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U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.

    The committee met, pursuant to call, at 10 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.

    Present: Chairman Leach; Representatives Roukema, Bereuter, Baker, Royce, Lucas, Kelly, Biggert, LaFalce, Kanjorski, C. Maloney of New York, Bentsen, J. Maloney of Connecticut, Weygand, Sherman, Inslee, Schakowsky, Moore, Jones, and Capuano.

    Chairman LEACH. The hearing will come to order. First, let me say I would like to ask unanimous consent to place a statement of mine in the record, also the statement of Peter King, the Oversight Subcommittee Chairman, as well as the statement of the Inspector General of the FDIC. Without objection, they will be placed in the record.

    In summary, let me just say that, first, I want to welcome this distinguished panel. Second, perspective is always difficult to apply to almost any issue of the day, particularly those where there is a little bit of bad news. The bad news here is that we have approximately eight failed institutions in the last year that have cost a little over a billion dollars to the FDIC fund.
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    The good news is that in comparison with all other parts of the American economy, bank failures are less than any other kind of industry. The good news is these appear to be aberrations rather than systemic problems. The good news is that this fund that costs over a billion dollars is derived from the private sector, that is, the monies that came into this fund came from assessments of America's commercial banks.

    The bad news is that there are any failures at all. In a way, it is always awkward to hold hearings in failed circumstances, but sometimes there are lessons to be learned from the failed that are very important to concentrate on. In this case, there appears to be a bit of a pattern of institutions that have had disproportionate growth, that have to some degree been involved in riskier investments, such as sub-prime lending.

    One of the institutions followed the S&L pattern of paying a little higher salaries than might be its due. In fact, one of the things we learned in the S&L morass was that often insiders know of problems before outsiders and as long as they can continue with FDIC insurance to draw deposits, there is a vested interest in remunerating rather well.

    In any regard, the reason we have regulators is to ensure that these institutions are looked at carefully and when the public interest so requires, they are closed; and in this case, in each of these instances that has occurred.

    From the committee's perspective, I think to the degree that there is a major issue at play, it is not only attention to the issues that have caused the problem, but a concern that there be interagency cooperation to the maximum degree possible in this and other circumstances.
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    In any regard, I welcome our four witnesses today, all of whom represent the height of professionalism in American public service.

    John, do you have an opening statement?

    Mr. LAFALCE. First let me associate myself with the remarks of our Chairman. The subject of our hearing today is very appropriate, but it is also troubling. Once again, we are discussing failures of depository institutions, one of which is estimated to be the tenth most expensive failure in the history of the FDIC. It is troubling that we take up the subject of bank failures during such unprecedented prosperity in the national economy, but this may be a very good heads-up to everyone.

    Good economic times often engender overconfidence, financial speculation, excessive risk taking. And complex new activities and technologies can make fraud easier to conceal, but we need to keep the recent difficulties in perspective.

    During the 1980's, more than a thousand commercial banks, almost a thousand thrifts, and according to the credit union regulator, at least one thousand credit unions failed. In the past year-and-a-half, we have had eleven failures. So we have to keep this in perspective.

    In many ways, the hearing is a positive reflection of how bank regulation and supervision has worked and works in this country. Rather than avoid public discussion or disclosure of bank failures, as is still the practice in many developed countries, we not only publicly report failures, but Congress reviews their causes and the way these failures were handled by the Federal regulators; and this oversight process is critical. It is important, especially critical, given the recent modernization legislation.
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    There are at least four areas of concern that I have. The first, several of the institutions were under close scrutiny by the regulators for an extended period of time; and the bank examination process is complex, can generate legal confrontations, I understand. But we must ask whether the problems which ultimately led to the closure of these institutions could have been identified earlier. Both the regulators and the committee should reassess whether we need changes in the bank examination and supervisory approach, or whether the length and cost to the regulatory effort in regard to these institutions was unavoidable.

    Second, I really want your opinion as to whether the bank examination process today, generally speaking, may be too one dimensional. All the agencies have been extremely cooperative. They have given us briefings, background materials. You have helped us understand what went on with these failures. But it appears to me that the regulators are focusing now on examining how the bank manages risk. Certainly most appropriate, but not using—or at least not adequately using—some of the older examination techniques that were helpful for monitoring fraud or gross negligence. I am wondering if the supervisors, the regulators, could be more flexible in utilizing various techniques for uncovering problems and just a little less reliant on the bank management process or outside auditors. I would appreciate your perspectives on that and on the findings of the GAO's recent study on bank examination.

    Third, I am concerned that the regulators' primary response may be on the alleged riskiness of some banking activities. Although different activities do indeed carry different risks, we know from experience that depository institutions can and do fail most often, performing the most traditional and seemingly safest of authorized activities. Appropriate controls should certainly be adjusted to reflect relative risk, but we must be careful not to prematurely regulate or potentially delimit an activity because a few banks have had difficulty in engaging it.
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    The very newness of an activity can present problems to both bankers and regulators, and we will inevitably be seeing the faster evolution of more complex products and investment activities. So I am interested in knowing how the regulators allow the examination process to evolve in response to a new activity or an activity that might be new for a particular kind or size of bank.

    And finally, one particular activity that has received substantial attention in regard to some of the failures is sub-prime lending. This activity is poorly defined and the nature of its regulation could carry safety and soundness consumer and even CRA implications. It might also be wise to ask the Congressional Budget Office to provide us with an economic analysis.

    I am particularly concerned about predatory lending practices. Consumers with flawed credit histories are in some cases being preyed upon by financial institutions that offer more than they deliver.

    I would like to insert into the record a letter I recently received from a Washington, DC., resident that articulates some of these practices in troubling detail. One of the institutions at issue today engaged in similar practices. In this letter that I insert as part of the record, I have redacted the name and address of the person who wrote to me.

    An example is cited, a bank which offered a Visa/MasterCard with a limit to $1,500, although in the fine print it said it was only required to extend $400. The catch to getting the card was that the customer had to agree to a bank-sponsored credit education program for a fee of $289 plus $11.95 in shipping and handling. The card also came with an annual fee of $49 and a processing fee of $19. And the author of the letter goes on to cite numerous other examples.
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    Another bank offered a deal to sub-prime customers that is similar. While working with a third-party financial institution, the bank targeted customers by telephone and offered a card with a $600 credit limit. The card also charged $20 application fee and a travel certificate that cost $545.

    And finally, I would urge our committee to take a prudential approach before changing the laws on bank backup examination authority. We certainly need cooperation amongst the regulators, and I think this is always in need of improvement, particularly in light of last year's major financial services modernization bill, but I am not persuaded that making it easier for the Chairperson of the FDIC to unilaterally decide to do backup exams would be the best approach to protect depositors. We might well unnecessarily risk increasing the burden on institutions and undercutting the system of primary regulators that we recently embraced through functional regulation.

    So I would look forward to drawing on the considerable bank regulatory experience of our witnesses to better understand the appropriate role of backup exams and the practical aspects of how their agencies share supervisory information.

    Mr. Chairman, I thank you very, very much.

    Chairman LEACH. Thank you.

    Mrs. Roukema.

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    Mrs. ROUKEMA. Thank you, Mr. Chairman. I would just ask unanimous consent to have my full statement be included in the record.

    Chairman LEACH. Without objection.

    Mrs. ROUKEMA. But I would also like to associate myself with the observations that the Chairman and the Ranking Member have made. I think this is a particularly timely and useful hearing today and as has already been noted, these failures, these bank failures, are particularly troublesome given the excellent, healthy economy that we are in and the relative strength, by all objective standards, to be judging the banks; and in this particular economic environment, it is difficult to understand why they are failing.

    But, Mr. Chairman, I would also like to say that it is very important for us to hear today, begin today an in-depth investigation and find out what the regulators and/or Congress should be doing about this troublesome evidence out there and whether or not the laws are adequate enough at this point in time to continue giving that discretion to both the Comptroller as well as the FDIC and others. And that is really the focus of my interest and concern beginning with today's hearing, and it is also the reason why I am happy to co-sponsor, Mr. Chairman, your legislation.

    I heard the Ranking Member reference the prudential approach to things, and I hope we are going to be—not hope—I know we are going to be prudential, and we will learn a great deal today about the specifics of how such legislation could or should work or why there are limitations on it. But we have to be objective about it. Obviously, what we have here now is evidence that the present system may not be working, and so we are going to ask some specific questions with respect to that. But it does point out that the BIF/SAIF question—we are very happy that there has been enough money to avoid any taxpayer liability here, but I might also note it is time, as I think I already anticipated, to give serious consideration to whether BIF/SAIF should be merged. And as you know, I will simply remind my colleagues that we have hearings upcoming on that subject on February 16.
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    Mr. Chairman, I thank you for this hearing, and hope that we will be able to move ahead in a prudential manner. Thank you.

