October 21, 2010
Center for Financial Policy Briefing Note
Bank Supervision: Penny Wise & Pound Foolish?
Seemingly pervasive deficiencies at mortgage servicers and their associated vendors to properly
process foreclosure documents point to a serious but little known set of facts about the capacity
and expertise of the nation’s safety and soundness regulators to oversee critical and increasingly
complex banking networks such as mortgage underwriting and servicing. The same regulatory
agencies charged with ensuring that exotic mortgage products were well understood and
managed by depositories are also responsible for overseeing the processes used to service
mortgage debt in this country. The data suggest that regulatory agencies are largely outgunned
by banks in terms of manpower, expertise, data and analytics. Dodd-Frank has focused much
attention on restructuring the oversight system in this country, however, the basic blocking and
tackling of bank regulation, namely the bank examination teams that are the first line of defense
at spotting problems are not sufficiently armed with the resources to be effective. Finally, the
cost of bank supervision is relatively low when compared to the economic costs of the crisis.
Preventing the next financial crisis requires then that efforts to significantly upgrade the
resources of bank supervision be a centerpiece for next steps in regulatory reform.
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Bank Regulators Understaffed
To provide some flavor for regulatory efforts relating to the foreclosure crisis, Table 1 illustrates
the concentration of mortgage servicing by banks that are largely overseen by the OCC.
Table 1
Total Loans Market
Serviced
Share
$B
%
2,135.3
19.9
1,812.0
16.9
1,353.6
12.6
677.8
6.3
349.1
3.2
189.9
1.8
175.9
1.6
156.0
1.4
155.0
1.4
149.9
1.4
7,154.5
10,640.0
Bank
Bank of America
Wells Fargo
JP Morgan Chase
Citigroup
GMAC/Ally Financial
US Bancorp
SunTrust Banks
PHH Mortgage
OneWest Bank
PNC Financial Services
Total Mortgages Outstanding
Source: Inside Mortgage Finance
The massive scale and scope of these operations and their associated vendors creates an
enormous challenge for OCC to effectively manage the activities of these entities.
Some disturbing trends in regulatory resource management provide some context for explaining
industry relaxation of credit guidelines during the mortgage boom and widespread lapses in
collections and default management mortgage servicing shops in the period following. First, the
bank regulatory agencies are relatively small, both in terms of budget and manpower when
compared to the depositories they regulate.
2
Figure 11
Bank Regulatory Personnel Trends
#
O
C
C
/
F
D
I
C
E
m
p
l
o
y
e
e
s
7,000
2,000,000
6,000
1,950,000
5,000
1,900,000
#
4,000
1,850,000
3,000
1,800,000
2,000
1,750,000
B
a
n
k
1,000
1,700,000
-
E
m
p
l
o
y
e
e
s
1,650,000
2000
2002
2004
OCC
2006
2008
FDIC
2010
All Banks
Figure 2
Bank Regulatory Growth rates (Indexed to
2001)
R
a
t
i
o
%
1.20
1.00
0.80
0.60
0.40
0.20
2001
2002
2003
OCC
1
2004
FDIC
OCC Annual Reports, 2001-2009
3
2005
2006
2007
All Banks
2008
2009
For example, as of 2009, there were about 409 national bank employees for every OCC
employee.2 As banks ramped up their employment in the years preceding the crisis (Figure 1),
the OCC and FDIC either reduced staffing levels or held relatively flat over the period (Figure
2). Meanwhile, industry asset growth rose dramatically over the period (Figure 3) as did the
complexity and number of new products during these years.
Figure 33
Bank Asset Growth Rate (Indexed to 2001)
2.00
1.50
1.00
0.50
0.00
2001
2002
2003
2004
2005
2006
2007
2008
2009
Growth Rate
Finally, to put this regulatory to bank disparity in greater perspective, consider that over time the
ratio of the number of OCC personnel to every active national bank in the system ranged
between 1.27 – 2.06 (Figure 4).4 The largest banks under OCC supervision of course have larger
exam teams; even so, they remain understaffed. The trend is slowly improving since the crisis;
however, these facts provide some empirical support for why regulators systematically failed to
see a pervasive industry buildup of risk and associated process deficiencies to effectively manage
those risks.
2
OCC Annual Reports 2003-2009 and FDIC Statistics on Depository Institutions, 2003-2009.
OCC Annual Reports 2003-2009.
4
OCC Annual Reports 2003-2009 and FDIC Statistics on Depository Institutions, 2003-2009.
3
4
Figure 4
Bank/OCC Employee Ratio
2.50
2.00
1.50
1.00
0.50
0.00
2001
2002
2003
2004
2005
2006
2007
2008
2009
Regulator Bench Strength is Low
While banks make available to examination teams virtually any management report and data
available upon request, the ability to dive deep inside intricate and extensive underwriting and
servicing processes is limited by personnel capacity and expertise. For example, OCC maintains
a small cadre of subject matter experts for specialized areas such as collateral valuation, capital
markets and commercial lending; however; these resources are limited within the agency.
