[Senate Hearing 112-172]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-172

 
 ENHANCING SAFETY AND SOUNDNESS: LESSONS LEARNED AND OPPORTUNITIES FOR 
                         CONTINUED IMPROVEMENT

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
             FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

  EXAMINING OPPORTUNITIES FOR CONTINUED IMPROVEMENT IN THE SAFETY AND 
                    SOUNDNESS OF OUR BANKING SYSTEM

                               __________

                             JUNE 15, 2011

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     Levon Bagramian, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

     Subcommittee on Financial Institutions and Consumer Protection

                     SHERROD BROWN, Ohio, Chairman

            BOB CORKER, Tennessee, Ranking Republican Member

JACK REED, Rhode Island              JERRY MORAN, Kansas
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MIKE JOHANNS, Nebraska
DANIEL K. AKAKA, Hawaii              PATRICK J. TOOMEY, Pennsylvania
JON TESTER, Montana                  JIM DeMINT, South Carolina
HERB KOHL, Wisconsin                 DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon
KAY HAGAN, North Carolina

               Graham Steele, Subcommittee Staff Director

         Michael Bright, Republican Subcommittee Staff Director

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, JUNE 15, 2011

                                                                   Page

Opening statement of Chairman Brown..............................     1

Opening statements, comments, or prepared statements of:
    Senator Corker...............................................     2

                               WITNESSES

Michael R. Foley, Senior Associate Director, Division of Banking 
  Supervision and Regulation, Board of Governors of the Federal 
  Reserve System.................................................     4
    Prepared statement...........................................    31
    Responses to written questions of:
        Senator Reed.............................................    59
        Senator Merkley..........................................    59
Christopher J. Spoth, Senior Deputy Director, Division of Risk 
  Management Supervision, Federal Deposit Insurance Corporation..     6
    Prepared statement...........................................    34
David K. Wilson, Deputy Comptroller, Credit and Market Risk, 
  Office of the Comptroller of the Currency......................     8
    Prepared statement...........................................    39
    Responses to written questions of:
        Chairman Brown...........................................    61
        Senator Reed.............................................    63
        Senator Merkley..........................................    64
Salvatore Marranca, Director, President, and Chief Executive 
  Officer, Cattraugus County Bank, Little Valley, New York.......    19
    Prepared statement...........................................    52
Frank A. Suellentrop, Chairman and President, Legacy Bank, 
  Colwich,
  Kansas.........................................................    21
    Prepared statement...........................................    56

              Additional Material Supplied for the Record

Statement submitted by the American Bankers Association..........    68

                                 (iii)


 ENHANCING SAFETY AND SOUNDNESS: LESSONS LEARNED AND OPPORTUNITIES FOR 
                         CONTINUED IMPROVEMENT

                              ----------                              


                        WEDNESDAY, JUNE 15, 2011

                                       U.S. Senate,
                 Subcommittee on Financial Institutions and
                                       Consumer Protection,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 10:04 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Sherrod Brown, Chairman of the 
Subcommittee, presiding.

          OPENING STATEMENT OF CHAIRMAN SHERROD BROWN

    Chairman Brown. The Subcommittee on Financial Institutions 
and Consumer Protection will come to order. I will do a brief 
opening statement, call on the Ranking Member, Senator Corker 
from Tennessee, and then I think Senator Reed and I believe 
Senator Moran will be here for opening statements, and Senator 
Moran wants to introduce somebody in the second panel.
    From 1999 to 2007, Wall Street in many ways was a big party 
without adult supervision. Mortgage originators, investors, and 
investment banks all made money. Large megabanks made lots and 
lots of money. Citigroup's CEO, Chuck Prince, famously asked 
Treasury Secretary Hank Paulson, ``Isn't there something you 
can do to order us not to take all of these risks?'' The answer 
was, ``Yes, but no one did.'' And so Prince concluded, ``As 
long as the music is playing, you have got to get up and 
dance.''
    As a former Fed Chairman once said, ``The Fed's job is to 
take away the punch bowl just as the party gets going.'' So 
where were the regulators? One Fed supervisor told the 
Financial Crisis Inquiry Commission, ``Citigroup was earning $4 
to $5 billion a quarter. When that kind of money is flowing out 
quarter after quarter, it is very hard to challenge.''
    While the securitization machine was in full swing, Wall 
Street basically wrote its own rules. Banking regulators relied 
on Wall Street's own internal risk models and allowed the banks 
to hold no capital buffer against their subprime securities 
while these securities were rubber-stamped as AAA by the rating 
agencies. The OCC's head of large bank supervision has 
acknowledged that they did not have enough information about 
market risk and failed to intervene before the crisis.
    According to a 2009 evaluation, the New York Fed's 
supervision of Citigroup ``lacked a disciplined and proactive 
approach in assessing and validating actions taken by the firm 
to address supervisory issues.''
    The former head of the Office of Thrift Supervision 
compared its ability to regulate AIG to that of a gnat on an 
elephant. With supervision like this, the party was sure to end 
in financial disaster.
    Now there is a constant drumbeat on Wall Street and in 
Washington that focusing on safe and sound financial practices 
will hold back our economic recovery. Wall Street and my 
conservative colleagues in Washington have a bad case of 
amnesia. They have forgotten that poor safety and soundness 
oversight helped push us toward a fiscal crisis and a disaster 
in our economy. The Congressional Budget Office projects the 
financial crisis will increase Federal debt held by the private 
sector by 40 percent of GDP. Standard & Poor's estimates that 
another financial sector bailout could have up-front costs as 
high as $5 trillion.
    These are not the only costs. We know home prices have 
fallen by more than they did during the Depression; 28 percent 
of homeowners are currently underwater, owing more on their 
house than their house is worth. Reports of foreclosure fraud 
and mortgage-backed security failures are all too commonplace.
    Lax supervision also makes it harder to hold wrongdoers 
accountable because law enforcement agencies rely only on 
referrals too often only from bank regulators. As the New York 
Times noted in April, the Office of Thrift Supervision has not 
referred a single case to the Justice Department since 2000 and 
the OCC has referred only three. When laws can be ignored, then 
property can be taken from its rightful owners, homeowners and 
investors, and given to servicers and originators. A safe and 
sound banking system should attract capital from investors and 
provide it to borrowers to finance productive economic 
activity.
    Guided by clear-cut, sensible rules, our banking system for 
over five decades has been a model of safety and security for 
the world, yet it is clear that we forgot the lessons learned 
in prior bank crises at home and abroad that an unsafe and 
unsound banking system destroys wealth and drains resources 
from the rest of the economy. I am afraid that American 
families and investors, simply put, have lost faith in our 
financial system.
    So my question to the witnesses is: What are you doing--and 
those questions will be more specific from all of us after 
statements from us and you. What are you doing to restore Main 
Street's confidence? What have you learned about sound bank 
regulation? How has your approach changed? And what is being 
done right now before all the provisions of Dodd-Frank take 
effect to prevent another collapse of our banking system?
    Senator Corker.

                STATEMENT OF SENATOR BOB CORKER

    Senator Corker. Thank you, Mr. Chairman. That was quite a 
statement.
    I want to thank each of you for coming and thank you for 
what you do. I will say that there is no question that I think 
people on both sides of the aisle would agree that we have to 
figure out a way to keep regulation from being procyclical 
where, when things are really good, people loosen up, and when 
things are really bad, we create a self-fulfilling prophecy by 
overregulating. And I think probably everybody would agree that 
that is a problem that we have got to keep from happening.
    But I have to tell you, I think I am amazed. Congress 
certainly was part of the party and was pouring some of the 
alcohol in the punch bowl, and, you know, I look at Dodd-Frank 
as an incredible exercise of laziness by Congress where 
basically Congress punted all the tough decisions to 
regulators, trying to act like it had done something great. And 
I think the Financial Times had the best summary of it about a 
week after they had an analysis, and it said, ``So many pages, 
so little content.'' And I find it hilarious--it would be 
hilarious except for the damage that it is doing to our country 
right now.
    You know, Dodd-Frank was basically put in place and rushed 
the way that it was to create clarity in the markets, and 
anything but that has happened. The fact is that, you know, 
Congress punted all tough decisions to regulators, did not give 
the clarity. Then I find it, again, hilarious except for the 
damage that is being done that we now have Senators on both 
sides of the aisle acting as supplicants to regulators, begging 
them not to do certain things because we have turned over all 
of the power as it relates to these financial institutions to 
regulators without really giving the type of direction that we 
should have given.
    So I think over time historically, looking at Dodd-Frank, 
people are going to look at it as a minor disaster as it 
relates to our economy. I do wish we had taken more time to do 
the work we needed to do to understand the issues instead of 
just, as Congress typically does, acting like we did something 
great but basically have asked the regulators to make hundreds 
and hundreds of rules in a short amount of time. I mean, that 
alone we all know is going to lead to all kinds of unintended 
consequences.
    So as we are pointing fingers, I certainly hope fingers 
will be pointed, as they should be, at the U.S. Senate and 
Congress for not doing the oversight that it should have done 
while the party was going on, for basically fueling it with 
much of the housing policies, and then now basically punting 
much of our responsibilities to regulators, creating a 
tremendous lack of clarity out there. And I do hope while the 
regulators, in my opinion, have made some bad decisions over 
the course of the last couple months, several months, this last 
year, the fact is that we are all in this together, and I think 
we all do want a sound financial system with appropriate 
reserves and all of those types of things.
    So I think the pendulum has swung too far. I think 
Congress, just like regulators do, on a procyclical basis, the 
regulators overregulate during the bad times. We are seeing it 
throughout our country, especially with community banks. I 
think Congress has done the same thing, and instead of 
surgically looking at the problems and prescriptively trying to 
deal with those, we wrote this massive, massive, massive bill 
that has given the regulators tremendous powers, many of which 
the regulators do not want.
    You know, we complain about regulatory overreach, and in 
the case of Dodd-Frank, I think the regulators are saying, 
``Please, do not ask us to do all these things in the short 
amount of time that you have given us.''
    So, with that, I look forward to your testimony, and I do 
that with a smile, and I thank you for being here.
    Chairman Brown. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman, for convening this 
hearing.
    Chairman Brown. Good statement. Thank you.
    Michael Foley is a Senior Associate Director of the Federal 
Reserve Board with responsibility for large bank supervision. 
In that role he cochairs a system-wide multidisciplinary 
committee that is responsible for implementing a coordinated, 
comprehensive supervisory program for large complex banking 
organizations overseeing horizontal examinations and evaluating 
the findings from key supervisory activities. He has served in 
that capacity since the formation of this group in mid-2010. 
Previously, he was senior adviser to the Director of Banking 
Supervision and Regulation beginning in late 2008.
    Christopher Spoth is Senior Deputy Director of the FDIC's 
Division of Risk Management Supervision. His responsibilities 
include oversight of the FDIC's supervisory programs for safety 
and soundness and bank secrecy, antimoney laundering. Prior to 
his current appointment, Mr. Spoth was regional director of the 
FDIC's New York Region. Welcome.
    David Wilson was appointed Deputy Comptroller for Credit 
and Market Risk at the Office of the Comptroller of the 
Currency in June 2010. In this role Mr. Wilson is a key adviser 
to OCC's senior management on evaluating credit risk. He also 
provides expertise on other major policy matters affecting 
national bank lending activities. Mr. Wilson cochairs OCC's 
National Risk Committee and supplies executive direction in 
analyzing emerging risks to the financial banking system and 
establishing bank supervisory policy.
    Mr. Foley, if you would begin.

   STATEMENT OF MICHAEL R. FOLEY, SENIOR ASSOCIATE DIRECTOR, 
   DIVISION OF BANKING SUPERVISION AND REGULATION, BOARD OF 
            GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Foley. Thank you, Chairman Brown, Ranking Member 
Corker, and other Members of the Subcommittee. I appreciate the 
opportunity to testify today regarding the Federal Reserve 
Board's supervision of financial institutions and, in 
particular, changes that we have made and are in the process of 
making to enhance our supervisory opportunities over these 
firms. As you mentioned, I am a Senior Associate Director at 
the Federal Reserve. I am responsible for the largest banking 
institutions.
    The financial crisis revealed a number of vulnerabilities 
in the financial system and in the regulatory framework in the 
United States. Many of those have been addressed by the Dodd-
Frank Act, but in addition, the Federal Reserve has taken a 
number of steps to strengthen our oversight of the largest, 
most complex financial institutions and to broaden our 
perspective to include a more macroprudential approach to 
supervision.
    To that end, as you mentioned, we have established a new 
governance structure for large bank supervision. This was led 
by a number of senior officials from across the Federal Reserve 
System with expertise in a number of areas--macroeconomics, 
capital markets, payment systems--in addition to bank 
supervisors.
    This committee is responsible for helping us to identify 
potential threats both to individual firms and to the system 
more broadly, to set supervisory priorities and strategies for 
the largest institutions, and to review the findings and the 
work of the examiners on-site at these institutions.
    The Supervisory Capital Assessment Program, which was led 
by the Federal Reserve in early 2009, helped to stabilize the 
U.S. financial system, but also demonstrated the feasibility 
and the benefits of employing an across-firm macroprudential 
approach to the supervision of the largest firms. As a result, 
our examiners are making greater use of these horizontal 
assessments. The most recent example of this is the 
Comprehensive Capital Analysis and Review, or the CCAR, which 
we completed earlier this year in cooperation with our 
colleagues from the OCC and the FDIC.
    The CCAR also, very importantly, represented a substantial 
strengthening of previous approaches by supervisors to ensure 
that large firms themselves have robust internal processes for 
managing their capital resources, that resulted in a forward-
looking assessment of capital adequacy, both for individual 
firms and also for a majority of the assets of the U.S. banking 
system.
    We also are strengthening our firm-specific supervisory 
techniques. We are using more detailed data, more frequent and 
more granular collection of data, and improved quantitative 
methods and models in analyzing that data.
    I would like to add that while many of our recent actions 
have been focused on enhancing the supervision for the largest 
institutions, we also have been making adjustments to our 
oversight for community and regional banks. As liquidity 
strains developed during the course of the crisis, we adjusted 
our focus to place greater emphasis on evaluating liquidity 
contingency funding plans at those organizations. And as 
commercial real estate began to deteriorate and affected the 
performance of those firms, we conducted reviews of the 
implementation of the 2006 interagency guidance addressing 
commercial real estate concentrations. And as a result of those 
reviews, we identified a number of issues for which examiners 
and bankers needed clarification. That contributed to the 2009 
interagency guidance aimed at facilitating prudent workouts of 
commercial real estate loans and prudent modifications of those 
loans.
    So while the crisis made it clear that tightening of 
supervisory expectations and our processes was needed and 
appropriate, we are also mindful of the importance of 
maintaining banks' ability and willingness to lend to 
creditworthy small businesses and consumers. Consequently, we 
have worked hard to ensure that our examiners employ a balanced 
approach when they are reviewing banks' underwriting and when 
they are reviewing banks' risk management and mitigation 
practices. We expect our examiners to strive for consistency in 
the examination process throughout the business cycle.
    I would add that credit markets have been recovering slowly 
since the financial crisis. Recent measures of aggregate credit 
outstanding that have shown some signs of improvement. But, 
clearly, the residential and commercial real estate lending 
sectors remain lagging. They are going to continue to present 
challenges for banks and supervisors for quite some time to 
come. With housing values flat or deteriorating in many 
markets, there are renewed concerns about the health of the 
mortgage market in general, and home equity loans and the 
activities of firms in that regard.
    So with residential and commercial property values still 
under strain, heightened reserve levels at banks remain 
appropriate. We expect that banks will continue to incur 
higher-than-historical losses in these sectors for some time to 
come, certainly through the remainder of this year and beyond. 
In conclusion, the Federal Reserve has made significant 
enhancements to our supervisory process, and those 
enhancements, coupled with the Dodd-Frank Act, support enhanced 
regulation and supervision of large complex firms, but we have 
also enhanced our supervision of regional and community banks, 
placing greater emphasis on sound risk management practices. In 
so doing, we have been mindful of the need to ensure that bank 
supervision is scaled to the size and the complexity of the 
supervised firm, and that bank management and examiners take a 
balanced approach to ensuring the safety and soundness of the 
banking system and also serving the credit needs of their 
communities.
    Thank you for inviting me to appear before the Committee 
today on these important issues. I would be pleased to take any 
questions that you may have.
    Chairman Brown. Thank you, Mr. Foley.
    Mr. Spoth.

  STATEMENT OF CHRISTOPHER J. SPOTH, SENIOR DEPUTY DIRECTOR, 
   DIVISION OF RISK MANAGEMENT SUPERVISION, FEDERAL DEPOSIT 
                     INSURANCE CORPORATION

    Mr. Spoth. Chairman Brown, Ranking Member Corker, Members 
of the Committee, thank you for the opportunity to testify on 
behalf of the FDIC about our supervisory process. As Senior 
Deputy Director, Division of Risk Management, I oversee our 
nationwide safety and soundness examination program.
    As the primary Federal supervisor of most community banks, 
the FDIC seeks to maintain a balanced approach to bank 
supervision, regardless of economic conditions. In our unique 
role as deposit insurer, we have a vital interest in assessing 
risks to the Deposit Insurance Fund posed by all FDIC-insured 
institutions.
    Overall, we are cautiously optimistic regarding the current 
condition and trends in banking. The number of institutions on 
the FDIC Problem List is leveling off, and the number of failed 
insured financial institutions appear to have peaked in 2010. 
However, the number of problem institutions remains high at 12 
percent of all insured institutions, indicating that a portion 
of the industry continues to struggle with lingering credit 
quality issues. These issues limit the ability of some 
institutions to grow their lending activity.
    We identify four broad factors that led to the financial 
crisis: excessive leverage, misaligned incentives, regulatory 
gaps, and weak market discipline. Much of the risk centered on 
poorly underwritten mortgage loans originated for 
securitization in the so called shadow banking system. 
Structured financial activities that generated the greatest 
losses were undertaken at the intersection of the lightly 
regulated shadow banking system and the more heavily regulated 
traditional banking system. This experience motivated 
legislative reforms and supervisory improvements.
    The establishment of the Financial Stability Oversight 
Council, the designation of systemically important financial 
institutions, or SIFIs, and the heightened supervision of 
systemic institutions along with other regulatory changes will 
help restore market discipline to our financial system. At the 
FDIC we established the Office of Complex Financial 
Institutions to continuously monitor and, potentially, resolve 
SIFIs. Among other requirements the office will review SIFI 
resolution plans which must demonstrate that the firm is 
resolvable under the Bankruptcy Code.
    With respect to community banks, they were generally not 
involved in the mortgage-related issues that were at the center 
of the financial crisis, but they were impacted in the fallout. 
Hit first was construction and development lending. Credit 
losses subsequently spread across all loan types. Further, home 
prices continued to fall because of several factors, including 
the foreclosure inventory.
    Growth in well-underwritten loans is essential for bank 
revenue growth and for our economy to grow. However, recent 
independent surveys and some bankers indicate that borrower 
demand remains sluggish. Despite the challenges, community 
banks continue their vital role as lenders. In fact, they have 
increased their loan balances since the second quarter of 2008.
    To address the significant challenges faced by banks and 
their borrowers, we continue our active engagement with banks. 
For example, 2 years ago the FDIC established its Advisory 
Committee on Community Banking. The committee provides the FDIC 
with advice on a broad range of policies. In addition, bank 
CEOs received a letter reiterating various channels, including 
confidential ones, for bankers to raise any concern about an 
examination.
    The FDIC continues to work on eliminating unnecessary 
burdens on community banks whose structure and business lines 
are relatively noncomplex. As noted in my written testimony and 
appropriate for the causes of the crisis, much of the Dodd-
Frank Act should not directly impact community banks, and 
certain provisions of the act provide some benefits.
    We will continue to pursue methods to streamline our 
supervisory process using technology and other means to reduce 
disruption associated with examinations. We strive to be 
efficient in our work while also conducting effective 
examinations. Having our office locations in numerous 
communities across the country helps our examiners be 
knowledgeable about community banks in their areas and about 
local conditions.
    The FDIC has been incorporating lessons learned into our 
examination program. We are encouraging banks to make loans to 
creditworthy borrowers, and we recognize their important role 
in the economy.
    Thank you. I would be pleased to take your questions.
    Chairman Brown. Thank you, Mr. Spoth.
    Mr. Wilson.

 STATEMENT OF DAVID K. WILSON, DEPUTY COMPTROLLER, CREDIT AND 
     MARKET RISK, OFFICE OF THE COMPTROLLER OF THE CURRENCY

