We have argued that bank regulators should disclose more bank information than is now required.[1]  This is because supervisory practices generally do little to promote transparency, which leads to opacity that interferes with the pricing of risk and undermines financial stability. More complete and timely disclosure would improve market discipline and ultimately complement supervisory efforts.

In this post, we argue that supervisors should disclose specific aspects of bank examination ratings.  Though bank examinations can play a central role in promoting the stability of banks and the U.S. banking system, it is difficult for outsiders to assess whether bank examinations are timely and robust and whether current practices make them effective in preventing bank failures and promoting financial stability. These difficulties arise because examination ratings are currently confidential. (See for example, Tahyar (2018)[2] and Conti-Brown (2019)[3] for discussions of the history of disclosure of supervisory examination.)

There is little research on the benefits and costs of making more of the information collected in supervisory examinations available to the public. One theoretical analysis shows that if information is publicly disclosed, bankers may have greater incentives to distort the information they give to supervisors, which potentially undermines supervision, see Prescott (2008).[4] However, Prescott does assume that even if the information is not publicly disclosed, banks have incentives to hoodwink supervisors, and so penalties must be imposed when this is detected. What Prescott does not include in his analysis is mention of any benefit from public disclosure in promoting market discipline and financial stability. When there are such benefits, the clear solution is to increase the penalties for bankers for being untruthful or incomplete in their disclosures and publicly disclose information that leads to greater market discipline.  On the empirical side, there is no way for researchers (other than the staff in regulatory agencies overseeing financial institutions) or the public to assess how much bank examinations contribute to financial stability and how effectively bank supervisors execute their mandate. The public could also contribute to financial stability by promoting market discipline if people had access to this information.

It is true that the public can gain some information after a banking crisis about the performance of regulators and supervisors, but the insights that we have gained recently are quite concerning. For example, as we summarized in our post, there is a general agreement that the Silicon Valley Bank (SVB) collapse was a clear example of supervisory failure. According to congressional testimony, SVB supervisors struggled in executing their tasks for over 18 months before the bank failed. It is concerning that only at the time of the collapse did the public learn about the bank’s financial condition (see Mehran and Spatt on how regulation and supervision crowds out information production by analysts). Guynn (2024) shows that the SVB was effectively insolvent by September 22, 2022.[5] Why supervisors did not assess the Call Report data on SVB and did not internalize the mark-to-market value of the bonds that SVB owned remains a puzzle. Newell and Parkinson (2023) present the timeline of SVB’s supervisory ratings disclosed following bank failure, which suggests the examiners’ confusion and indecisiveness in updating the bank’s rating as the bank’s viability became more uncertain.[6]  Further, the typical delays in updating ratings to reflect worsening conditions suggest that incentives are not set appropriately for examiners to act in a timely manner. It is important to keep in mind that full disclosure of supervisory assessments most likely would not have helped resolve SVB because of the inadequacy of these assessments.

We discuss why examinations and assignments of ratings is a slow process and why incentives may be a significant part of the problem. We then argue that delays in downgrading a bank to reflect its true condition are detrimental to that bank’s strategic decision to turn itself around or sell itself to a healthy bank (as a failure is likely to impose costs on the public). Next, we advocate that more timely and informative disclosures are the only options for improving bank supervision, given that the dynamics of the rating assignment process are unlikely to be improved. Further, even when supervisors are highly active, disclosure of some aspects of ratings is still incredibly important as it improves bank governance. Supervision cannot solve every potential problem, and financial stability can require involvement from the market and investors, particularly for large institutions. We argue that letting in the light through more timely and informative disclosures is vital to the safety of the banking system and ultimately to the public welfare. We underscore that ratings’ disclosure has the potential to unmask supervisory failures and improve Federal Reserve governance accountability, a general point raised in our earlier post.

Supervisory bank examinations are intended to “ensure the stability of insured depository institutions by identifying undue risks and weak risk management practices.”[7]  A critical task in a bank examination is determining whether the bank’s financial condition has deteriorated and therefore merits a ratings downgrade. The aim of a downgrade is to communicate supervisory concerns to the bank and to serve as a warning that enforcement actions could be in the offing, see Bergin and Stiroh (2021).[8]  We argue that information should be communicated to the market to get the bank’s attention as well as to alert the public that supervisors are active.  In practice, downgrades often come too late for effective supervision. In communications with supervisors, we learned that the fear of being wrong in an assessment of bank risk often causes examiners and supervisors to delay decisions sometimes for several quarters or longer, even when it is quite clear that the bank is in a poor condition and the risks of further deterioration are high. Further, examiners realize that, if they change a rating without overwhelming evidence, they might be challenged by the bank’s management and perhaps by regional leaders of the reserve banks supervising the large banks. This implies that examiners will wait a long time for negative information to accumulate so that they have, given their fears, a sufficiently compelling case to downgrade. This wait often means that valuable time is lost before pressure can be put on a bank to undertake corrective actions (as in SVB’s case). Furthermore, in the case of large banks, rather than downgrading the bank — even when there is sufficient evidence to do so — supervisors may exercise a sort of “moral suasion” by warning that a downgrade is coming if management fails to undertake corrective measures. The warning might be given more than once, further delaying any enforcement actions.

