institutions with total assets under $50 billion. This service,

also known as real-time monitoring, rejects Fedwire funds transfers that would cause an overdraft in a participating institution’s Reserve Bank account in excess of its net debit cap, unless the institution has opted out of the program. SCRM expects that this program will provide risk mitigation benefits for the participating institutions as well as the Reserve Banks.

Last summer, the Board of Governors of the Federal Reserve System sought input on expanding the real-time monitoring service to institutions of all asset sizes. While the comments are being considered, SCRM continues to work on your behalf. The Federal Reserve strives to offer secure and reliable liquidity to financial institutions via the discount window. Your feedback is critical to helping us determine how we’re doing, identifying opportunities for improvement, and developing new functions.

Around August 6, we released a short survey consisting of about a dozen questions. We hope that you completed the survey to share your valuable insights with SCRM. As another option, if you have questions or would like to discuss future services, please email frbsurveys@chi.frb.org or, for general questions, contact your Reserve Bank’s discount window staff.

Your feedback is critical to

helping us determine how we’re

doing, identifying opportunities

for improvement, and

developing new functions.

NINTH DISTRICT HIGHLIGHTS continued from page 1

Federal Reserve initiative to advance community banking regulatory reliefChris Riba, Assistant Vice President

For the past several years, the Federal Reserve System, banking industry, other regulators, and Congress have increased their focus

on supporting community banks and right-sizing regulations for smaller institutions. We are now almost 18 months removed from the passing of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), and the impact of the provisions on community banks is becoming clearer. The supervisory agencies are currently implementing the community bank leverage ratio and collaborating with the banking industry to identify additional opportunities to streamline regulatory reporting. However, debate continues about whether EGRRCPA went far enough in providing regulatory relief, especially for community banking organizations. To help address this concern, the Federal Reserve has established a working group solely focused on reviewing small bank supervision and regulation.

Since taking office as a member of the Board of Governors of the Federal Reserve System on November 26, 2018, Governor Michelle Bowman has spoken often about the importance of community banking and appropriately tailoring supervision and regulation. Bowman is the first to fill the Federal Reserve Board position created by statute in 2015 to ensure adequate representation of community banking interests. She is well-positioned for the role, given her post-crisis experience as a fifth-generation community banker from rural Kansas, as well as her recent time serving as the Kansas State bank commissioner. Since taking office, Governor Bowman has conducted extensive outreach to hear firsthand the issues affecting community banks and the communities they serve.

On June 5, 2019, Bowman testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs regarding her nomination to serve a full term on the board in the community-banking seat. Bowman stated that she “formed a working group of experts from across the Federal Reserve System to launch a comprehensive review of the Fed’s supervisory work with small regional and community banks.” She also stated that the working group is “looking for ways to optimize our supervision and regulation to ensure it adapts to the on-the-ground realities of an evolving industry and changing consumer expectations while maintaining the safety and soundness of our banking system.”

The Federal Reserve Bank of Minneapolis supports additional changes to community bank supervision and regulation and has a unique opportunity to significantly contribute to the working group, named the Small Bank Supervision Working Group (SBSWG), through Senior Vice President Christine Gaffney’s role as co-chair.

At the SBSWG’s kickoff meeting in mid-July, Bowman provided her vision for the group, in which her passion for community banks was evident. SBSWG members shared this same passion and came well-stocked with ideas, sharing about opportunities to reduce burden related to small bank supervision.

The SBSWG reports directly to Bowman and is distinctly focused on the small, low-risk banks throughout the nation that are so vital to their local communities. The primary responsibilities of the SBSWG will be to:

1. Identify initiatives and prepare proposals for consideration that have the potential to reduce burden, improve supervisory effectiveness, or generate supervisory efficiencies in small bank supervision while maintaining safety and soundness.

2. Consult and advise Bowman on policy and regulation proposals, with a focus on the capacity of smaller banks to comply with such proposals.

The scope of activities is not limited to just safety and soundness–related supervision. The SBSWG has been tasked with assessing the burden associated with all aspects of community bank supervision and regulation, including IT, BSA/AML, Consumer Affairs, Applications, and Enforcement Actions. To further that initiative, Bowman chose group members with varying backgrounds and expertise.

Although the SBSWG will leverage previous Federal Reserve initiatives to reduce burden, the group has been tasked with developing new and innovative approaches to supervision and regulation. These directives align with the Minneapolis Fed’s strategies of achieving excellence in core operations and growing a culture of continuous improvement, as well as the Federal Reserve Board’s Supervision and Regulation strategic plan themes of being innovative, agile, and optimal. The directives also align with the final step of The Minneapolis Plan to End Too Big to Fail, a policy proposal published in December 2017 that recommends allowing “the government to reform its current supervision and regulation of community banks to a simpler and less-burdensome system while maintaining its ability to identify and address bank risk-taking that threatens solvency.” The SBSWG plans to have initial proposals for Bowman’s consideration by the end of September, knowing that implementing changes will require more time, especially if the proposals require interagency or legislative action.