    Mr. Wilson. Chairman Brown, Ranking Member Corker, and 
Members of the Subcommittee, I appreciate the opportunity to 
discuss the OCC's perspectives on lessons learned from the 
financial crisis and our ensuing approach to bank supervision. 
While not covered in my remarks, pursuant to the Subcommittee's 
request, my written statement does provide an update on the 
current state of small business and real estate lending, 
mortgage servicing, and trading lines of business.
    The financial crisis underscored the importance of prudent 
underwriting practices, adequate loan loss reserves, strong 
capital cushions, and it also highlighted the need for 
supervisors to develop better tools to evaluate and address 
emerging risks across the system. The OCC has taken action to 
strengthen our supervision and practices of the banks we 
supervise in each of these areas.
    The primary driver of the financial crisis was the 
progressive slippage in underwriting practices that occurred as 
banks responded to competitive pressures from the shadow 
banking system. We closely monitor national bank underwriting 
and have directed our banks not to compromise their 
underwriting standards due to competitive or other pressures, 
and as well, we have strengthened our analytical tools to help 
monitor for slippage in loan quality so we can intervene at an 
earlier stage. This includes granular loan-level data on major 
credit portfolios that we are collecting from the largest 
national banks that allow us to conduct forward-looking 
analysis under varying economic scenarios.
    The financial crisis also highlighted that risk management 
is and must be much more than simply a collection of policies, 
procedures, limits, and models. Effective risk management 
requires a strong corporate culture and corporate risk 
governance. This culture must be set, embraced, and enforced by 
the bank's board of directors and its senior management, and it 
must permeate through all the bank's activities. This is a 
point of emphasis in all of our meetings with senior management 
teams, directors, and senior management at large, midsized, and 
community banks.
    We have also updated our risk assessment system that we use 
as a part of our examinations at each national bank to reflect 
and incorporate lessons learned from the financial crisis and 
have directed examiners to be more forward-looking when they 
assess and assign these risk assessments. Given the importance 
and role of large national banks and the importance they play 
in the financial stability of the U.S., we have made it clear 
that these firms should not operate without strong risk 
management and audit functions. Anything less would not be 
sufficient.
    Further, we are directing large banks to incorporate 
robust, enterprise-wide stress testing as a part of their 
ongoing risk management. We are also working with smaller banks 
to improve their ability to assess potential concentrations in 
key portfolios, most notably commercial real estate, so they 
can address potential problems before they occur.
    To improve our ability to identify emerging systemic risks, 
we have established a financial markets group to monitor and 
gather market intelligence, and we developed a system of early 
indicators that signal a buildup of risk within the system. 
Under this system warning signals across a number of measures 
will trigger a more formal review and assessment of the risk 
and the need for a supervisory response.
    The OCC has worked with supervisors across the globe to 
enhance and strengthen capital and liquidity standards. These 
efforts culminated in Basel III. These reforms tighten the 
definition of what counts as regulatory capital, expand the 
type of risk captured within the regulatory capital framework, 
increase overall capital requirements, establish an 
international leverage ratio, and introduce global minimum 
liquidity standards for large banks.
    The OCC has also been a vocal advocate with the accounting 
standard setters to revise the current accounting model for 
loan loss reserves to make them more forward-looking.
    In closing, the financial crisis exposed fundamental 
weaknesses in risk management and supervisory practices across 
the financial industry and the supervisory community. The OCC 
has taken numerous steps to enhance its supervision programs. 
As we implement these changes and those mandated by the Dodd-
Frank Act, we are cognizant of the need to tailor our 
expectations to the scope and complexity of each bank's 
activities. We must also avoid wringing all risk out of the 
banking system. Banks' fundamental role is risk intermediation, 
and financial innovation and expansion of credit are important 
drivers of our economy. Banks must be able to respond to 
customer and investor demand for new and innovative products 
and services, and in this respect our overarching goal and 
mission remain the same: to assure banks conduct their 
activities with integrity and in a safe and sound manner, and 
that our supervision remains balanced and fair.
    Thank you, and I would be happy to take questions.
    Chairman Brown. Thank you, Mr. Wilson. I do not think 
anybody wants, to your last comment, wring all the risk out of 
the financial system. I do not think that is where anybody is 
going in this.
    Last week the Treasury Department--and this question will 
be for you, Mr. Wilson, but anybody can weigh in--announced it 
was withholding payments from three servicers due to poor 
performance in the HAMP program. We do not always in these 
hearings and in our deliberations think about human beings and 
the consequences of all of these actions.
    I want to tell a quick story about Frank Vance from Medina 
County, an exurban county just south of Cleveland. He worked at 
the Arcelor Mittal Steel Plant as a railroad engineer. He and 
his wife bought their dream house in Chatham, Ohio, with a 
Countrywide mortgage. The financial crisis hit. The plant 
closed. The plant laid him off in 2009. He went to his lender, 
now Bank of America, entered into a trial modification that 
lowered his monthly payment by extending the loan 12 years. 
When a paper bill came in the mail showing the old payment 
amount, Frank called his bank. They told him not to worry, to 
keep making his payments, that no negative reports were being 
made to the credit bureaus. The bank did not approve a 
permanent modification until August 2010 when his payments 
increased by $200 a month. He later discovered that all his 
payments for a period of 13 months were sitting in an escrow 
account, and his credit report made it appear as if he was not 
making any payments over that year. In addition to placing his 
home in jeopardy, it is now more expensive for him to make the 
second biggest purchase in his life--his car.
    My question for the regulator is: What is the OCC doing to 
scrutinize these loans? What are you doing to help the Frank 
Vances of the world?
    Mr. Wilson. Yes, Senator, HAMP is a Treasury program, but 
these problems are indicative of our findings of the reviews 
that we did late last year. They are the subject of the consent 
orders that we issued in April. Those consent orders get to the 
heart of, you know, where consumers were harmed because of 
foreclosure management practices. The consent orders 
specifically talk about dual-track processing and things like 
that. It is, unfortunately, not something that can be corrected 
overnight. But one of the reasons that the OCC and my colleague 
agencies moved forward with consent orders is to get them 
corrected as quickly as possible.
    Chairman Brown. Anyone else want to weigh in?
    [No response.]
    Chairman Brown. Let me go somewhere else. National City 
Bank in Cleveland was a huge regional bank founded in Cleveland 
in 1845. As recently as 2007, it was the ninth largest U.S. 
commercial bank with $140 billion in assets. It was sold to PNC 
a year later during this terrible crisis. It is a case study in 
regulatory failure.
    After buying subprime lender First Franklin in 1999, the 
bank's mortgage annual profits grew 20-fold in 4 years from $50 
million to $1 billion. These volatile, unpredictable mortgages 
eventually did in National City. National City executives 
started talking about selling First Franklin in early 2005. It 
took until late 2006 for them to sell it. They were forced to 
retain $10 billion of the riskiest loans, half of the loans 
that ultimately brought National City down.
    In the summer of 2006, their chief economist wrote a 
research report arguing that the housing market was headed for 
collapse. That report was ignored by the bank's own executives. 
A few months later, the bank spent 42 billion buying two 
Florida banks, a market that has been crushed by declining 
property values and foreclosures.
    In early 2007 the bank bought back $3 billion of its own 
stock. A year later it was forced to raise a very expensive $7 
billion from private investors. National City wound up losing 
$6 billion in 2008 and was bought by PNC for only $2.23 a 
share. The company and its regulators--the Fed and the OCC had 
known for almost a year the bank was in trouble.
    What have we learned from this? What would you do 
differently? What are you doing now to prevent failures such as 
National City? And understanding that bank still exists as part 
of PNC, they still have a lot of employees in my State, but 
they have significantly fewer employees, and a whole lot of 
stockholders in National City lost a lot of money.
    Mr. Wilson. I will refer back to some of the comments about 
when do you take away the punch bowl. That is one of the most 
difficult things that regulators and supervisors have. And I 
referred to it in my testimony. We have developed a number of 
tools and indicators that really indicate when times are too 
good. For example, the best loans are often made during the 
worst of times and vice versa. So the worst loans are made 
during the best of times. Being able to identify that and flag 
it early and take early action I think is the key to preventing 
your description of National City.
    Chairman Brown. And you are capable of that, and the other 
regulators are now capable of that?
    Mr. Wilson. We have a renewed emphasis, and we are going to 
do the best we can.
    Chairman Brown. Mr. Foley.
    Mr. Foley. From our perspective the first step is to go 
back and consider the lessons learned in the crisis. The very 
situation you talked about really describes a collective 
failure of imagination by the banks and by the regulators 
themselves. Of course, this is in the context of very strong 
economic growth, a long benign economic environment, strong 
profitability from firms, and exceptionally low losses on 
mortgage lending.
    But against that backdrop, bankers and supervisors did not 
consider the potential for a significant decline in house 
prices. We did not consider the potential that what were 
assumed to be stable sources of funding could go away in that 
type of environment. The result was that these firms were 
undercapitalized, and they were not prepared for the liquidity 
strains that they saw in the crisis.
    One of the appropriate responses, we think, is that bankers 
themselves need to have stronger risk management in place and 
supervisors have to have better tools to assess the potential 
for low profitability, but high-impact stress events. Stress 
testing is one effective way to do that. That is required under 
the Dodd-Frank Act. That is reflective of the activities 
undertaken in the SCAP and the CCAR process. But one important 
element of this is the need for a forward-looking assessment of 
the potential risks of the firms. We need to consider more 
extreme economic events and idiosyncratic risks that can affect 
individual firms and relate that back to potential future 
losses, the ability to earn and supplement their capital base, 
and evaluate their need for capital and liquidity under those 
types of adverse circumstances.
    Mr. Spoth. Senator, I would only add, the one thing FDIC 
has done with the other regulators is reframe our back-up 
examination activities to protect the insurance fund wherein we 
adopted a new memorandum of understanding to engage in back-up 
activities where necessary.
    Chairman Brown. OK. Thank you. Senator Corker, before you 
begin, in light of your opening statement, I hope there are 
some statutory issues that maybe with Dodd-Frank we can work 
together on to help us with that. Thank you.
    Senator Corker. I appreciate that. As a matter of fact, I 
think there are, and I think that a lot of us are seeing a lot 
of unintended consequences and I think a lot of folks wanted to 
see appropriate financial regulation, so I hope we can do that.
    As I go through our State, people from all kinds of 
backgrounds and persuasions politically that are in community 
banking come up to me and say, ``You know, Corker, I am 
beginning to think that the Federal Government just really does 
not want community banks in the number that they have today, 
that they really want to force consolidation, that they really 
are doing everything they can to keep us from being 
successful.''
    And I guess my question to each of you, without being too 
elaborate with your answers, is what is happening right now 
throughout community banks, the banking system? Is it a result 
of procyclicality, where, in essence, we are clamping down more 
than we should at a time when the economy is slow and creating 
a self-fulfilling prophecy? Is it that Dodd-Frank is forcing 
you to do things that you were not doing before? Or is it some 
other answer? But I really do believe that amongst community 
bankers in our country, there is a belief that the Federal 
Government really has stacked the deck in a way that makes it 
very difficult for them to compete.
    Mr. Spoth. I might touch on that first, Senator, as 
principally we are the regulator for most of the community 
banks. I think with respect to Dodd-Frank, the burden falls, as 
it should, on the largest financial institutions and we should 
work in that regard for implementation.
    I hear the same things that you do when I am talking with 
bankers about burden. I am optimistic that the community bank 
franchise is a strong one and a valuable one and will continue 
to be so for our country. Looking at the numbers, I know that 
of all the 7,500 insured banks in this country, 90 percent of 
them are community banks serving their communities well. They 
have under a billion dollars in assets each, but they have a 
disproportionately large share of the commercial loans in their 
markets.
    Mr. Wilson. At the OCC, we respect and support the role of 
community banks and have no intention of trying to reduce the 
number of community banks or anything like that. In addition to 
what Chris said, community banks are under a lot of pressure 
right now because they tended to be overly concentrated in 
commercial real estate, and commercial real estate, 
particularly income-producing commercial real estate, has 
lagged the recovery. A lot of banks are continuing to struggle 
with those concentrations and working through those 
concentrations. We are doing the best we can, and I know my 
colleagues are, as well, to make sure that we are fair and 
balanced in allowing the banks to work through those. But in 
some cases, it is just not possible.
    Senator Corker. Yes. We kind of forced them out of 
residential into commercial due to our policies here, and that 
is one of the problems that we, Congress, helped create.
    The one thing I would say, Mr. Spoth, I know you mentioned 
that, somehow or other, this is tilted toward the large 
institutions. The fact is, that is not the case. I mean, the 
big just get bigger when we regulate the way that we have, and 
what has happened is with the community banks, their back 
offices now are much, much, much larger and are getting larger 
just to deal with all the things that are in Dodd-Frank. So I 
would just say your statement is just categorically untrue, 
because larger institutions have the ability to absorb 
regulations in a much more efficient way. They can spread it 
over a larger mass than community banks do. So that is just 
categorically an incorrect statement. And you can go talk to 
any community bank in our country and they will tell you that 
the burden per asset base that they have is much larger on a 
community bank than it is on something that is much larger.
    Let me ask another question. The risk retention piece, I 
thought, was ridiculous, and I think it is going to have 
tremendous effects on our securitization market. So, again, 
Congress punted and basically said, oh, well, we do not really 
want to get--we do not know how this works, really, so set up a 
Qualified Residential Mortgage. You guys have, in your wisdom, 
come up with a 20 percent downpayment and now Congress, being 
the supplicants that we now are in this process--everybody is 
writing letters to say, well, we really--oh, gosh, we wish you 
had not done that. Would you all like to respond to the 
Qualified Residential Mortgage and just the whole risk 
retention piece and how you guys, in your wisdom, have come up 
with a 20 percent downpayment that now Senators who punted 
their responsibilities are trying to keep you from doing.
    Mr. Wilson. Of course, Senator. That rule is out for 
comment and we have invited comments on that very issue, 
especially the 20 percent downpayment. I think the policy 
makers looked at the rule as primarily a risk retention rule. 
The intent of the rule is that the securitizer would retain 
risk. It did allow, as you mentioned, the option of designing a 
very, very high quality asset that would be exempt from that 
risk retention rule. So the design of it was very conservative, 
not only in residential real estate, but in the other asset 
classes that are mentioned in the proposed rule. And, again, 
the intent of the law was risk retention, and so the exceptions 
to risk retention should be narrow.
    Senator Corker. So, basically, this is--for those out in 
the real estate world that are slightly upset, if you can 
imagine, about a 20 percent downpayment, what you would say is 
that is exactly what the U.S. Senate told you to do.
    Mr. Wilson. We believe that there are many, many good 
mortgages, we would hope, that would still be made that are 
outside of QRM if you include----
    Senator Corker. But the institutions would have to hold 
risk against those.
    Mr. Wilson. But they would have to hold----
    Senator Corker. And so that means that no community bank--
let me just go back to the other statement--no community bank 
could possibly, possibly be in that world. It means that, now, 
home mortgages will be concentrated in the JPMorgans and the 
Citibanks and the Bank of Americas because nobody else has the 
ability to hold risk on their balance sheet, is that correct?
    Mr. Wilson. We have tried to design the rule to not have 
that happen. The risk retention is the primary responsibility 
of the securitizer, not the originator. So under the current 
model where you have a community bank that will originate a 
handful of loans and then sell them to a securitizer, the 
community bank does not have to retain the risk. It is the 
securitizer that has to retain that risk.
    Senator Corker. But will it not concentrate that market 
when you have to have a large balance sheet like that to hold 
the risk?
    Mr. Wilson. To the extent that the community bank decides 
to sell that loan, that would be the model that existed before 
Dodd-Frank. So if the community bank decides to hold the loan 
on the books, then risk retention does not come into play. But 
we consciously tried to consider this factor when we debated 
whether we would make the originator retain the risk versus the 
securitizer themselves, and it was this consideration that went 
into that debate.
    Senator Corker. Listen, thank you. I know I have taken over 
my time. Thanks for having the hearing. I would just close by 
saying that I know you guys have 300 rulemakings to make, and I 
know in many cases you feel like you are making them too 
quickly, trying to meet deadlines. And I do know for a fact 
that it is creating tremendous lack of clarity out in the 
financial markets and people have no idea what the rules of the 
road are and I know that is hurting our economy. I know that. I 
do not know many things, but I know that.
    I do hope that as you move along, if you see things that 
you feel like you are rushing, that you will not be cowered by 
those people who just want to see Dodd-Frank pushed through 
regardless, but that you will tell us that you need more time, 
and I thank you very much for what you do and appreciate the 
opportunity to be with you today.
    Chairman Brown. Thank you, Senator Corker.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Just to follow, a point of clarification, Mr. Wilson. The 
20 percent downpayment is not specified--I do not believe it is 
specified in Dodd-Frank in terms of qualifying. Is it 
specified?
    Mr. Wilson. No, the 20 percent down is not specified.
    Senator Reed. Yes. In fact, the agencies have the 
flexibility to design a rule which would reflect an appropriate 
downpayment, but 20 percent is something you are proposing now.
    Mr. Wilson. That is correct.
    Senator Reed. Thank you. Mr. Wilson, I am still, as you are 
probably aware, awaiting questions, or responses from the May 
12 hearing from the OCC and I would appreciate very much if 
those responses would be forthcoming. I know my staff has 
talked to you. I appreciate that. But they are important 
questions and I would like answers. Any idea when we are going 
to get them?
    Mr. Wilson. Senator Reed, we understand that. We are well 
along on answering those questions and I would hope it would be 
very soon.
    Senator Reed. Thank you.
    Mr. Wilson. We take it very seriously.
    Senator Reed. Thank you. You have mentioned the OCC consent 
order. At the heart of it seems to be the requirement that the 
banks engage an independent consultant to look back at their 
servicing processes, which begs a couple of questions. First, 
why was the OCC looking at these processes? And then a related 
question is at what point did the OCC become aware of what 
appears to be, and Senator Brown's example is just one of 
thousands, hundreds of thousands, serious deficiencies, in 
fact, deficiencies that appear to be violating law? So could 
you respond to those two issues?
    Mr. Wilson. Yes, sir. We become aware, not really until it 
became public with the Allied Bank publicity, but we jumped in 
very quickly after that with horizontal examinations on an 
interagency basis.
    As to why were we not looking at before, this is another 
lesson learned, but we do look at mortgage servicing 
operations. We do look at modification procedures, the basic 
transaction of the notary signing and affidavits, and things 
like that traditionally was a low-risk business. We did not 
have any indicators from internal audit or other risk 
management functions around the bank. We did not pick up any 
complaints in our consumer complaint process. So it was not 
something that we had a big focus on until we understood the 
nature of the problems.
    Senator Reed. Let me--just two points. One, I presume based 
on not only the response to this question but your previous 
responses that you have taken corrective action with respect to 
these issues in terms of your examination procedures, the 
training of examiners, and I would also sort of emphasize the 
consumer complaint process, because, frankly, our offices are 
deluged by consumer complaints. If you were getting a quarter 
of the complaints which were originating two or 3 years ago 
that I think some of them are also getting, then you have to 
look very carefully at your consumer relations and how you 
identify complaints and follow them up, because there was a lot 
of noise out there in terms of consumers, frustrated consumers 
literally banging down our doors, and I think I speak for 
everybody on this Committee and in every part of the country.
    Let me shift gears briefly, and still in the context of 
this process of mortgage foreclosures. Yesterday, 11 of my 
colleagues, including the Chairman of the Committee, Chairman 
Brown, Chairman Leahy of the Judiciary Committee, sent a letter 
to the Comptroller asking the Comptroller to work very closely 
with the States' Attorneys General, with the Department of 
Justice, with the Department of Housing and Urban Development, 
to produce a comprehensive solution to this foreclosure crisis, 
not just rectifying the robosigns, et cetera. And I think at 
the heart of it is the notion that we have--until we stabilize 
the housing market, which we have not, we will not have any 
economic growth of consequence nor will the safety and 
soundness of banks begin to be self-sustaining and something 
that you have to worry about.
    So let me just specifically ask, can you describe your 
proposed collaboration with the Attorneys General at all?
    Mr. Wilson. I will try. I will say, number one, we agree 
with the letter. We agree that not only should we fix what is 
wrong with the foreclosure process, provide restitution to 
consumers that have been harmed, but then also address the 
broader issue of servicing and servicing standards and some of 
the things that got us to this place in the first place.
    In terms of cooperation, we went forward with the consent 
orders to do that first piece of the two-piece puzzle, but we 
were very careful not to interfere with ongoing negotiations 
from the Department of Justice and the State AGs, and, in fact, 
we are trying to coordinate. We just announced that we delayed 
the responses back from the banks by 30 days at the specific 
request of the Department of Justice, and so we do look forward 
to going forward. There are a number of groups working on 
national servicing standards and we all agree that we need to 
get to a commonplace at some point.
    Senator Reed. Let me, again, in the context of a 
comprehensive approach, I think--and the letter indicates 
this--there is also the possibility of modification, including 
principal reductions, in terms of terms, extensions of 
mortgages, so that we avoid foreclosures, basically. I think 
simply getting the foreclosure process correct, then go out and 
foreclosing more homes is not going to help anybody. And, in 
fact, in talking to the Attorneys General, this modification 
process is one of the things that was used in the Iowa farm 
crisis of the 1980s in terms of trying to correct similar 
situations. So I would presume that you would be working as 
best you can along with the Attorneys General in this regard, 
too, is that correct?
    Mr. Wilson. That would be correct. I mean, the devil is in 
the details, but yes.
    Senator Reed. Thank you very much. Thank you, Mr. Chairman.
    Chairman Brown. Thank you.
    Before turning to Senator Merkley and Senator Moran, we 
will also in a moment introduce one of the members of the next 
panel. A couple of questions before Senator Merkley.
    For you, Mr. Wilson, brief questions. As Dodd-Frank in the 
Senate and the House worked together on sort of, obviously, 
reconfiguring the regulatory agencies with OCC and FDIC and the 
Fed and the new CFPB, I have two brief questions for you, Mr. 
Wilson, just so I understand, so we understand the structure 
better as we move forward. Does the OCC have a single head or a 
board? I understand they have a single head, correct?
    Mr. Wilson. We have a single head, yes.
    Chairman Brown. OK. And the OCC is subject to the 
appropriations process or not?
    Mr. Wilson. They are not, no.
    Chairman Brown. They are not. OK. It is important to make 
that clear.
    Senator Merkley.
    Senator Merkley. Thank you, Mr. Chair, and thank you all 
for your testimony.
    I wanted to get a better sense of the contrast between the 
strategies used for overseeing or supervising or auditing the 
large, complex financial institutions as compared with 
community banks. Certainly in a smaller institution, the FDIC 
as it supervises community banks can go in and basically look 
at every loan file. In large, complex institutions, the 
strategy is more on the side of having, as I understand it, a 
staff member on-site working with the risk management staff of 
that institution.
    I would like to get a sense of whether that embedded risk 
management approach is the best strategy. What have we learned 
from this financial crisis? Do we need to have kind of some 
more, if not loan level, but more deeper understanding or 
inspection of what is going on in the guts of complex 
institutions? And Mr. Wilson and Mr. Foley, if you could share 
your thoughts on that, it would be helpful.
    Mr. Wilson. I will start. We do have a significant 
difference between the way we supervise large institutions and 
community banks. Community banks tend to be more of a point in 
time examination where we go in periodically. In our large 
banks, we have core staffs--some of them can be quite large--
that are resident in the bank at all times. And you are right. 
We try to work with risk management, audit, some of the risk 
functions. But to say that that is all we do is not correct. We 
do a lot of transaction testing, especially looking at 
individual loans, sampling individual loans. Every spring, we 
do a Shared National Credit Program, which is where we review 
all the big shared credits in the country that are significant. 
So that testing is there.
    I think the question is, do we need to do more? I think in 
some cases we should. And in products that were homogeneous, we 
may have become a little more comfortable with the process and 
did not call a residential mortgage and say, how is this thing 
actually being underwritten. I think it is a lesson learned for 
the future.
    Senator Merkley. Well, you are talking about transaction 
testing. Are you randomly selecting a few out of, of course, a 
very large volume of transactions to see kind of just what you 
find, whether, one, it was real, and two, presented to reflect 
the reality of the transaction and so forth?
    Mr. Wilson. For things like credit, structural products, 
bonds, things like that, we would do a random selection. For 
example, in CMBS for commercial real estate, we will look at 
the quality of the loans that are going into those structures.
    Senator Merkley. And before we shift over, is there 
anything that you feel has really been a modification of your 
strategy based on the lessons learned from the 2008-2009 
crisis?
    Mr. Wilson. Yes, as I said in my testimony, we are doing a 
lot more data collection from the banks, the large banks 
themselves. This is loan level data collection which started in 
2008 and we have expanded it to additional asset classes to the 
point now where we are collecting on almost all major asset 
classes. We are doing a lot more modeling on that.
    From our core staffs on our large banks, we have 
significantly ramped up our expectations for risk management in 
those institutions. I think before we were somewhat OK if we 
rated the risk management functions as satisfactory. We have 
communicated to our banks that that is no longer the grade. 
They have to be strong and we are working toward getting to 
strong risk management.
    Senator Merkley. So are you designing any independent risk 
models or utilizing just simply kind of following what the bank 
itself is using?
    Mr. Wilson. We do both, but on the loan level data 
collection that I was talking about, those are independent.
    Senator Merkley. Mr. Foley.
    Mr. Foley. Thank you, Senator. I think, again, part of this 
is looking at the structure in place before, and I think there 
were a number of limitations, many of which have been addressed 
by the Dodd-Frank Act. But the Federal Reserve, for example, by 
statute, was very narrowly focused to consider nonbank 
subsidiaries and the impact they could have on depository 
institutions. Primary and functional regulators were very 
focused on the particular legal entities they were responsible 
for. But no Federal regulator had sufficient authority to 
consider those risks across the entire organization, and for 
very large, complex firms. For example, they may have a client 
in Asia that enters into a contract that is booked in the U.S., 
with the risk on that contract hedged in the U.K. Therefore the 
supervisory approaches that we take have to recognize the 
underlying business approaches that these firms use.
    Transaction testing is a key element of that, but we are 
increasingly using techniques such as the SCAP, which involve a 
broader horizontal assessment. The nature of that exercise is 
to have the firms consider, for example, a particular stress 
situation. That could be an economic stress. That could be an 
idiosyncratic stress particular to the businesses that firm is 
engaged in. We collect extensive information from the firm to 
understand the impact of a stress on each of their loan 
portfolios, to understand the impact on their profitability 
going forward, to understand the impact on their liquidity.
    It is important for the firm to be able to demonstrate they 
can collect data across the entire consolidated organization, 
that they can aggregate their risk exposures, that they can 
understand the potential impact on their profitability going 
forward and be able to translate that into what their capital 
and liquidity needs might be, not just as a point in time, but 
under a more stressful scenario going forward.
    Those approaches are much more sophisticated. They allow us 
as supervisors to collect extensive, robust data on these firms 
that permits us to independently validate the firms' 
suggestions in their models. Additionally, we are able to run 
scenario analysis on any range of scenarios that we may have to 
consider beyond what the firms are focused on.
    Senator Merkley. Thank you.
    Chairman Brown. Thank you, Senator Merkley.
    Thank you very much for joining us. We very much appreciate 
it.
    I call the second panel forward, Salvatore Marranca and 
Frank Suellentrop, and Senator Moran, as you get situated--he 
can wait a moment if he wants--but introduce Mr. Suellentrop.
    Senator Moran. Mr. Chairman, thank you very much. Thank you 
for accommodating our desire to have a Kansas community banker 
testify before this Subcommittee, and I appreciate your 
cooperation in that regard.
    Frank Suellentrop is a fourth generation banker. The bank 
has been in his family for four generations and his bank is 
outside of Wichita, Kansas. He is an active member of the 
Kansas Bankers Association as well as the independent community 
bankers. Like community bankers across the country, he is so 
actively engaged in his community.
    You have heard me say many times in this Subcommittee and 
more so in the full committee about my concern about the 
potential demise of community banking because of the regulatory 
environment. I do not know exactly what Mr. Suellentrop will 
testify to, but I am anxious to hear his and our other 
witness's testimony in regard to the regulatory environment and 
the changes that have occurred since Dodd-Frank, and I thank 
you for allowing this Kansan to join us today.
    Chairman Brown. Thank you, Senator Moran, and welcome, Mr. 
Suellentrop.
    Salvatore Marranca is Chairman of the Independent Community 
Bankers of America, the only national trade organization that 
exclusively represents community banks. He is Director, 
President, and CEO of Cattraugus County Bank in Little Valley, 
New York. He has served the community banking industry in many 
leadership positions.
    Mr. Marranca served in the U.S. Army with a tour of duty 
during the Vietnam War. Thank you for your service to our 
country, Mr. Marranca. He is the past Board President of the 
New York State Banking Department, Director and Past President 
of the Independent Bankers Association of New York State.
    Welcome to both of you. Mr. Marranca, if you would begin. 
Thank you.

STATEMENT OF SALVATORE MARRANCA, DIRECTOR, PRESIDENT, AND CHIEF 
 EXECUTIVE OFFICER, CATTRAUGUS COUNTY BANK, LITTLE VALLEY, NEW 
                              YORK

    Mr. Marranca. Thank you. Chairman Brown, Senator Moran, 
Senator Merkley, I am Sal Marranca, Director, President, and 
CEO of Cattraugus County Bank, a $174 million community bank 
founded in 1902 in Little Valley, New York. I am pleased to be 
here today as Chairman of the Independent Community Bankers of 
America, the ICBA.
    The safety and soundness of our banking system is a 
significant concern to the nearly 5,000 community bank members 
of the ICBA. Early in my banking career, for more than a 
decade, I was a senior bank examiner with the FDIC. The 
commitment I made then to safety and soundness is still 
ingrained.
    The recent financial crisis was fueled by high-risk lending 
and speculation by the megabanks and Wall Street firms. 
Significant harm was done to taxpayers and the economy. 
Community banks, too, were harmed. The economic decline 
retracted consumer spending and dramatically reduced the demand 
for credit. Residential and commercial real estate markets 
remain stressed in some areas. Still, the community banking 
industry remains well capitalized and, because we take a 
conservative, common sense approach to lending, has fewer 
problem assets than any other segment of the industry.
    We must ensure this crisis never repeats itself and 
appropriate supervision of all financial services providers is 
a key component of that effort. However, the way safety and 
soundness is achieved is also very important. Misguided, though 
well intentioned, efforts could be very economically damaging. 
Frankly, many community bankers are deeply frustrated with the 
current exam environment.
    I am fortunate to enjoy a cooperative and constructive 
working relationship with my regulator, the FDIC. Having been a 
bank examiner, I have been on both sides of the table and 
appreciate the concerns and the challenges examiners face. It 
is a difficult job with a great deal at stake. The stakes were 
raised sharply after the financial crisis.
    The pendulum has swung too far in the direction of 
overregulation. As a community banker, I have met with 
thousands of bankers from every part of the country in recent 
years and I can tell you there is an unmistakable trend toward 
arbitrary, micromanaged, unreasonable examinations that have 
the effect of suffocating lending. What is more, these exams--
in fact, all regulatory compliance--are more costly and a 
burden to small banks because we have a smaller asset base and 
staff over which to spread the costs.
    ICBA supports bringing consistency to the examination 
process. Arbitrary loan classifications are a particular source 
of frustration to community bankers. ICBA strongly supports 
legislation recently introduced in the House by Representative 
Bill Posey, the Common Sense Economic Recovery Act. This 
legislation would help establish conservative common sense 
criteria for determining when a loan is performing and provide 
more consistent classifications. We are hopeful a Senate 
companion bill will soon be introduced and considered by this 
Committee.
    ICBA also supports House legislation introduced by 
Representative Blaine Luetkemeyer, the Communities First Act, 
the CFA. This bill contains many reforms that would improve the 
regulatory environment and community bank viability to the 
benefit of our customers and communities. To cite just a few 
examples, this bill would raise the threshold number of bank 
shareholders that triggers costly SEC registration, from 500 to 
2,000. Another provision would extend the 5-year net operating 
loss carryback provision to free up community bank capital, 
when it is needed most. Again, ICBA hopes to see a companion 
bill introduced in the Senate.
    The greatest threat to safety and soundness remains the 
too-big-to-fail institutions that dominate the financial 
services sector. The financial crisis has, in fact, accelerated 
industry concentration. Today, the ten largest banks hold 77 
percent of all bank assets. A more diverse financial system 
would reduce risk and promote competition, innovation, and 
access to credit. This is why ICBA generally supports the too-
big-to-fail measures in the Dodd-Frank Act.
    Finally, I would note that some of the housing finance 
reforms being considered by the agencies and by Congress, if 
not done carefully, could have the unintended effect of driving 
further industry consolidation and jeopardizing safety and 
soundness. For example, the Dodd-Frank risk retention rule on 
securitized mortgages should include a fairly broad exemption 
for Qualified Residential Mortgages.
    Thank you again for convening this hearing and giving ICBA 
the opportunity to testify. We share your commitment to 
enhancing the safety and soundness of our financial 
institution. I look forward to your questions. Thank you.
    Chairman Brown. Thank you, Mr. Marranca, and thanks to the 
Independent Community Bankers.
    Mr. Suellentrop, welcome.