Efforts to uncover defects in vendor management by major mortgage servicers of foreclosure
processing subcontractors would be difficult for the agencies given the scope of operations to
examine across the banking system.
Some startling statistics also emerge regarding the depth of expertise in bank regulation. As
reported in their 2007 Annual Report, OCC claimed that over the 2007-2012 period the agency
expected 32% of their workforce to be eligible for retirement. Within the examination team,
OCC expects 30% of their staff to be eligible for retirement and 50% of managers at the agency
with the most experience will be able to retire during this period. These latter figures have the
most effect on the Large Bank Supervision teams charged with overseeing the biggest banks in
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the system. Furthermore, the agency reported that 15.5% of their staff has 3 or fewer years of
tenure at the OCC. Clearly, there is expected to be a considerable brain drain at the OCC in the
next few years.
Regulatory Data is Inadequate
Beyond staffing and bench strength concerns, the regulatory agencies also have been severely
limited in efforts to understand emerging risks on and off-balance sheet. For decades
depositories have been reporting their aggregate balance sheet and net income positions via the
FDIC Call Report of Condition and Income (Call Reports). To illustrate how ineffective the data
are; each quarter banks report the amount of 1-4 family residential mortgages carried on-balance
sheet. There are some basic reporting splits for 1st and 2nd lien mortgages; however; there is no
reporting of the underlying characteristics of the mortgage that drive its risk profile such as FICO
or LTV. The same is true in the reporting of nonperforming loans. Consequently, the regulators
rely heavily on the banks themselves to provide detailed internal reporting. This reporting is
further handicapped by widespread gaps in accurate and timely reporting due to underinvestment
in data warehousing systems over time by banks generally. A poignant example is that one large
mortgage lender did not originate option ARM mortgages not because their risk appetite
precluded them from doing so, but rather they could not figure out a way to service the multiple
payments of the product. Some of this is due to historically poor merger integration at a number
of large firms that hamper reporting efforts. This varies from firm to firm with the agencies
having great difficulty developing a consistent view of risk across the banking system. In this
regard, Dodd-Frank’s provision to establish the Office of Financial Research charged with
developing standard data reporting requirements to assess systemic risks is a positive
development.
Cost of Supervision Relative to Cost of Crisis is Low
Finally, the cost of safety and soundness regulation is low compared to the risks prevented;
unfortunately in good economic times, this tradeoff is not well understood and regulatory
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agencies are hard pressed to ramp up staffing levels consistent with industry trends. For
example, OCC’s annual total program costs of operation ranged between $451 – 732 million per
year between 2003 and 2009.5 Even a doubling or tripling of supervision costs during the period
given the post-bubble investments made to support the economy and banking appear to be a
good investment.
The revenue model for the supervisory agencies in some sense has created regulatory conflicts
and arbitrage by banks. The regulators charge bank supervision fees for the ongoing expenses of
the agency. However, in extreme cases this can lead to regulatory conflict where agencies may
be reluctant to issue severe penalties on banks due to potential disruption to bank and industry
performance as well as to operational impacts on the agency itself. For example, in March 2007,
combined assets of WaMu, World Savings, Countrywide Bank, Indy Mac and Lehman Bros.
thrift represented 40% of OTS’s total assets under supervision.6 Investigation of OTS
supervision practices during this period by the Financial Crisis Inquiry Commission found
significant issues in overseeing these entities. Fee-based supervision models pose potential
principal-agent problems downstream unless carefully managed. A lesson for the future is that
regulatory agencies must first decide the level of prudent supervision required regardless of the
impact to the industry and that this level be supported by some combination of fee-based
assessments and supplemental general appropriations that cannot be held hostage to political
subterfuge.
Summary
The foreclosure crisis has uncovered widespread allegations of fraudulent activity and process
deficiencies among mortgage servicers and associated vendors. Much less attention has been
given to regulatory oversight of these activities. When put into the larger perspective of the
financial crisis and lax underwriting practices during the boom, it is clear that the primary
regulators are not equipped with the resources to adequately monitor and oversee the extensive
5
6
OCC Annual Reports, 2003-2009.
FDIC Statistics on Depository Institutions, 3/2007.
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front- and back-end activities of depositories they regulate. Regulatory reform must address
these deficiencies in order to prevent another financial crisis.
Clifford V. Rossi, PhD, Executive-in-Residence and Tyser Teaching Fellow
Center for Financial Policy
Robert H. Smith School of Business
University of Maryland
Contact Information: crossi@rhsmith.umd.edu, 301-908-2536
The views of this article are those of the author solely and do not represent those of the
Center for Financial Policy or the University of Maryland.
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