The Federal Reserve System is committed to the community bank model and is keenly focused on its continued success. In an age of innovation, the Fed wants to encourage creativity in bankers to adapt to the changing environment. While the overall goal is to right-size supervision, it is important to keep in mind that supervision is intended to improve bank stability and viability into the future.

The Minneapolis Fed recognizes that regulatory burden has different meanings for different institutions. We would love to hear where you think we can provide further relief, especially those areas that cause the most pain for the least gain. Please send any questions or comments to Chris Riba at christian.riba@mpls.frb.org.

SAFETY & SOUNDNESS UPDATE

In this article, we will discuss Ninth District banks’ (primarily community banks) reliance on noninterest income and how it has changed over time.

BackgroundBank profits are attributable to both interest (revenue earned from lending and investment securities) and noninterest (charges and fees) income. The interest margin banks earn by serving as the intermediary between depositors and borrowers continues to be the primary source of revenue for most financial institutions. However, banks also view noninterest income as a strategic line item on the income statement. When net interest margins are compressed and interest rates are low, banks seek other revenue streams such as noninterest income to boost profitability. Institutions charge fees that generate noninterest income as a way to increase revenue and ensure liquidity in the event of increased default rates. Banks also look to noninterest income because it may have traits different from interest income and could lead to lower risk through greater revenue diversification.

Sources of noninterest incomeBanks earn noninterest income by charging for activities related to traditional banking services, such as taking deposits and processing transactions. In recent years, larger banks have also generated significant noninterest income from nontraditional activities such as investment banking, securities brokerage, underwriting, and mutual funds

sales. However, nontraditional activities are not common among community banks.

In Call Reports, noninterest income for Ninth District banks is classified primarily into two segments: deposit service charges (monthly account, minimum balance, NSF, overdraft, ATM, stop payment, and returned item fees) and other noninterest income (credit-card-related fees, safe deposit box and safekeeping services, lending fees, cash management services, fiduciary account services, and insurance activities).

The relative contribution of the two segments of noninterest income to total noninterest income has changed over time for Ninth District

banks. The contribution of deposit service charges has declined, whereas other noninterest income has increased. The nearly simultaneous changes in the regulatory environment and in macroeconomic conditions between 2009 and 2011 make it hard to determine the direct contributing factors for these changes. The factors contributing to reduced deposit service charges include regulatory changes, such as amendments to Regulation E, as well as changes in industry practices, such as time-order posting. The Regulation E amendments require customers to opt in to have overdraft coverage for their deposit accounts, which has resulted in fewer accounts with overdraft coverage and therefore reduced fee income. Transaction-posting practices changed from an approach

CONDITIONS CORNER

Noninterest Income in Ninth District Banksby Steven Enfield, Supervisory Examiner

The factors contributing to

reduced deposit service charges

include regulatory changes,

such as amendments to

Regulation E, as well as changes

in industry practices, such as

time-order posting.

based on transaction size (from highest to lowest) to processing of transactions chronologically, resulting in lower overdraft fees.

However, the increasing number of loan originations, credit card transactions, and debit interchange transactions all contribute to the continued growth of the other-noninterest-income segment since the recession. While the average debit interchange fee has declined due to implementation of the Durbin Amendment in 2012, the effect on institutions with less than $10 billion in total assets (a majority of Ninth District institutions) has been lower because debit interchange transactions at such banks are exempt from the fee cap.

Noninterest income trendsThe time trend of the ratio of noninterest income to net income for the median firm shows that noninterest income accounted for about 50 percent of net income in 2001 and again in 2013. Since 2013, noninterest income has declined to 33 percent of net income. Banks continue to generate an increasing volume of noninterest income dollars. However, interest income has risen more rapidly due to loan growth as well as rising interest rates, resulting in a declining share for noninterest income.

An alternative way to look at Ninth District banks’ median noninterest income is to compare it with total revenue (interest income plus noninterest income plus realized gains/losses on securities),

since net income can be significantly affected by expenses and income taxes. Noninterest income contributes modestly to total revenue. However, since 2013, the volume of noninterest income has increased at a slower rate than total revenues, which have outpaced noninterest income because of increased loan activity and rising interest rates.

The ratio of noninterest income to average assets is less susceptible to economic cycles and therefore more suited to observing broader trends over time. Median noninterest income as a percentage of average assets has declined from 0.57 percent of total assets in Q1 2001 to 0.37 percent in Q1 2019, a 35 percent decline. However, the ratio remained relatively static from late 2000 to 2003 and again from late 2009 through 2014; these periods include recessions, when loans and consequently net interest income grow slowly or even shrink. This lack of sensitivity to the economic cycle and interest rates makes this income stream appealing to banks. Since 2014, as loans have continued to grow and interest rates have increased, noninterest income has been a less significant segment of total income.

ConclusionThe noncyclical nature of noninterest income enhances its appeal for community banks. This appeal is tempered by customer preference for lowered transaction costs and limited by consumer regulation in some areas. Noninterest income continues to contribute to the revenues at community banks, albeit at a lower level than in the past.

Since 2014, as loans have

continued to grow and

interest rates have increased,

noninterest income has been

a less significant segment of

total income.