  STATEMENT OF FRANK A. SUELLENTROP, CHAIRMAN AND PRESIDENT, 
                  LEGACY BANK, COLWICH, KANSAS

    Mr. Suellentrop. Thank you, Mr. Chairman, Senator Brown, 
Ranking Member Corker, and Members of the Subcommittee. Thank 
you for the opportunity to testify before you today regarding 
lessons learned and opportunities for continued improvement.
    My name is Frank Suellentrop. I am President and Chairman 
of Legacy Bank in Colwich, Kansas. We are a $250 million 
closely held community bank providing banking services to the 
area of Sedgwick County, Kansas. We have five branch locations, 
our charter bank location in Colwich, Kansas, population 1,400, 
and four branch locations in the Wichita, Kansas, community. 
Our bank was established in 1886, which means we are 
celebrating our 125th year in banking this year. I am fourth 
generation President of our bank since 1991. From that 
experience, I have seen the beginning of the consumer 
regulation in the early 1970s, the agriculture and real estate 
crisis of the 1980s, and now the Wall Street-induced real 
estate crisis of 2008.
    Legacy Bank is significantly involved in residential 
development, residential construction, and commercial property 
lending, therefore, greatly impacted by the economic slowdown 
and depressed real estate market values. Fortunately, the 
economy in Wichita, Kansas, has fared reasonably well 
throughout the current crisis relative to other markets, 
primarily due to the fact that Kansas, specifically Wichita, 
had not experienced inflated real estate values of the past 
decade.
    I would like to preference my comments regarding recent 
examination by saying that I understand examiners are charged 
with a difficult task. On one hand, they are expected to 
protect against bank failures, ensure consumer compliance and 
regulations are adhered to, to satisfy community groups and 
organizations' demand for fair banking practices, and heed 
Congressional demands for banking or financial oversight. On 
the other hand, regulators should be tasked with not 
interfering with the bank's corporate mission of creating value 
for its shareholders. Legacy Bank is a for-profit corporation.
    Our most recent 2010 examination revealed stark differences 
from prior exams: Expectations of higher capital and liquidity 
standards, more demanding asset loan quality evaluations, 
expectations for higher allowance for loan and lease loss 
reserves, increased focus on management assessment and 
compensation practices. Comments made by regulators during our 
last exam include, ``We do not like your risk profile,'' and 
``We are not going to bat for you in Washington.''
    To put the first comment in context, our bank has been a 
lender to residential real estate developers, home builders, 
and commercial property owners since the late 1980s. We feel 
our lending staff has the knowledge and experience to manage 
our loan portfolio composition. Examiners were significantly 
more aggressive compared to prior examination observations. Due 
to recent failures of problem banks in other areas of the 
country, our lending risk profile is now unacceptable.
    In addition to the standard underwriting criteria of 
evaluating a borrower's capital, collateral, and capacity to 
repay, and market conditions, our loan committee has added a 
new component to our loan approval discussion: Will the loan 
pass examiner review and approval? This component should not be 
a part of the loan approval process. A customer's loan request 
should be based on its viability and productive value. With 
respect to the latter comment, it illustrates the regulatory 
attitude that banks in real estate lending may be unsafe and 
unsound in their practices.
    Banks are evaluated on a CAMELS component rating, which 
measures a bank's capital, asset quality, management, earnings, 
liquidity, and sensitivity to market risk. My comments on each 
of those follows.
    Capital standards are being dictated above the levels for 
regulatory defined well capitalized banks and those standards 
that are required for our Nation's largest institutions. 
Regulators quite often use discretionary capital standards to 
demand higher capital levels for community banks--than those at 
large banks. Capital below the mandated Tier One risk-based 
levels are likely to receive a lower capital component rating 
in an examination, which may subject the bank to troubled bank 
status. The discretionary capital standards create a difficult 
moving target for community banks as we seek to achieve an 
acceptable capital component rating.
    Asset quality loan evaluations have become more critical. 
Examiners are slow to recognize when a credit risk has been 
mitigated and classifications can be inconsistent.
    Community banks' management compensation is being reviewed 
by examiners by suggesting potential negative impact to 
earnings and capital. Without a significant discussion, 
examiner comments dictated that we justify management 
compensation benefits by use of an outside source. Somehow, 
Wall Street excesses on executive pay have crept into the 
regulators' view of Main Street banking compensation practices 
when there is no valid comparison to Wall Street compensation 
abuses.
    Earnings were reviewed and projected to be half by 
examiners of what actual 2010 actual earnings were for our 
bank, causing concerns for our earnings component.
    In summary, micromanaging community banks is unproductive. 
Examiners should expect results, but if capital is solid and 
management is capable, then overregulation is unnecessary. 
Regulatory burden and examiner expectations are 
disproportionate in their impact on community banks versus the 
largest banks.
    I appreciate the opportunity to comment and am open to your 
questions. Thank you.
    Chairman Brown. Thank you very much, Mr. Suellentrop and 
Mr. Marranca. Thank you very much.
    I think that across the political spectrum and across both 
parties and everyone on this Committee is supportive of efforts 
to work with community banks, one, to help community banks deal 
with the difficulties of Dodd-Frank. I think that all of us 
want to see community banks succeed. I think all of us 
understand that the guilty parties on Wall Street caused--as 
Mr. Suellentrop said, the Wall Street-caused debacle to our 
financial system and to our economy had little to do with 
community bank practices, and all of us I think are disturbed--
I can just talk for myself, but I think we all are. Mr. 
Marranca, your comments that the ten largest banks today hold 
77 percent of all U.S. bank assets, I am quoting you, compared 
with 55 percent of total assets in 2002. We know what that bank 
crisis, what the disaster on Wall Street, we know what it did 
to community banks as we have seen more concentration just in 
that 9-year period. We know what it has done to our economy. We 
also know how it has made regulation more difficult. When you 
put up the OCC or the Office of Thrift Supervision or any of 
these regulatory--the FDIC, any of these regulatory bodies 
dealing with the sophistication and the resources of the 
biggest banks, it obviously is too often a mismatch.
    The former head of the OTS said an organization like OTS 
cannot supervise AIG, Merrill Lynch, or entities that have 
worldwide offices. There is no way. And that makes all of this 
more difficult.
    But shifting, Mr. Marranca, to your comments and 
understanding that megabanks were rewarded so often for the 
regulatory failures with bailouts while community banks too 
often are being shut down and the concentration of the larger 
banks gets greater and greater, talk to me specifically--and I 
like the thoughts of--and your testimony was helpful in this 
way from both of you. Talk about the costs and burden and 
supervision for your bank as compared to a too-big-to-fail 
bank. Put that in context, if you would, with your bank 
personally or with some of your member banks, but obviously you 
know yours best.
    Mr. Marranca. Yes, sir, Senator, and I would confidently 
say that my experience is the same as the vast majority of 
community banks across the country, and I will give you an 
example. I received an email 2 days ago that we would be--that 
soon an upcoming compliance examination by the FDIC would occur 
in my bank and that it would have a minimum of two people in my 
bank for a minimum of 4 weeks. That is just one compliance 
examination. I should add that at the current time I have the 
New York State Banking Department in my bank for a compliance 
examination.
    The point is we have a small shop, approximately 30 people. 
There is an opportunity cost for all the time, attention, and 
energy let alone what I feel is there could be a better 
utilization of the resources of the examiners.
    Again, this is just specialized compliance. In addition to 
compliance, we have a CRA examination, which is a separate 
examination. In my particular case, in New York State, I have a 
separate CRA examination by the State and by the FDIC.
    In addition to that, I have a BSA examination. I have an 
IAT or ADP examination. I just completed an examination by the 
Federal Home Loan regarding our secondary mortgage market. We 
just completed--the IRS just left our bank.
    There are very few times in my small, one-light town in 
Little Valley, New York, that I do not have examiners in my 
bank, and we are a 109-year-old institution, highly rated, low 
risk profile, and not a complex organization. It seems to me 
there is a better way to allocate the resources of examination. 
And this takes me away from lending and away from my consumers 
and away from my customers.
    Chairman Brown. You are a $174 million bank.
    Mr. Marranca. Yes, sir.
    Chairman Brown. Your comments about that, if you would, Mr. 
Suellentrop.
    Mr. Suellentrop. Thank you, Senator. Truth be known, we 
actually started an examination on Monday, so I should probably 
be there. We have, I believe, 17 examiners at our bank for 
probably a period of 2 to 3 weeks. We will review safety and 
soundness, information technology, BSA, and I am sure I am 
forgetting something, but it will take the time of the majority 
of our staff to accommodate getting their information and 
support, the bank's practices.
    Our bank is fortunate in that we are of the size where we 
have a sufficient number of employees where those efforts can 
be delegated amongst a number of our staff, although it is 
still a tremendous burden. We have many banks in the State of 
Kansas and throughout the Nation, substantially smaller than we 
are, who those burdens fall on one or two individuals and can 
be tremendous in terms of their cost to the bank as well as the 
time that it takes away from serving their customers and their 
community.
    So that is just the examination part. That does not take 
into account the daily routines of going through processes to 
ensure compliance and ensure safety and soundness and bank 
secrecy and the like. So it is a tremendous burden for 
community banks, and hopefully there are some alternative 
options to reducing that burden.
    Chairman Brown. You expressed, Mr. Suellentrop, you are 
reflecting, I think, what many community bankers, at least in 
my State and the conversations I have, and I think what you 
seemed to say of anger at what Wall Street did and the damage 
it caused to the economy, writ large, but obviously the damage 
it did to community banks, and the added scrutiny and pressure 
and costs to community banks.
    Do you think regulators are doing enough to oversee the--
understanding that you do not want it to spill on you in terms 
of more regulation, but do you think the regulators are doing 
enough to oversee these trillion-dollar banks? The last 
question for each of you.
    Mr. Marranca. I would be happy to jump in there. The answer 
is no. I am held accountable for--my board and I are held 
accountable for what we do at our bank. We have skin in the 
game. We take care of our communities, we take care of our 
customers, and we take care of our employees. To bail out the 
largest banks because of their failures, and in some cases 
borderline criminal behavior, I think goes against the 
capitalistic ways of this country and I think has done great 
harm.
    I have a tremendous competitive disadvantage when the 20 
largest banks in this country are too big to fail, and my 
customers know that.
    Are they held accountable? No. Are they scrutinized to the 
degree that we are? No. Should they be? Yes.
    Chairman Brown. Mr. Suellentrop, your comments on that?
    Mr. Suellentrop. Thank you, Senator. Probably examiners' 
efforts with the largest banks is above my pay grade in making 
that determination, but I can tell you from sitting in our bank 
and the impact that we feel from recent economic problems and 
the conditions we have today, it certainly feels like we are 
receiving the brunt of the examination overload.
    What additional regulation and examination is needed for 
the largest banks? I do not pretend to know that, but I know 
that for community banks the overload is significant, and they 
are certainly not slowing down. As the gentleman before us 
noted, there is a myriad of rules and regulations that are 
forthcoming.
    Chairman Brown. Thank you. And then a last comment. It 
seems that some in this town have been sort of lobbying the 
press and the media, and the agencies are using your situation 
to weaken the rules on some of the big banks, and I just do not 
want that ever conflated, that while virtually all of us I 
think here want to see the regulatory burden lifted from 
community banks and the banks in towns like where I grew up in 
Mansfield, Ohio, we do not want to see that as an excuse to 
weaken rules and further deregulation and weaken the Dodd-Frank 
implementation of the big banks that Mr. Marranca referred to.
    Senator Moran.
    Mr. Moran. Mr. Chairman, thank you very much. I thank both 
witnesses for their testimony.
    Let me ask in this case both of you, you heard--let me 
start with you, Mr. Suellentrop. You heard the previous panel 
in which we had representatives from the Federal Reserve, the 
Office of the Comptroller of the Currency, and the FDIC. Did 
you hear anything there that you would like to comment on as--
at least it has been in my experience in every conversation I 
have had with regulators at the table that you are seated at, 
they all indicate to me they make special consideration for 
community banks, they understand the challenges they face, they 
have task forces that have been created to make sure that 
community banks are not overregulated. There is the whole list 
of disclaimers about all the things we are doing to address the 
concerns that we are talking about, overregulation of community 
banks. And yet it never seems to me in my conversations with my 
bankers that there is any consequence to that constant effort 
that is claimed by the regulators to avoid overregulation. And 
I wondered if you heard anything from the witnesses today that 
did or did not make sense to you.
    Mr. Suellentrop. No, I cannot say that I did hear anything 
that would change my perspective on how community banks are 
going to be regulated or examined going forward. I would say 
that there is a significant persuasive attitude that an 
examiner in the field would be the same as the examiner in 
Washington, that they are not interested in having a problem 
bank or a failure on their watch. In other words, the comment 
was also made, ``We are going to err on the side of caution,'' 
in the first part of our examination in 2010. And I do not 
think that is going to change. I think they have a significant 
interest in protecting their reputation, and one way to do that 
is to be aggressive and to be thorough in their examinations. 
We are not suggesting they should not be thorough. We just ask 
that they are equitable.
    Mr. Marranca. Senator Moran, I would just ask--and the word 
that comes to my mind is--and it has been used often--is the 
``disconnect'' between Washington and the examiner in the 
field. Again, the examiner in the field has a difficult job, 
but yet they are out there and, generally speaking, there is no 
compromise, there is no discussion, there is no ``Let us get 
this fixed now, and we will take care of this.'' The way it--
ancient history now. The way it used to be in the examination 
field was a more cooperative basis and working together with 
the banker. Today's world--and I understand the world has 
changed. In the last 29 years that I have been CEO at 
Cattaraugus County Bank, every regulation that has landed on 
Wells Fargo or Bank of America has landed on my desk. There 
needs to be some type of tiered regulation. There needs to be a 
function where the examiners realize a difference between my 
risk profile and my business model and my relationship banking 
and the way that a $2 trillion bank does business. They do not 
have the flexibility to do that right now, so there is a real 
disconnect.
    Senator Moran. So the common conversation that we have that 
community banks, by regulators headquartered here in 
Washington, DC, their leadership tells us that community banks 
are treated differently. But your statement, your sentence 
stands out to me about what happens to Wells Fargo--every 
regulation that has been imposed upon them is imposed upon a 
community bank. Is that true?
    Mr. Marranca. That is true. And I look around, and Wells 
Fargo, or whoever it may be, has X number of attorneys and X 
number of resources that they can allocate toward that new 
regulation. And, again, over 30 years they have built up and 
built up and built up. Every time I get that regulation, I look 
out of my office, and I am looking at Sue or Mary or Bob and 
trying to figure out how are we going to do this. In some 
cases, it does not relate to my market or my business model in 
a very rural part of New York State.
    Senator Moran. Any sense of the qualifications, the 
background, and experience of the examiners that are in your 
banks today as compared to what they were in the past? Is there 
a change in the personnel that are examining your banks and 
their qualifications or characteristics? You mentioned in a 
sense the good old days, but is there a change in who is in our 
banks today as far as ability?
    Mr. Marranca. My perspective would be--and these are 
extremely sharp, smart, intelligent young people in many cases. 
In many cases--I do not know the average age of the examiner 
today, but the old corps, if you will, is gone, and the new 
youth is there. They are very smart. They are very intelligent. 
Do they have experience in banking? Not specifically.
    Also, I do want to add, in today's world when you have an 
ADP specialist, a compliance specialist, a BSA specialist, a 
CRA specialist, none of those examiners have a holistic 
approach to the bank as a whole. They are not in any way 
concerned about my capital, my 100-year-old history, even my 
CAMELS rating or my profits. They are only concerned with their 
very narrow point of view of their expertise. So they are 
smart, they are intelligent, they are experts. But in my humble 
opinion, they need to broaden their holistic approach to the 
bank as a whole. We are not a risk to the FDIC fund, nor are we 
a risk to the economic system. So treat us in that way. 
Understand the role that we provide in the community. Because 
if they put us out of business, when we are gone we are gone, 
and it will be too late for my community.
    Mr. Moran. Mr. Suellentrop, Kansas has lost thirty banks in 
the last 5 years, as I understand the numbers. One of my 
concerns is that community banking may become a thing of the 
past based upon increasing regulations and the cost associated 
with that. And by that I mean that community banks will need to 
have more branches, be acquired by a larger bank to spread 
those costs among, more assets, more loans, more customers.
    Is there a consequence to the ability to keep community 
banking alive and well? Is there a consequence to this 
regulatory environment? And is there anything you see that is 
coming down the road? We still have the Consumer Protection 
Financial Bureau regulations to be put in place. Are there 
fears about what the next--my guess is you may tell me you may 
survive today, but are you worried about what is coming in the 
future and the uncertainty of that? How does it affect the 
operations of your bank?
    Mr. Suellentrop. Senator, I would say that there is a 
concern in terms of the number of community banks continuing to 
decline. In conversations with bankers through meetings I 
attended, I would say that in the past year or 2 years there is 
a significant concern that bankers who are likely to sell their 
bank and to probably merge with another institution. And one of 
the things that I think is holding them back is that their 
market for that is not good right now. But there are many 
bankers frustrated by the rules and regulations and 
examinations and looking to possibly get out of the banking 
business in the next several years. I do not see anything 
immediate that is on the horizon that is going to change that. 
The Consumer Protection Bureau, as you suggested, has not yet 
begun to issue its regulations. That has certainly bankers 
concerned about the potential impact of additional regulatory 
burden.
    Things that were discussed earlier, such as access to the 
secondary mortgage market, are very important to our bank and 
community banks because that is one of the significant ways we 
can increase our business exposure in our community.
    Mr. Moran. Thank you, Mr. Chairman.
    Chairman Brown. Thank you, Senator Moran.
    Senator Merkley.
    Senator Merkley. Thank you, Mr. Chairman, and thank you 
both for bringing your insights from the front line, if you 
will.
    Mr. Marranca, you addressed in part the risk retention rule 
and noted that we should have a broad exemption for qualified 
mortgages. By broad exemption, I wanted to interpret that, but 
I wanted to make sure I had the correct interpretation. 
Currently there is discussion of a very sizable downpayment 
requirement, which has been of great concern to me. When you 
are speaking about a broad exemption, are you talking about a 
much smaller downpayment requirement, if you will?
    Mr. Marranca. I think--and I will use the word 
``arbitrary''--20 percent is just unrealistic in the market, at 
least for a community bank, especially in my rural market. We 
have a very low per capita income and so forth. We have two 
family income earners struggling to either get into their first 
home or upgrade their home. We try very hard to make that dream 
come true and get a person in the right house. Mandatory 20 
percent or a concentration of the secondary mortgage market out 
of my control, and I would hate to see it be with one of those 
20 largest banks, I think would be--do a disservice to the 
housing market in our country and in my market.
    Senator Merkley. Thank you. I think of what 20 percent is 
in the working community that I live in where houses are about 
$200,000, and the idea of families having $40,000 in savings to 
put down on a house seems one in a million. Thus, the folks 
would fall into a second category or a different mortgage 
market with yet to be understood interest penalties for that. 
My concern--and it sounds like you are echoing this--is that we 
essentially put home ownership out of reach of families.
    Mr. Marranca. I do not think you can legislate or mandate, 
if you will, the underwriting process. Our job--and I have 30 
years' experience, and I have a mortgage officer with many--our 
job is to underwrite our consumers when they walk in and they 
want that mortgage. We know how to do that, and it is not just 
downpayment. It is the ability to pay and certainly their 
credit and the debt-to-income. There are many, many factors 
involved.
    We can make a business judgment if somebody can afford it 
and that is the right home for them at the right price. We 
certainly have never done any subprime and 110-percent loans, 
et cetera, et cetera. So leave the business of lending to us.
    Senator Merkley. Mr. Suellentrop, do you share that concern 
over the potential 20-percent requirement?
    Mr. Suellentrop. Absolutely, Senator. We have been in the 
business of making residential lending since I joined the bank 
40 years ago almost as a key component of what we do for our 
customers in our community. Twenty percent down for the vast 
majority of homeowners is unreasonable. With the use of private 
mortgage insurance, there are many, many ways to satisfy safety 
and soundness in a mortgage transaction, and we originated over 
$30 million in mortgage lending last year. A very important 
part of our business and serving our customers and our 
community, and 20 percent would be a substantial impact to that 
process and that product for our customers.
    Senator Merkley. Thank you both. I want to turn to a 
different topic, which is the ability to make additional loans. 
Mr. Marranca, in your testimony you note that banks have had to 
pass up sound loan opportunities, or at least your bank has, in 
order to preserve capital. This goes to the leverage ratio that 
the FDIC holds. And as I was talking to community banks in 
Oregon, they expressed the challenge of raising capital. We 
have gone from irrational exuberance to irrational fear, if you 
will, of investing in community banks.
    So the result was developing the Small Business Lending 
Fund, which ICBA endorsed and assists with. We have had 600 to 
700 applications so far to Treasury for Small Business Lending 
Fund equity so that banks could do additional lending but are 
constrained by the capital requirements, and not a single 
decision has been made yet by Treasury.
    What is going wrong? Why isn't Treasury making decisions 
and using this program to increase access to capital, both 
important to the community banks and important to small Main 
Street businesses across America?
    Mr. Marranca. Senator, I certainly cannot speak for the 
Treasury, but I would comment--I would love to participate in 
that, but I have looked at it very carefully, and there is just 
no way I can do it. First of all, one capital ratio size does 
not fit all, just like one regulation does not fit all. We have 
plenty of capital at our bank, and, in fact, we need to grow 
our capital, but for a good reason: because our bank has grown 
30 percent in the last 3 to 4 years. We acquired two branches 
in an adjoining county. That dropped our capital level down. 
But I am making a decision for my shareholders in the long run. 
What is in the best interests of the bank in the long run? So 
we dropped down, if you will, to a 7-percent capital level. 
Given our CAMELS ratings, our risk rating and so forth, 7 
percent capital is more than adequate.
    When an examiner comes in and says, ``I do not know about 
that 7. It looks like you have dropped. I think you need to get 
up to 9, and we will see how you do, and we are going to be 
watching,'' that gets my attention. It does not make me not 
make a loan, but yet it gets my attention. And I have had to 
slow down the growth of our bank from a depository standpoint 
because that affects the capital ratio, too.
    On the Small Business Lending Fund, our bank has $100 
million--we are a small bank--a $100 million loan portfolio. It 
takes $1 million a month in new loans just to maintain that 
level at $100 million, $1 million in new loans a month. I am in 
a very rural, nongrowth market. It is very difficult to do 
that. But we are doing it.
    If it is very difficult to do that, it is going to be 
extremely difficult if not impossible for me to raise my 
lending 5 percent, 6 percent, 4 percent. Thus, I cannot 
participate in the Small Business Lending Fund. I cannot create 
loan demand. I have the products, I have the people, I have the 
money to lend. But I cannot create loan demand in a 
recessionary, very challenges economic market.
    Senator Merkley. Yes. And you are in a different situation 
than some community banks in that access to capital was not 
your primary challenge, if you will, so that makes a lot of 
sense.
    Any thoughts on this, Mr. Suellentrop?
    Mr. Suellentrop. Well, Senator, I know there is a lot of 
interest in the Small Business Lending Fund, but I honestly do 
not have any insight into why the program is floundering.
    Senator Merkley. Well, the main challenge is Treasury is 
not making any decisions.
    Mr. Suellentrop. That is right.
    Senator Merkley. So I am just trying to get a sense from 
the field. I know I am hearing from community banks that are 
very frustrated that have applied, feel like this would--these 
are banks that are constrained by their capital ratios, and so 
their ability to make additional loans is directly impacted by 
that.
    I wanted to go back to--actually I am over my time, so 
thank you all.
    Chairman Brown. Thank you, Senator Merkley.
    I wanted to follow up on one comment that Senator Merkley 
made or your response to the question about the 20 percent. I 
appreciate the flexibility and how you know your customers and 
know your communities, and a 20-percent downpayment might make 
sense for some, somebody else doing 15 percent, but having a 
strong financial credibility with you and all. So I certainly 
understand that flexibility.
    Senator Corker mentioned that earlier. He had had an 
amendment, my recollection is, on the Senate floor during Dodd-
Frank. He had an amendment for a requirement of a downpayment 
of 5 or 10 percent. I cannot remember. Understanding if we had 
had that, some standard across the country, some of our 
problems might not have--surely would not have happened. Would 
any requirement make sense? I understand 20 percent can be 
harsh when you know your customers well and need flexibility. 
If there were--and, again, this is not in the statute, to my 
understanding, but if there were a 5- or 10-percent 
requirement, would community banks object to that? Is that 
something that would make sense to you?
    Mr. Marranca. It makes a lot of sense to me, Senator. I am 
a strong proponent of you have to have some skin in the game, 
whether it is buying a car, a house----
    Chairman Brown. And you do not mind a Federal rule perhaps 
saying 5 or 10? You would rather not have 20, but 5 or 10?
    Mr. Marranca. If there were some flexibility there with 
some limited skin in the game, I do not see--I do not believe 
in 100-percent lending.
    Chairman Brown. OK. Any thoughts, Mr. Marranca?
    Mr. Marranca. Well, I know that the recent past has proven 
that downpayments are important. However, I know that there are 
a number of first-time home buyer programs out there through 
various sources that are important to the housing industry and 
individuals and families getting into their own homes. So I 
think we would need to recognize that there are some programs 
that might be impacted if we demand a minimum amount of 5 or 10 
percent.
    Chairman Brown. OK. Thank you very much, Mr. Suellentrop 
and Mr. Marranca. Thank you very, very much.
    The record will remain open for 5 days, as we typically do. 
I appreciate your attendance, and thank you, Senator Merkley 
and Senator Moran.
    The Subcommittee is adjourned.
    [Whereupon, at 11:44 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]

                 PREPARED STATEMENT OF MICHAEL R. FOLEY

    Senior Associate Director, Division of Banking Supervision and 
      Regulation, Board of Governors of the Federal Reserve System
                             June 15, 2011

Introduction
    Chairman Brown, Ranking Member Corker, and other Members of the 
Subcommittee, thank you for the opportunity to testify today regarding 
the Federal Reserve Board's supervision and examination of financial 
institutions and changes to our supervisory policies and procedures for 
these institutions in response to the recent financial crisis. I am a 
senior associate director in our Banking Supervision and Regulation 
division.

Background
    The Federal Reserve has supervisory and regulatory authority for 
bank holding companies, including the consolidated supervision of 
large, complex financial firms, State-chartered banks that are members 
of the Federal Reserve System (State member banks), and certain other 
financial institutions and activities. We work with other Federal and 
State supervisory authorities to ensure the safety and soundness of the 
banking industry, foster the stability of the financial system, and 
provide for fair and equitable treatment of consumers in their 
financial transactions.
    The Federal Reserve is involved in both regulation, that is, 
establishing the rules within which banking organizations must operate, 
and supervision, ensuring that banking organizations abide by those 
rules and remain, overall, in safe and sound condition. A key aspect of 
the supervisory process is evaluating risk-management practices. 
Because rules and regulations cannot always reasonably prescribe the 
exact practices each individual bank should use for risk management, 
supervisors design policies and guidance that expand upon requirements 
set in rules and regulations and establish expectations for the range 
of acceptable practices. Supervisors rely extensively on these policies 
and guidance as they conduct examinations and assign supervisory 
ratings.

Enhancing Supervision of Large Institutions
    The recent financial crisis revealed critical vulnerabilities in 
the financial regulatory framework and the financial system. In the 
years before the crisis, nonbank financial entities proliferated by 
exploiting gaps in the regulatory framework. This occurred during a 
period of increasing asset prices and abundant capital and liquidity, 
which eventually led to a relaxing of underwriting standards, 
deterioration in risk-management practices, and rapid growth of complex 
and opaque financial products for both consumers and investors. The 
combination of these factors created the vulnerabilities that 
ultimately led to the financial crisis and, in response, the Congress 
and the Administration last year addressed many of these issues by 
enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act.
    However, even before passage of the Dodd-Frank Act, the Federal 
Reserve had been taking action to reorient its supervisory structure 
and strengthen its supervision of the largest, most complex financial 
firms in response to the crisis. In so doing, the Federal Reserve 
enhanced its large bank supervision program through the creation of the 
Large Institution Supervision Coordinating Committee, a centralized, 
multidisciplinary body made up of bank supervisors, economists, 
attorneys, and others. Relative to previous practices, this body makes 
greater use of horizontal, or cross-firm, evaluations of the practices 
and portfolios of the largest institutions. It relies more on 
additional and improved quantitative methods for evaluating the 
performance of firms, and it employs the broad range of skills of 
Federal Reserve staff more effectively. In addition, we have 
reorganized to more effectively coordinate and integrate policy 
development for, and supervision of, systemically important financial 
market utilities.
    More recently, we have also created an Office of Financial 
Stability Policy and Research at the Federal Reserve Board. This office 
coordinates our efforts to identify and analyze potential risks to the 
broader financial system and the economy. It also helps evaluate 
policies to promote financial stability and serves as the Board's 
liaison to the Financial Stability Oversight Council.
    The crisis demonstrated that a too narrow focus on the safety and 
soundness of individual firms can result in a failure to detect and 
thwart emerging threats to financial stability that cut across many 
firms. The Dodd-Frank Act requires supervisors to take more of a 
macroprudential approach; that is, to supervise financial institutions 
and critical infrastructures with an eye toward not only the safety and 
soundness of each individual firm, but also taking into account risks 
to overall financial stability. The Supervisory Capital Assessment 
Program (SCAP), led by the Federal Reserve in early 2009 as a key 
element of the plan to stabilize the U.S. financial system, 
demonstrated the feasibility and benefits of employing such a 
perspective.
    Building on SCAP and other supervisory work coming out of the 
crisis, the Federal Reserve initiated the Comprehensive Capital 
Analysis and Review (CCAR) in late 2010 to evaluate the internal 
capital planning processes of large, complex bank holding companies. 
The CCAR represented a substantial strengthening of previous approaches 
to ensuring that large firms have thorough and robust processes for 
managing and allocating their capital resources. We also focused on the 
risk measurement and management practices supporting firms' capital 
adequacy assessments, including their ability to deliver credible 
inputs to their loss estimation techniques.
    While our revised internal organizational structure facilitates our 
implementation of a macroprudential approach to supervision, it does 
not diminish the need for careful microprudential oversight of 
individual institutions. This serves many purposes beyond the 
enhancement of systemic stability, including the protection of the 
deposit insurance fund, the detection of money laundering and other 
forms of financial crime, and the prevention of unlawful discrimination 
or abusive lending practices. Equally important, is that 
microprudential oversight also provides the knowledge base on which a 
more systemic approach must be built; we cannot understand what is 
going on in the system as a whole without a clear view of developments 
within key firms and markets. Without a strong microprudential 
framework, macroprudential policies would be ineffective.