    Chairman LEACH. Thank you, Madam Chairwoman.

    Does anyone else seek recognition? The gentlelady from New York.

    Mrs. MALONEY. Thank you, Mr. Chairman. I would just like to thank you now for having this hearing. I would like my statement in full to be put in the record, but I would just like to briefly state that the regulators testifying before us today, they all have a very difficult job on a daily basis. They are called on to oversee the safety and soundness of the world's most dynamic banking system without dragging the system down with unneeded regulatory burdens.

    As banks continue to evolve, creating increasingly complex products and seeking out new markets, striking the correct regulatory balance becomes even more challenging. To meet this challenge, I realize that the regulators need to use arbitrary standards to examine banks on a uniform basis. Even so, in certain areas, there may not be a sufficient substitute for case-by-case examination.

    I look forward to hearing the FDIC's explanation of its coming proposal for increased capital standards for sub-prime lending. While I share the FDIC's goal of ensuring the safety and soundness of our banking system, I am concerned that a rigid regulatory approach to the sub-prime market could have a chilling effect on the availability of credit to traditionally underserved communities before the record is well established as to the risk these types of loans pose.
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    As for the bank failures that the committee is reviewing today, I find the case of Keystone National Bank particularly troubling. Massive fraud at the bank doomed its survival, but if the relationship between the OCC and the FDIC in this instance is an accurate case study of how all financial service regulators will work together on the functioning regulated organizations committed by the financial modernization bill, Congress will have to go further than clearly delineating the FDIC's backup examination authority.

    I look forward to examining other issues, and as I said, I would like to put my entire statement in the record.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you. Without objection, that statement will be placed in the record.

    Does anyone else on the Republican side seek recognition?

    Mr. Inslee.

    Excuse me. I take it back. Mr. Weygand.

    Mr. WEYGAND. Thank you, Mr. Chairman. I want to echo some of the comments of my colleagues who have already mentioned the concern that we have for what happened in West Virginia at Keystone, because there seems to be a conflict within or between the regulators as to exactly how and why this occurred. Clearly, the cause seems to be more one of fraud than anything else.
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    I want to talk just briefly, Mr. Chairman. There are many opportunists out there that indeed cause the problems within the system. There are also many good institutions out there doing the kind of job that they should do. My concern with some of the suggested regulations is that many of the finer institutions that are doing the proper job of providing the kind of assistance that is necessary for sub-prime borrowers, may indeed be swept into the pool with all the other opportunistic kinds of institutions. Certainly the loan loss reserve ratio, the percentage that is being talked about for many institutions would be a problem and therefore many of them may end up not existing in the near future if these regulations are to be instituted.

    Second, there are many institutions out there right now that far exceed even the proposed regulations that would see and have suggested to me that such a regulation change would have an impact, not so much on them because they are covered, but onto the many other institutions that provide great service to many sub-prime lenders.

    The other side of the coin is that we are talking about the consumer lending and not the commercial side. Some of the people that we would not lend to, or be suggested that we shouldn't lend to, are indeed getting commercial loans on the other side; and so whether they happen to be getting a commercial loan from one entity, but a consumer loan from the other, we have different standards for both facilities. It seems also to be unfair, because the problem is not necessarily the institutions; in many cases it happens to be the borrowers.

    I clearly want to see the best regulation to ensure that consumers are protected. I also want to see the opportunity for borrowers be there; as many people are sub-prime borrowers of high regard and of great determination to pay back their loans. We shouldn't discriminate against them because of a few bad apples, but we should clear up this concern that many of us have regarding the conflict between the regulators.
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    Thank you very much, Mr. Chairman.

    Chairman LEACH. Thank you, Mr. Weygand.

    Mr. Inslee, did you seek recognition?

    Mr. INSLEE. Thank you, no, Mr. Chairman.

    Chairman LEACH. Thank you.

    Before turning to the regulators, I would like to ask unanimous consent also to place in the record a letter that the former Chairman, Henry Gonzalez, and I wrote in 1993 on the subject of the cooperation between the OCC and the FDIC; and I would like to state in this regard that from 1983 to 1993, there was a clear understanding between the OCC and the FDIC that there would be integration of cooperation on examinations. In 1993, this arrangement was changed when the Treasury Department had command and control of the FDIC board because of two vacancies. Chairman Gonzalez and I wrote a letter objecting to that prospective change.

    I have introduced legislation that returns to the former arrangement, but I will say to the panel that I am not of a mind to necessarily press if it is very clear that cooperative arrangements can be made institutionally without legislation. I don't think there are answers to all problems that are of a legislative nature, and it is not something that I necessarily eagerly seek. But it is the Chair's singular concern that we have maximal possible coordination between all of the regulatory bodies and that there should be an emphasis on prudence, rather than the reverse. One thing that from a public policy perspective is self-evident, is that there is a bit of competition for regulatory preeminence. But if the competition ever leans in a direction against prudence, that is not a healthy competition. It is a healthy competition in other kinds of circumstances, but not in the prudential arena. And that is what I think should be the concern of all at any particular point in time.
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    With that, I would like to turn to our witnesses, and the panel is set up in a particular order. But I think the Comptroller has the preeminent position structurally.

    Would you like to lead forth Mr. Hawke?

    Mr. HAWKE. I would be happy to, Mr. Chairman.

    Chairman LEACH. In that regard, let me introduce Jerry Hawke, who is the twenty-eighth Comptroller of the Currency and he was sworn in for a full five-year term in October of 1999. Prior to his appointment, Mr. Hawke served as Under Secretary of the Treasury. He is also served as a senior partner in a Washington, DC., law firm and as General Counsel to the Board of Directors of the Federal Reserve System.

    Please proceed.


    Mr. HAWKE. Thank you, Mr. Chairman, Congressman LaFalce, Members of the committee, I appreciate this opportunity to discuss the implications of recent national bank failures.

    Let me say at the outset that national banks today are in a far better position to weather an economic downturn than they were a decade ago. Compared with the period leading up to the last recession, inflation and interest rates are lower, bank capital and earnings are at record high levels, and risk management practices are better. In addition, most quantitative measures of credit quality are stronger now than they were a decade ago. The three national bank failures that occurred during 1999 do not, in any way, foreshadow a much larger number of failures in 2000, nor do they present systemic implications. Based on the current state of the national banking system and the consensus outlook for the economy, we don't expect any appreciable increase in bank failures in 2000.
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    The three 1999 national bank failures are discussed in greater detail in my prepared statement, but let me say that each was the result of unique circumstances at the respective institution. Peoples National Bank of Commerce, a $37 million bank, failed because of poor lending practices, particularly in its management of risks in the purchase of automobile loans originated by dealers; improper recordkeeping and accounting; an innefective board; and frequent turnover in management and key staff.

    East Texas National Bank, $125 million in assets, failed because of poor credit underwriting and loan administration practices; apparent fraudulent activities; and inadequate supervision by the board of directors.

    First National Bank of Keystone, West Virginia, whose books showed $1.1 billion in assets at the time of closure, was placed in receivership when the OCC discovered that $515 million in loans being carried on the bank's books were not owned by the bank.

    My prepared statement discusses in detail the various supervisory initiatives that we and the other agencies have been taking to address concerns such as those raised by these cases, and I will mention them only briefly. They include: the deployment of examiners specially trained in fraud detection and prevention; the issuance of formal guidance on both sub-prime and high loan-to-value lending—two forms of credit that played a significant role in recent bank problems; intense supervisory focus on asset securitization, once the sole domain of large banks, but now being encountered in smaller, less sophisticated banks; strong emphasis on maintaining effective internal controls and audit functions; and improvement of our early warning tools and systems for tracking trends in the system.
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    You have asked, and Members of the committee have raised in their opening statements, questions about our policies and practices regarding coordination with the FDIC. Let me say that we fully recognize the FDIC's responsibilities as the insurer of deposits and the receiver for failed banks. I believe that our relationship with the FDIC over a period of many years has been cooperative and productive.

    To ensure that that relationship remains productive, I have stressed to my staff the importance of keeping the FDIC fully informed about serious concerns we may have about any national bank and of maintaining mutually supportive working relationships between our two agencies at all levels.

