Ready or not, bank examination is changing for good

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• Key insight: Changes to supervisory policy are bringing welcomed relief to banks. They also raise questions about the objectives of bank oversight, and the means of obtaining those objectives going forward. 
• Expert quote: “Should the proposed changes go forward, it could undercut all the advances in risk management, organizational stature and effectiveness that have been in place since the ’08 crisis.” — Cliff Rossi, University of Maryland professor and former chief risk officer at Citigroup.
• Forward Look: Regulators say the reforms will free banks from burdensome box-checking exercises. Skeptics say they will allow issues to go unchecked. 

The nature of bank supervision is changing. What that means for banks and the broader financial system is open to interpretation.
Federal regulators have, in recent weeks, sought to change the way they evaluate bank soundness while purging all references to reputation risk from their supervisory guidelines. 

The moves are part of a broader push to make bank oversight more quantitative, less process-oriented and focused squarely on issues of financial health. The centerpiece of this effort is a revision to the treatment of management quality in regulators’ confidential rating system known as CAMELS.

It’s a shift banks and their advisers have wanted for years.

“I’ve lived in a post-crisis environment where the management component has been inappropriately used, over-indexed, and a catch-all phrase,” said Meg Tahyar, a partner and co-head of the financial institutions group at the law firm Davis Polk. “I’m not saying it can’t be used correctly, I’m just saying my experience since 2010 has been that it’s not being used in the right way most of the time.”

The Federal Financial Institutions Examination Council, or FFIEC — an interagency body that includes representatives from each of the federal bank regulatory agencies as well as a rotating state regulator — has proposed a set of changes to the management oversight component of CAMELS, the six-part rating system for bank soundness. CAMELS is an acronym that stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk — the six elements of the bank examination framework. 

The reforms would strip the management leg of the CAMELS framework of the “special consideration” it currently enjoys, a treatment that many believe gives it primacy over the other factors. It also seeks to narrow the scope of management, removing certain elements from consideration. The proposal also swaps out broad authorizing language for more explicit directives about what elements of management that can be evaluated and the thresholds examiners must meet to go beyond those parameters. 

If implemented, the changes would raise the bar for management-related ratings downgrades. It would also remove the possibility that a bank with strong marks in capital adequacy, asset quality, earnings, liquidity and sensitivity to market risk is given an overall rating of less than satisfactory.

“The revisions introduce clearer, more objective metrics for each component and replace subjective management assessments with measurable factors,” Federal Reserve Vice Chair for Supervision Michelle Bowman told members of Congress last week. “This approach ensures ratings reflect a bank’s overall safety and soundness rather than isolated or process-driven deficiencies.”

Yet some former risk officers, academics and other policy experts say these changes would water down examiners’ discretion and limit their ability to call out emerging risks before they materialize on bank balance sheets.

Cliff Rossi, a University of Maryland professor and former chief risk officer for Citigroup’s consumer lending group, said he is concerned about the proposed changes to CAMELS, especially its insistence that management concerns be tied to a specific financial weakness — a shift that he feels ignores a key lesson of the subprime lending crisis. 

Rossi served as credit risk officer at Washington Mutual Bank before its failure in 2008. At the time, he said, the bank’s financial position was strong. Meanwhile, the company’s incentive structure was encouraging loan officers to prioritize the volume of mortgages issued while disregarding borrower quality. A closer look at management, he said, could have captured what financial data alone could not. 

“The material risks that we saw — in terms of, let’s say, credit risk metrics — would not have risen to a level that would have warranted downgrading them to [below satisfactory] at that time. That’s a really big miss on the part of the FFIEC,” Rossi said. “Should the proposed changes go forward, it could undercut all the advances in risk management, organizational stature and effectiveness that have been in place since the ’08 crisis.”

Others say the reform could bring a different set of unintended consequences. Phillip Basil, director of economic growth and financial stability for the advocacy group Better Markets and former supervisory policy specialist for the Federal Reserve Board, said the new framework could eventually lead to a more restrictive supervisory environment for banks. 

Basil said banks benefit from the flexibility that comes with examiner discretion. A more rigidly defined approach to management oversight might be appealing in the short run, but under such a regime, he argued, the agencies will eventually be forced to define what exactly constitutes material financial risk. The end result, he said, would look something like universal thresholds for banking activities — effectively putting risk management entirely in the hands of regulators.

“It becomes the government telling banks how to manage their risks, which has never been the role of supervision. There was always supposed to be a separation between the public and the private sector,” Basil said. “The regulators haven’t thought this all the way through — they’re just giving the banks what they want.”