Supervision of Community and Regional Banks
    While many of our recent actions have focused on enhancing the 
supervision programs for the largest institutions, we have also been 
making adjustments to the supervision programs for community and 
regional banks in response to lessons learned. As liquidity strains 
developed at many banks during the crisis, we adjusted our focus to 
place greater emphasis on evaluating liquidity contingency funding 
plans at supervised community and regional banks. Liquidity pressures 
have eased considerably due to actions taken by the banking agencies 
during the crisis, recent legislative changes to increase the level of 
deposits insured by the Federal Deposit Insurance Corporation, and more 
stable market conditions. But given our experience during the crisis we 
are retaining a heightened focus on liquidity management and planning, 
particularly for institutions that rely on more volatile or 
nontraditional funding sources.
    As commercial real estate (CRE) began to deteriorate and affect the 
performance of supervised institutions, we conducted reviews of our 
implementation of the 2006 interagency guidance addressing CRE 
concentrations. These reviews helped us to identify issues for which 
examiners and bankers needed clarification and to contribute to the 
2009 interagency guidance aimed at facilitating prudent workouts of CRE 
loans. As real estate conditions have remained weak and adversely 
affected the performance of many banks, we have continued to refine our 
examination procedures to address emerging supervisory issues related 
to CRE lending.
    To learn more from recent events, we have begun to analyze the 
characteristics of community banks that remained in sound condition 
throughout the crisis. Our preliminary work suggests that these 
institutions had many fundamental characteristics in common. For 
example, most of these banks had relatively well-diversified loan 
portfolios and because of that were able to report strong earnings and 
net interest margins throughout the crisis. They tended to have limited 
reliance on noncore funding and had strong capital levels as they 
entered the crisis. As we continue our study, we hope that what we 
learn will prove helpful in our efforts to evaluate and refine 
supervisory processes in the wake of the crisis.
    In addition to these efforts, we have also increased our outreach 
efforts with community and regional banks. In October 2010, the Board 
formed a Community Depository Institutions Advisory Council that 
includes representatives from across the country and provides the 
Federal Reserve with direct insight and information from community 
bankers about the economy, lending conditions, supervisory matters, and 
other issues of interest. We expect these ongoing discussions will 
provide a particularly useful and relevant forum for improving our 
community bank supervision program, and a better understanding of how 
legislation, regulation, and evolving examination activities affect 
small banking organizations.
    Additionally, the Board recently established a special supervision 
subcommittee that provides leadership and oversight on a variety of 
matters related specifically to community bank supervision. A primary 
role of this subcommittee, which includes Governors Elizabeth A. Duke 
and Sarah Bloom Raskin, two Board members with significant community 
banking experience, is to review policy proposals and evaluate their 
potential effect on smaller institutions, both in terms of safety and 
soundness and potential regulatory burden.
    While the crisis has made it clear that some tightening of 
supervisory expectations was needed, we are also mindful of the risks 
that excessive tightening could have on banks' willingness to lend to 
creditworthy small businesses and consumers. Consequently, we have 
worked hard to ensure that our examiners are well-trained and employ a 
balanced approach when reviewing banks' underwriting and risk-
management practices. We expect examiners to strive for consistency in 
the examination process throughout the business cycle. Our Rapid 
Response program, which has been in effect since the crisis, is a 
widely attended weekly conference call for examiners that has been 
invaluable in delivering these messages, and others, to our field 
examiners.

Compliance and Examination Costs
    Banks consistently tell us that they face a number of regulatory 
uncertainties, which makes it hard for them to calculate the potential 
cost of compliance and its potential effect on operations and 
profitability. Firms of all sizes have been communicating these 
concerns, despite the fact that the requirements of the Dodd-Frank Act 
are primarily directed at firms with consolidated assets of $50 billion 
or more. Smaller institutions voice concerns that supervisory 
expectations being set for the largest institutions could ultimately be 
imposed on them in a burdensome way, which will adversely affect 
community bank competitiveness and profitability, as these institutions 
have less ability to absorb increased compliance costs and have less 
staff available to manage new processes.
    The Federal Reserve is cognizant of the challenges institutions, 
especially smaller institutions, face in the current environment. 
Banking supervision should be conducted in a way that is effective for 
all institutions, but it should also be scaled to the size and 
complexity of the supervised firm. The largest, most complex banks will 
incur costs to comply with the requirements of the Dodd-Frank Act. For 
example, stress testing provisions in the Dodd-Frank Act require these 
institutions to adequately identify the risks associated with their 
diverse business lines and to quantify this risk taking, which will 
require investments in data management technology and other risk 
identification systems. Smaller institutions, while still expected to 
adequately measure, monitor, and control risk in their organizations, 
will not necessarily need to incur additional costs, assuming existing 
risk management structures are sufficiently robust.

Continuing Credit Challenges
    Credit markets have been recovering slowly since the financial 
crises, and recent measures of aggregate credit outstanding have shown 
signs of improvement after declining throughout 2009 and much of 2010. 
Nonrevolving consumer credit outstanding, which includes auto and 
student loans, has increased for the past 9 months. Issuance of 
corporate bonds and syndicated loans has been robust for the past few 
quarters, and new issuance of commercial mortgage-backed securities 
increased in the first quarter of 2011, albeit from very low levels. 
Outstanding balances of commercial and industrial loans have also 
resumed modest growth.
    However, residential and commercial real estate remain lagging 
sectors. This continues to present challenges for banks and 
supervisors. With housing values flat or deteriorating in many markets, 
there are renewed concerns about the health of the mortgage market and 
home equity loans in particular. In addition, weak fundamentals in the 
CRE sector, including high vacancy rates and declining rents, continue 
to place pressure on all but the highest quality properties with strong 
tenants in healthier markets. With residential and commercial property 
values still under strain, heightened reserve levels at banks remain 
appropriate for these sectors, and we expect that banks will continue 
to incur losses due to ongoing weakness in real estate markets. It will 
take time to make progress on the overhang of distressed commercial and 
residential real estate, and banks will need to take strong steps to 
ensure that losses are recognized in a timely manner, and that reserves 
and capital levels remain adequate.

Conclusion
    The crisis demonstrated the need to always be mindful of and 
diligent about addressing the possible implications of severely adverse 
outcomes for individual institutions and the financial system more 
broadly. Enhancements the Federal Reserve has made to its supervisory 
process, coupled with improvements required by the Dodd-Frank Act, 
support enhanced regulation and supervision of large, complex firms 
that have the potential to trigger systemic risks. But, improvements in 
the supervisory framework will lead to better outcomes only if day-to-
day supervision is well executed, with risks identified early and 
promptly remediated. When we have significant concerns about risk 
management at complex firms, we are raising those concerns forcefully 
with senior management at the firms, holding them accountable to 
respond, and tracking their progress.
    The Federal Reserve is also enhancing supervision of regional and 
community banks, placing greater emphasis on the development of sound 
risk-management practices. In so doing, we are mindful of the need to 
ensure that bank supervision is scaled to the size and complexity of 
the supervised firm; and that bank management and examiners take a 
balanced approach to ensuring the safety and soundness of the banking 
system and serving the credit needs of the community.
                                 ______
                                 
               PREPARED STATEMENT OF CHRISTOPHER J. SPOTH

   Senior Deputy Director, Division of Risk Management Supervision, 
                 Federal Deposit Insurance Corporation
                             June 15, 2011

    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee, thank you for the opportunity to testify on behalf of the 
Federal Deposit Insurance Corporation (FDIC) about our supervisory 
process, how it has changed based on lessons we learned from the 
crisis, and what we see as opportunities for continued improvement.
    Congress created the FDIC in 1933 in response to the most serious 
financial crisis in U.S. history. Our mission is to promote financial 
stability and public confidence in individual banks and in our Nation's 
banking system through bank supervision, deposit insurance, consumer 
protection, and the orderly resolution of failed banking institutions. 
As the primary Federal supervisor for the majority of U.S. community 
banks, the FDIC seeks to maintain a balanced approach to bank 
supervision, regardless of financial and economic conditions. In our 
unique role as deposit insurer, we have a vital interest in assessing 
risks to the Deposit Insurance Fund (DIF) posed by all FDIC-insured 
institutions.
    My testimony today first provides some background information on 
the condition of the industry and the problems that led to the recent 
financial crisis. I will discuss our approaches to supervising large 
institutions and smaller community banks. Finally, I will discuss some 
provisions of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (Dodd-Frank Act) that we are incorporating into our supervisory 
process.

Condition of the Industry
    Leading up to the financial crisis, FDIC-insured institutions 
recorded 6 consecutive years of record earnings, culminating in $145.2 
billion in 2006. However, this extended period of industry 
profitability masked the underlying weaknesses in credit quality that 
would emerge starting in 2007 as real estate markets weakened and the 
U.S. economy moved into recession. By 2008, annual industry earnings 
had fallen to just $4.5 billion and, in 2009, the industry recorded a 
net loss of $9.8 billion--the largest loss in its history. Quarterly 
provisions for loan losses taken by FDIC-insured institutions since the 
end of 2007 now total just under $645 billion, equal to over 8 percent 
of the book value of loans outstanding at the beginning of 2008.
    During the first quarter of 2011, FDIC-insured institutions 
recorded annual net income of $29 billion, the highest level since 
before the recession, but still well below the all-time highs of the 
mid-2000s. The main driver of earnings improvement has been steadily 
reduced provisions for loan losses. This reflects general improvement 
in asset quality indicators, including declining levels of noncurrent 
loans and net charge-offs for all major loan types. However, the ratio 
of noncurrent loans \1\ to total loans, at 4.7 percent, is still 
relatively high and remains above the levels seen in the late 1980s and 
early 1990s. While the reduced provisions for loan losses are 
encouraging, it is important to note that net operating revenue fell by 
$5.5 billion in the first quarter of 2011 compared to 1 year ago. Lower 
revenues, in part, reflect reduced loan balances, which have declined 
in 10 of the past 11 quarters. Growth in well-underwritten loans is 
essential not only for banks to build revenues but also to provide a 
stronger foundation for economic recovery. Recent surveys, such as the 
Federal Reserve Senior Loan Officers' Opinion Survey and the National 
Federation of Independent Businesses' Survey on Small Business Economic 
Trends, also indicate that borrower demand remains sluggish.
---------------------------------------------------------------------------
     \1\ Noncurrent loans are those that are 90 or more days past due 
or are on nonaccrual.
---------------------------------------------------------------------------
    Despite the economic challenges, community banks, which comprise 
the vast majority of banks that we supervise, continue to play a vital 
role in credit creation across the country, especially for small 
businesses. This has been borne out by loan originations over the past 
several years. On a merger-adjusted basis, community bank loan balances 
have increased by about 1 percent since the second quarter of 2008. \2\ 
However, over the same period, overall industry loan balances fell by 
about 9 percent.
---------------------------------------------------------------------------
     \2\ In merger-adjusted growth analysis, loan balances reported by 
banks with assets less than $1 billion in the current quarter are 
compared with these same institutions' loan balances in a prior period. 
Prior-period loan balances include those of any institutions merged or 
acquired in intervening periods.
---------------------------------------------------------------------------
    While commercial property fundamentals point to stabilization, 
recent weakness in both residential and commercial property price 
trends highlight continued concerns. The S&P/Case-Shiller National 
Housing Index is down 5.1 percent year-over-year through first quarter 
2011 and the Moody's/REAL Commercial Property Price Index has decreased 
by 8.5 percent in the year ending in March 2011. In both cases, 
distressed properties are weighing down prices.
    Overall, we are cautiously optimistic regarding the current 
condition and trends in the banking industry. The number of 
institutions on the FDIC's ``Problem List'' is leveling off and the 
number of institution failures appears to have peaked in 2010. During 
the first quarter of 2011, the number of institutions on the FDIC's 
``Problem List'' increased slightly from 884 to 888. Similarly, the 
current pace of failures is lower than the 157 failures in 2010. 
Nevertheless, the number of troubled institutions remains high at 12 
percent of all insured institutions, indicating that a portion of the 
industry continues to struggle with lingering credit-quality issues. 
These issues adversely impact the ability of many institutions to grow 
their lending activity.

Factors That Led to the Recent Financial Crisis
    Factors that led to the crisis of 2008 and motivated the 
legislative reforms were in four broad areas: excessive reliance on 
debt and financial leverage, misaligned incentives in financial 
markets, failures and gaps in financial regulation, and the erosion of 
market discipline due to regulatory arbitrage and ``Too Big to Fail.''
    With regard to financial regulation, the regulatory reforms put in 
place for federally insured depository institutions following the 
banking crisis of the 1980s and early 1990s helped to constrain risk-
taking on bank balance sheets. However, opportunities for regulatory 
arbitrage allowed risks to grow in the so-called shadow banking 
system--a network of large-bank affiliates, special-purpose vehicles, 
and nonbank financial companies that existed largely outside of the 
prudential supervision, capital requirements, and FDIC receivership 
powers that apply to federally insured depository institutions in the 
U.S. The migration of financial activities outside of regulated 
financial institutions to the shadow banking system ultimately lessened 
the effectiveness of regulation and made the financial markets more 
vulnerable to a breakdown.
    Many of the structured finance activities that generated the 
largest losses were complex and opaque transactions undertaken at the 
intersection of the lightly regulated shadow banking system and the 
more heavily regulated traditional banking system. For instance, 
private-label mortgage backed securities (MBS) and associated 
derivatives were originated through mortgage companies and brokers and 
facilitated by banks that were securitizers. As became evident, many of 
the underlying mortgage loans were poorly underwritten and contained a 
host of layered risks.
    The housing bubble ensued, fueled with poorly underwritten loans 
originated for sale into the securitization market. The MBS were 
subject to minimum securities disclosure rules that are not designed to 
evaluate loan underwriting quality. For banks, once these loans were 
securitized, they were off the balance sheet and no longer on the radar 
of many banks and bank regulators. The mortgage loans began to default 
in high numbers undermining the MBS market. Eventually, the housing 
bubble collapsed, construction and development slowed, unemployment 
rose, and the economy went into recession. In addition, home prices 
continue to be depressed due to several factors including flawed 
mortgage servicing practices, which are not yet fully corrected, the 
overhang of foreclosure inventory, and the potential for litigation 
exposure.
    One of the most powerful inducements toward excess leverage and 
institutional risk-taking in the period leading up to the crisis was 
the lack of effective market discipline. Several large, complex U.S. 
financial companies at the center of the 2008 crisis could not be wound 
down in an orderly manner when they became nonviable. With the 
exception of any insured depository institutions that they owned, their 
operations were subject to the commercial bankruptcy code, as opposed 
to FDIC receivership laws. In addition, some major important segments 
of their operations were located abroad and therefore outside of U.S. 
jurisdiction. In the heat of the crisis, policy makers in several 
instances resorted to bailouts instead of letting these firms collapse 
into bankruptcy because they feared that the losses generated in a 
failure would create a cascade of defaults through the financial 
system, freezing financial markets and seriously damaging our economic 
system.
    Community banks were generally not involved in the mortgage-related 
issues at the first stages of the financial crisis, but were impacted 
as the recession took hold. Community banks tend to focus on local 
markets and loans for which local knowledge and personal service 
provide a competitive advantage, such as residential construction loans 
and other smaller commercial real estate projects. Construction and 
development (C&D) lending in areas that had experienced the steepest 
increase in home prices during the boom was hit first. Credit losses 
rose and subsequently spread across all loan types and rose as 
borrowers were caught in the recession and then slow recovery. At the 
same time, community banks' other sources of revenue used to offset 
credit losses from real estate portfolios was limited.

FDIC Supervisory Responsibilities
    Despite the recent economic disruptions and subsequent 
stabilization, the FDIC's supervisory programs, while responsive to 
intensified problems in the industry, remain balanced. To accomplish 
this goal, the FDIC continuously enhances its examination and other 
supervisory approaches and maintains dialogue with institutions 
throughout the examination cycle.
    The FDIC serves as the primary Federal regulator for State-
chartered institutions that are not members of the Federal Reserve 
System. The FDIC currently supervises 4,664 institutions, 4,358 of 
which have total assets of less than $1 billion. Regardless of size, as 
deposit insurer, the FDIC has an important interest in the condition of 
all insured institutions and their individual and aggregate impact on 
the DIF. As a result, the FDIC also has back-up authority to 
participate in examinations, with the primary Federal regulator, at any 
insured institution.
    The FDIC has, for a number of years, had different approaches to 
its supervision of larger, complex institutions from that of community 
banks. The larger, more complex institutions, and some mid-tier 
institutions, are subject to continuous on-site examination by teams of 
examiners and to extensive reporting. The smaller community banks have 
an annual or 18-month exam cycle and are also monitored off-site using 
quarterly Call Report information. The differences in the supervision 
of large and small banks are discussed in more detail below.

Supervision of Large Banks and Financial Firms
    Supervisory programs, particularly for the larger institutions, 
have evolved to address the issues that led to the financial crisis, 
and to reflect the important protections and changes added by the Dodd-
Frank Act. The Act requires that the FDIC and the Federal Reserve Board 
jointly issue regulations to implement new resolution planning and 
reporting requirements. These rules will apply to bank holding 
companies with total assets of $50 billion or more and nonbank 
financial companies designated by the Financial Stability Oversight 
Council (FSOC) as ``Systemically Important Financial Institutions'' 
(SIFIs).
    In addition, covered companies would be required to submit a 
resolution plan. Resolution plans should identify and map covered 
companies' business lines to legal entities and provide integrated 
analyses of their corporate structure; credit and other exposures; 
funding, capital, and cash flows; domestic and foreign jurisdictions in 
which they operate; their supporting information systems and other 
essential services; and other key components of their business 
operations. The resolution plan requirement in the Dodd-Frank Act 
appropriately places the responsibility on financial companies to 
develop their own plans ``for rapid and orderly resolution in the event 
of material financial distress or failure'' with review by the FDIC and 
the Federal Reserve Board.
    The agencies are also working to develop a substantive process for 
reviewing resolution plans to determine whether a plan is both credible 
and would facilitate an orderly resolution of the company under the 
Bankruptcy Code. If a resolution plan is found to be ``not credible,'' 
then the FDIC and the Federal Reserve Board may impose more stringent 
standards and take other action. If, after 2 years, the company's plan 
is still ``not credible,'' the FDIC and the Federal Reserve Board may, 
in consultation with the FSOC, direct a company to divest certain 
assets or operations.
    To focus the FDIC's expanded responsibilities to monitor and, 
potentially, resolve SIFIs, we established an Office of Complex 
Financial Institutions (OCFI). The OCFI will be responsible for the 
FDIC's role in the oversight of large bank holding companies and their 
corresponding insured depository institutions as well as for nonbank 
financial companies designated as systemically important by the FSOC. 
The OCFI will handle the FDIC's responsibilities, in concert with the 
Federal Reserve Board, for reviewing resolution plans and credit 
exposure reports developed by the SIFIs. Also, the OCFI will be 
responsible for implementing and administering the FDIC's SIFI 
resolution authority and for conducting special examinations of SIFIs 
under the FDIC's back-up examination and enforcement authority.

Supervision of Community Banks
    Supervision of community banks consists of regular on-site 
examinations along with quarterly off-site monitoring of financial 
performance. Where conditions dictate closer supervision, we conduct 
on-site visits and collect supplemental information. As the supervisor 
of 4,358 community banks, \3\ the FDIC has a keen appreciation for the 
important role community banks play in the national economy. Community 
banks have branches in nearly all towns and urban areas, and about two-
thirds of all branches in rural areas belong to community banks.
---------------------------------------------------------------------------
     \3\ Throughout this testimony, for purposes of data analysis, 
community banks are defined as banks and thrifts with total assets of 
less than $1 billion.
---------------------------------------------------------------------------
    The FDIC's supervisory activities are carried out by examiners 
working from field offices located in 85 communities across the 
country. These examiners know the community banks in their areas and 
are familiar with the local conditions facing those banks. Many have 
seen more than one previous economic down cycle and recognize the 
critical role that community banks play in credit availability.
    As discussed earlier, community banks still face lingering problems 
in their real estate loan portfolios and spillover effects caused by 
the collapsed housing bubble and the slow economy. Asset quality is not 
deteriorating as before, but volumes of troubled assets and charge-offs 
remain high, especially in the most affected geographic areas. The FDIC 
supervisory responses are scaled according to the severity of the 
weaknesses that a bank may exhibit. Banks with significant loan 
problems require close supervisory attention.

Supervisory Action To Encourage Real Estate Recovery and Lending
    Throughout the real estate and economic downturn, the FDIC has 
advocated for policies that will help community banks and their 
customers navigate this challenging period and mitigate unnecessary 
losses. We share community banks' desire to restore profitability, 
strengthen asset quality, and serve the credit needs of local markets. 
The FDIC has worked closely with banks as they have taken steps to 
raise capital, enhance their loan workout functions, and revise 
strategic plans to remain competitive in the financial services 
industry. Through our regional and field offices located throughout the 
country, the FDIC actively communicates with the community banks we 
supervise and provides recommendations for addressing operational and 
financial weaknesses as appropriate.
    In addition, the FDIC has joined several interagency efforts that 
encourage banks to originate and restructure loans to creditworthy 
borrowers, and to clarify outstanding guidance. For example, the 
Federal bank regulatory agencies issued the Interagency Statement on 
Meeting the Needs of Creditworthy Borrowers on November 12, 2008, which 
encouraged banks to prudently make loans available in their markets. 
The agencies also issued the Interagency Statement on Meeting the 
Credit Needs of Creditworthy Small Business Borrowers on February 12, 
2010, to encourage prudent small business lending and emphasize that 
examiners will apply a balanced approach in evaluating loans. This 
guidance was issued subsequent to the October 30, 2009, Policy 
Statement on Prudent Commercial Real Estate Workouts that encourages 
banks to restructure loans for commercial real estate mortgage 
customers experiencing difficulties making payments. The CRE Workouts 
Guidance reinforces long-standing supervisory principles in a manner 
that recognizes pragmatic actions by lenders and small business 
borrowers are necessary to weather this difficult economic period.
    The FDIC also joined the other banking agencies in issuing the 
Interagency Appraisal and Evaluation Guidelines on December 2, 2010, to 
clarify expectations for real estate appraisals. Clarification of these 
guidelines was important for the industry given changes in property 
values over the past several years. We do not require banks to 
recognize losses on loans solely because of collateral depreciation or 
require appraisals on performing loans unless an advance of new funds 
is being contemplated. Moreover, the interagency guidance recognizes 
that borrowers' ability to repay real estate loans according to 
reasonable terms remains the primary consideration in a lending 
decision.
    We also actively engage with community banks at the State level and 
nationally through various trade associations, which helps our agency 
articulate its supervisory expectations on important issues through a 
variety of forums. For example, the FDIC established an Advisory 
Committee on Community Banking to provide us with advice and guidance 
on a broad range of policy issues impacting small community banks, as 
well as the local communities they serve, with a focus on rural areas. 
The Advisory Committee has provided valuable input on examination 
policies and procedures, credit and lending practices, deposit 
insurance assessments, insurance coverage issues, regulatory compliance 
matters, and obstacles to the continued growth and ability to extend 
financial services in their local markets. We also sponsor training 
events for community banks including regional and national 
teleconferences on risk management and consumer protection matters, as 
well as Directors Colleges to help bank directors better understand the 
supervisory process.
    The FDIC conducts more than 2,500 on-site examinations annually, 
and we recognize that questions and even disagreements with individual 
examination findings may sometimes arise, especially in difficult 
economic times. The FDIC has a number of outlets for bankers to express 
their concerns when this occurs. On March 1, we issued guidance 
reiterating that FDIC-supervised institutions can voice their concerns 
about an examination or other supervisory determination through 
informal and formal channels. The FDIC takes pride in the 
professionalism of its examination force but also strongly encourages 
banks to provide feedback on FDIC examinations. The guidance highlights 
that often the most effective method for understanding why the FDIC 
reached a particular conclusion during its examination is for the 
bankers to discuss the issue with the examiner-in-charge, field office 
supervisor, or the appropriate official in the Regional Office.

Addressing Regulatory Burden
    The FDIC is interested in finding ways to eliminate unnecessary 
regulatory burden on community banks, whose balance sheets are much 
less complicated than those of the larger banks. We continuously pursue 
methods to streamline our supervisory process through the use of 
technology and other means to reduce disruption associated with 
examination activity. While maintaining an effective examination 
process is paramount, we are sensitive to banks' business priorities 
and strive to be efficient in our work.
    Certain supervisory programs are designed to be less burdensome on 
small banks compared to the larger, more complex institutions. For 
example, statutorily mandated examinations are less frequent for 
certain well-managed, well-capitalized institutions under $500 million 
in size. There are also fewer reporting requirements for smaller 
institutions, including Call Report line items and requirements for 
other reporting. In addition, to make it easier for smaller 
institutions to understand the impact of new regulatory changes or 
guidance, we specifically note up front in our Financial Institution 
Letters (the vehicle used to alert banks to any regulatory changes or 
guidance) whether the change applies to institutions under $1 billion. 
Finally, there are less burdensome requirements for smaller 
institutions in their implementation of the Community Reinvestment Act.
    As we testified before this Subcommittee in April, much of the 
Dodd-Frank Act should have no direct impact on community banks, and 
certain changes in the Act provide benefits. For example, the Act 
permanently increased deposit insurance coverage to $250,000 and made 
changes in the assessment base that will result in significantly lower 
premiums for most banks under $10 billion in assets. Further, 
provisions of the Act that impose additional capital and other 
heightened prudential requirements on the largest financial 
institutions are aimed at reducing systemic risks. Those and other 
provisions of the Act should do much to return competitive balance to 
the marketplace by restoring market discipline and ensuring appropriate 
regulatory oversight of systemically important financial companies.
    Finally, the Dodd-Frank Act should help level the playing field 
with nonbanks as they will now be required to meet the same standards 
as banking institutions, especially in the mortgage finance arena. 
However, it is clear that consumers have come to expect, and depend 
greatly on, insured institutions to design and offer fair and equitable 
financial products and services. We believe the public's significant 
trust in community banks has been fostered by their diligence in 
maintaining effective consumer protection programs.
    Much of the regulatory cost of the Dodd-Frank Act will fall, as it 
should, directly on the large institutions that create systemic risk. 
The leveling of the competitive playing field will help preserve the 
essential diversity of our financial system, and prevent any 
institution from taking undue risks at the expense of the public.

Conclusion
    The FDIC understands the significant challenges faced by banks and 
their borrowers as the real estate markets and the financial sector 
recover from the dislocations that precipitated the crisis. The FDIC 
has made supervisory enhancements that address the lessons learned from 
the recent crisis and organizational changes to implement our new 
responsibilities from the Dodd-Frank Act. The FDIC has joined with 
other Federal financial regulators in encouraging lenders to continue 
making prudent loans and working with borrowers experiencing financial 
difficulties. As the primary Federal regulator for most community 
banks, the FDIC recognizes their critical role in helping local 
businesses fuel economic growth and we support their efforts to make 
good loans in this challenging environment.
    Thank you and I would be pleased to answer any questions.
                                 ______
                                 
                 PREPARED STATEMENT OF DAVID K. WILSON

 Deputy Comptroller, Credit and Market Risk, Office of the Comptroller 
                            of the Currency
                             June 15, 2011

I. Introduction*
    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee, my name is Dave Wilson, and I am currently the Deputy 
Comptroller for Credit and Market Risk at the Office of the Comptroller 
of the Currency. In July, I will assume the position of Senior Deputy 
Comptroller for Bank Supervision Policy and Chief National Bank 
Examiner at the OCC. I appreciate the opportunity to discuss the OCC's 
perspectives on lessons learned from the financial crisis and our 
ensuing approach to bank supervision.
---------------------------------------------------------------------------
    * Statement Required by 12 U.S.C. 250: The views expressed herein 
are those of the Office of the Comptroller of the Currency and do not 
necessarily represent the views of the President.
---------------------------------------------------------------------------
    My testimony addresses four key areas. First, I briefly summarize 
some of the major factors that contributed to the financial crisis. 
Next, I discuss lessons learned from the crisis and specific steps the 
OCC is taking to incorporate those lessons learned into our bank 
supervision activities and practices. With this background, I then 
describe the OCC's overall approach to bank supervision--our role as 
supervisors, and the efforts we are taking to ensure that as we 
implement needed supervisory enhancements and the reforms mandated by 
the Dodd-Frank Act, our supervision remains balanced, fair, and 
appropriately tailored to the size and risk of individual institutions. 
Finally, pursuant to the Subcommittee's request, I provide a brief 
update on small business and real estate lending, mortgage servicing, 
and trading.