    We have just reiterated to our supervisory staff the desirability of inviting FDIC participation in our examinations when deterioration of a bank's condition gives rise to concerns about the potential impact of that particular institution on the deposit insurance fund, even if the FDIC has made no request for participation.

    Furthermore, I have rescinded all delegations to disapprove FDIC requests to participate in OCC examinations. That authority resides only with me. This will continue to ensure that the FDIC will have access to any national bank whose condition poses any threat whatsoever to the FDIC insurance fund.

    In this context, I would like to comment briefly on H.R. 3374, which would transfer authority to authorize so-called backup FDIC examinations from the board of directors of the FDIC to the FDIC chairperson. The clear intent of H.R. 3374 is to make the OCC and FDIC examination coordination smooth and efficient. I support that objective very strongly, but I believe that objective has already been achieved without the need for legislative changes. I am aware of no case in which the FDIC has been denied access to a national bank in a troubled or deteriorating condition, and access has been provided in literally hundreds of instances without any need for board action.
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    I should say that a number of Members have mentioned the Keystone incident, and I would be happy to address the question of FDIC and OCC cooperation at Keystone at more length, but I think, frankly, there is less there than meets the eye. I think the history of cooperation in Keystone was extremely good. There was one unfortunate incident where we initially denied an FDIC request to participate in the 1998 examination. That decision was reversed. The schedule of the examination was actually accelerated and FDIC examiners did participate in that examination as they did in previous examinations and the subsequent examination.

    Going back to H.R. 3374, however, if a case should arise requiring board action, and I think that should be a rarity, I believe the entire FDIC board of directors should participate in the decision. All members of the board share equal responsibility for the effectiveness of the FDIC's performance. All are Presidential appointees confirmed by the Senate, and their judgments on all matters coming before the FDIC board deserve equal weight and respect. I repeat, however, that there should be little or no occasion for such issues to reach the board level since we fully recognize the appropriateness of involving the FDIC at an early stage in any bank whose condition raises any concerns about a possible impact on the FDIC fund.

    Thank you, Mr. Chairman. I would be happy to address any of these issues at greater length.

    Chairman LEACH. Thank you, Mr. Hawke.

    Our second statement will be from Donna Tanoue, who is Chairman of the Federal Deposit Insurance Corporation. Chairman Tanoue became the FDIC's seventeenth Chairman in May of 1998. She has significant experience in both the public and private sectors, including being a partner in a Hawaiian law firm and serving as the Commissioner of Financial Institutions for the State of Hawaii.
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    Ms. Tanoue.


    Ms. TANOUE. Mr. Chairman, Congressman LaFalce, and Members of the Committee. Good morning. I appreciate the opportunity to testify on behalf of the FDIC.

    This morning, I would like to discuss three subjects: First, what the FDIC is doing to address sub-prime lending; second, what we are doing to address fraud; and third, H.R. 3374 and our support for it.

    This hearing follows an uptick in bank failures and losses, and particularly three failures where the estimated loss rates for the FDIC are significantly above historical averages: Best Bank in Boulder, Colorado; First National Bank of Keystone, Keystone, West Virginia; and Pacific Thrift and Loan Company in Woodland Hills, California.

    Why are banks failing during these extraordinarily profitable times? Of course, banks are in the business of managing risks and not all will be successful. Some bank managements have not been up to the job. Furthermore, it appears a few bank managements have been up to no good. Apparent fraud contributed significantly to losses in two of the recent high loss failures.

    All three of the high loss institutions had concentrations in sub-prime lending—so I would like to discuss that subject first.
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    With proper safeguards, sub-prime lending can be an acceptable activity for insured institutions, and can be beneficial for consumers and the economy. Most banks active in this type of lending have such safeguards, but some do not. Because these safeguards are not always maintained, sub-prime lenders represent a disproportionate share of our problem institutions. Sub-prime lenders represent just over 1 percent of all insured institutions, yet they account for 20 percent of all problem institutions—that is, those institutions with CAMELS ratings of ''4'' or ''5''. In other words, they are twenty times more likely to be problem institutions. In addition, while not necessarily the cause of the failure, significant sub-prime portfolios were held by six out of the eleven banks that failed over the last eighteen months.

    At the FDIC, we have been addressing sub-prime lending since 1997. Most recently, we developed a proposal that would require some institutions, and I underscore some, with concentrations of sub-prime portfolios to hold more capital. We are currently discussing that proposal with the other agencies.

    Sub-prime lending is moving into the banking business because the capital requirements for banks are less than what the markets require for non-bank sub-prime lenders. Our capital proposal would help to level the playing field.

    Turning to the second subject, fraud appears to have played a major role in two of the recent high loss failures and in the most recent bank failure, that of Hartford-Carlisle Savings Bank of Carlisle, Iowa, as well. Because fraud is both purposeful and hard to detect, it can significantly raise the cost of a bank failure.

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    Bank management is the first line of defense against fraud and the banks' independent auditors are the second line of defense. Bank examiners and supervisors, of course, also have a role to play—assessing an institution's internal control systems.

    In a recent memorandum, we reemphasized to our examiners that if they suspect fraud at an institution, they are to investigate it, using whatever resources are necessary. They are to give these investigations the highest priority and they are to call in our fraud specialists immediately. We also reemphasized and listed particular warning signs or ''red flags'' that indicate a potential for fraud; the number one warning sign being management that obstructs us from doing our job. My written testimony also discusses several other initiatives that we are undertaking to address potential fraud.

    Finally, the FDIC supports passage of H.R. 3374. The FDIC needs to be in a position to expeditiously examine institutions that pose higher risk profiles to the insurance funds and the bill would accomplish this objective. We also strongly support the information sharing provisions of the legislation.

    I would like to emphasize that the current FDIC board and agencies are working together well now, but this legislation would settle a long-standing issue among the banking regulators. Along with initiatives discussed in my written testimony, H.R. 3374 would enable the FDIC and the other agencies to proceed in a unified, coordinated effort to ensure stability in the banking system and to minimize losses to the insurance funds.

    Thank you, and I look forward to addressing your questions.

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    Chairman LEACH. Our third witness is Ellen Seidman. Director Seidman has been head of the Office of Thrift Supervision since October of 1997. Prior to her appointment at the OTS, she served in the White House National Economic Council. Director Seidman has a wide range of experience in both the public and private sectors, including serving in an executive position with Fannie Mae.

    Ellen, please proceed.


    Ms. SEIDMAN. Thank you very much. Mr. Chairman, Congressman LaFalce, and Members of the Committee, thank you for this opportunity to testify on recent bank and thrift failures, to discuss what the Office of Thrift Supervision does to try to keep failures small in terms of numbers of institutions and costs, and how we work with our fellow regulators, particularly the FDIC, to accomplish this.

    There has been only one thrift failure since 1996. Oceanmark Bank FSB failed in July 1999, due in part to a poorly executed sub-prime lending program. This failure will likely cost the SAIF about $1.3 million, an amount less than one-half of 1 percent of the SAIF's semiannual interest earnings.

    I am proud of the men and women at OTS and the Office of Thrift Management who, together with a spectacular economy, helped create that record. But a record economy is exactly when intense competition can lead to poor underwriting and pricing that does not cover risk. The challenge to effective supervision, as well as to detection of fraud is, in many ways, the greatest when a booming economy enables an institution to earn profits that can hide structural flaws.
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    Failures are a part of banking, like all other businesses, and we certainly have not seen the last thrift failure. Our goal is reduction and moderation of failures. It cannot and should not be elimination.

    There are important lessons to be learned from the recent failures as well as from institutions that have required our supervisory attention to prevent failure.

    First, the importance of the agencies working together effectively to identify and deal with emerging risks. This increasingly includes not only Federal and State bank regulators, but also securities and insurance regulators.

    Second, the need for effective internal controls and reliable books and records. In an era of unprecedented profitability and intense competition, banks, like other firms, have a strong temptation to cut corners on internal controls. As regulators, we have an equally strong responsibility to make certain that does not happen.

    Third, a world of changing risks requires changing supervisory strategies. When a firm originates hundreds of times more loans in a year than it holds on its books or pursues non-traditional, higher risk activities, such as sub-prime lending, traditional means of evaluating capital and credit risk can fall far short. Conversely, interest rate and liquidity risk, as well as legal and reputation risks, may become far more important and require enhanced supervisory emphasis. When institutions begin to engage in these practices, we need to supplement regular full scope exams with more frequent field visits relating to specific concerns and with enhanced off-site monitoring.
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    Fourth, supervision must follow the business. When a bank or thrift outsources its back office, the investment management of its trust portfolio or other parts of its operations, examiners need to understand what is being done, be able to pursue an effective examination strategy, and have the authority to intervene when there are problems.