Advocates and opponents of discretionary management oversight say there is an inherent “squishiness” to the current framework, in that it is often based on qualitative judgements about how bank officials are conducting themselves. Defenders of the status quo say this enables supervision to be forward-looking and catch issues early, before they become problems that might threaten the bank or the broader financial system. 

“Management is the last early warning system,” Basil said. “If management is failing to do their job appropriately, it’s creating financial risks.”

Skeptics, meanwhile, say the examiners making these judgments often lack the experience to distinguish good management from bad. They also say management oversight ends up getting overly bogged down in the minutiae of policies, procedures and documentation.

“There’s this idea that supervision of management is too composed of ‘Did you dot your i’s and cross your t’s when you looked at this thing in your risk management process? If not, we’re going to sanction you,'” said David Zaring, professor of legal studies and business ethics at the University of Pennsylvania’s Wharton School of Business.

The question is how often is management oversight rooting out issues that would not materialize in the other components of the CAMELS rating. The answer is difficult to surmise, because of the confidential nature of the scoring system. The only instances in which a bank’s CAMELS report card is made available is after it has failed. 

An examination of recent, high-profile bank failures sheds little light on the subject. 

In its report on the failure of Signature Bank in 2023, the Federal Deposit Insurance Corp. concluded that the “root cause” of the failure was poor management. Specifically, it pointed to the bank’s pursuit of “rapid, unrestrained growth” without implementing sufficient risk management practices and controls. Yet, FDIC examiners never downgraded Signature’s management rating, scoring it 2, or “satisfactory,” every year from 2017 through 2021. The agency acknowledged that it failed to properly follow its own management oversight policies in supervising the bank.

The Federal Reserve Board, on the other hand, did downgrade Silicon Valley Bank’s management score from a 2 in 2021 to a 3, or “less than satisfactory,” in 2022. The change, along with a downgrade to the bank’s liquidity rating from 1 to 2, dropped SVB’s overall composite score from 2 to 3. The Fed’s report calls out poor management practices repeatedly in its post-mortem on SVB, but the most critical failures were related to interest rate risk management, which should have been captured in the sensitivity to market risk category. 

Parties on both sides of the management supervision debate have found evidence to support their stance in the failure reports for Signature and SVB. Ultimately, neither presents a good outcome for the regulators or the banks, as both institutions failed. And it is impossible to demonstrate whether these are emblematic of broader oversight practices or outliers, said Sean Vanatta, senior lecturer on financial history and policy at the University of Glasgow in Scotland, because of the strict confidentiality of CAMELS scoring.

“We’re so dependent on the experiences that bankers convey, the voice of the banking lobby to say this form of supervision is a problem. But, it’s not obvious to me that we have enough evidence to evaluate that effectively, at least from the outside,” said Vanetta. “This has always been a problem of confidential supervisory information. We’re all guessing about what works and what doesn’t, and we only get these moments of crisis to provide some kind of external evaluation.”

Another moment of crisis that could shine light on the effectiveness of management oversight is the Wells Fargo fake accounts scandal, which surfaced in 2016. The company’s cross-selling culture incentivized employees to aggressively push existing customers into new products. As a result bank workers opened millions of accounts under customers’ names without permission to inflate their sales numbers. At the time, Wells Fargo’s finances were strong and not jeopardized by the cross-selling culture, indicating that, had examiners been held to the newly proposed standards of material financial risk, the issue might not have been raised. 

Yet, a closer look reveals a muddier picture. A congressional review of the scandal found that both the Fed and the Office of the Comptroller of the Currency were slow to take “serious action” against Wells Fargo. It notes that the OCC initiated an investigation into the bank’s enterprise sales practice only after the City of Los Angeles filed a lawsuit against the company. 

As for the proposed changes to CAMELS, they still allow examiners to downgrade a bank’s management score if it is in “significant noncompliance with law or regulation.”

The effectiveness of management oversight in the CAMELS framework is an open debate. Likewise, the degree to which the current push to de-emphasize it allows for weaknesses to proliferate remains to be seen. What is clear is that the nature of bank supervision is changing substantially.

“There’s always been a deal between the government and the banks: banks get access to cheap funding from depositors and they get a lot of intrusive and discretionary supervision that they can’t really complain about,” Zaring said. “What we’re seeing now is a different approach, and it’s not wrong for being different. It’s just a less collaborative and more by-the-numbers way of doing bank supervision. It’s not necessarily putting us on the road to disaster.”