II. Factors That Contributed to the Financial Crisis
    Numerous studies and papers have been written that explore in depth 
the causes and factors that led to the recent crisis. Rather than 
catalog and summarize those findings, I want to offer my perspective, 
as a bank examiner and supervisor, on key precipitating factors that 
both supervisors and bankers failed to adequately recognize and 
mitigate.
    In many respects, the seeds for the crisis were sown by the 
prolonged period of a relatively benign economy that fostered a market 
environment where investors, lenders, and supervisors became overly 
complacent about risk. This environment, characterized by low interest 
rates, strong economic growth, excess liquidity, and very low rates of 
borrower defaults spurred investors to chase yields, and U.S. mortgage-
backed securities offered higher yields on historically safe 
investments. Hungry investors tolerated increased risk to obtain those 
higher yields, especially from securities backed by subprime markets, 
where yields were highest. This demand attracted new mortgage lenders 
and brokers many of whom had limited business experience or financial 
strength and operated outside of the commercial banking system and with 
little regulatory oversight. Increased risk layering--in the form of 
smaller downpayments, lower required credit scores, higher debt-to-
income ratios, reduced documentation of income, and temporary 
reductions in monthly payments--became prevalent as lenders and 
borrowers became willing to finance and take on ever higher levels of 
debt, often on the belief that such debt could be easily refinanced or 
extinguished through the sale of underlying assets whose prices, it was 
assumed, would continue to escalate. The rapid increase in market share 
by unregulated brokers and originators put pressure on regulated banks 
to lower their underwriting standards, which they did, though not to 
the same extent as was true for unregulated mortgage lenders.
    Investor demand for yield was also affecting the commercial 
leveraged loan market as many institutional investors were willing to 
accept increasingly liberal repayment terms, reduced financial 
covenants, and higher borrower leverage in return for marginally higher 
yields. The apparent risk to commercial banks' own loan portfolios was 
considered limited, because such banks and bank affiliates increasingly 
followed an ``originate-to-distribute'' model, syndicating most of 
these exposures for sale to institutional investors rather than holding 
them on their balance sheets for extended periods.
    Compensation structures that rewarded loan production over loan 
quality placed added incentives for lenders to originate and produce 
loan products. Over time, product structures and funding mechanisms 
became more complex and opaque as underlying loans were repackaged, 
tranched, and further leveraged and financed in the form of various 
securitization and off-balance sheet funding conduits. Some of these 
structures, such as complex collateralized debt obligations, were 
poorly understood. Credit rating agencies and investors had a false 
sense of security that, no matter how poor the underwriting of the 
underlying asset, the risk could be adequately mitigated through 
geographic and product diversification, sufficient credit tranching, 
and other financial engineering. In many cases, the net result was 
poorly underwritten loans that financed longer-term assets and that 
were funded through short-term wholesale funds providers who, as it was 
later revealed, were extremely sensitive to real or perceived risks.
    Smaller community banks were not immune from the build-up of risks 
occurring in the system. In particular, as the larger players increased 
their market shares in various retail credit products, such as 
residential mortgage loans and credit cards, community banks 
increasingly had to look elsewhere for profitable lending 
opportunities. For many community bankers, the housing and attendant 
real estate boom provided a natural area for growth--CRE (commercial 
real estate) lending for construction and development. This was 
especially true in areas with vibrant housing markets, where home 
building was a key part of the regional economy. Because this type of 
lending puts more of a premium on knowledge of individual borrowers and 
local market conditions, this type of lending is often well-suited for 
community banks. However, many smaller banks became overly concentrated 
in this sector and a smaller, but not insignificant, number fueled 
their rapid CRE growth--often in areas outside of their home market--
with short-term volatile funding sources.
    Lax underwriting, excessive leverage, rapid growth, and 
concentrations are all too familiar refrains from past credit cycles 
and were symptoms that, with the benefit of hindsight, supervisors and 
market participants should have better mitigated at a much earlier 
stage. What amplified these factors from past cycles was the manner in 
which these excesses were spread and disbursed throughout the global 
financial system. When the subprime mortgage market began to collapse, 
the opaqueness of the more complex product and funding structures made 
it difficult for bankers, investors, funds providers, and supervisors 
to readily assess the nature and scope of potential risk exposures. 
This uncertainty contributed to an abrupt shift in risk tolerance by 
many market participants across the globe and served to compound losses 
as investors attempted to unwind positions. Secondary market liquidity 
for mortgages and leveraged loan products largely evaporated, leaving 
many larger banks with an unfunded pipeline of loan commitments that 
would require on-balance sheet funding. Likewise, short-term funding 
vehicles, such as asset-backed commercial paper conduits, became 
strained as investors increasingly chose not to roll over maturing 
paper, placing further strains on the balance sheets of banks that 
served as sponsors to such conduits. Bankers and supervisors 
underestimated the resulting rapidity and depth of the global liquidity 
freeze.
    As various external funding sources evaporated, concentrations and 
correlations that bank risk managers believed had been diversified away 
became more apparent. For example, direct exposures to subprime 
mortgages that had been avoided in a bank's lending operations 
nonetheless emerged through bank affiliate activities and affiliate-
sponsored off-balance sheet vehicles. Products, markets, and geographic 
regions that previously were looked to as a source of risk 
diversification became more highly correlated as contagion effects 
spread across the globe and industry sectors.
    The resulting strains of the financial crisis have been felt by 
both large and small banks. While the initial impact was largely 
confined to the largest institutions that were heavily reliant on 
wholesale funding, as the economy continued to deteriorate, banks of 
all sizes faced higher loan losses, lower margins, and reduced 
profitability, and are only now showing signs of recovery.

III. Lessons Learned and Areas for Continued Improvement for Bank 
        Supervision
    The financial crisis underscored that no amount of financial 
engineering can obviate the need for bankers and bank supervisors to 
adhere to and monitor the basic precepts of sound banking practice: 
prudent underwriting practices throughout the credit cycle; strong 
risk-management systems that identify and control the build-up of risk 
concentrations across products and business lines; diversified funding 
sources, adequate loan loss reserves, and strong capital cushions that 
allow the bank to continue its normal operations during downturns or 
funding strains; and strong corporate governance, including 
compensation structures, that set the tone for balanced and prudent 
risk taking. While these fundamentals are clearly important, they 
primarily focus on the risks within an individual banking organization. 
As the financial crisis highlighted, bankers, and more importantly 
supervisors, must develop better tools to evaluate and address emerging 
risks across the system and how those risks may be interconnected. 
Similarly, regulators need to take steps to restore greater 
transparency and accountability by all market participants--lenders, 
borrowers, and investors--to facilitate market discipline on excessive 
risk taking and dispel reliance on potential or perceived Government 
backstops.
    The sections that follow describe in some detail steps that the OCC 
has or is taking to address each of these areas. But let me begin by 
noting that while the OCC believes that these lessons are applicable 
for banks of all sizes, we are cognizant of the need to tailor our 
expectations to the scope and complexity of each bank's activities. As 
a result, our expectations for large banking organizations are 
generally more stringent and higher than for community banks whose 
scale of operations and complexity are considerably smaller. While we 
believe large banks must be held to higher standards, we do not 
subscribe to the view that big, in and of itself, is bad. Our country's 
economic well-being is inevitably linked to the global economy and if 
the U.S. financial system is to remain a predominant force in the 
global environment, we need to have banking organizations that can 
compete effectively with their global counterparts across product and 
business lines. Similarly, as we institute reforms to address some of 
the problems and abuses stemming from the last crisis, we need be 
careful that we do not attempt to wring all the risk or complexity out 
of the banking system. Banks' fundamental role is risk intermediation, 
and financial innovation and expansion of credit are important drivers 
of our economy. Banks must be able to respond to customer and investor 
demand for new and innovative products and services. As corporations 
become more risk management savvy, so do their demands for risk 
management products, such as various derivative instruments. Similarly, 
as technology advances, the methods and ways that consumers choose to 
interface with banks will become more complex and varied. We must allow 
banks to respond to this changing landscape provided that they do so in 
a manner that is safe and sound and conducted with integrity.

A. Prudent Underwriting Throughout the Cycle
    The financial crisis underscored that underwriting standards 
matter, regardless of whether loans are being originated to hold on the 
bank's own balance sheet or sold to third party investors. Supervisors 
and banking organizations must be more diligent in ensuring that 
underwriting standards are not compromised by competitive pressures 
from unregulated firms, by investors who may be willing to take on more 
risk for incremental yield, or by desire for rapid growth or market 
share in products or geographic regions.
    In the immediate aftermath of the subprime crisis, the OCC 
cautioned national banks that they should apply sound, consistent 
underwriting standards regardless of whether a loan is originated with 
the intent to hold or sell. Likewise, we have admonished national banks 
not to compromise their underwriting standards due to competitive 
pressures. Where we see signs of such slippage, we are intervening at 
an early stage. For example, last June in response to signs of slippage 
that examiners were seeing in some leveraged loan facilities, we issued 
guidance to our examiners that reinforced our supervisory expectations 
for this type of lending and directed them to criticize or classify 
credits that exhibit minimal repayment capacity, excessive leverage or 
weak/nonexistent covenants, even when the credits had been recently 
advanced.
    Because of the adverse impact that competitive pressures can have 
on underwriting standards, the OCC has been a strong proponent for 
national, uniform standards for certain lending products, most notably 
residential mortgage loans.
    As we take steps to promote more consistent and uniform 
underwriting practices and standards and to lean in more forcefully 
when we see slippage either in the system or at individual banks, we 
are mindful of the need to strike an appropriate balance. Ensuring that 
banks remain safe and sound, while at the same time meeting the credit 
needs of their communities and customers is one of the OCC's core 
missions, and knowing when to bear down is one of the most fundamental 
calls that examiners and policy makers must make. Waiting too long or 
supervising too lightly will result in some banks using federally 
insured deposits to make unsafe loans that can ultimately cause them to 
fail. On the other hand, supervising too strictly or inconsistently can 
cause banks to become too conservative and deny loans to creditworthy 
borrowers.
    Since the onset of the financial crisis, the OCC has taken a number 
of actions to improve our ability to objectively monitor trends in 
credit quality and underwriting standards to help us determine when 
stronger supervisory intervention is needed. These actions supplement 
our more traditional tools of on-site examinations, the annual 
interagency Shared National Credit review, and the OCC's annual 
underwriting survey. In 2009, we began collecting and analyzing 
detailed loan-level data on home equity, credit card, CRE, and large 
corporate syndicated credits at some of the largest national banks. 
This effort builds off of the highly valuable Mortgage Metrics data 
project that the OCC initiated in 2008 and provides us with much more 
granular level data than could be collected cost-effectively through 
the Call Report. This comprehensive loan-level credit data allows us to 
conduct comparative analysis of credit risk across large banks in a 
timelier manner and to identify potential systemic risk issues. In 
addition, these large comprehensive data sets provide us with the 
ability to conduct more forward-looking analyses to determine what 
could happen to credit quality under varying economic scenarios and 
assumptions. A key focus of our large bank examination and policy staff 
will be to identify and institutionalize critical underwriting metrics 
and related benchmarks so that we can objectively track the migration 
of practices over the course of future credit cycles. By limiting our 
data collection to the largest players, we are able to develop a 
system-wide view while minimizing undue reporting and compliance costs 
on smaller institutions.
    For smaller institutions, our emphasis has been more tailored and 
focused on ensuring that these banks effectively recognize and manage 
the inherent concentrations that they may have in their lending 
portfolios. These efforts have included targeted examinations of key 
portfolios, most notably CRE portfolios, and providing examiners and 
bankers more analytical tools to assess how stresses in external market 
factors may affect those portfolios.

B. Strong Risk Management Systems That Identify and Control Risk 
        Concentrations
    The financial crisis exposed weaknesses in many banks' risk 
management systems and models. In many cases, risk concentrations 
accumulated undetected across products, business lines, and legal 
entities within an organization. Complex product structures and various 
off-balance sheet funding structures obfuscated certain exposures and 
risks. Credit risk models relied too heavily on historical correlations 
and did not adequately address their risk exposures to highly rated 
CDOs and other structured securities. Similarly, banks' internal stress 
tests failed to fully capture the risks that could be posed from 
various ``tail'' events and from off-balance sheet structures that were 
legally separate from the firm, but that the firm ultimately supported 
in order to maintain relationships with counterparties, funds 
providers, and investors. Many stress tests failed to fully estimate 
the potential severity and duration of stress events or focused on a 
single line of business.
    Strengthening risk management practices and institutionalizing more 
robust and enterprise-wide stress testing has and continues to be a 
point of supervisory emphasis, particularly at the largest national 
banks. Given the need to implement such practices across the entire 
banking organization, we are working closely with our colleagues at the 
Federal Reserve on many of these efforts.
    Given the importance and the role that these large institutions 
play in the overall financial stability of the U.S., we have instructed 
our examiners that these organizations should not operate with anything 
less than strong risk management and audit functions--anything less 
will no longer be sufficient. To build out this capability, examiners 
are directing these banks to improve their risk concentration 
aggregation and stress testing processes, requiring more robust model 
validations, and stepping up their challenges of quantitative models 
and the key assumptions supporting those models. These examiner 
directives have been supplemented with supervisory guidance, including 
the enhanced risk management requirements adopted by the Basel 
Committee for banks operating under the Basel II capital framework. 
Critics of Basel II have focused on the potential for an internal-
models-based approach to produce lower capital charges for certain 
portfolios, a concern that has been addressed in the past year by 
substantial strengthening of the framework and the increased capital 
levels under Basel III. Meanwhile, the great benefit of the framework 
has been, and remains, its requirement for more stringent and robust 
risk management standards at applicable banks. The compliance costs 
associated with the Basel II advanced approaches rule is one reason why 
the OCC and other U.S. banking agencies limited its mandatory 
application to the largest U.S. banking organizations.
    More recently, in April, the OCC and Federal Reserve issued 
guidance on model risk management that expands upon the OCC's previous 
guidance on model validation. The guidance articulates the elements of 
a sound program for effective management of risks that arise when using 
quantitative models in bank decision making. It also provides guidance 
to OCC examining personnel and national banks on prudent model risk 
management policies, procedures, practices, and standards. Last week, 
the OCC, Federal Reserve, and FDIC issued for comment Proposed Guidance 
on Stress Testing for Banking Organizations With More Than $10 Billion 
in Total Consolidated Assets. This joint interagency guidance outlines 
high-level principles for stress testing practices, applicable to all 
banking organizations with more than $10 billion in total consolidated 
assets. The proposed guidance highlights the importance of stress 
testing as an ongoing risk management practice that supports a banking 
organization's forward-looking assessment of its risks. It outlines 
broad principles for a satisfactory stress testing framework, and 
describes the manner in which stress testing should be employed as an 
integral component of risk management. While not intended to provide 
detailed instructions for conducting stress testing for any particular 
risk or business area, the proposed guidance describes several types of 
stress testing activities and how they may be most appropriately used 
by banking organizations. Although the guidance does not explicitly 
address the stress testing requirements imposed upon certain companies 
by section 165 (i) of the Dodd-Frank Act, the agencies anticipate those 
provisions, to be addressed in a future rulemaking, will be consistent 
with the principles in the proposed guidance.
    As with other risk management practices, the OCC believes certain 
aspects of stress testing--such as scenario analysis of key 
portfolios--can also be a valuable tool for smaller banks. Thus, as 
previously noted, we have been working with community bankers to 
improve their ability to stress test CRE and other highly concentrated 
and volatile portfolios. For example, we have instructed banks that 
their stress testing of CRE transactions should consider the effect of 
multiple variables (e.g., changes in interest rates, vacancy rates, and 
capitalization rates), and that such stress tests should be performed 
periodically throughout the life of the loan.
    To assist community bankers in identifying and assessing potential 
CRE vulnerabilities, we developed, and have made available via our 
National BankNet Web site, loan level CRE stress testing tools that 
bankers can use. We also have developed a portfolio level model, which 
our examiners are now testing. Our intent is to also publish this on 
BankNet after proper validation. In addition to these tools, we provide 
examiners with access to various market databases that allow them to 
monitor and analyze CRE trends by major geographies and product types 
and are developing additional tools that they can use in their 
discussions with bank management about potential concentrations.
    While more robust stress testing and improved risk management can 
help identify and mitigate the risks arising from concentrations, the 
financial crisis illustrated that there may be some types and levels of 
concentrations that, in a severe or protracted downturn, may simply be 
too large for a bank to absorb. Indeed, a common thread in the vast 
majority of bank failures in both this and previous credit cycles has 
been a concentration in certain types of CRE lending. Many of these 
banks had other risk management weaknesses that accentuated their CRE 
problems; however, some banks that had sound underwriting and internal 
controls for the CRE operations nonetheless failed due to their level 
of concentrations to this sector and the cascading effects that the 
downturn had on their borrowers and projects. This is the primary 
reason why we are directing smaller banks with these types of 
concentrations to shore up their capital base and to maintain capital 
levels above required regulatory minimums. Consistent with the GAO's 
recent report on CRE concentrations, we are continuing to assess and 
discuss with our supervisory colleagues whether additional 
clarification on supervisory expectations or other measures, such as 
more explicit limits, capital requirements, or triggers within the 
Prompt Corrective Action framework may be warranted to address the 
risks posed by excessive concentrations.

C. Diversified Funding, Strong Capital Cushions, and Adequate Loan Loss 
        Reserves
    In periods of severe financial stress, having sufficient liquidity, 
loan loss reserves, and capital become paramount in ensuring a bank's 
continued operations. Each of these components of a strong balance 
sheet had weakened in the years preceding the crisis.
    As previously noted, many banks--both large and small--relied 
excessively on short-term and volatile funding sources to expand and 
fuel their growth. As banks competed for short-term profits and higher 
margins, traditional sources of asset-based liquidity, such as short-
term, readily marketable securities were replaced with less liquid 
assets that offered higher yields. Many banks' liquidity plans assumed 
that there would be a continuously ready market for highly rated assets 
that could provide liquidity and likewise failed to fully anticipate 
the liquidity demands resulting from their ``originate to distribute'' 
loan pipelines or off-balance sheet conduits. This combination of 
factors--undue reliance on short-term liabilities, little asset 
liquidity, and a growing accumulation of off-balance sheet assets that 
would require funding--proved disastrous for some firms when the short-
term funding markets abruptly shut down in 2007.
    Similarly, the crisis clearly demonstrated that common equity is 
superior to other capital instruments in its ability to absorb losses 
on a going-concern basis. Hybrid capital instruments that paid 
cumulative dividends and/or had a set maturity date had become an ever-
larger proportion of the capital base for bank holding companies of all 
sizes, but were found lacking. While many banks hold innovative 
instruments that would have permitted them to defer or cancel 
dividends, during the financial crisis many banks did not exercise this 
option, which could have preserved liquidity and capital, for fear that 
such actions would reinforce market perceptions of the bank's weakened 
financial condition. Many non-U.S. banks even exercised call options to 
redeem hybrid instruments for fear that failure to do so would send 
strong market signals about the deteriorating condition of the bank.
    Correcting these shortcomings has been the focus of considerable 
work by the OCC and other regulators and, as Acting Comptroller Walsh 
noted in his testimony before the full Committee in February, is the 
objective of various provisions of the Dodd-Frank Act. \1\ The hallmark 
of this work internationally has been the enhanced and more stringent 
global capital and liquidity standards for large, internationally 
active banks adopted by the Basel Committee, known as Basel III. These 
reforms, when integrated with the various capital and liquidity 
provisions of Dodd-Frank will materially affect the level and 
composition of capital and liquidity for large banks. Together, these 
reforms tighten the definition of what counts as regulatory capital; 
expand the types of risk captured within the regulatory capital 
framework; increase overall capital requirements; establish an 
international leverage ratio applicable to global financial 
institutions that constrains leverage from both on- and off-balance 
sheet exposures; and provide for a more balanced consideration of 
financial stability in bank supervision practices and capital rules. 
The Basel reforms also introduce global minimum liquidity standards 
that set forth explicit ratios that banks must meet to ensure that they 
have adequate short-term liquidity to offset cash outflows under acute 
short-term stresses and maintain a sustainable maturity structure of 
assets and liabilities.
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     \1\ See, Testimony of John Walsh, Acting Comptroller of the 
Currency, before the Committee on Banking, Housing, and Urban Affairs 
of the United States Senate, February 17, 2011.
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    Since the Basel III enhancements can take effect in the U.S. only 
through formal rulemaking by the banking agencies, U.S. agencies have 
the opportunity to integrate certain Basel III implementation efforts 
with the heightened prudential standards required by the Dodd-Frank 
Act. Such coordination in rulemaking will ensure consistency in the 
establishment of capital and liquidity standards for similarly situated 
organizations, appropriately differentiate relevant standards for less 
complex organizations, and consider broader economic impact assessments 
in the development of these standards. Beyond the Basel III reforms, we 
have been directing banks of all sizes to improve their capital 
planning and liquidity risk management processes to ensure their 
ability to adequately fund and support anticipated growth and withstand 
unforeseen events. As part of this effort, we expect all banks to 
maintain a contingency funding plan that sets forth the bank's strategy 
for addressing unexpected liquidity shortfalls.
    One of the most striking sidebars in the story of the financial 
crisis is the unprecedented speed with which once well-capitalized 
institutions succumbed to their credit losses. One reason for this is 
that banks held historically low levels of loan-loss reserves coming 
into the current recession. We agree with the findings and 
recommendations of the Financial Accounting Standards Board (FASB) and 
the International Accounting Standards Board (IASB) Financial Crisis 
Advisory Group on the need to amend accounting standards that 
contributed to the delayed recognition of losses on loans. 
Specifically, the accounting rules and the way they were applied made 
it difficult for bankers to reserve for losses that could be reasonably 
anticipated. The result was that when subsequent charge-offs on 
impaired loans did occur, the loan loss reserves were not there to 
support them, and higher provision levels reduced capital. This 
accelerated the spiral into insolvency for many financial institutions. 
As the FASB and IASB (collectively, the Boards) have recognized, this 
emphasizes the need for a revised accounting model for more adequate 
loan losses to supplement the strong capital cushions required by 
prudential regulators. The OCC has been a strong proponent of this need 
to make the loan loss allowances more forward looking so that banks can 
appropriately build their reserves when inherent credit risk is 
increasing, rather than waiting until loan problems are obvious. The 
OCC has been actively engaged in efforts by the Boards to revise the 
current impairment model for recognizing loan losses to provide for 
more forward-looking reserves. As part of this effort, OCC staff has 
served as the U.S. banking agencies' representative on the IASB's 
Expert Advisory Panel on Impairment and participated in various 
educational sessions as well as drafting interagency and Basel 
Committee comments to the Boards on this issue.
    A challenge we and the industry face as implementation of these and 
other reforms mandated by the Dodd-Frank Act move forward is assessing 
their potential interaction and cumulative impact on banks' business 
models and strategic plans. While we support efforts to raise and 
strengthen capital and liquidity cushions, these standards must be 
reflective of the underlying risks and not become so excessive that 
they serve to promote rather than discourage risk-taking. In addition, 
we are concerned that some of the parameters underlying the Basel III 
liquidity standards are excessively conservative and, if implemented in 
their current form, could unnecessarily impede banks' balance sheet 
capacity for lending activities.

D. Strong Corporate Governance
    The financial crisis highlighted that risk management is, and must 
be, more than simply a collection of policies, procedures, limits, and 
models. Effective risk management requires a strong corporate culture 
and corporate risk governance. This culture must be set, embraced, and 
enforced by the bank's board of directors and its senior management, 
and it must permeate all of the bank's activities. This is a point of 
emphasis in all of our meetings with senior management teams and 
directors. We are reminding bank directors that they should not be 
passive bystanders and should be willing and able to provide credible 
challenges to bank management on key issues and strategic plans. 
Informed directors are well positioned to engage in value-added 
discussions that provide knowledgeable approvals, guidance to clarify 
areas of uncertainty, and prudently question the propriety of strategic 
initiatives, human capital decisions (including compensation 
arrangements), and the balance between risk taking and reward.
    Fulfilling these roles and responsibilities can be especially 
challenging for directors at smaller institutions who may have fewer 
resources or outside expertise to assist them. To assist them in this 
task, we offer a comprehensive series of director workshops, taught by 
some of our senior supervisory staff. These workshops, offered 
throughout the year in various locations across the country, cover four 
topics: a director's fundamental responsibilities, risk assessment, 
compliance risk, and credit risk. Participants receive an extensive 
package of resources, including a precourse reading packet, course 
materials, a CD containing selected OCC Web and telephone seminars, and 
other supporting materials.
    A key component of prudent corporate governance is the 
establishment of well-defined and understood risk tolerances and 
limits. At larger banks, the science of defining and measuring risk 
tolerance levels has typically been confined to the business unit and 
more micro levels of the organization. While these lower level risk 
limits are generally effective in controlling individual areas of risk 
taking, they do not enable senior management or board members to 
monitor or evaluate concentrations and risks on a firm-wide basis. 
Consequently, we are directing larger banks to complement existing risk 
tolerance structures with more comprehensive measures and limits of 
risk addressing the amount of capital or earnings that may be at risk 
on a firm-wide basis, including the amount of risk that may be taken in 
each line of business, and the amount of risk that may be taken in each 
of the key risk categories monitored by the banks. For banks of all 
sizes, we are emphasizing the need for sound enterprise-wide asset-
liability management systems that identify, monitor, and effectively 
limit the bank's liquidity and interest rate risks exposures. As part 
of our ongoing supervisory process, we are reviewing compliance with 
these directives.
    As previously noted, flawed incentive compensation practices in the 
financial industry were among the factors contributing to the financial 
crisis. To address this issue, in June 2010, the OCC and other Federal 
banking agencies issued guidance on sound incentive compensation 
policies and practices. Key tenets of that guidance are that such 
practices should appropriately balance risk and reward; be compatible 
with effective controls and risk management; and be supported by strong 
corporate governance, including active and effective oversight by the 
organization's board of directors. In April, the OCC and other 
regulators issued proposed rules to implement the incentive-based 
compensation provisions of section 956 of the Dodd-Frank Act. This rule 
would build upon the agencies' June 2010 guidance by requiring the 
reporting of certain incentive-based compensation arrangements and 
prohibit incentive-based compensation arrangements that provide 
excessive compensation or that could expose the institution to 
inappropriate risks that could lead to material financial loss. 
Consistent with the statute, institutions with less than $1 billion in 
assets would not be subject to this rule.

E. Identifying, Assessing, and Addressing Emerging Risks Across the 
        Financial System
    As I noted earlier, the financial crisis demonstrated the need for 
supervisors to improve their ability to identify, assess, and address 
emerging risks not only within a banking organization, but across the 
banking and broader financial system. Strengthening supervisors' 
ability to identify and respond to emerging systemic risks is clearly a 
key objective of the Dodd-Frank Act and a core mission of the FSOC. 
Beyond the measures provided for by the Dodd-Frank Act and the 
activities being conducted through the FSOC and its various staff 
committees, the OCC has taken a number of steps to enhance our ability 
to identify and respond to risks across the industry and financial 
system.
    As previously noted, we are now obtaining granular, loan level 
information on key credit portfolios from the largest national banks to 
help identify underwriting and performance trends across the system. We 
have also developed a liquidity risk monitoring program to standardize 
liquidity monitoring information across 15 of the largest national 
banks and to provide more forward looking assessments of liquidity 
mismatches and capacity constraints that could signal future problems. 
We also have established network groups among our examiners at large 
national banks to facilitate information sharing and promote consistent 
supervisory actions for nine key risk areas.
    In 2008, we established a Financial Markets Group within the agency 
and tasked it with the build-out of a market intelligence program. 
Their mission is to seek out early warning signs of emerging and 
systemic risk issues. This team is comprised of highly experienced bank 
examiners and subject matter specialists, and they spend considerable 
time meeting with bank investors, bank counterparties, bank analysts, 
and other relevant stakeholders to gain insights on emerging trends. To 
support the work of the OCC's National Risk Committee (NRC), this group 
has also developed a dashboard of metrics that provide early indicators 
of the build-up of risks within the system that may signal the need for 
firmer supervisory intervention at a juncture when such action can be 
modulated and most effective. These metrics are designed to provide 
warning signs before risks become manifested in market performance such 
as prolonged periods of low volatility that can promote complacency 
among investors and bankers and lead to excessive risk taking. While 
any one metric would be insufficient grounds for firmer intervention, 
warning signals across a number of measures will trigger a more formal 
review and assessment of the risks and the need for appropriate 
supervisory response by the OCC's NRC and Committee on Bank 
Supervision.