    Fifth, we need to recognize and minimize potential accounting distortions. American accounting practices are the best in the world and have gotten better over the last twenty years. But as regulators who ultimately need to rely on economic capital to prevent or cushion a failure, we have to understand where the potential distortions are and we have to deal with them. We already do this on an individual supervisory basis. Jointly we are exploring additional ways to ensure that all institutions, including those that report residuals, have adequate capital.

    Sixth, examiners must never be intimidated. Our examiners are highly trained, highly skilled individuals of long experience. Intimidating examiners is a sure sign that the institution is having problems and is trying to hide them. OTS examiners have guidance on how to spot early signs of intimidation or ''hiding the ball'' and what to do about it, and they know they have the support of our entire management structure.

    Finally, regulators must be supervisors as well as examiners. We don't just take a look and find out what is happening. We analyze it and evaluate it. If we think there are excessive risks, we have an escalating program of supervisory strategies to do something about it. I am pleased to say that the vast majority of our supervisory concerns are taken care of before the examiners ever leave the institution or when brought to management's attention between exams.
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    Because of the still overwhelming proportion of thrift assets held in mortgages, we at OTS emphasize quarterly monitoring and supervision of interest rate risk in addition to the more traditional risks. Each quarter, about 91 percent of the institutions we regulate file with us detailed information about their on- and off-balance sheet assets and liabilities, and more than half do that voluntarily. Their filing, and the quarterly analysis we send them in response, helps them understand the interest rate risk they are taking and how it compares to the rest of the industry and to their own institution over time.

    Ten times each year, our five regional directors and senior Washington supervisory staff, including me, meet face-to-face to discuss and develop policy with respect to developing issues and concerns. And an additional three times a year, each regional director and his supervisory staff discuss each of the region's high risk or high profile institutions with senior Washington staff, again, including me. Our topics: The institution's current profile; what has happened since our last discussion; and what our future supervisory strategy will be. We have begun a series of all-day seminars in each of our regions for directors of thrifts to help them fully understand their important responsibilities. And we hold similar meetings for thrift CFOs and external auditors. We send out regular information on risks and how to minimize them. All of these techniques and the others described in my statement keep both us and the industry current.

    Finally, let me say something about our relationship with the FDIC. First, I strongly believe my active participation on both the FDIC board of directors and the FDIC audit committee makes for a better FDIC and for a better OTS. For example, we have learned a tremendous amount from the bank failures, which we understand far better because of my participation on the board and the audit committee. But of course, most of the interaction between the agencies occurs in the field. Our philosophy is straightforward: we value the FDIC. Our regional directors and other regional staff are in regular contact with their FDIC counterparts. The FDIC receives a copy of every exam report before it is transmitted to the institution, and not only do we honor requests by the FDIC to join us on exams, we also reach out to invite them when we sense a serious supervisory problem may be developing. And when they decline our invitation, as sometimes happens, we keep them fully informed.
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    This is a good relationship that works well, and while improvements are always possible and desirable, we really do not believe there is any need for statutory change. Thank you for your time. I would be happy to answer questions.

    Chairman LEACH. Our fourth witness is Governor Meyer of the Board of Governors of the Federal Reserve. Governor Meyer has been a member of the Board since June of 1996, and he oversees the banking supervision and regulation for the Board. Prior to becoming a member of the Board, Governor Meyer was a professor at Washington University in St. Louis and headed a St. Louis-based economic consulting firm. As a Midwesterner, I think it is important for the committee to understand that in economic forecasting, one can be proved right or wrong, and Governor Meyer's forecasts over a period of years were more prescient than any of his coastal competitors. So we are honored to have a Midwestern perspective.

    Governor Meyer.


    Mr. MEYER. Thank you. Mr. Chairman, Congressman LaFalce, and Members of the Committee. I am pleased to appear on behalf of the Federal Reserve Board to discuss issues regarding recent bank failures as well as steps being taken to minimize unnecessary costs to the bank insurance fund and disruption to the financial system or the public that failures could pose.

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    Recent experience has shown that despite vibrant economic conditions and a banking industry in an exceptionally strong financial condition, small pockets of lax standards, excesses or fraud, even within smaller organizations, can cause noticeable losses to the insurance fund. Since the tumultuous banking conditions in the late 1980's and early 1990's, the number of problem banks and failures has fallen steeply to levels more in line with other quiescent periods in banking. This past year one State member bank with $17 million in assets failed, with an estimated cost to the FDIC of approximately $1.6 million.

    Although the number of recent bank failures is minimal, the number of State member banks in less than fully satisfactory condition has risen over the past two years, suggesting that State member bank failures during 2000 may also rise slightly. This assumes, of course, continuation of current strong economic conditions.

    Despite the slight uptick in institutions with less than satisfactory ratings, the banking industry appears to be better prepared today to weather an economic downturn than it was during previous recessions. On the other hand, banks today face new challenges in funding growth and managing the risk of newer and more complex activities.

    While banks have been improving their risk management practices to meet new challenges, so too have bank supervisors by employing a risk-focused approach to supervision. However, in keeping with the spirit of minimizing regulatory burden as set forth by statute, opportunities for on-site reviews have become less frequent for well-capitalized and well-managed small banks. In response, we have stepped up our surveillance and off-site monitoring systems to track, for example, institutions involved in sub-prime lending and securitizations. We are also engaged in a number of other preventative initiatives. Some involve guidance regarding sound practices for sub-prime lending and evaluating residual assets, and others involve potential capital treatment for sub-prime loans and securitizations. While supervisory tools have been generally effective, the incidence of fraud at banking organizations raises different challenges. The examination process is not designed to ferret out fraud. Moreover, fraud is extremely difficult to detect. In light of recent trends, we are reevaluating our reliance on internal and external audit evaluations.
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    In cases where red flags are apparent, asset verification or more in-depth investigation is clearly warranted. Absent such red flags, however, less reliance on internal and external audit evaluations could result in increased burden to the many banking organizations that are not engaged in fraudulent banking activities.

    Other Federal Reserve initiatives to combat fraud have included the development of specialized training programs, examination tools, and reference materials. We also rely on our long-standing Special Investigations Unit to investigate potential fraud that is identified during the course of an examination.

    Another key part of our supervisory strategy has been to coordinate closely and share information with other regulators and authorities involved with institutions we supervise. With regard to failing and problem State member banks, we coordinate closely with the FDIC early in the process when material problems are first identified. When the FDIC has requested to exercise its special examination authority for State member banks, we have benefited from its expertise and assistance in resolving problem institutions and believe that historically both agencies have benefited from information-sharing.

    The proposed H.R. 3374, the Federal Deposit Insurance Corporation Examination Enhancement and Insurance Fund Protection Act, deals with certain corporate governance and agency coordination issues. Recent events, of course, have certainly highlighted the importance of interagency coordination and sharing of information. While we do not necessarily view the legislation as essential, because it mandates cooperation and coordination that should already be taking place, we see no harm in formalizing those processes.
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    Chairman LEACH. Thank you very much, each of the witnesses.

    Let me just begin by perspective. It strikes me that we are looking at a billion dollars in failure in the last year. These have been strikingly strong economic times, and these failures involve very small banks. So we have a billion dollars in failures in good times with very, very small banks, and so the question that seems to me particularly relevant is, in terms of coordination, do we not only have adequate coordination with small banks, but what about larger banks and what about situations where instruments at issue may be much more sophisticated?

    The sub-prime lending problem is self-evident in several of these failures, but as risky as sub-prime lending may be, it still is a straightforward, unsophisticated kind of product. And so the question I would pose to each of you is of a little different nature than what has been testified to, and that is: Are you confident of adequate coordination, and are there any problems of coordination with the larger banks in the country; and in particular, are there procedures in place that may be able to deal with economic times that are a little more difficult than those that have existed over the last half decade?

    Let me begin with you, Mrs. Tanoue.

    Ms. TANOUE. Chairman Leach, one of the greatest challenges currently for the FDIC is to work with the other agencies to develop protocols for sharing information as to the risks inherent in the largest complex banking organizations. It is an effort that we are currently discussing with our agency counterparts, and it is certainly one of our highest priorities.
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    Chairman LEACH. Mr. Hawke.