Also, it is important to note that political constraints affect the implementation of supervisory decisions and policies. According to one bank CEO, delays in downgrading have occurred “because many banks had political contacts.” The political connection is likely to have played a role in SVB’s slow supervisory decision.[9] The influence of political connections has been documented in a large sample of regulatory enforcement actions, see Yue, et al. (2022).[10]  Further, Lambert (2019) documents that regulators are nearly 44 percent less likely to initiate enforcement actions against banks with lobbying activities.[11]  It is reasonable to suspect that a similar dynamic may have a strong influence on supervisors’ judgment on a downgrade decision.  If political influence does lead to poor practice, it is more likely that it does so in the case of larger banks since they can in many cases exert greater influence.

All this suggests that as the financial health of a bank deteriorates, several behavioral factors could lead to downgrades being made too late. At the same time, the downgrade persists for a long time. Turning around banks is difficult, especially when a bank is in a crisis. Raising capital and pursuing other restructuring plans will not quickly change the market’s or regulators’ perceptions about the bank risk. Once a bank is severely downgraded, bank management and regulators can hope for the arrival of an acquirer. Prescott (2024) provides an example on how regulators attempted to turnaround Commonwealth Bank, which is instructive since it suggests that little has changed since the 1970s.[12]

This underscores the contribution that the control market can potentially make to bank stability. The market can reduce the costs of failure that are imposed on the FDIC and the public. If downgrades happen faster and in a world with more disclosure, acquisitions can be made when risks are lower, thereby improving market stability. Yet, given the absence of disclosure, acquirers are likely to absorb risks that they did not identify and pay a higher acquisition premium, thus becoming vulnerable. Anticipating the unobservable risk, acquirers might be reluctant to purchase unhealthy banks unless the public absorbs some of the costs. Undoubtedly the risks are much higher for an acquisition made during a crisis (for example, Bank of America Corporation’s acquisition of Countrywide Financial and Merrill Lynch in 2008).

Objective and timely downgrades put pressure on bank management to take corrective actions, while delay tends to kick the proverbial can down the road. If regulators and supervisors are powerless to influence a bank’s governance and conduct, or are reluctant to use their authority when most needed, then it is prudent to rely on the corporate control market. What’s more, when downgrades are substantially delayed, they are likely to be ineffective in saving the bank.

A recent OCC leak indicating that 11 of 22 large banks were rated a 3 (or fair) in operational risk and governance represents a step in the right direction.[13] However, it is unclear whether the news was a delayed disclosure, see Baer (2024) for further discussion on the OCC announcement.[14]

How could the supervisory process be improved? Directing more resources for supervision at larger banks, as noted by Hirtle, et al. (2019), does not seem to lead to more timely downgrades of supervisory ratings.[15]  The U.S. banking industry has already gone through a few reforms, including improvements in supervisory processes following the regional banking crisis of 2023, but they are unlikely to fix delays in downgrades.  Further, the 2024 GAO study,  “More Timely Escalation Supervisory Action Needed,” also does not address the issues discussed here.[16]  Escalation does not overcome the frictions in the downgrade process when senior supervisors and the presidents of the reserve banks are reluctant to take actions against large banks.  The banking industry itself has also offered ways to improve examination and supervision, but does not address delays in ratings, see Baer (2024).[17]

Stricter regulators might facilitate the downgrade process, and Costello, et al., 2018, document that they are more likely to influence banks to restate Call Reports.[18]  The release of information has also been shown to affect security prices, see Badertscher, et al. (2021).[19]  Similarly, Berger, et al. (1998) document that examination ratings will also affect security prices.[20]  Thus, the transmission of information through the market would complement supervisory efforts by improving bank governance. While this is important, it is not likely to be a substitute for timely downgrades.

Given the pressures supervisors face, they cannot be relied on to address banking problems before banks get into serious trouble. Their fears, reluctance, and at times poor judgment have led to delayed downgrades that ultimately created instability in the market and the economy. Critically, we believe that these delays will persist and perhaps get worse. This is partly due to increasing concentration in the banking industry that increases banks’ political influence, which weakens supervisory independence and undermines objective judgment.

Requiring more disclosure on downgrades or examinations can partially overcome these problems. The market and analysts notice late disclosure, and that can force regulators to justify their decisions. In the process of price discovery, the market is likely to produce more information that might improve assessment of the bank’s condition. The information could pressure a bank to address its governance sooner, and early disclosures of a bank’s shaky condition could pressure it to restructure and disclose more information about prospects. Asset sales, for example, could occur in an orderly fashion and at higher prices than is typical in fire-sales. The critical point is that the risk drivers that influence supervisory examination findings are slow to revert. A slow downgrade is not likely to facilitate a turnaround, and a change in management is difficult when the bank is struggling.