F. Restoring Transparency and Market Discipline
    The problems that supervisors and market participants faced when 
trying to assess the nature and scope of exposures in complex 
structured products, off-balance sheet funding vehicles, derivatives, 
and trading strategies have been well documented. In many cases these 
challenges were further exacerbated by complex organizational 
structures of individual firms.
    Providing greater transparency in financial statements has been a 
key objective of recent proposals by the FASB, and the OCC has provided 
its views and expertise on these proposals. One of the most significant 
revisions, as it pertains to various securitization and off-balance 
sheet funding vehicles that were prevalent before the crisis, has been 
the adoption and implementation of revisions to the Accounting 
Standards Codification (ASC) Topic 860, Transfers and Servicing, and 
ASC Topic 810, Consolidation (through Statements No. 166, Accounting 
for Transfers of Financial Assets--an amendment of FASB Statement No. 
140, No. 167, Amendments to FASB Interpretation No. 46(R)). As a result 
of these statements, many securitized assets must now be reflected on 
banks' balance sheets. The OCC and other Federal banking agencies have 
amended the agencies' risk-based capital rules to be consistent with 
these accounting changes. Many of the derivatives-related provisions of 
the Dodd-Frank Act will likewise provide greater transparency through 
increased disclosures and more extensive use of central counterparties 
or clearinghouses.
    The combined provisions of Titles I and II of the Dodd-Frank Act 
that provide the authority to extend the Federal Reserve's supervisory 
oversight of certain nonbank financial companies and for the orderly 
liquidation of failing financial companies that pose significant risk 
to the financial stability of the U.S., are critical tools in restoring 
market discipline and accountability for large financial firms. Through 
FSOC, the OCC is actively engaged in efforts to implement these 
provisions.
    As problems in the mortgage market have vividly demonstrated, 
improved transparency and disclosures about the terms, costs, and risks 
of retail banking products are critical to promote informed consumer 
choice and responsibility. We have long supported that goal and applaud 
the Consumer Financial Protection Bureau's initiative to start this 
process through the testing of revised residential mortgage disclosure 
forms.

IV. OCC's Supervisory Approach--Balanced Supervision, Tailored to Risks
    The OCC's core mission is to assure the safety and soundness of the 
institutions subject to our jurisdiction and to ensure that those 
institutions support fair access to financial services and fair 
treatment of their customers. We carry out this mission through our 
ongoing supervisory activities. Through these activities we evaluate 
banks' compliance with applicable laws, regulations, and supervisory 
requirements, and we assess whether they have adequate risk management 
systems, controls, and capital to support the size, scope, and 
complexity of their activities. Where we find weaknesses or violations, 
we direct management to take appropriate and timely corrective action. 
Provided that the bank has the requisite corporate governance, risk 
management, and capital infrastructure to support risk taking, it is 
not the job or role of an examiner to determine whether or what lines 
of business, products, or strategic focus is appropriate--these are 
decisions that the bank's board must make. Likewise, examiners do not 
tell bankers which loans to make or deny. However, they will assess 
whether such loans have been prudently underwritten, properly risk-
rated, and, if any show signs of trouble, are appropriately classified 
and reserved for.
    As I previously noted, one of the most difficult jobs we have in 
carrying our this mission is knowing when and how hard to tap on the 
brakes to rein in excessive risk taking without causing bankers to 
become so conservative or uncertain about regulatory actions that they 
unduly restrict credit. We are acutely aware that our actions--both on 
the policy side at the 50,000 foot level, and on the ground, through 
our on-site examinations--can and do influence banks' behavior and 
their appetite for taking risk. We also recognize that in past 
downturns, many believed that overzealous regulators and examiners 
exacerbated the contraction in credit.
    One of the lessons we learned is the detrimental effect of waiting 
too long to warn the industry about excesses building up in the system, 
resulting in bankers and examiners slamming on the brakes too hard when 
the economy experienced problems. This is one reason why we are working 
to develop better tools that will enable us to identify signs of 
accelerating risk taking at an earlier stage when our actions can be 
more modulated. We know that it is critical that our expectations for 
bankers be clear and consistent, that the ``rules of the game'' under 
which banks operate not be changed abruptly, and that changes in 
regulatory policies are made in an open and transparent manner that 
provides bankers with reasonable time frames to make necessary 
adjustments. This will be especially true as bankers try to absorb and 
comply with the myriad of rules and regulations that will result from 
the implementation of the Dodd-Frank Act.
    We are particularly mindful that new or changing regulatory 
requirements can often have a disproportionate cost and burden on 
community banks due to their limited size and resources. For this 
reason, as we develop regulations, supervisory policies, and 
examination standards, we strive to provide sufficient flexibility in 
the application of those standards to reflect the size and complexity 
of the institution. As the complexity and scope of a bank's activities 
and its potential impact on the financial system increases, so do our 
expectations for their internal controls and risk management systems.
    To provide consistency and continuity in our supervision, we 
organize our supervision programs around a common framework and 
national perspective that is then supplemented by the hands-on 
knowledge of our examiners. Our supervision by risk framework 
establishes a common examination philosophy and structure that is used 
at all national banks. This structure includes a common risk assessment 
system (RAS) that evaluates each bank's risk profile across eight risk 
areas--compliance, credit, interest rate, liquidity, operational, 
price, reputation, and strategic--and assigns each bank an overall 
composite rating and component ratings on the bank's capital adequacy, 
asset quality, management, earnings, liquidity, and sensitivity to 
market risks using the interagency Uniform Financial Ratings System 
(informally known as CAMELS). Specific examination activities and 
supervisory strategies are tailored to each bank's risk profile. These 
strategies are updated and approved annually. While tailored to each 
individual bank's risk profile, they also incorporate key agency 
supervisory priorities for the coming year.
    To reflect the different expectations for controls and risk 
management between large and small banks, our bank supervision programs 
and core examination procedures to determine a bank's RAS and CAMELS 
ratings are aligned across two primary lines of business: Midsize and 
Community Bank Supervision, and Large Bank Supervision. Upon full 
integration of OTS, we will align Federal thrifts into these lines of 
business.
    Our community bank supervision program is built around our local 
field offices located in over 60 cities throughout the U.S. Every 
national community bank is assigned to an examiner who monitors the 
bank's condition on an ongoing basis and who serves as the focal point 
for communications with the bank. The primary responsibility for the 
supervision of individual community banks is delegated to the local 
Assistant Deputy Comptroller, who is under the oversight of a district 
Deputy Comptroller, who in turn, reports to our Senior Deputy 
Comptroller, Jennifer Kelly. The frequency of our on-site examinations 
for community banks follows the statutory provisions set forth in 12 
USC 1820(d), with on-site exams occurring every 12 to 18 months. The 
scope of these examinations is set forth in the OCC's Community Bank 
Supervision handbook and requires sufficient examination work and 
transaction testing to complete the core assessment activities in that 
handbook, and to determine the bank's RAS and CAMELS ratings. On-site 
activities are supplemented by off-site monitoring and quarterly 
analyses to determine if significant changes have occurred in the 
bank's condition or activities.
    Our Large Bank program is organized with a national perspective. It 
is centralized and headquartered in Washington, and structured to 
promote consistent uniform coordination across institutions. As part of 
our Large Bank Supervision program, we maintain on-site resident 
examination staff that conducts ongoing supervisory activities and 
targeted examinations of specific areas of focus. This process allows 
the OCC to maintain an ongoing program of risk assessment, monitoring, 
and communication with bank management and directors. Given the volume 
and complexity of the literally hundreds of thousands of transactions 
that flow through large banking organizations, it is not feasible to 
review every transaction in each bank, or for that matter, every single 
product line or bank activity in each supervisory cycle. Nonetheless, 
as in our community bank examinations, examiners must complete 
sufficient work and transaction testing throughout the year to complete 
the core assessment activities set forth in the OCC's Large Bank 
Supervision handbook, and to determine the bank's RAS and CAMELS 
ratings. The on-site teams at each bank are led by an Examiner-in-
Charge, who reports directly to the Deputy Comptrollers in our Large 
Bank Supervision Office, and in turn, to our Senior Deputy Comptroller, 
Mike Brosnan.
    In January 2010, we updated and revised our RAS system as it 
applies to both community and large banks to reflect and incorporate 
lessons learned from the financial crisis. We also have directed 
examiners to be more forward looking when they are assessing and 
assigning RAS ratings. Specifically, when assessing direction of risk 
for all risk categories, examiners should consider current practices in 
the bank and how those practices, combined with other quantitative and 
qualitative factors, affect direction of risk over the next 12 months. 
For example, the direction of credit risk may be increasing if a bank 
has relaxed its underwriting standards during a strong economic cycle, 
even though the volume of troubled credits and credit losses remain 
low. Similarly, the direction of liquidity risk may be increasing if a 
bank has not implemented a well-developed contingency funding plan 
during a strong economic cycle, even though existing liquidity sources 
are sufficient for current conditions. We will be reinforcing this 
message with our examination staffs at our upcoming staff conferences 
in July that will bring together all of our examination staffs across 
our lines of business and those examiners who are joining the OCC from 
the Office of Thrift Supervision.
    In both our Midsize and Community Bank Supervision and Large Bank 
Supervision programs, we have mechanisms in place to ensure that our 
supervisory policies and procedures are applied in a consistent and 
balanced manner. Every report of examination is reviewed and approved 
by the responsible ADC or Deputy Comptroller before it is finalized. 
Both units have formal quality assurance processes that assess the 
effectiveness of our supervision and compliance with OCC policies. Our 
examination force is kept abreast of emerging issues and supervisory 
policies through weekly email updates and periodic nationwide 
conference calls, team meetings, and staff conferences.
    A key element of the OCC's supervisory philosophy is open and 
frequent communication with the banks we supervise. In this regard, our 
senior management teams encourage any banker that has concerns about a 
particular examination finding to raise those concerns with his or her 
examination team and with the district management team that oversees 
the bank. Should a banker not want to pursue those chains of 
communication, our Ombudsman's office provides a venue for bankers to 
discuss their concerns informally or to formally request an appeal of 
examination findings. The OCC's Ombudsman is fully independent of the 
supervisory process, and he reports directly to the Comptroller. In 
addition to hearing formal appeals, the Ombudsman's office provides 
bankers with an impartial ear to hear complaints and a mechanism to 
facilitate the resolution of disputes with our supervisory staff.
    The OCC also recognizes the importance of communicating regularly 
with the industry outside of the supervision process to clarify our 
expectations, discuss emerging issues of interest to the industry, and 
respond to bankers' concerns. We participate in numerous industry-
sponsored events, as well as conduct a variety of outreach activities, 
including Meet the Comptroller events, chief executive officer 
roundtables, and teleconferences on topical issues.

V. Current State of Small Business and Real Estate Lending, Mortgage 
        Servicing, and Trading Lines of Business
    The Subcommittee's letter of invitation noted the uncertainty that 
remains in small business and real estate lending, mortgage servicing, 
and trading, and requested the OCC's views on the state of those 
business lines. Let me conclude with a brief overview of each.

A. Small Business Lending
    National banks are significant providers of small business credit, 
but discerning trends in small business lending is difficult due to the 
variety of lending facilities that small business owners use for 
financing. One proxy for a portion of small business lending is the 
data collected in the quarterly Call Reports on commercial and 
industrial loans in amounts less than $1 million and agricultural loans 
less than $500,000. In the last few years, the outstanding balance of 
these loans has declined, reflecting both demand and supply factors. 
Mirroring trends in the broader economy, demand for credit by many 
businesses has weakened as both businesses and their consumers have 
scaled back spending and investments. It is also true that some 
bankers, in response to deteriorating credit and economic conditions, 
have become more risk averse and selective in their lending.
    The OCC recognizes the important role of small businesses in the 
economy, their dependence on banks for credit, and the difficulty that 
some small business owners have reported in obtaining new credit or 
renewing existing credit. In response to these concerns, in February 
2010, the OCC and other Federal banking agencies issued a statement on 
creditworthy small businesses. The statement is intended to facilitate 
small business lending and provide bankers with more regulatory 
certainty by outlining our expectations for prudent underwriting 
practices. In this statement and in our ongoing discussions with 
examiners and bankers, we reiterate our policies that we encourage 
bankers to lend to creditworthy borrowers and to work constructively 
with borrowers who may be facing difficulties, and that examiners 
should take a balanced approach and not criticize banks that follow 
sound lending practices.
    We actively encourage national banks to participate in various 
Government programs that are designed to support small business 
lending. These include the Small Business Administration loan guarantee 
programs and the $30 billion Small Business Lending Fund program 
established as part of the Small Business Jobs Act of 2010. To-date 
approximately 106 national banks have applied for this program, and we 
are in the process of providing Treasury with information to assist 
them in evaluating those requests.
    There is some evidence that credit conditions for small business 
lending are improving. In our recent annual credit underwriting survey, 
a few respondents have eased small business underwriting standards in 
anticipation of market growth and an opportunity to compete. Just over 
half of the banks in the survey are planning to grow their small 
business lending portfolio greater than 10 percent over the next year. 
Many of the largest national banks have revamped and built up their 
small business lending operations.
    Despite these positive signs, the ongoing lack of sales revenue and 
widespread uncertainty about the economy continue to hamper small 
business owners' sentiments and bankers' ability to develop loan growth 
in this market segment. In its May 2011 report on small business 
economic trends, the National Federation of Independent Business (NFIB) 
stated credit supply was not the problem for the overwhelming majority 
of small business owners and that weak sales and uncertainty continue 
to be major factors for the lack of credit demand. \2\ This uncertainty 
is reflected in the NFIB's small business optimism index: while this 
index has bounced back from the 2009 lows, its level has declined in 
March and April. \3\
---------------------------------------------------------------------------
     \2\ See, NFIB Small Business Economic Trends, May 2011, p. 2.
     \3\ Ibid., p. 4.
---------------------------------------------------------------------------
B. Real Estate Lending
    Commercial real estate lending is a prominent business line for 
many national banks and is a sector that the OCC monitors very closely. 
While there are signs that the commercial real estate markets are 
beginning to stabilize, we are a long way away from a full recovery. 
Vacancy rates across all major property types are starting to recover, 
but remain high by historical standards. We expect vacancy rates to 
remain elevated and recovery to be slow.
    Capitalization rates--the rate of return demanded by investors--
have also shown recent signs of stabilization. Cap rates fell 
substantially from 2002 through 2007 to a point where they often did 
not fully reflect the risks associated with the properties being 
financed. Then they increased markedly in 2008 and 2009 as investors 
became more risk averse. Recently, cap rates appear to have stabilized, 
particularly for high quality assets, but the spreads being demanded by 
investors, relative to Treasuries, for lower quality assets remain 
wide.
    A key driver for property values and CRE loan performance is the 
net operating income (NOI)--or cash flows--generated by the underlying 
commercial properties. Overall, NOI has continued to decline due to 
soft rental rates. While we expect the rate of decline to lessen, only 
apartments are expected to show meaningful NOI growth this year, with 
other major market segments expected to turn positive in 2012.
    Property prices have also shown some signs of stabilization. 
Although the Moody's All Property Index recorded a decline of 4.2 
percent in March 2011, transaction volumes have increased. We expect 
volatile prices until underlying market fundamentals improve 
consistently.
    The trends and performance of CRE loans within the national banking 
system mirror those in the broader CRE market. While there are signs of 
stabilization in charge-off rates and a decline in nonperforming loans, 
levels remain elevated and continue to require significant attention by 
bank management and supervisors. The effect of the distressed CRE 
market on individual national banks varies by the size, location, and 
type of CRE exposure. Because charge-off rates for construction loans 
led performance problems in the sector, banks with heavier 
concentrations in this segment tended to experience losses at an 
earlier stage. Performance in this segment is expected to improve more 
rapidly as the pool of potentially distressed construction loans has 
diminished. In contrast, performance of income-producing commercial 
mortgages continues to be more stressed and one that we continue to 
monitor closely.

C. Mortgage Servicing
    As the Subcommittee's letter of invitation references, the mortgage 
servicing business is also under severe stress. Its business model was 
already challenged by the mortgage crisis, and that challenge is now 
compounded by widespread deficiencies in foreclosure processing. 
Through our recent consent orders, the OCC is focused on fixing the 
very serious problems we found in foreclosure processing; ensuring that 
any borrowers harmed by shoddy practices receive appropriate remedies; 
and getting mortgage markets operating again. Yet as Acting Comptroller 
Walsh recently noted in his remarks before the Housing Policy Council 
of the Financial Services Roundtable, additional challenges and 
uncertainties loom ahead for this line of business. \4\ The new Basel 
III framework will require that servicing rights beyond relatively 
modest levels be deducted from capital for regulatory capital 
calculations, effectively increasing the capital requirements for 
mortgage servicers. The Dodd-Frank Act will impose a myriad of new 
requirements that mortgage lenders will need to address. As the Acting 
Comptroller noted, while each of these requirements individually have 
merit, it is hard to predict how all of these requirements will work 
together.
---------------------------------------------------------------------------
     \4\ See, Remarks by John Walsh, Acting Comptroller of the 
Currency, Before the Housing Policy Council of The Financial Services 
Roundtable, May 19, 2011, available at: http://www.occ.gov/news-
issuances/speeches/2011/pubspeech-2011-60.pdf.
---------------------------------------------------------------------------
    In addition to the requirements of Dodd-Frank, an important area 
for reform in the mortgage servicing business is the need for uniform 
mortgage servicing standards that apply to all facets of servicing the 
loan, from loan closing to payoff. A number of months ago, to further 
this effort and interagency discussions, the OCC developed a framework 
for comprehensive mortgage servicing standards that we shared with 
other agencies, and other agencies put forward their recommendations as 
well. We now have underway an active interagency effort to develop a 
set of comprehensive, nationally applicable mortgage servicing 
standards. As an example, these standards would address:

    Handling borrower payments, including applying payments to 
        principal and interest and taxes and insurance before they are 
        applied to fees, and avoiding payment allocation processes 
        designed primarily to increase fee income;

    Providing adequate borrower notices about their accounts 
        and payment records, including a schedule of fees, periodic and 
        annual statements, and notices of payment history, payoff 
        amount, late payment, delinquency, and loss mitigation;

    Providing an easily accessible single point of contact for 
        borrower inquiries about loss mitigation and loan 
        modifications;

    Ensuring appropriate levels of trained staff to meet 
        current and projected workloads;

    Responding promptly to borrower inquiries and complaints, 
        and promptly resolving disputes;

    Providing an avenue for escalation and appeal of unresolved 
        disputes;

    Effective incentives to work with troubled borrowers, 
        including early outreach and counseling;

    Making good faith efforts to engage in loss mitigation and 
        foreclosure prevention for delinquent loans, including 
        modifying loans to provide affordable and sustainable payments 
        for eligible troubled borrowers;

    Implementing procedures to ensure that documents provided 
        by borrowers and third parties are maintained and tracked so 
        that borrowers generally will not be required to resubmit the 
        same documented information;

    Eliminating ``dual track'' processes where legal steps to 
        foreclose on a property or conduct a foreclosure sale go 
        forward even when a borrower has completed an application for a 
        loan modification or is in a trial or permanent modification 
        and is not in default on the modification agreement;

    Notifying borrowers of the reasons for denial of a loan 
        modification, including information on the NPV calculation; and

    Implementing strong foreclosure governance processes that 
        ensure compliance with all applicable legal standards and 
        documentation requirements, and oversight and audit of third 
        party vendors.

    While we are at an early stage in this interagency process, the OCC 
is optimistic that the agencies can achieve significant reforms in 
mortgage servicing practices across the board for all types of mortgage 
servicing firms. These types of standards should help put the mortgage 
servicing business on sound footing for the future.

D. Trading Activities
    Trading revenues in the banking system have been quite strong, as 
the industry reported record trading revenues in both 2009 and 2010. 
After a loss of $836 million in 2008, insured commercial banks reported 
trading revenues of $22.6 billion and $22.5 billion in 2009 and 2010 
respectively despite reductions in trading assets and risk. A key 
driver of the strong results has been predominately one-way bull 
markets as bonds, equities, commodities, and foreign currencies 
rallied. In the first quarter of 2011, insured commercial banks added 
another $7.4 billion in trading revenues. Notwithstanding the current 
strength of trading revenues, however, there are a number of issues 
that create uncertainty, and will likely limit, trading revenues 
prospectively. Section 619 of the Dodd-Frank Act restricts many forms 
of proprietary trading, but for banks, stand alone proprietary trading 
has generally accounted for a relatively small portion of trading 
activity, so the impact of this change should be limited. There are, 
however, other provisions of the Act that could affect trading 
activities at national banks. Legislative mandates to increase central 
clearing may reduce trading activity generally and narrow profit 
margins. Recently proposed swap margin rules require, for the first 
time, initial margin for inter-dealer and dealer/financial end-user 
trading activity, raising costs and potentially reducing the 
transaction volumes that create revenue. Revenues from securitization 
activities remain weak due to continued weakness in loan volumes and 
underlying asset prices for housing. In addition, securitization 
markets may be affected by uncertainty associated with implementation 
of the Dodd-Frank Act risk retention requirements and proposed changes 
in the regulatory capital treatment of mortgage servicing rights. 
Finally, bull markets for the past 2 years have stimulated client 
demand for risk management products, reduced market-making risk, and 
increased interest income spread on market-making inventory resulting 
from the steep yield curve. The potential for markets to be less 
bullish and to become more volatile may put further pressure on bank 
trading revenues.

VI. Conclusion
    The financial crisis exposed fundamental weaknesses in risk 
management and supervisory practices across the financial industry and 
supervisory community. Numerous initiatives, including those mandated 
by the Dodd-Frank Act, are underway to address these failures. The OCC 
has and is continuing to take steps to enhance its supervision programs 
and to implement its responsibilities under the Dodd-Frank Act. As we 
implement these changes, we will strive to do so in a manner that, to 
the greatest extent possible, continues to allow all U.S. financial 
firms to compete fairly both within our own financial system and the 
broader global economy. We are also mindful of the special role that 
community banks play in our financial system and the disproportionate 
burden that changing regulatory requirements can pose to these 
entities. In this respect, our overarching goal and mission remains the 
same--to assure the safety and soundness of the institutions under our 
jurisdiction, to ensure that they treat their customers fairly, and in 
carrying out this mission, to conduct our supervision in a balanced and 
fair manner that reflects and is tailored to the risks posed by each 
institution.
                                 ______
                                 
                PREPARED STATEMENT OF SALVATORE MARRANCA

  Director, President, and Chief Executive Officer, Cattraugus County 
                     Bank, Little Valley, New York
                             June 15, 2011

    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee, I am Sal Marranca, Director, President, and CEO of 
Cattaraugus County Bank, a $174 million asset bank in Little Valley, 
New York. I am pleased to be here today to represent the nearly 5,000 
members of the Independent Community Bankers of America. Thank you for 
convening this hearing on ``Enhancing Safety and Soundness: Lessons 
Learned and Opportunities for Continued Improvement.''
    The safety and soundness of our banking system is a significant 
concern to community banks. Early in my career, I was a Senior Bank 
Examiner with the FDIC for over a decade, and the commitment I made 
then to safety and soundness I still carry with me today as President 
of Cattaraugus County Bank and as Chairman of ICBA.
    The recent financial crisis was caused by high risk lending and 
speculation by the megabanks and Wall Street firms. Significant harm 
was done to taxpayers and the economy. Community banks too were harmed. 
The economic decline retracted consumer spending and dramatically 
reduced the demand for credit. Residential and commercial real estate 
markets remain stressed in some areas. Still, the community banking 
industry remains well capitalized and--because we take a conservative, 
commonsense approach to lending--we have fewer problem assets than 
other segments of the industry.
    We must ensure the crisis never repeats itself, and appropriate 
supervision of all financial services providers is an important part of 
that. But how safety and soundness is achieved is very important. 
Misguided, though well intentioned, efforts could be very economically 
damaging. Frankly, many community bankers are deeply frustrated with 
the current exam environment, which has consistently registered as a 
top concern among ICBA members.

Difficult Exam Environment
    As we consider the topic of safety and soundness, we must remember 
that community banks did not cause the financial crisis, nor are they a 
source of ongoing systemic risk. Community banks have a starkly 
different risk profile from other financial services providers because 
of their smaller scale, which precludes systemic risk, and more 
importantly, because they practice conservative, common sense lending 
to customers they often know personally. This different risk profile 
must be taken into consideration as policy makers consider how 
community banks should be examined. Community banks are eager to make 
prudent loans in their communities, and as we consider ways to enhance 
safety and soundness, we must not tip the scale into actions that will 
suffocate economic activity. Safety and soundness is a very real 
concern, but so is the seemingly intractable unemployment that has 
plagued our economy for nearly 3 years. Smart examination and 
compliance practices will allow for more lending without creating undue 
risk to the financial system.
    Specifically, exams could be greatly improved by being more 
consistent and rational. This would encourage prudent lending without 
loosening standards. Arbitrary exams chill lending indiscriminately--
sound loans as well as risky loans. There are more thoughtful, 
systematic ways to reduce risk without discouraging sound lending.
    I'm fortunate to enjoy a cooperative and constructive working 
relationship with my regulator, the FDIC. I value this relationship 
very highly. It is an important part of the success of my bank and has 
allowed me to weather the financial crisis. Having worked as a bank 
examiner, I've been on both sides of the table and can appreciate the 
concerns and challenges examiners face. It's a difficult job with a 
great deal at stake. The stakes were raised sharply after the financial 
crisis, but I believe many examiners overreacted and the pendulum has 
swung too far in the direction of overregulation. I've met with 
thousands of community bankers from every part of the country in recent 
years, and I can tell you there is an unmistakable trend toward 
arbitrary, micromanaged, unreasonably harsh examinations that have the 
effect of suffocating lending.
    This has not always been the case. Before the crisis, examiners 
frequently worked in partnership with the banks they examined. They 
were a resource, a help in interpreting often ambiguous guidance. Where 
corrections were needed, opportunity was given to make them, and 
compliance was a mutual goal. This was the model of examination I 
followed when I was an examiner. I believed then and still believe 
today it is the best means of achieving safety and soundness without 
interfering with the business of lending. Currently, the relationships 
are too often adversarial. Understandably, an examiner does not want to 
be blamed for the next crisis. Examiners are not evaluated on banks' 
contributions to the economy. At all costs, they want to avoid a bank 
failure that would put a black mark on their record. The examiner's 
incentive is to err on the side of writing down too many loans, 
demanding too much capital.
    The crisis was not caused by a failure to adequately examine 
community banks, but examiners have reacted to the crisis with 
overreaching exams that have harmed the economy and made it harder to 
emerge from the recession.
    A particularly frustrating aspect of the exam environment is the 
disconnect between the examiners in the field and the directives from 
Washington. A November 2008, Interagency Statement on Meeting the Needs 
of Creditworthy Borrowers established a national policy for banks to 
extend credit to creditworthy borrowers in order to help initiate and 
sustain an economic recovery. It stated, ``The agencies expect all 
banking organizations to fulfill their fundamental role in the economy 
as intermediaries of credit to businesses, consumers, and other 
creditworthy borrowers.'' Unfortunately, this policy is often neglected 
by examiners in the field, especially in the regions most severely 
affected by the recession. Field examiners are second guessing bankers 
and independent professional appraisers. They are demanding 
unreasonably aggressive write-downs and reclassifications of viable 
commercial real estate loans and other assets. The misplaced zeal of 
these examiners is having a chilling effect on lending. Good loan 
opportunities are passed over for fear of examiner write-down and the 
resulting loss of income and capital. The contraction in credit is 
having a direct, adverse impact on the recovery.
    Furthermore, examiners are demanding capital levels higher than 
those required by regulation. To bankers, the process feels arbitrary 
and punitive. Many community banks complain that the required capital 
level goalpost is unpredictable. Regulators simply keep moving it 
further, making it nearly impossible to satisfy capital demands in a 
difficult economy and capital marketplace. So bankers are forced to 
pull in their horns and pass up sound loan opportunities in order to 
preserve capital. This is not helpful for their communities and 
economic growth. Bankers used to expect prompt feedback that they could 
act on immediately as part of the exam process. Quick, useful feedback 
has been replaced by examination reports that follow months after the 
examiner's visit, with no opportunity for the banker to sit down with 
the examiner, go over the results, and respond to the examiner's 
concerns on the spot.

Legislative Help Is Needed
    ICBA supports legislation to bring more consistency to the 
examination process. With regard to loan classifications, for example, 
one of community bankers' greatest concerns, a bill recently introduced 
in the House would establish criteria for determining when a loan is 
performing and thereby provide for more consistent classifications. 
When loans become troubled often the best course for the borrower, 
lender, and the community is a modification that will keep the loan out 
of foreclosure. But in recent years, many examiners have penalized loan 
modifications by aggressively placing loans on nonaccrual status 
following a modification--even though the borrower has demonstrated a 
pattern of making contractual principal and interest payments under the 
loan's modified terms. This adverse regulatory classification results 
in the appearance of a weak capital position for the lender, which 
dampens further lending in the community and puts a drag on the 
economic recovery. Representative Bill Posey's Common Sense Economic 
Recovery Act of 2011 (H.R. 1723) would establish conservative, 
commonsense criteria for loan classifications.
    Community bankers enthusiastically support this bill because it 
resonates with their experience in examination. It would give bankers 
flexibility to work with struggling but viable borrowers and help them 
maintain the capital they need to support their communities. We hope a 
counterpart bill will soon be introduced in the Senate and considered 
by this Committee.