    Mr. HAWKE. I agree with Chairman Tanoue. This is a tremendously important topic. We are discussing it, and I think it is important also for the committee to understand how much coordination already goes on with respect to large banks. The FDIC not only has access to our reports of examination and our supervisory monitoring system, but there are monthly meetings between our head of supervision and their head of supervision; there are quarterly briefings of the FDIC senior management with respect to all of the large banks that we supervise; and there are ad hoc meetings as events occur. In addition, with respect to problem banks—none of our large banks is in the problem bank category—we have even increased communication and cooperation.

    This is a subject that needs to be discussed further. I think we need to strike the right balance between assuring that the FDIC has all of the information it needs to understand the risks that are in the system, particularly in large banks, and assuring that our largest institutions are not subjected needlessly to the burdens of duplicative examinations. That is one of the concerns, Mr. Chairman, that you expressed in your 1993 letter.

    Chairman LEACH. What about with regard to the Federal Reserve? Is there, likewise, cooperation?

    Mr. HAWKE. We are pursuing the same discussions with the Federal Reserve, and we have exchanged drafts of protocols that we are hopeful of entering into within the near future.
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    Chairman LEACH. Ms. Seidman.

    Ms. SEIDMAN. This issue of coordination on the larger banks is obviously extremely important. We are, I think, in a slightly different position. The thirty-nine mega-banks that are cited in the FDIC IG's report, three are OTS-regulated institutions. One is significantly larger than the other two. In the case of that one institution, there is an FDIC-supervised entity in the holding company system, and we work extremely closely with the FDIC on a very regular basis, so this issue simply didn't arise. The other two are a good deal smaller and indeed raise the very issue that you have raised. They are doing essentially traditional thrift activities.

    There are two other OTS-regulated institutions that apparently are about to go on that list, one of which is in a bank holding company, so that the issue of coordination with the Fed is extremely important.

    I did want to raise an issue relating to resident examiners, which is raised in the IG's report. OTS regularly reexamines this issue, and in part because of the kinds of institutions that we supervise, we have come to the conclusion that the benefits of resident examiners being there all the time, knowing what is going on, having an opportunity to examine a wide range of very different, very sophisticated, ever-changing kinds of issues are outweighed by the costs, which in our opinion include a potential for management to begin to regard the examiners as part of management and for the examiners to begin to regard themselves as part of management. The temptation to say, ''What do you think about this?'' is there.

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    So we have made a considered decision not to put resident examiners in any of our institutions. For our very largest, we have quarterly meetings with management in addition to our regular exams, and we are on the phone with them virtually once a week, if not more. So I think we have tight, serious oversight.

    We have made the decision not to have resident examiners. I would not like a situation where we have made a considered decision not to have resident examiners, and the FDIC unilaterally could make a decision to put resident examiners in those institutions. I think this is one of those coordination issues that we need to work together very carefully on.

    Chairman LEACH. Before turning to Mr. Meyer, you have raised an issue that wasn't asked, but it is a very important one and it becomes a competitive one. As I understand it, the OCC may have lost an institution because of its desire to be firm and put in a resident examiner.

    Mr. HAWKE. I'm sorry. I couldn't hear what you said.

    Chairman LEACH. It is my understanding that you may have lost an institution from your supervision to a State charter, because you decided to be firm on the resident issue. The reason I say this is I hate to have two regulatory agencies within the Executive Branch, let alone State versus Federal regulators, make decisions based on being in favor of putting a resident supervisor in place versus not and in given kinds of situations.

    And so I am not sure I like the ''never-ever'' description of yours, Ms. Seidman.
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    Mr. HAWKE. Mr. Chairman, to answer your question, I am not aware that we have lost a bank because of our resident examination program. That may have happened sometime in the past.

    Chairman LEACH. It is my understanding a bank in Tennessee has recently shifted to a State charter, and this might have been the cause, but I don't know that.

    Mr. HAWKE. That bank has reversed that decision, but it was not because of a resident examiner issue. We think the resident examination program is extremely effective; it enables our examiners to really understand the culture of an institution. While it might not be something that bankers intuitively embrace, the thirty banks that are in our large bank program almost unanimously view the resident examiner program as very beneficial.

    Chairman LEACH. Fair enough. But we have two institutions at the Department of the Treasury in opposite positions on this.

    Ms. SEIDMAN. Let me just say I don't think we are in opposite positions.

    Chairman LEACH. You said you have a policy against resident examiners and OCC has said that it has a policy for them. Is that not opposite?

    Ms. SEIDMAN. We reexamine that policy regularly based on the changing nature of the institutions we regulate.
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    I think what I was trying to say is very consistent with the point you were raising earlier about the different kinds of activities that are undertaken by different kinds of institutions. We have made the decision—as I said, we reexamine it periodically—that there is no need for a resident examiner program at this time. We do reexamine it. If our institutions began engaging in activities that we felt could not be effectively supervised by a combination of regular exams and quarterly meetings and weekly phone calls, we would reverse that decision.

    I think there are downsides and I think we need to be aware of them, and that is why we make a considered decision. It is not that we have made a decision for all time.

    Chairman LEACH. I am sorry, I have extended my time, but Governor Meyer has not responded to the first question.

    Mr. MEYER. During the last year, the Federal Reserve has been involved in a system-wide study of changes going on in the banking system that might affect systemic risk and how we as supervisors should respond.

    I recently gave a talk on this subject and outlined a number of the recommendations that we have come up with. This work builds on the work over the last several years to refine the supervisory approach we take to the largest and most complex banking organizations, what we call LCBOs.

    In addition, we would say we have special responsibilities in terms of coordination among the various supervisors of banking organizations because of our umbrella supervisor role. And we work very hard and we are working hard to refine that role in light of the new financial modernization legislation.
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    A fourth element here in dealing with larger institutions as part of our system-wide study, we have looked at issues relating to the resolution of mega-banks. We have been talking to FDIC about that, and we are going to be sharing with each of the other banking agencies our findings of this analysis.

    We have also been thinking that the banking agencies perhaps should be getting together on a regular basis, perhaps quarterly, to talk about systemic risks relating to the large banking organizations and how they are supervising in light of that.

    As you perhaps know, in virtually all my talks about banking these days, I emphasize the importance of cooperation and coordination among the agencies. We have a very complex and convoluted regulatory structure. The only way we can make it work is to have excellent cooperation and coordination. The changes going on in banking and the new financial modernization legislation only make this more important. That is not to say that the relationships are not good; they are very good today. They need to get better because of the challenges we face.

    Chairman LEACH. Thank you.

    Mr. LaFalce.

    Mr. LAFALCE. Thank you, Mr. Chairman. Let me make a number of observations.

    Over the years, whenever I have traveled to foreign countries and met with ambassadors or DCMs or individuals—our ambassadors that are the representatives of the United States to those countries—it is always possible that ''clientitis'' sets in and all of a sudden the ambassadors might think they are representatives of that country to the United States. There is always that difficulty.
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    And that is true with resident examiners, too. So whenever you have resident examiners, you have to be careful, as Ms. Seidman wants to be, but you don't dispute the wisdom of having them, at least in certain institutions, as Mr. Hawke underscores. And I don't think you are at opposite ends, it is just that there could be different approaches, each with its own set of validities. That is just one observation.

    A second observation is with respect to risk. It is the business of banks to engage in risk, because if banks avoided risk, we might as well have an elimination of our banking system. Of course, that risk must be well managed, and therein lies the potential difficulty.

    So we don't want to strive so hard to avoid risk that we choke credit. And this, in my judgment, has happened. I think there have been instances when we browbeat examiners to such an extent—we being the Congress, we being the media, and so forth—that we choked credit, helped contribute to credit crunches. So we don't want to do that; and we are not, we are not.

    And we also want to define the problem accurately, too. By ''define it accurately,'' you know, what is it precisely? What is its extent, too. And I do think it is important to always facilitate cooperation and coordination amongst the regulators, and you can always improve upon that. But to the extent that that is a small portion of the total difficulty, to the extent that we emphasize it 99 percent of the time—and maybe we ought emphasize that 1 to 10 percent—we are doing a disservice to an understanding and a resolution of the real difficulties.
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    I suspect that the coordination—I don't know of any instance where there is a failed bank that would have been prevented had we had better coordination amongst the examiners. I could be mistaken on that, but that is my understanding. And so it is appropriate to talk about it, but I don't want to talk about it out of context.

    And I was very, very pleased with the Chairman's remarks, where he said that he doesn't believe that a legislative solution is necessary to deal with that aspect of the total problem to whatever extent it exists.