Supervisors should question whether the goals of supervision are being achieved by the current practices of bank downgrades. What can be done differently, given political and other influences that tend to distort decisions? We argue that the answer is to rely more on capital markets. To improve market discipline, Mehran, and Mollineaux (2012) state that “regulators can mandate information production outside of markets through increased regulatory disclosure”.[21]The authors add that the current approaches to supervision interfere with the information content of prices. Thus, the approach produces poor bank governance and imposes costs on the public.

Three points should be noted. First, there is a perception, not grounded in evidence, that supervisors should not disclose banks’ private information as it could cause bank runs. The argument is likely a myth. The OCC leak noted earlier, and the press report on another leak on October 23, 2023 addressing regional bank conditions, are in effect disclosures.[22]These disclosures did not produce disturbance in the market or a run on any bank.  Markets and depositors react strongly when they realize that regulators are not in control, as in the 2023 crisis. Structured disclosure serves the opposite goal and reduces the risk of interconnected shocks. Thus, structured disclosure is not subject to an endogeneity critique, e.g., Bond and Goldstein (2014).[23] Second, the absence of supervisory disclosure inflicts risks, and thus cost, on the banking system and the U.S.. To reduce the risk, banks need higher equity capital in their capital structure. But a crisis leads to permanent loss of capital, Baron at al. (2024).[24]  Further, more capital erodes lending opportunities, see Bowman (2024).[25] The loss to the economy should justify the need for more bank disclosure.

There are three important lessons here. First, inspection of banks (examination ratings) is important. Second, so is determining correct ratings, considering their time-sensitive nature. Third, disclosure of ratings that can contribute to stability is vital. But progress on the first two points is likely to be limited for the reasons discussed above.

What should supervisors do differently? Fed Governor Bowman recently said, “An important step in the reform agenda – and one of the most effective reforms to build resilience against future banking stress – is to improve the prioritization of safety and soundness in the examination process, ensuring a careful focus on core financial risks. In my mind, successful prioritization involves increased transparency of expectations and a renewed focus on core financial risks.”[26] We agree, and our focus is on appropriate real-time disclosure. Supervisory practices that encourage opacity in the banking industry should be balanced against the limitations of agencies that enforce regulation and supervision and cost on the economy.

Finally, some supervisors have stressed to us that in certain supervisory cases, they felt that they were under some pressure from delays in downgrades. They saw the need, for downgrades but the decision had to be deferred without objective reasons. Ethical issues in supervisory settings should be addressed, perhaps the Fed’s Board of Governors and other agencies could ask an independent group to study the concerns of supervisors (HR and legal groups in supervisory entities cannot address this important issue). When employees who serve the public are concerned with supervisory lapses, they should be heard.

ENDNOTES

[1] https://clsbluesky.law.columbia.edu/2024/05/14/how-bank-regulation-and-supervision-can-weaken-financial-stability/

[2] https://www.davispolk.com/sites/default/files/tch_banking_perspectives_-_are_banking_regulators_special.pdf

[3] https://www.brookings.edu/articles/the-curse-of-confidential-supervisory-information/

[4] https://www.richmondfed.org/publications/research/economic_quarterly/2008/winter/prescott

[5] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4897571

[6] https://bpi.com/a-failure-of-self-examination-a-thorough-review-of-svbs-exam-reports-yields-conclusions-very-different-from-those-in-the-feds-self-assessment/

[7] https://www.fdic.gov/resources/supervision-and-examinations/examination-policies-manual/section1-1.pdf

[8] https://www.newyorkfed.org/medialibrary/media/research/epr/2021/EPR_2021_bank-ratings_bergin.pdf?sc_lang=en

[9] https://www.nytimes.com/2023/05/15/business/economy/san-francisco-fed-silicon-valley-bank.html

[10] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3075115

[11] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2517235

[12] https://www.clevelandfed.org/publications/economic-commentary/2024/ec-202406-failure-of-bank-of-the-commonwealth

[13] https://www.bloomberg.com/news/articles/2024-07-21/secret-bank-ratings-show-us-regulator-s-concern-on-handling-risk

[14] https://internationalbanker.com/banking/us-banking-agencies-have-an-operational-risk-problem/

[15] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2750313

[16] https://www.gao.gov/assets/d24106974.pdf

[17] https://bpi.com/the-bank-examination-problem-and-how-to-fix-it/

[18] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2620853

[19] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2598372

[20] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=121651

[21] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1995666

[22] https://www.americanbanker.com/news/recent-leaks-and-disclosures-reignite-debate-over-csi

[23] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1571431

[24] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3762043

[25] https://www.federalreserve.gov/newsevents/speech/bowman20240626a.htm

[26] https://www.federalreserve.gov/newsevents/speech/bowman20240718a.htm?utm_campaign=Hutchins%20Roundup&utm_medium=email&utm_content=317312060&utm_source=hs_email

This post comes to us from Hamid Mehran, a financial economist, and Chester Spatt, the Pamela R. and Kenneth B. Dunn Professor of Finance at Carnegie Mellon’s Tepper School of Business.