Consumer Financial Protection Bureau
    The new Consumer Financial Protection Bureau (CFPB) presents 
another potential challenge to the safety and soundness of community 
banks, which will be subject to its rules though institutions with less 
than $10 billion in assets are exempt from primary examination. Because 
the CFPB is not charged with protecting safety and soundness, and does 
not have experience or expertise in this area, there is a real risk 
CFPB rules could promote consumer protection at the expense of safety 
and soundness. For example, any rule that interferes with a bank's 
ability to price for risk in a given product, or that disrupts an 
important revenue stream, could compromise safety and soundness. 
Prudential regulators, on the other hand, have long experience with 
regulating consumer protection in the context of safety and soundness. 
This is why ICBA supports legislation that would give prudential 
regulators a stronger voice in CFPB rulemaking.
    There are different ways of accomplishing this. One example is a 
bill recently passed by the House Financial Services Committee. The 
Consumer Financial Protection Safety and Soundness Improvement Act, 
sponsored by Representative Sean Duffy, would strengthen prudential 
regulatory review of CFPB rules, which is extremely limited under the 
Dodd-Frank Act. Prudential regulators have the ability to comment on 
CFPB proposals before they are released for comment and an extremely 
limited ability to veto regulations before they become final. This veto 
can only be exercised if, by a \2/3\ vote, the Financial Stability 
Oversight Council (FSOC) determines that a rule ``puts at risk the 
safety and soundness of the banking system or the stability of the 
financial system,'' a standard that is nearly impossible to meet. A 
rule that doesn't meet this high standard could nevertheless do 
extraordinary harm to banks and consumers. H.R. 1315 would change the 
voting requirement for an FSOC veto to a simple majority, excluding the 
CFPB Director, and change the standard to allow for a veto of a rule 
that ``is inconsistent with the safe and sound operations of United 
States financial institutions.'' While this change would improve CFPB 
rulemaking, ICBA has proposed language that would further broaden the 
standard to allow FSOC to veto a rule that could adversely impact a 
subset of the industry in a disproportionate way. We believe that this 
standard would give prudential regulators a more meaningful role in 
CFPB rule writing.

Communities First Act
    The ICBA-backed Communities First Act (CFA, H.R. 1697) captures 
many reforms the community banking sector deems necessary to alleviate 
the difficult regulatory burden they face, including a change to the 
FSOC veto standard for CFPB rules very similar to H.R. 1315 discussed 
above. This legislation was recently introduced in the House and 
cosponsored by members from both sides of the aisle. ICBA is working to 
introduce a similar bill in the Senate. Notably CFA would:

    Increase the threshold number of bank shareholders from 500 
        to 2,000 that trigger SEC registration. Annual SEC compliance 
        costs are a significant expense for listed banks.

    Reduce the paperwork burden that acts as a dead-weight cost 
        for community banks, consuming scarce resources that could 
        support lending.

    Defer taxation of interest on long-term certificates of 
        deposits and tax the interest at capital gains rates so more 
        consumers are rewarded for saving and investing.

    Extend the 5-year net operating loss (NOL) carryback 
        provision to free up community bank capital now when it is most 
        needed to boost local economies.

    These and other provisions would improve the regulatory environment 
and community bank viability, to the benefit of their customers and 
communities.

Moral Hazard and Too-Big-To-Fail Institutions
    The greatest threat to safety and soundness remains the too-big-to-
fail institutions that dominate the financial services sector. Today, 
the four largest banking companies control more than 40 percent of the 
Nation's deposits and more than 50 percent of the assets held by U.S. 
banks. The largest banks have grown larger since the financial crisis. 
The ten largest hold 77 percent of all U.S. bank assets compared with 
55 percent of total assets in 2002, according to a recent Bloomberg 
study. ICBA does not believe it is in the public interest to have 10 
institutions controlling a significant majority of the assets of the 
banking industry. A more diverse financial system would reduce risk and 
promote competition, innovation, and the availability of credit to 
consumers of various means and businesses of all sizes.
    As a result of the financial crisis, our Nation went through an 
agonizing series of forced buy-outs or mergers of some of the Nation's 
largest banking and investment houses, costing American taxpayers 
hundreds of billions of dollars. Some mega-institutions--too-big-to-
fail and also too big-to-be-sold to another firm--were directly propped 
up by the Government. One large institution, Lehman Brothers, was 
allowed to go bankrupt, with disastrous consequences that only 
confirmed the policy of too-big-to-fail. The doctrine of too-big--or 
too-interconnected--to-fail finally came home to roost, to the 
detriment of the American taxpayer and our economy. Our Nation cannot 
afford to go through that again. Systemic risk institutions that are 
too big or interconnected to manage, regulate or fail should either be 
broken up or required to divest assets until they no longer pose 
systemic risk.
    In a speech made as the country was emerging from the crisis, 
Federal Reserve Chairman Ben S. Bernanke outlined the risks of the too-
big-to-fail system:

        The belief of market participants that a particular firm is 
        considered too big to fail has many undesirable effects. For 
        instance, it reduces market discipline and encourages excessive 
        risk-taking by the firm. It also provides an artificial 
        incentive for firms to grow in order to be perceived as too big 
        to fail. And it creates an unlevel playing field with smaller 
        firms, which may not be regarded as having implicit Government 
        support. Moreover, Government rescues of too-big-to-fail firms 
        can be costly to taxpayers, as we have seen recently. Indeed, 
        in the present crisis, the too-big-to-fail issue has emerged as 
        an enormous problem.

    Unfortunately, Government interventions necessitated by the too-
big-to-fail policy have exacerbated rather than abated the long-term 
problems in our financial structure. Through Federal Reserve and 
Treasury orchestrated mergers, acquisitions and closures, the big have 
become bigger. A recent Bloomberg Government study concluded that the 
number of too-big-to-fail banks will increase by 40 percent over the 
next 15 years.
    Government efforts to stabilize the financial system, though 
necessary to stave off a full scale financial collapse and even deeper 
recession, were deeply unfair to community banks. The Government bailed 
out too-big-to-fail institutions, while the FDIC summarily closed too-
small-to-save institutions, victims of a crisis created on Wall Street. 
Community bankers across the country were deeply angered by the results 
of too big to fail.
    This is why ICBA generally supports the too-big-to-fail measures in 
the Dodd-Frank Act. These include measures to prevent firms from 
getting too big; offset the advantages of being too big; more diligent 
monitoring for systemic risk; subject large, interconnected firms to 
enhanced capital and prudential standards; and create a resolution 
authority for large firms so the Government is never again forced to 
choose between propping up a failing firm and allowing it to fail and 
wreak havoc on the financial system. However, whether the Dodd-Frank 
Act will succeed in ending the market perception that large, 
interconnected firms are too big to fail will largely depend on the 
implementing rules and how diligently they are enforced in the coming 
months and years.

Housing Finance Reform, If Not Done Properly, Could Lead to Industry 
        Concentration
    Key aspects of the housing finance system--the rules governing 
underwriting, risk retention, servicing, foreclosure, securitization, 
and the structure of secondary market entities--are facing review and 
revision. This is an expected and appropriate response to the housing-
driven financial and economic crisis we've just experienced. But we 
must recognize that ill-considered changes--singly and cumulatively 
across a number of areas--could unintentionally reduce competition, 
amplify moral hazard, and jeopardize safety and soundness. 
Specifically:

    The agencies ``qualified residential mortgage'' (QRM) 
        exemption from the Dodd-Frank risk retention requirement on 
        mortgages sold and securitized should be sufficiently broad to 
        encompass the majority of the residential mortgage market, 
        consistent with stronger underwriting standards. Because risk 
        retention will require increased capital, which will pose a 
        challenge for community banks, a narrow definition of QRM will 
        drive thousands of community banks and other lenders from the 
        residential mortgage market, leaving it to the largest lenders 
        whose actions brought about the financial crisis. In our view, 
        the QRM definition currently proposed by the banking agencies, 
        which includes a 20 percent downpayment requirement, is too 
        narrow.

    While policy makers are rightly alarmed by the sloppy and 
        abusive servicing standards of some large lenders, they must 
        recognize that community banks have fundamentally different 
        standards, practices, and risks. With smaller servicing 
        portfolios, better control of mortgage documents, and close 
        ties to their customers and communities, community banks have 
        generally been able to identify repayment problems at the first 
        signs of distress and work out mutually agreeable solutions 
        with struggling borrowers. Overly prescriptive servicing 
        requirements--a burden for community banks which do not have 
        the staffing and financial resources to implement extensive new 
        programs--could cause many community banks to exit the mortgage 
        servicing business and accelerate consolidation of the 
        servicing industry with only the largest too-big-to-fail 
        lenders surviving.

    As proposals for replacing Fannie Mae and Freddie Mac are 
        considered, policy makers should be extremely careful not to 
        recreate the moral hazard they represented. Some of the 
        proposals put forward would, by allowing just a small number of 
        large banks to dominate the secondary mortgage market, create a 
        new variety of moral hazard, just as pernicious as the old 
        variety. Any solution that fuels consolidation is only setting 
        up the financial system for an even bigger collapse than the 
        one we've just been through.

    Policy makers must proceed with caution in housing finance reform. 
The mortgage market is critical to the broader economy, as we learned 
during the recent crisis, and the potential for unintended consequences 
is significant.

Conclusion
    Thank you again for convening this hearing and giving ICBA the 
opportunity to testify. We share your commitment to enhancing the 
safety and soundness of our financial system and hope that the 
community bank perspective has been valuable.
                                 ______
                                 
               PREPARED STATEMENT OF FRANK A. SUELLENTROP

          Chairman and President, Legacy Bank, Colwich, Kansas
                             June 15, 2011

    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee, thank you for the opportunity to testify before you today 
regarding the topic of ``Enhancing Safety and Soundness: Lessons 
Learned and Opportunities for Continued Improvement.''
    My name is Frank Suellentrop and I am President and Chairman of 
Legacy Bank in Colwich, Kansas. We are a $250 million closely held 
community bank providing banking services to the area of Sedgwick 
County, Kansas. We have five branch locations: our charter bank 
location in Colwich, Kansas, population 1,400, and four branch 
locations in the Wichita, Kansas, community.
    Our bank was established in February 1886, which means that we are 
celebrating 125 years in 2011. I am fourth generation President of our 
bank with over 38 years of employment at Legacy Bank. I have been 
President of our bank since 1991. From that experience, I have seen the 
beginnings of consumer regulation in the early 1970s, the agriculture 
crisis, the savings and loan and real estate crisis of the 1980s and 
early 1990s, and now, the Wall Street-induced real estate crisis of 
2008.
    Legacy Bank is significantly involved in residential development, 
residential construction, and commercial property lending and 
therefore, has been impacted greatly by the economic slowdown and 
depressed real estate market values. Fortunately, the economy in the 
Wichita, Kansas, area has fared reasonably well throughout the current 
crisis relative to other markets, primarily due to the fact that 
Kansas, specifically Wichita, had not experienced inflated real estate 
values of the past decade.
    I would like to preface my comments regarding a recent examination 
by saying that I understand examiners are charged with a difficult 
task. On one hand, they are expected to protect against bank failures, 
insure consumer compliance and regulation are adhered to, satisfy 
community groups and organizations demand for fair banking practices, 
and Congressional demands for banking/financial oversight. On the other 
hand, regulators are/should be tasked with not interfering with a 
bank's corporate mission of creating value for its shareholders. Legacy 
Bank is a ``for-profit'' corporation. Our most recent 2010 examination 
revealed stark differences from prior exams: higher capital and 
liquidity standards, more demanding asset quality evaluations, 
expectations for higher allowance for loan and lease loss reserves 
(ALLL), and increased focus on management assessment and compensation 
practices.
    Comments made by regulators during our last exam include, ``We 
don't like your risk profile'' and ``We're not going `to bat' for you 
in Washington.'' To put the first comment in context, our bank has been 
a lender to residential real estate developers, homebuilders, and 
commercial property owners since the late 1980s. We feel our lending 
staff has the experience and knowledge to manage our loan portfolio 
composition. These comments were significantly more aggressive compared 
to prior examination observations. Due to recent failures or problem 
banks in other areas of the country, our lending ``risk profile'' is 
now unacceptable. In addition to standard loan underwriting criteria of 
evaluating a borrower's capital, collateral, capacity to repay, and 
market conditions, we have added a new component to our loan approval 
discussion process--``Will the loan pass examiners' review and 
approval?'' This component should not be a loan approval consideration. 
A customer's loan request should be based on its viability and 
productive value. With respect to the latter comment, it illustrates a 
regulatory attitude that all banks in real estate lending are unsafe 
and unsound in their practices.
    Banks are evaluated based on their CAMELS component ratings, which 
measures a bank's capital, asset quality, management, earnings, 
liquidity, and sensitivity to interest rates. My comments on each of 
these bank evaluation components under the current regulatory 
environment are provided below.

Capital
    Capital standards for most banks are being dictated above levels 
for regulatory defined ``well-capitalized' banks and standards required 
for our Nation's largest financial institutions. Regulators are using 
their discretionary capital standards caveat to demand capital levels 
above those banks defined as ``well-capitalized.'' Capital below the 
mandated Tier-One and risk-based levels are likely to receive a lower 
``capital component,'' which may subject banks to a ``troubled bank'' 
status. Discretionary capital standards create a difficult moving 
target for banks as we seek to achieve an acceptable capital component 
rating.

Asset Quality
    Examiners are slow to recognize when credit risk has been 
mitigated. Classifications are inconsistent. No credit given for past 
performance of the borrower. Some classifications are backdated after 
the borrower begins to show improvement.

Management
    Management compensation is now being reviewed by examiners, 
suggesting potential negative impact to earnings and capital. Without 
significant discussion during our last examination, examiner comments 
dictated a requirement that we justify management compensation and 
benefits. Somehow ``Wall Street'' excesses on executive pay have crept 
into regulators view of ``Main Street'' banking compensation practices 
when there is no valid comparison to their abuses.

Earnings
    Earnings evaluations are focused on budget expectations and provide 
a source of capital growth. Budgets are a fluid document where changes 
occur relative to changing market conditions. Variances occur 
throughout the year and are detailed in monthly review of performance 
vs. a rebudgeting process as suggested by an examiner.

Liquidity
    Current examination expectations dictate a higher level of 
liquidity to protect against the ``what ifs'' for funding assets. 
Examiners are reluctant to recognize the value of purchased funding 
costs vs. core deposit funding. Levels of purchased funding should be 
variable to the institution and not an industry standard.
    At each examination, an Examiner in Charge (EIC) is designated. My 
experience with this practice is that often an EIC does not want to 
overrule another examiner's findings regarding loan quality issues or 
other components of an examination. On completion of an examination, 
EIC comments are submitted to a Review Examiner. The Review Examiner 
then does not want to overrule an EIC's submitted comments; therefore, 
the process can be problematic for bankers where an inexperienced or 
unqualified examiner's findings become a part of the ``report of 
examination.'' These results then become a part of the final report for 
bank examination ratings and mandated actions to address findings. Only 
experienced examiners capable of managing others' activities should be 
designated as an ``Examiner in Charge'' to insure quality in a final 
report of examination. Recourse for bankers disputes regarding 
examination findings are often treated as we agree to disagree by 
examiners.
    In summary, micromanaging is unproductive. Part of the regulator's 
role is to offer insight into latest industry trends and issues. 
Instead, exam outcomes now seem predetermined with enforcement actions 
imposed for minor issues that do not enhance a bank's viability. To 
move forward in a productive, mutually beneficial manner, there should 
be more focus on the root cause of examination findings. Examiners 
should expect results, but if capital is solid and management is 
capable, then overregulation is unnecessary. Regulatory burden and 
examiner expectations are disproportionate in their impact on community 
banks vs. the largest banks. Many community banks have a limited staff 
to respond to examiner expectations vs. the largest banks full-time 
staff devoted to regulatory compliance.
    Thank you again for the opportunity to comment. I hope that this 
testimony provides productive insight into the current regulatory 
environment for community banks.

         RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM MICHAEL R. FOLEY

Q.1. What is the purpose of the Commercial Bank Examination 
Manual? While certain sections were updated in April (which was 
identified as ``Supplement 35''), it appears that there has 
been no comprehensive review and update of the entire manual. 
Does the Federal Reserve intend to conduct a comprehensive 
rewrite of this manual? Why or why not?

A.1. Response not provided.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR MERKLEY
                     FROM MICHAEL R. FOLEY

Q.1. Examination Staffing--Recent reports indicate the Federal 
banking agencies are increasing their on-site examination teams 
at the largest banks. For each of the six largest banking 
organizations that your agency respectively supervises today, 
please detail: (a) how many examiners you have had dedicated to 
supervising each such organization for each year beginning in 
2005 through the present; (b) whether those examiners resided 
on-site at the firm's headquarters permanently, whether those 
examiners resided on-site occasionally for examination periods, 
or whether those examiners remained at the agency (and if so, 
which office/Reserve Bank); and (c) what the principal 
responsibilities of those examiners were (for example, data 
analysis of risk models, supervising management compliance with 
policies and procedures, etc.).
    For those 6 largest banking organizations, please also 
quantify the number of personnel at each banking organization 
working in the risk management group, or the internal audit 
department.

A.1. Response not provided.

Q.2. Examination Staffing--Please provide specific detail 
regarding the methodology you used/use for determining how many 
examiners you dedicate to firms you supervise. Please provide 
other information relevant to staffing levels and practices for 
your examinations, such as the FTE examination hours applicable 
per $10 billion of assets at the 10 largest banking 
organizations and the FTE examination hours applicable for $10 
billion of assets at all other banking organizations.

A.2. Response not provided.

Q.3. Examination Staffing--During the 2005 through 2010 period, 
please detail the dates on which peer reviews or other internal 
reviews were conducted within your organizations that evaluated 
the sufficiency of examination staffing for the six largest 
institutions under your supervision. Please state the staffing 
conclusions for each such peer review.

A.3. Response not provided.

Q.4. Interagency Cooperation--Senior examiners have indicated 
that the largest banking organizations run their businesses 
without respect to the legal entity involved, and that specific 
business operations can straddle entities with different 
regulatory jurisdictions. In light of Dodd-Frank, how has the 
communication among agencies changed? When multiple regulators 
oversee a banking organization, what procedures do you have in 
place to review and follow-up on concerns raised by one 
regulator when such concerns may touch upon oversight conducted 
by other regulators or the entire firm?

A.4. Response not provided.

Q.5. Investigations--The HUD Inspector General has recently 
issued findings that at least one major financial institution 
has obstructed a State attorneys general investigation and a 
HUD investigation into foreclosure and servicing abuses. What 
specific steps have you taken to ensure that all institutions 
under your supervision are complying with both your supervision 
and with relevant investigations by other regulatory agencies 
and law enforcement officials?

A.5. Response not provided.

Q.6. Documentation Oversight--Following the robosigning scandal 
and the difficulty some banks have had documenting the claim of 
ownership on mortgages on which they are pursuing foreclosure, 
what steps have you taken to increase oversight of 
documentation requirements at large complex financial 
institutions?

A.6. Response not provided.

Q.7. International--What systems do you have in place or do you 
envision needing to ensure the proper supervision of large 
complex foreign financial institutions which either operate in 
the U.S. or which materially affect U.S. financial markets?

A.7. Response not provided.

Q.8. Trading Book--For the firms that now make up the six 
largest bank holding companies, what percentage of losses by 
those firms on a consolidated basis during the 2008 financial 
crisis were due to losses in their respective trading books as 
opposed to their banking books? Please include within that 
analysis assets which would have been losses had those assets 
not been transferred from the trading book to the banking book 
and therefore not subject to fair value accounting. Also 
include in those losses assets or positions that were placed on 
the books of that national bank, after the outbreak of the 
crisis, such as the liquidity puts that were used to bring back 
CDQs onto a bank's balance sheet.
    Please provide relevant data/analysis as appropriate.

A.8. Response not provided.

Q.9. Review of Trading Operations Under FRB Manuals--Section 
2030.3 of the Federal Reserve's Commercial Bank Examination 
Manual, in effect since March 1994, lists certain specific 
procedures that examiners are expected to conduct in their 
supervision of commercial banks' trading operations. For 
example it asks examiners to ``test for compliance with 
policies, practices, procedures, and internal controls . . . '' 
(#3); requests a series of schedules, including ``an aged 
schedule of securities,'' ``an aged schedule of trading account 
securities . . . held for trading or arbitrage purposes,'' ``a 
schedule of loaned securities,'' etc. (#4); requests the 
examiner to ``review customer ledgers, securities position 
ledgers, etc., and analyze the soundness of the bank's trading 
practices by . . . reviewing a representative sample of agency 
and contemporaneous principal trades . . . and reviewing 
significant inventory positions taken since the prior 
examination'' (#9).
    Today, some of the largest bank holding companies conduct 
their derivatives trading operations directly through Federal 
Reserve-regulated member banks. How frequently do examiners 
conduct the reviews directed by section 2030.3? Under what 
circumstances will you discipline an examination team for 
failing to follow policies and procedures set out in agency 
manuals--please describe up to three examples?

A.9. Response not provided.

Q.10. Safety and Soundness Review of Trading Operations--The 
Federal Reserve Trading and Capital Markets manual sets out a 
wide range of approaches to monitoring firms' trading 
activities, in particular focusing on whether firms have in 
place policies and procedures to monitor risks. As part of this 
monitoring of risks, on what occasions might you make an 
independent evaluation of the trading positions themselves on a 
safety and soundness basis, rather than simply the policies and 
procedures regarding risk management?
    For example, the former CEO of one large banking group said 
he couldn't be bothered with his firm's $43 billion dollar 
exposure on subprime CDOs because he had a $2 trillion balance 
sheet to manage. However, that $43 billion dollar exposure 
represented \1/3\ of the group's capital. Meanwhile, community 
bank examiners regularly examine the substance of large loans 
for conformance with safety and soundness. Under what 
circumstances would a trading position such as the one outlined 
above be reviewed for the underlying risk by your examiners? 
Please detail at least three examples in the last 5 years.
    How has oversight of trading activities changed between 
prefinancial crisis and now?

A.10. Response not provided.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
                      FROM DAVID K. WILSON

Q.1. In a speech in London yesterday, Acting Comptroller Walsh 
cited a 2007 study which stated that ``there is widespread 
agreement in the theoretical academic literature that the 
immediate effects of constraining capital standards are likely 
to be a reduction in total lending and accompanying increases 
in market loan rates and substitution away from lending to 
holding alternative assets.'' If this was true prior to the 
financial crisis, when this study was conducted, it is no 
longer the case today. There now appears to be widespread 
agreement that equity is not expensive and that increased 
capital buffers are a good thing.
    In August of 2010, Professor Anat Admati and several of her 
colleagues published a paper explaining that requiring banks to 
increase their funding through equity will not contract 
lending.
    David Scharfstein and Jeremy Stein of Harvard University 
argued last September in the Financial Times that increased 
capital will make institutions safer, and actually reduce the 
risk of a credit crunch.
    A study by the Bank for International Settlements suggests 
an optimal capital ratio of about 13 percent.
    A Government-sponsored panel in Switzerland has said that 
massive banks UBS and Credit Suisse should hold a 19 percent 
capital buffer.
    The Bank of England is reportedly considering capital 
ratios as high as 20 percent.
    In his recent testimony before the Congressional Oversight 
Panel of TARP (COP), Professor Allan Meltzer noted that large 
banks in the 1920s held capital equal to 15 to 20 percent of 
their assets.
    In response to written questions pursuant to a February 
hearing in the Senate Banking Committee, FDIC Chairman Sheila 
Bair stated, ``we do not agree that the new [capital] 
requirements will reduce the availability of credit or 
significantly raise borrowing costs.''
    a. Do you believe that equity is expensive despite the work 
of respected academics showing that it is not?
    b. What are the costs of increasing banks funding through 
equity?
    c. What other evidence, aside from the study cited by Mr. 
Walsh, supports your conclusion that banks increasing their 
equity funding would be expensive and contract lending?
    d. Does the OCC have any evidence suggesting that the 
alleged costs of additional equity funding outweigh the costs 
associated with undercapitalization at rates below those 
required by Basel III combined with an additional SIFI capital 
buffer?
    e. What does the OCC believe to be the optimum capital 
buffer?

A.1. Response not provided.

Q.2. According to a June 12th report in the Financial Times, 
OCC data shows that nearly 20 percent of private label 
mortgage-backed securities held by banks are at least 30 days 
late or in some stage of foreclosure. Amherst Securities 
estimates that 30 percent of mortgages contained in PLS held by 
outside investors are at least 60 days delinquent.
    The COP estimates that, at the end of the third quarter 
2010, the four largest banks reported $420.0 billion in second 
lien mortgages. The OCC sent a letter to Representative Brad 
Miller in December in which you estimated that banks' total 
losses on second liens would not exceed $18 billion.
    COP estimates that banks are subject to $52 billion in 
mortgage-backed security put-back claims. Institutional Risk 
Analytics estimates that JPMorgan Chase alone is subject to $50 
billion in investor claims under the Securities Act.
    a. What losses does the OCCproject the banks to incur on 
their private label MBS holdings? Please provide a specific 
number, and please explain the assumptions and rationale behind 
your calculation.
    b. What losses does the OCC project banks to incur on their 
second lien portfolios? Please provide a specific number, and 
please explain the assumptions and rationale behind your 
calculation.
    c. What losses does the OCC project banks to incur through 
investors' securities claims? Please provide a specific number, 
and please explain the assumptions and rationale behind your 
calculation.

A.2. Response not provided.

Q.3. In February, Acting Comptroller Walsh testified that 
``[mortgage servicing] deficiencies have resulted in violations 
of State and local foreclosure laws, regulations, or rules.''
    a. In written questions for that hearing I asked Mr. Walsh 
what specific laws, regulations, or rules were violated. The 
only specific laws cited were State attestation and 
notarization laws. In a subsequent answer, he noted violations 
of the Servicemembers Civil Relief Act, bankruptcy law, and 
mortgage modification programs.
    i. Please list all of the violations of specific laws, 
regulations, or rules--either local, State, or Federal--that 
your reviews uncovered.
    ii. How many violations of each law, regulation, or rule 
did you uncover?
    b. The Treasury Department was unable to determine in 18.8 
percent of Bank of America's HAMP files whether a second look 
had been conducted, and there were income miscalculations in 22 
percent of cases. The numbers for JPMorgan Chase were 11.3 
percent and 31 percent, respectively.
    Mr. Walsh noted in his written responses that ``Documents 
in the foreclosure files may not have disclosed certain facts 
that might have led examiners to conclude that a foreclosure 
should not have proceeded however, such as misapplication of 
payments that could have precipitated a foreclosure action or 
oral communications between the borrower and servicer staff 
that were not documented in the foreclosure file.''
    i. What other errors did you uncover in your reviews that 
might have led examiners to conclude that a foreclosure should 
not have proceeded? Please describe every error that you 
uncovered.
    ii. How many files reviewed by the OCC contained such 
errors?

A.3. Response not provided.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM DAVID K. WILSON

Q.1. Please provide a response to May 12, 2011, questions that 
were submitted to the Office of the Comptroller of the Currency 
(OCC). No response has been received to date.

A.1. Response not provided.

Q.2. What is the purpose of the Comptroller's Handbook? What 
revisions have been made to the Comptroller's Handbook to 
address observations from the financial crisis? When will there 
be a comprehensive rewrite?

A.2. Response not provided.

Q.3. Please describe the specific changes you have made to the 
training programs for examiners in response to matters observed 
during the financial crisis.

A.3. Response not provided.

Q.4. What reliance do you place on a bank's internal control 
system? What basis do you have for that reliance? Describe what 
work the OCC has done to be assured that there are no 
significant weaknesses the agency is inherently relying on.
    Please describe any meetings that the OCC has had with the 
Public Company Accounting Oversight Board (PCAOB) to discuss 
any weaknesses the OCC identified in the internal control? 
Please indicate the date of such meetings and the substance of 
the matters discussed.
    Please describe any meetings that the OCC has had with the 
Securities and Exchange Commission (SEC) about such weaknesses. 
Please indicate the date of such meetings and the substance of 
the matters discussed.

A.4. Response not provided.