    And then I am pleased that in your comments each of you evidenced a desire to have greater coordination. On the other hand, we do not want redundancy. If every single member of my staff had to meet on every issue and discuss every issue, as they often would like—and they often get annoyed when they don't know something—well, you would never get anything done and you would not focus in on the real problems. So we don't want you to coordinate to such an extent that you don't get anything done. You are the primary regulator. Do your job.

    Let's talk about what I think we should be focusing on. We have had a relatively small number of failures. We would like to have fewer, but we don't want to stifle credit either. But it seems to me that in these few instances, these few failures, the two principal difficulties have been sub-prime lending and fraud.

    Is that a correct statement, would you say Ms. Tanoue?

    Ms. TANOUE. Yes, sir.
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    Mr. LAFALCE. Mr. Hawke.

    Ms. Seidman.

    Mr. Meyer.

    Mr. MEYER. There are a few other issues.

    Mr. LAFALCE. OK, fine.

    Now, with respect to sub-prime, I would like you to focus in on what we could do. One thing is to talk about capital requirements for sub-prime lenders. How can we better identify institutions, at least insured depository institutions, that are engaged in sub-prime lending; and what risk management devices can we use, and most especially, focus in on capital. I understand you have some ideas on that.

    And second, with respect to fraud, we do not want to apply examination techniques to ferret out fraud in every single institution, because then we wouldn't be able to go after the institutions we should go after, and the examination process would be unduly, unreasonably burdensome. And I think this is a point you made, Mr. Meyer; but how can we detect possible fraud a little bit better and adjust our examination techniques to look at not so much systemic problems with respect to those institutions, but ferret out possible fraudulent practices?

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    So, if the four of you could address those two issues, which I think are perhaps the two most important issues we should be talking about.

    Ms. TANOUE. If I could tackle the issue you discussed first—in terms of sub-prime lending, I would like to emphasize that there is a great deal of attention on the FDIC's sub-prime proposal, but it is only that—a draft proposal. In circulating that proposal among the agencies, I would like to emphasize that it wasn't originally intended to have such broad-spread distribution before the agencies had an opportunity to discuss it extensively and reach a consensus.

    Mr. LAFALCE. Speaking of consensus, the members of the FDIC board do have existing authority to make a backup examination wherever the board so decides; is that correct?

    Ms. TANOUE. That is right.

    Mr. LAFALCE. So it is not a question of backup examination for the FDIC; you have it whenever the board wants it.

    But the members of the board are you, the vice chairman of the FDIC; correct? Who is that?

    Ms. TANOUE. Vice Chairman Skip Hove.

    Mr. LAFALCE. Skip has been around for a long time. And the OCC, and the OTS, and then——
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    Ms. TANOUE. And there is ordinarily one other independent seat.

    Mr. LAFALCE. A consumer seat.

    How long have you been Chairman of the FDIC?

    Ms. TANOUE. Almost two years.

    Mr. LAFALCE. Has there been an instance during those two years when, with respect to backup exams, you sought a backup exam and you haven't been able to get it?

    Ms. TANOUE. No. But there has been——

    Mr. LAFALCE. Let me go on. We will come back.

    How many times has a decision been made by the FDIC board that has not been unanimous?

    Ms. TANOUE. In terms of a request for a backup?

    Mr. LAFALCE. No. In terms of anything.

    Ms. TANOUE. In my memory, in terms of my experience, we have not had those situations.
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    Mr. LAFALCE. OK. Now, I may have unfairly limited you, but I wanted to get to this point. And now I will delimit you, so whatever you would like to——

    Ms. TANOUE. It is a fair point to raise in terms of the backup request. The board has never denied such a request. I think the real issue here is the potential for delay as the FDIC seeks to participate in a special insurance examination.

    Currently, the board has taken steps. I have asked that any types of disagreements, any types of interagency disagreements, are elevated to the board level immediately.

    Mr. LAFALCE. Going back to the issue of capital, I am a bit concerned that insured depository institutions engaging in sub-prime lending have less capital than non-insured financial institutions that, according to my understanding, would have no legislative requirements, but would simply be acting on market-based demands for capital.

    But wouldn't you be able to make a demand of the insured depository institutions that they have higher levels of capital than the minimum amounts required by law, especially if they were engaged in sub-prime lending?

    Ms. TANOUE. Yes, we absolutely do.

    Mr. LAFALCE. So you do have that authority right now?

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    Ms. TANOUE. In the interim, as we are working on this proposal, the FDIC actually is requiring on a case-by-case basis higher capital from certain institutions that are engaged in this type of lending and that don't have adequate safeguards.

    Mr. LAFALCE. Could you address the second issue; maybe you would take the first crack at it, Dr. Meyer, and that is, how and when do you make adjustments to the systemic risk approach whenever there is the possibility of fraud or you smell the possibility of fraud?

    Mr. MEYER. Well, as you appreciate, that is a very difficult exercise, and we are trying to have this balance between relying on internal-external audit to deal with the integrity of the information that the examiners use and more intrusive sort of supervision. And, as you indicated, what you have to do, I believe, is look for red flags, look for indicators such as resistance of management to providing the information that you want, that indicates that you have to go further than you otherwise would.

    You don't want, in all cases, to disregard or not make full use of the internal and external audit information, but there are times when you have indications that tell you that you have to directly involve yourself in verifying, doing more transaction testing.

    Earlier you talked about mainly coming in and looking at the risk management process, and that has been a tendency—less transaction testing, more emphasis on risk management process. But again that is the art of supervision, knowing how that balance should be struck and again looking for red flags that tell you to pay more attention to going in, doing transaction testing where you are more likely to uncover examples of the fraud.
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    Mr. LAFALCE. My time has expired. I thank the Chairman.

    Chairman LEACH. Mrs. Roukema.

    Mrs. ROUKEMA. Thank you.

    I am not quite sure I understood completely that question that Mr. LaFalce—or the answer to the question about the sub-prime lending standards and the capital requirements. I would like to ask Mr. Hawke to respond to that, and perhaps Mr. Meyer as well, specifically to whether or not we need to be reviewing those standards for capital requirements and how we would do that.

    Mr. HAWKE. Mrs. Roukema, let me say, first of all, that sub-prime lending is not something new, not something of recent vintage. Sub-prime lending has existed for many, many years. In earlier times, the consumer finance industry specialized in what was essentially sub-prime lending. It was not a regulated industry, and the market essentially set the capital for sub-prime lending by consumer finance companies.

    What is different today is that much of the consumer finance industry has come into the banking industry: either formerly independent consumer finance companies have been acquired by banks, or banks have engaged in similar kinds of lending. That is certainly what focused the FDIC's attention—I think properly—on questions of capital, because banking organizations started funding loans of this sort with insured deposits and other kinds of bank borrowings that were not subject to the same kind of market discipline that traditional finance company lending was.
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    Sub-prime lending, I think, is probably a riskier business than other kinds of lending, and the important thing from a supervisory point of view is to make sure that a bank that engages in sub-prime lending has the proper kind of controls in place, understands what it is doing, and manages and prices risk appropriately. And those are the issues that the agencies jointly have borne down on over the last year, both from a supervisory point of view and in the published statements that we put out.

    Mrs. ROUKEMA. Are you suggesting that there is no way that you should or would establish higher capital standards?

    Mr. HAWKE. No, I think attention needs to be paid to what the appropriate approach is to capital for sub-prime lending. I don't believe the FDIC proposal has been formally issued. It is still being discussed on an interagency basis.

    Mrs. ROUKEMA. Currently?

    Mr. HAWKE. Currently, yes.

    Mrs. ROUKEMA. Mr. Meyer, did you want to comment on that?

    Mr. MEYER. Yes, we all agree that more capital needs to be held against higher risk activities and we know that in the Basel minimum capital standards there is no differentiation among different types of non-mortgage loans, which all have the same minimum requirements.
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    So we have two basic approaches to deal with higher risk lending as with sub-prime. One, we could change the capital requirements themselves and enforce higher capital standards on higher-risk components.

    Now, the problem with that approach is that it is very hard to get a rigorous definition of sub-prime lending that cannot be gamed and therefore avoided. If we could, that could be an option. So we have to work on that, to see whether we can define it rigorously enough.

    The second problem is that it is one category. We have singled out one category of higher risk. What about all the other categories of higher-risk lending? It is still a constructive proposal to put on the table and think about, and one of the attractive features about it is that it is triggered by concentration.

    There is another option, and the option is to handle the capital issue through the supervisory process, through examiner discretion, going into a bank and saying that banks have to hold appropriate capital in light of their risks and their risk management capabilities. That could be handled as it is today through the supervisory process.