Q.5. Describe the facts and circumstances, if any, that may 
prevent principal reduction, whether structured as forbearance 
or forgiveness, from being considered as a viable option in 
mortgage modifications. Please indicate whether the agency has 
taken any position with respect to mortgage servicer accounting 
for all forms of mortgage modifications. Please include any 
guidance provided to servicers or other regulators, including 
the date and substance of the guidance provided.

A.5. Response not provided.

Q.6. Describe the facts, circumstances, and relevant accounting 
guidance that applies to accounting for mortgage modifications 
by mortgage servicers. Please provide internal or external 
guidance.

A.6. Response not provided.

Q.7. Describe the facts, circumstances, and relevant accounting 
guidance that concerns servicers consolidation of 
securitization trusts. Please describe the total mix of 
information considered, including all quantitative and 
qualitative factors, with respect to defining ``significance.'' 
Please indicate the reasons that servicers have or have not 
consolidated securitization trusts as a result of recently 
implemented generally accepted accounting principles (including 
SFAS Nos. 166 and 167). Please include specific discussion of 
anticipated losses as a result of servicer conduct that is the 
subject of the OCC Consent Orders and other reviews.

A.7. Response not provided.

Q.8. Provide the data that serves as the basis for the 
statement made by Mr. Walsh on June 21, 2011, ``Capital levels 
are now extraordinarily high by historical standards.'' Please 
include the period of time considered and the relevant 
quantitative measure at each interval.

A.8. Response not provided.
                                ------                                


       RESPONSES TO WRITTEN QUESTIONS OF SENATOR MERKLEY
                      FROM DAVID K. WILSON

Q.1. Examination Staffing--Recent reports indicate the Federal 
banking agencies are increasing their on-site examination teams 
at the largest banks. For each of the six largest banking 
organizations that your agency respectively supervises today, 
please detail: (a) how many examiners you have had dedicated to 
supervising each such organization for each year beginning in 
2005 through the present; (b) whether those examiners resided 
on-site at the firm's headquarters permanently, whether those 
examiners resided on-site occasionally for examination periods, 
or whether those examiners remained at the agency (and if so, 
which office/Reserve Bank); and (c) what the principal 
responsibilities of those examiners were (for example, data 
analysis of risk models, supervising management compliance with 
policies and procedures, etc.).
    For those 6 largest banking organizations, please also 
quantify the number of personnel at each banking organization 
working in the risk management group, or the internal audit 
department.

A.1. Response not provided.

Q.2. Examination Staffing--Please provide specific detail 
regarding the methodology you used/use for determining how many 
examiners you dedicate to firms you supervise. Please provide 
other information relevant to staffing levels and practices for 
your examinations, such as the FTE examination hours applicable 
per $10 billion of assets at the 10 largest banking 
organizations and the FTE examination hours applicable for $10 
billion of assets at all other banking organizations.

A.2. Response not provided.

Q.3. Examination Staffing--During the 2005 through 2010 period, 
please detail the dates on which peer reviews or other internal 
reviews were conducted within your organizations that evaluated 
the sufficiency of examination staffing for the six largest 
institutions under your supervision. Please state the staffing 
conclusions for each such peer review.

A.3. Response not provided.

Q.4. Interagency Cooperation--Senior examiners have indicated 
that the largest banking organizations run their businesses 
without respect to the legal entity involved, and that specific 
business operations can straddle entities with different 
regulatory jurisdictions. In light of Dodd-Frank, how has the 
communication among agencies changed? When multiple regulators 
oversee a banking organization, what procedures do you have in 
place to review and follow-up on concerns raised by one 
regulator when such concerns may touch upon oversight conducted 
by other regulators or the entire firm?

A.4. Response not provided.

Q.5. Investigations--The HUD Inspector General has recently 
issued findings that at least one major financial institution 
has obstructed a State attorneys general investigation and a 
HUD investigation into foreclosure and servicing abuses. What 
specific steps have you taken to ensure that all institutions 
under your supervision are complying with both your supervision 
and with relevant investigations by other regulatory agencies 
and law enforcement officials?

A.5. Response not provided.

Q.6. Documentation Oversight--Following the robosigning scandal 
and the difficulty some banks have had documenting the claim of 
ownership on mortgages on which they are pursuing foreclosure, 
what steps have you taken to increase oversight of 
documentation requirements at large complex financial 
institutions?

A.6. Response not provided.

Q.7. International--What systems do you have in place or do you 
envision needing to ensure the proper supervision of large 
complex foreign financial institutions which either operate in 
the U.S. or which materially affect U.S. financial markets?

A.7. Response not provided.

Q.8. Trading Book--For the firms that now make up the six 
largest bank holding companies, what percentage of losses by 
those firms on a consolidated basis during the 2008 financial 
crisis were due to losses in their respective trading books as 
opposed to their banking books? Please include within that 
analysis assets which would have been losses had those assets 
not been transferred from the trading book to the banking book 
and therefore not subject to fair value accounting. Also 
include in those losses assets or positions that were placed on 
the books of that national bank, after the outbreak of the 
crisis, such as the liquidity puts that were used to bring back 
CDQs onto a bank's balance sheet.
    Please provide relevant data/analysis as appropriate.

A.8. Response not provided.

Q.9. Review of Trading Operations Under FRB Manuals--Section 
2030.3 of the Federal Reserve's Commercial Bank Examination 
Manual, in effect since March 1994, lists certain specific 
procedures that examiners are expected to conduct in their 
supervision of commercial banks' trading operations. For 
example it asks examiners to ``test for compliance with 
policies, practices, procedures, and internal controls . . . '' 
(#3); requests a series of schedules, including ``an aged 
schedule of securities,'' ``an aged schedule of trading account 
securities . . . held for trading or arbitrage purposes,'' ``a 
schedule of loaned securities,'' etc. (#4); requests the 
examiner to ``review customer ledgers, securities position 
ledgers, etc., and analyze the soundness of the bank's trading 
practices by . . . reviewing a representative sample of agency 
and contemporaneous principal trades . . . and reviewing 
significant inventory positions taken since the prior 
examination'' (#9).
    Today, some of the largest bank holding companies conduct 
their derivatives trading operations directly through Federal 
Reserve-regulated member banks. How frequently do examiners 
conduct the reviews directed by section 2030.3? Under what 
circumstances will you discipline an examination team for 
failing to follow policies and procedures set out in agency 
manuals--please describe up to three examples?

A.9. Response not provided.

Q.10. Safety and Soundness Review of Trading Operations--The 
Federal Reserve Trading and Capital Markets manual sets out a 
wide range of approaches to monitoring firms' trading 
activities, in particular focusing on whether firms have in 
place policies and procedures to monitor risks. As part of this 
monitoring of risks, on what occasions might you make an 
independent evaluation of the trading positions themselves on a 
safety and soundness basis, rather than simply the policies and 
procedures regarding risk management?
    For example, the former CEO of one large banking group said 
he couldn't be bothered with his firm's $43 billion dollar 
exposure on subprime CDOs because he had a $2 trillion balance 
sheet to manage. However, that $43 billion dollar exposure 
represented \1/3\ of the group's capital. Meanwhile, community 
bank examiners regularly examine the substance of large loans 
for conformance with safety and soundness. Under what 
circumstances would a trading position such as the one outlined 
above be reviewed for the underlying risk by your examiners? 
Please detail at least three examples in the last 5 years.
    How has oversight of trading activities changed between 
prefinancial crisis and now?

A.10. Response not provided.

Q.11. Your testimony on page 24 [Editor: See, Page 51, Part D, 
of this hearing] regarding section 619 suggests a narrow view 
of proprietary trading that seems to envision a world wherein 
all proprietary trading occurs on distinct, separate stand-
alone proprietary trading desks.
    Please provide details on what, if any, analysis the OCC 
has made on the conflicts of interest and risks to institutions 
from proprietary trading wherever it may occur, and 
particularly that which occurs on market-making desks and in 
other business units of a firm, such as securitization-
structured product underwriting and merchant banking.
    For example, the U.S. Permanent Subcommittee on 
Investigations found that large, conflicted proprietary trading 
activities of one firm occurred on its mortgage desks, which 
were non- stand-alone proprietary trading desks. How does the 
OCC identify those conflicts and risks now and what new forms 
of oversight are you contemplating putting in place to ensure 
the statutory intent of section 619 is implemented?

A.11. Response not provided.

              Additional Material Supplied for the Record

        STATEMENT SUBMITTED BY THE AMERICAN BANKERS ASSOCIATION

    Chairman Brown, Ranking Member Corker, and Members of the 
Subcommittee, the American Bankers Association appreciates the 
opportunity to submit this statement for the record on ways to enhance 
safety and soundness in the aftermath of the financial crisis. The ABA 
represents banks of all sizes and charters and is the voice of the 
Nation's $13 trillion banking industry and its two million employees.
    The topic of this hearing is very important. In an effort to deal 
with the aftermath of the financial crisis, the response by Congress 
and the regulators has been to drive out all the risk from the system 
in the name of safety and soundness. This has meant that good loans 
that could and should be made are left unfunded. The pendulum has swung 
too far in favor of tighter regulation, micromanagement, and second-
guessing. This has made the daily efforts of banks to make credit and 
financial services available much more difficult. Combined with 
hundreds of new regulations expected from the Dodd-Frank Act, these 
pressures are slowly but surely strangling traditional community banks, 
handicapping their ability to meet the credit needs of communities 
across the country.
    Congress must be vigilant in overseeing regulatory actions that 
unnecessarily restrict loans to creditworthy borrowers. Holding 
oversight hearings like this one is critical to ensure that banks are 
allowed to do what they do best--namely, meet the credit needs of their 
communities.
    For banks to be successful and meet the needs of their customers, 
they need to be profitable. There is no better assurance of safety and 
soundness than a healthy, profitable industry. Once again, Congress and 
the regulators have acted to reduce sources of income, made it much 
harder to raise capital, and threaten to drive some banks completely 
out of business lines, such as acting as municipal advisors or making 
residential mortgage loans.
    One of those very important sources of income that will be 
significantly diminished is a direct result of the Durbin Amendment in 
the Dodd-Frank Act that imposes severe restrictions on interchange 
prices. The ABA and the thousands of banks we represent were deeply 
disappointed with the outcome of Senate vote last week. Failure to 
approve the bipartisan amendment sponsored by Senators Tester (D-
Mont.), Corker (R-Tenn.), and others to address the serious concerns 
over the interchange amendment marks a dark day for every bank that 
issues debit cards and for consumers that have come to rely on them.
    American consumers will now have to pay more for basic banking 
services, while big-box retailers go off and count their unjustified 
profits. Community banks--the backbone of local communities--will 
suffer the most. They will see a reduction in a key source of revenue 
that allows them to offer low-cost banking services to everyday 
consumers and supports lending and fraud protection measures. Key 
banking regulators--including Federal Reserve Board Chairman Ben 
Bernanke and FDIC Chairwoman Sheila Bair--have unequivocally stated 
that small banks will be harmed by the implementation of the Durbin 
Amendment. While a majority of Senators supported the Tester/Corker 
amendment, it is simply unconscionable that the Senate will not 
complete the work and protect community banks from this destructive 
effect.
    It is within the Federal Reserve's power to mitigate the disastrous 
consequences that are sure to come from this policy initiative, and we 
urge the Fed to take all necessary action to do so.
    The entire banking industry thanks Senators Tester and Corker--and 
the other 52 senators that stood up for debit card customers--for their 
extraordinary effort to address this serious problem in a constructive 
and deliberate way.
    The remainder of this statement focuses on several key issues:

    Driving all the risk out of the system means slower 
        economic and job growth;

    Access to New Capital for Community Banks is Problematic; 
        and

    Restrictions may drive banks out of some lines of business 
        altogether.

I. Driving All the Risk out of the System Means Slower Economic and Job 
        Growth
    ABA believes that it is a mistake for policy makers to apply the 
most restrictive approach to every bank. By swinging the pendulum too 
far in the direction of minimizing risk, the Dodd-Frank Act risks 
choking off important banking activity that can and should be done by 
banks--particularly by banks that had no hand in creating the financial 
crisis. It is important to keep that pendulum close to the center in 
order to encourage diversity and innovation.
    The health of the banking industry and the economic strength of the 
Nation's communities are closely interwoven. ABA strongly believes that 
our communities cannot reach their full potential without the local 
presence of a bank--a bank that understands the financial and credit 
needs of its citizens, businesses, and Government. This model will 
collapse under the massive weight of new rules and regulations. The 
vast majority of banks never made an exotic mortgage loan or took on 
excessive risks. They had nothing to do with the events that led to the 
financial crisis and are as much victims of the devastation as the rest 
of the economy. These banks are the survivors of the problems, yet they 
are the ones that pay the price for the mess that others created.
    Managing this mountain of regulation will be a significant 
challenge for a bank of any size. For the median-sized bank with only 
37 employees this burden will be overwhelming. The new rules create 
more pressure to hire additional compliance staff, not customer-facing 
staff. They mean more money spent on outside lawyers to manage the risk 
of compliance errors and litigation. They mean more money to hire 
consulting firms to assist with the implementation of all of the 
changes, and more money to hire outside auditors to verify there are no 
compliance errors. They mean more risk of regulatory scrutiny, which 
can include penalties and fines. All of these expenditures take away 
precious resources that could be better used serving the bank's 
community.
    The consequences are real. Costs are rising, access to capital is 
limited, and revenue sources have been severely cut. It means that 
fewer loans get made. It means a weaker economy. It means slower job 
growth. With the regulatory overreaction, piles of new laws, and 
uncertainty about Government's role in the day-to-day business of 
banking, meeting local community needs is difficult at best. Without 
quick and bold action to relieve regulatory burden we will witness an 
appalling contraction of the banking industry.

II. Access to New Capital for Community Banks Is Problematic
    Banks have to be profitable and provide a reasonable return to 
investors. If they do not, capital quickly flows to other industries 
that have higher returns. Capital is critical as it is the foundation 
upon which all lending is built. Having sufficient capital is critical 
to support lending and to absorb losses when loans are not repaid. In 
fact, $1 worth of capital supports up to $10 in loans. Most banks 
entered this economic downturn with a great deal of capital, but the 
downward spiral of the economy has created losses and stressed capital 
levels. Not surprisingly, when the economy is weak, new sources of 
capital are scarce.
    The timing of the Dodd-Frank limitations on sources of capital 
could not have been worse, as banks struggle to replace capital used to 
absorb losses brought on by the recession. While the market for trust 
preferred securities (which had been an important source of capital for 
many community banks) is moribund at the moment, the industry needs the 
flexibility to raise capital through various means in order to meet 
increasing demands for capital. Moreover, the lack of readily available 
capital comes at a time when restrictions on interchange and higher 
operating expenses from Dodd-Frank have already made building capital 
through retained earnings more difficult.
    These limitations are bad enough on their own, but the consequences 
are exacerbated by bank regulators piling on new requests for even 
greater levels of capital. Many community banks have told us that 
regulators are pressing banks to increase capital-to-assets ratios by 
as much as 4 to 6 percentage points--50 to 75 percent--above minimum 
standards. For many banks, it seems like whatever level of capital they 
have, it is not enough to satisfy the regulators. This is excess 
capital not able to be redeployed into the market for economic growth.
    Thus, to maintain or increase capital-to-assets levels demanded by 
the regulators, these banks have been forced to limit, or even reduce, 
their lending. The result: the banking industry becomes smaller while 
loans become more expensive and harder to get.
    While more capital certainly can improve safety and soundness, it 
ignores the fundamental fact that banks are in the business of taking 
risk--every loan made runs the risk of not being repaid. Ever-
increasing demands for more capital are dragging down credit 
availability at the worst possible time for our Nation's recovery. 
Moreover, it works at cross purposes with banks' need for the strong 
and sustainable earnings that will be the key to addressing asset 
quality challenges. Therefore, anything that relieves the increasing 
regulatory demands for more capital will help banks make the loans that 
are needed for our Nation's recovery.

III. Regulatory Risk and Uncertainty Are Rising, Reducing Incentive To 
        Lend
    Businesses--including banks--cannot operate in an environment of 
uncertainty. Unfortunately, Dodd-Frank increases uncertainty for banks, 
and as a consequence, raises credit risks, raises litigation risks and 
costs (for even minor compliance issues), leads to less hiring or even 
a reduction in staff, makes hedging risks more difficult and costly, 
and restricts new business outreach. All of this translates into less 
willingness to make loans. In fact, banks' biggest risk has become 
regulatory risk. Four examples help to illustrate this increase in 
regulatory risk and uncertainty:
    First, the nature and extent of rules from the Consumer Financial 
Protection Bureau are unknown, but uncertainty about the potential 
actions creates potential litigation risk as actions taken today may 
conflict with the changes in rules devised by the Bureau. The 
expectation of significant new disclosures, for example, translates 
into less willingness to lend (and therefore less credit extended 
overall), and higher costs to borrowers that still have access to 
credit to cover the added risks and expenses assumed by banks.
    A second important example of uncertainty and unease created by 
Dodd-Frank arises from the provisions regarding preemption. Congress 
explicitly preserved in the Dodd-Frank Act the test for preemption 
articulated by the United States Supreme Court for deciding when a 
State law is preempted by the Federal laws that govern national banks' 
activities. Nevertheless, any mention of the preemption standard in a 
statute is likely to generate lawsuits from those who argue that the 
standard somehow has changed. The Dodd-Frank Act preemption provisions 
will affect all banks, including State-chartered banks and thrifts that 
benefit from wildcard statutes. State attorneys general will have 
greater authority to enforce rules and regulations, specifically 
including those promulgated by the Consumer Financial Protection 
Bureau. The potential changes and risk of litigation necessarily reduce 
the willingness of banks to lend to any business or individual with 
less than a stellar credit history.
    Third, Government involvement in price controls--such as the Durbin 
Amendment on interchange fees--sets a dangerous precedent, suggesting 
that financial institutions may be subject to future, unknowable price 
controls on other financial products and services, undermining 
important free-market principles. Banks have always accepted the 
operational, reputational, and financial risk associated with 
developing new products and services and making them available to 
millions of consumers. Now financial institutions risk losing their 
investments of billions of dollars into improvements of existing 
products and services, and the creation of new ones, through Government 
price controls. Why would any business invest in an innovative product 
knowing the Government ex post facto will interfere by imposing price 
controls? The Durbin Amendment serves as a strong disincentive for 
innovation and investment by financial institutions in other emerging 
payment systems and financial products and services. In the end, it is 
the American public who suffers.
    The fourth uncertainty relates to the implementation of the swap 
rules. Banks do not know yet how the swaps exchanges will operate, what 
impact the clearing requirements will have on banks' ability to 
customize swaps, or even which banks and transactions will be subject 
to each of the new rules. For example, while other end users will be 
exempt from complex and costly clearing requirements, we are waiting to 
find out if our community banks will receive the same treatment. If 
not, then these banks might not be able to use swaps and the end result 
would be reduced lending, increased risk for banks, and higher costs 
for customers if banks cannot hedge the risk.
    We urge Congress to actively oversee the Commodity Futures Trading 
Commission (CFTC) and SEC as they implement the new swaps requirements 
to be sure there are no adverse affects on lending or competition for 
U.S. banks. We also encourage Congress to enact legislation explicitly 
granting small banks the same exemption from swaps clearing 
requirements that is available to other end users.

IV. Restrictions May Drive Banks Out of Some Lines of Business 
        Altogether
    Safety and soundness is best protected when banks are able to meet 
the credit needs of their customers. This is what is so disturbing 
about the implementation of some rules under Dodd-Frank that would 
effectively drive banks out of lines of businesses altogether. This not 
only hurts the customers, but also means less income--and less 
diversified sources of income--that forms the base of financial health 
for any bank. New rules on registration as municipal advisors and on 
mortgage lending are two particularly problematic provisions.

Proposed SEC municipal advisor rules could limit banking options for 
        State and local governments.
    ABA believes that Dodd-Frank intended to establish a regulatory 
scheme for unregulated persons providing advice to municipalities with 
respect to municipal derivatives, guaranteed investment contracts, 
investment strategies or the issuance of municipal securities. Most 
community banks do not deal in bonds or securities. But banks do offer 
public sector customers banking services and are regulated closely by 
several Government agencies.
    The Securities and Exchange Commission has proposed a very broad 
definition of ``investment strategies'' that would cover traditional 
bank products and services such as deposit accounts, cash management 
products and loans to municipalities. This means that community banks 
would have to register as municipal advisors and be subject to a whole 
new layer of regulation on bank products for no meaningful public 
purpose. The result of this duplicative and costly regulation is that 
banks may decide not to provide banking services to their local 
municipalities--forcing these local and State entities to look outside 
of their community for the services they need. This proposal flies in 
the face of the President's initiative to streamline Federal oversight 
and avoid new regulations that impede innovation, diminish U.S. 
competitiveness, and restrain job creation and economic expansion.
    We urge Congress to oversee this implementation and ensure that the 
rule addresses unregulated parties and that neither Section 975 of 
Dodd-Frank nor its implementing regulation reaches through to 
traditional bank products and services.

New proposed mortgage rules likely to drive many community banks out of 
        mortgage lending.
    ABA has grave concerns that the risk retention proposal issued by 
the regulators will drive many banks from mortgage lending and shut 
many borrowers out of the credit market entirely. Responding to 
widespread objections from consumer groups, banks, and Senators and 
Congressman, the regulators extended the comment period from June 10th 
to August 1st. While more time for commenting on such a far reaching 
regulatory proposal is welcome, what is really necessary is for the 
rule to be withdrawn in its current form and substantially 
reconsidered.
    It is true that the proposal's immediate impact is muted by the 
fact that loans sold to Fannie Mae and Freddie Mac while they are in 
conservatorship escape risk retention. However, once the rule's 
requirements are imposed broadly on the market (should they be adopted) 
they would likely shut out many borrowers entirely and act to 
destabilize the housing market once again. Since it is also the stated 
goal of both the Congress and the Administration to end the 
conservatorship of Fannie and Freddie, it is important that risk 
retention requirements be rational and nondisruptive when they are 
applied broadly to the market. The rule as proposed does not meet those 
tests.
    Therefore, ABA urges Congress to ensure that the regulators revise 
the risk retention regulation before it is imposed on the mortgage 
market broadly. Specifically we recommend:

            Exemption from risk retention provisions must reflect 
                    changes in the market already imposed through other 
                    legislative and regulatory change.
    In the Dodd-Frank Act, Congress determined that some form of risk 
retention was desirable to ensure that participants in a mortgage 
securitization transaction had so-called ``skin in the game.'' The goal 
was to create incentives for originators to assure proper underwriting 
(e.g., ability to repay) and incentives to control default risk for 
participants beyond the origination stage. There have already been 
dramatic changes to the regulations governing mortgages. The result is 
that mortgage loans with lower risk characteristics--which include most 
mortgage loans being made by community banks today--should be exempted 
from the risk retention requirements--regardless of whether sold to 
Fannie Mae and Freddie Mac or to private securitizers.
    Exempting such ``qualified residential mortgage'' loans (QRM) is 
important to ensure the stability and recovery of the mortgage market 
and also to avoid capital requirements not necessary to address 
systemic issues. However, the QRM as proposed is very narrow and many 
high-quality loans posing little risk will end up being excluded. This 
will inevitably mean that fewer borrowers will qualify for loans to 
purchase or refinance a home. Instead, the QRM definition should more 
closely align with the proposed QM definition promulgated by the 
Federal Reserve Board. The QM definition (as proposed) focuses on a 
borrower's ability to repay and allows originators to measure that 
ability with traditional underwriting tools. The proposed QRM rule, in 
contrast, takes most underwriting decisions away from originators in 
favor of rigid loan to value and other targets.
    For example, for the loan to qualify for QRM status, borrowers must 
make at least a 20 percent downpayment--and at least 25 percent if the 
mortgage is a refinancing (and 30 percent if it is a cash-out 
refinance).
    Certainly loans with lower loan-to-value (LTV) ratios are likely to 
have lower default rates, and we agree that this is one of a number of 
characteristics to be considered. However, the LTV should not be the 
only characteristic for eligibility as a ``Qualified Residential 
Mortgage,'' and it should not be considered in isolation. Setting the 
QRM cutoff at a specific LTV without regard to other loan 
characteristics or features, including credit enhancements such as 
private mortgage insurance, will lead to an unnecessary restriction of 
credit. To illustrate the severity of the proposal, even with private 
mortgage insurance, loans with less than 20 percent down will not 
qualify for the QRM.
    ABA strongly believes that creating a narrow definition of QRM is 
an inappropriate method for achieving the desired underwriting reforms 
intended by Dodd-Frank.

            The Risk Retention Requirements as proposed will inhibit 
                    the return of private capital to the marketplace 
                    and will make ending the conservatorship of Fannie 
                    Mae and Freddie Mac more difficult.
    The proposal presented by the regulators will make it vastly more 
difficult to end the conservatorship of Fannie and Freddie and to 
shrink FHA back to a more rational portion of the mortgage market. As 
noted above, under the proposed rule, loans with a Federal guarantee 
are exempt from risk retention--which includes loans sold to Fannie Mae 
and Freddie Mac while they are in conservatorship and backed by the 
Federal Government. FHA loans (as well as other federally insured and 
guaranteed loan programs) are also exempt. Since almost 100 percent of 
new loans today being sold are bought by Fannie and Freddie or insured 
by FHA--and as long as these GSEs can buy loans without risk 
retention--it will be dramatically more difficult for private 
securitizers to compete. In fact, the economic incentives of the 
proposed risk retention strongly favor sales of mortgages to the GSEs 
in conservatorship and not to private securitizers. Thus, this proposal 
does not foster the growth of private label securitizations that would 
reduce the role of Government in backing loans.
    Equally important is the fact that the conservatorship situation is 
unsustainable over the long term. That means that eventually, these 
highly narrow and restrictive rules would apply to a much, much larger 
segment of the mortgage market. That means that fewer borrowers will 
qualify for these QRM mortgage loans and the risk retention rules make 
it less likely that community banks will underwrite non-QRM--but 
prudent and safe--loans. Some community banks may stop providing 
mortgages altogether as the requirements and compliance costs make such 
a service unreasonable without considerable volume. Driving community 
banks from the mortgage marketplace would be counterproductive as they 
have proven to be responsible underwriters that have served their 
borrowers and communities well. Instead of exempting the GSEs from risk 
retention, the QRM should also factor in the underwriting requirements 
of the GSEs. If a loan meets those requirements (which we anticipate 
will evolve to conform with any new QM definition) and is thus eligible 
for purchase by the GSEs, it should also be exempt from risk retention 
requirements. More closely conforming the QM, QRM, and GSE standards 
will set the foundation for a coherent and sustainable secondary 
mortgage market.
    The imposition of risk retention requirements to improve 
underwriting of mortgage loans is a significant change to the operation 
of the mortgage markets and must not be undertaken lightly. ABA urges 
Congress to exercise its oversight authority to assure that rules 
adopted are consistent with the intent of the statute and will not have 
adverse consequences for the housing market and mortgage credit 
availability.

Conclusion
    Safety and soundness is best protected by created an environment 
where banks can make good business decisions and take prudent risks. 
Unfortunately, the pendulum has shifted too far in favor of driving out 
risk entirely and constant second-guessing of banks' decisions.
    Ultimately, it is consumers that bear the consequences of 
Government imposed restrictions. The loss of interchange income will 
certainly mean higher costs of using debit cards for consumers. Greater 
mortgage restrictions and the lack of certainty on safe harbors for 
qualified mortgages means that community banks may no longer make 
mortgage loans or certainly not as many. Higher compliance costs mean 
more time and effort devoted to Government regulations and less time 
for our communities. Increased expenses often translate into layoffs 
within the bank.
    This all makes it harder to meet the needs of our communities. Jobs 
and local economic growth will slow as these impediments inevitably 
reduce the credit that can be provided and the cost of credit that is 
supplied. Fewer loans mean fewer jobs. Access to credit will be 
limited, leaving many promising ideas from entrepreneurs without 
funding. Capital moves to other industries, further limiting the 
ability of banks to grow. Since banks and communities grow together, 
the restrictions that limit one necessarily limit the other.
    Lack of earning potential, regulatory fatigue, lack of access to 
capital, limited resources to compete, inability to enhance shareholder 
value, and return on investment, all push community banks to sell. The 
Dodd-Frank Act drives all of these in the wrong direction and is 
leading to consolidations. The consequences for local communities are 
real.
    The regulatory burden from Dodd-Frank and the excessive regulatory 
second-guessing must be addressed in order to give all banks a fighting 
chance to maintain long-term viability and meet the needs of local 
communities everywhere.
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