    Mrs. ROUKEMA. Thank you. I hope you are all are going to keep working on this, and we will certainly follow this, but that is helpful. Your answers are helpful.

    Mr. Hawke, I do have the greatest respect for you and for the OCC, but I do have to get back now to the question of the Keystone situation and the initial denial of review by the FDIC and your opposition to 3374.
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    With all due respect, and I mean it respectfully, your explanation makes it sound like a turf fight. Can you give us more substance as to why we shouldn't be looking for further statutory definition that will control the checks and balances here between your responsibility and the FDIC's, as well as OTS?

    Mr. HAWKE. I would be happy to.

    Let me say, first of all, I feel somewhat constrained in what I can say publicly about Keystone, since there are pending indictments scheduled for trial this April, and the U.S. Attorney has asked us not to speak publicly about the details of Keystone. We are happy to brief the committee in executive session or in private.

    But with that caveat, let me say that I think when one looks closely at the record of Keystone, it was anything but a turf consideration. The FDIC was involved in Keystone from the very earliest times of our involvement. They participated in the 1996 examination; they were fully informed about the 1997 examination.

    They requested in, I believe, February of 1998, to participate in the 1998 examination. That was initially denied at the staff level, but that decision was reversed and the examination went forward with FDIC participation. The staff decision was made for reasons that our people, who were on the scene and dealing with the bank under circumstances that were really unprecedented, thought were appropriate at the time.

    I think, in retrospect, it was not a good judgment and should not have been made, but it was not made for reasons of turf. The FDIC was involved in Keystone and was kept informed of what was going on in Keystone from the very beginning to the very end.
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    Mrs. ROUKEMA. If you excuse me, perhaps I was wrong to specifically reference Keystone. What I really want is your explanation as to why you oppose 3374. What is the downside of it? It seems to me that going back to that pre-1993 position is a sound policy decision. I am not quite sure why you are opposing that.

    Mr. HAWKE. I am not opposing going back to the pre-1993 arrangement that we had with the FDIC. I think there was a good working relationship.

    Mrs. ROUKEMA. But you do oppose 3374?

    Mr. HAWKE. I oppose that part of H.R. 3374 that would change the internal governance of the FDIC and vest in one person rather than a board—appointed by the President and confirmed by the Senate—the decision to send examiners into national banks.

    I think that the objectives of H.R. 3374 are being accomplished. In any bank where there is any indication of trouble, any threat of deterioration that could affect the insurance fund, the FDIC will not only be allowed in, but invited in. Since 1995 alone, the FDIC has requested to participate in almost sixty OCC examinations, and there has not been a case where they have been prevented from doing that. The Keystone situation was an aberration that was based on the unique and unprecedented circumstances that our examiners faced in that bank.

    I think the objective of H.R. 3374 is certainly one that we share. It is to increase cooperation between the agencies, and we are committed to do that. But I don't think that divesting FDIC board members of their vote on an important issue is needed in order to accomplish that.
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    Mrs. ROUKEMA. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Mrs. Roukema.

    Mrs. Maloney.

    Mrs. MALONEY. Thank you, Mr. Chairman.

    Mr. Chairman, legitimate sub-prime lenders fill a very important market niche. They provide credit for underserved populations that have had limited opportunities for obtaining credit from traditional commercial lenders. Too often, low-income people looking for emergency funds are forced to fringe lenders such as payment loan centers, which Mr. LaFalce raised.

    Any regulatory proposal that has the effect of limiting these credit opportunities must be developed with the most exacting decisionmaking in the most exacting fashion. While I share the FDIC's concern for the safety and soundness of the banking system, I am concerned that adopting any arbitrarily high capital standard for sub-prime lending will unnecessarily reduce the number of sub-prime lenders offering these credit opportunities and may constitute a barrier to new lenders entering these markets.

    We know that certainly there are bad actors that are not handling risks appropriately, and where we have these bad actors, insurance premiums and capital standards should be raised. However, so as not to cut off creditworthy borrowers, this is an oversight process that I believe can be best handled in a case-by-case process.
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    In the November 1999 Federal Reserve bulletin, which was written by Federal staffers Glenn Canner and Wayne Passmore, entitled ''The Role of Specialized Lenders in Extending Mortgages to Lower Income and Minority Home Buyers,'' they raised many of these issues. And although I know, Chairman Tanoue, that this is not a definite proposal, it is one that you are reviewing. I hope that you will read this; I found it excellent, and really, since all of the other regulators would be in the position to approve any changes coming forward, I would like to recommend that you read it.

    In fact, Mr. Chairman, I would like to put it in the record if I could.

    Chairman LEACH. Without objection. We will place this in the record.

    Mrs. MALONEY. Thank you.

    Well, in this report, the Fed staff found that sub-prime lenders, and I quote, ''contributed significantly to the recent growth in conventional home purchase lending to lower-income and minority households and neighborhoods and that they accounted for much of the change in denial rates over the period from 1993 to 1998.''

    I understand that the FDIC proposal would not require a capital increase for first-time homebuyers, but has the FDIC considered the impact on low-income homebuyers generally, and doesn't this conclusion from this report make the case for case-by-case examination?
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    Mrs. Tanoue, and if anyone else would like to comment.

    Ms. TANOUE. First, from the FDIC standpoint, we believe strongly that as a matter of fairness and consistency, it is important to have a rule. We are currently not only seeing existing institutions engaging in this type of activity, but we are also seeing a number of new applicants to engage in this activity applying to the FDIC for deposit insurance and we believe it is important that, while you can handle these issues on a case-by-case basis, again, for purposes of fairness and consistency across the board, it would be wise to have a rule.

    Having said that, I would like to mention that in terms of our proposal, we very much realize that sub-prime lending is an important part of consumer finance. In fact, this may be the only way that many people can have access to credit.

    In developing the proposal, from the outset, we thought it important to develop a carve-out for community development lending and other types of loans that might merit credit. And as you mentioned, our carve-out also excludes loans to first-time homebuyers, emerging small businesses or other first-time borrowers, and loans made in conjunction with community organizations that provide credit counseling and screening, which mitigate the risk for these types of loans.

    I would also want to emphasize that if this proposal were implemented today, which, again, is subject to discussion amongst the agencies, it would not appreciably reduce the availability of credit to low- and moderate-income borrowers. Our preliminary assessment is, if applied today, this proposal would affect only some twenty or so sub-prime lenders.
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    Mrs. MALONEY. If I could respond, I believe the FDIC's proposal to require a doubling of the capital standards for banks with over 25 percent of the tier one capital in sub-prime lending is really, truly overly broad. Even if first-time homebuyers, community development loans and small business loans and loans based on borrowers' long-time relationship with the bank are exempted, as you stated, many sub-prime applicants have long been denied credit. This last exemption may prove especially inconsequential.

    I would like the regulators now to comment on these exemptions, specifically with regard to community development. And the Chairwoman's testimony, an exemption from the doubling capital standard listed for community development loans, and I quote from the top of page 12, ''because the incremental risks associated with using non-traditional underwriting factors in these cases is typically mitigated by public or private credit enhancements.''

    But as many CRA loans are not backed by such credit enhancements, the effect of double capital standards could reduce CRA commitments. Has the FDIC contemplated or thought about this likelihood? And, again, I would invite the other regulators to comment if they would like.

    Mr. HAWKE. Let me say that this proposal, which is still in draft form, is under active consideration by the agencies. I think it is premature for us to take public positions on elements of the proposal while our staffs are discussing it. I know that we do have some differences of views on the way capital is approached.

    I share Chairman Tanoue's concern about how sub-prime lending is defined. From a supervisory point of view, I don't think that there is any question but that sub-prime lending is a more risky type of lending than other, more conventional kinds of lending. Our primary focus has been on the systems and processes that banks have in place to manage that risk and on the way that risk is priced by lenders who are engaging in the activity.
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    I think the FDIC has taken an important step in raising the capital issue, and I think it is something that needs to be thoroughly discussed among the agencies.

    Ms. SEIDMAN. Let me associate myself with Comptroller Hawke's remarks, including the importance of the work that the FDIC has done here.

    There is a lot more work to be done. We are working on it.

    I would like to mention a couple of things. First of all, Congresswoman Maloney, you are absolutely right that if responsible lenders do not serve this community, irresponsible lenders will. And irresponsible lenders are already there, which I think is some of what Representative LaFalce was bringing up in talking about predatory lending. It is an issue that we are very concerned about.

    But the critical thing we as bank regulators need to understand is that there are different kinds of sub-prime lending, they are done in different ways, they are done more or less responsibly. Our obligation is both to ensure that the safety and soundness of these institutions is not significantly reduced by a decision to move into this field while simultaneously recognizing that depository institutions that are examined regularly with respect to consumer regulations, the fair lending regulations, all of those kinds of things, are some of the best alternatives for the people in the communities that have been underserved. We have got to strike that balance.

    I think we can, and I think the FDIC's proposal begins to lay out some of the questions and some of the ways we need to look at this. We need to build on the work we all did in March of 1999, when we put out a joint interagency statement about sub-prime lending that emphasized proper management, proper pricing, proper monitoring, all of those very critical issues that go into having a program that is responsible.
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    Mr. MEYER. Let me take a step back from the specific capital proposal to the broader issue, which is the tension between two public policy objectives. One is expanding access to credit and the other is guarding the safety and soundness of the banking system. And there can be a tension here.

    Look, sub-prime lending is an example of expanding access to credit, but sub-prime lending is defined as lending to borrowers who have higher default risks. You have to price that in and charge them higher interest rates. That is the only way to do it in a safe and sound way. Banks have to hold more capital against these loans precisely because they are riskier.

    Does this make these loans less available? Yes it does. Should banks do it anyway? Yes, they must for safety and soundness reasons. That brings us to the issue of exemption, a tough issue. We have to be very careful not to say that because of the public interest in some classes of loans that you are no longer going to price them for risk and/or hold capital against them. There are risk mitigators. If there are built-in guarantees, and so forth, that is fine. But for those loans where there are not those risk mitigators, we have to take a disciplined view about the appropriate capital that has to be held against them.

    That is not to say that it should be done in the form of a rigid minimum capital rule. We have to talk that out amongst ourselves. But if not that, we have to be careful to do it through the supervisory process.

    You talked about case-by-case, and that is kind of the approach taken, the supervisory approach, to a degree. But, case-by-case still has to be systematic to the extent that the sub-prime lending, to the extent it is higher risk, means higher rates, means more capital. It has to be systematic. Either of the two approaches has to result in a systematic treatment of capital in relationship to risk.
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    Chairman LEACH. The gentlewoman's time has expired.

    Mr. Bereuter.

    Mr. BEREUTER. Thank you, Mr. Chairman.

    Chairwoman Tanoue, your vice chairman is my constituent, I have not contacted him about the subject of this hearing and he hasn't contacted me about the legislation or the subject. But I recall that he has served as acting chairman on two occasions at least, for long periods of time overall; that for most of the last five years you have not had a full membership of five members. Sometimes, for substantial periods of time, you have been down to three during that period of time. Yet, it takes a majority decision of the board for a backup examination when you are not the primary Federal regulator, and that, it seems to me, increases the authority of the ex officio voting members from the OTS and the OCC.

    So, I think there is every reason to consider and to support the Chairman's initiative which would give to the Chairman the responsibility for making this decision.

    Now, I am wondering if I have correctly characterized the composition or non-full membership of the FDIC board for long periods during the last five years.

    Ms. TANOUE. You have. It has fluctuated over time.

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    And you raise a good point. While the FDIC and the OCC have implemented new procedures, I think, as the Chairman pointed out earlier this morning, this is a long-standing issue and one that has bedeviled, really, the regulators. The policies and procedures of the FDIC, depending on the composition of the board, have changed repeatedly over time, and that is why we believe a longer-term resolution to this issue is important.

    Mr. BEREUTER. Thank you.

    I would have to say to you, Mr. Hawke and Director Seidman, that I think your arguments against the legislation do look a lot like turf protection. I have to agree with Mrs. Roukema on that. If you don't know, I will state it once again that I thought your predecessor substantially politicized the OCC and that, if anything, the OCC needs greater oversight and supervision and you need to have some regulatory checks on the OCC's action.

    While I think it is a natural inclination of regulating entities, whether it is banking or whatever financial services, to resist congressional oversight, I think it is a tension that should cause us to be careful about overstepping authority and micro-managing. But I think the balance suggests at this moment that we make sure that a backup examination is not stalled by the OCC or by the OTS. And so I am inclined, given what I think are rather weak arguments against it and no objection from the Federal Reserve, at least, for making sure we have proper coordination and examination of troubled banks, to suggest that the Chairman's legislation is appropriate.

    I welcome any comments that you have, Mr. Hawke.

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    Mr. HAWKE. Let me say, first of all, that backup examination authority only requires a majority vote. It does not require a unanimous vote of the FDIC board. I should also say that I completely agree with your views on politicizing the process of basic supervision. I think it is absolutely essential that politics be kept out of that process, and I have tried as hard as I can in the fourteen months I have been in office to do that.

    Mr. BEREUTER. I pointed to your predecessor and not to you. I have no criticism of your leadership.

    Mr. HAWKE. I think Congress, in its wisdom, addressed the question of politicization by requiring that not more than a majority of the members of the FDIC board can be of the same political party. Under normal circumstances, that would mean that the chairman, the OTS representative, and the OCC representative would probably be members of the same party while the other two full-time appointed members of the FDIC board are very likely to be members of the minority party, the party not in the administration.

    To vest in the chairman alone the authority to make an important decision like authorizing backup examinations could well have the effect of divesting the minority representatives on the FDIC board of their ability to have a voice in that vote. So I think when you start tinkering with the internal governance of the FDIC, given the way that Congress has addressed the political balance of that entity, you are doing something that could have perverse consequences.

    The main thing is to continue to emphasize, as we have today, the importance of cooperation and mutual recognition of the significant roles that the agencies play. I think that is going to be the solution to the question of backup examinations.
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    I cannot speak for or justify things that may have happened under prior comptrollers, but I know that my attitude about this, and what I have directed internally, is that we should be reaching out to the FDIC to bring them in on any situation that presents the slightest question of risk to the deposit insurance fund.

    Mr. BEREUTER. Mr. Hawke, I will observe that we have had substantial periods of time in the last five years where we operated with only three members of the Board of Governors of the FDIC, not five, not four, but three.

    Mr. HAWKE. Even in those situations, there has been a question of what the political balance is on the FDIC. Over a longer time horizon, those situations will arise, but typically the FDIC operates with a full board. And I think there are unintended consequences that can come——

    Mr. BEREUTER. Well, that is a misstatement. I assume you mean because over the majority of the last five years the board has not operated with a full five members. The majority of the time it has had less than five members in the last five years.

    Chairman LEACH. Mr. Weygand.

    Mr. WEYGAND. Thank you, Mr. Chairman. I was earlier neglectful to ask that my opening statement be submitted for the record.

    Chairman LEACH. Without objection.
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    Mr. WEYGAND. I have two letters, one is from a Rhode Island-based bank, Home Loan and Investment Bank, and also a letter from OTS as a response to a letter from Home Loan and Investment Bank, which I would like to submit to the record.

    Chairman LEACH. Without objection.

    Mr. WEYGAND. Mr. Chairman, I would like to compliment all four witnesses on the panel. I have learned an awful lot, and I have taken in what you said with great interest.

    The particulars of the various bank failures over the last year, you have pointed out, each one of you, have been primarily because of either poor management or fraud or both. At least that is what the allegations are right now. The practice of these institutions to do sub-prime lending has also been perhaps a coincidence, but also a factor that attribute to their failure, although the two prior reasons poor management and fraud have been the primary reasons.

    So the question that I pose: Well, what should be the solution if that is the problem facing us with regard to these institutions, particularly those that do sub-prime lending?

    You have all indicated that we should have some sort of greater review or auditing, whether it be resident auditors or not, but there should be a better handle on the way these institutions operate, and that you need to do something about it. You can come to Congress with some suggestions about how we can address the problems.
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    The second thing that you have said is you really do cooperate very well, although there are many people that would suggest that perhaps you don't. But, in fact, all of you have said there is great cooperation among all of the agencies with regard to review. In fact, you have pushed aside some of the arguments that there was disagreement at Keystone or other institutions.

    But better coordination and cooperation among the agencies, you point out, would help with regard to the fraud and mismanagement. You could come up with and make suggestions to this panel and to Congress on how to accomplish it.

    Those two issues deal with the lenders, the lenders who you have indicated exhibited fraud or mismanagement. The other side is the borrowers, and how this impacts them or affects them. You have suggested that we need to have better standards or definitions about what they are or who they are and how to set our regulations which—again you could come forward and make those suggestions to us.

    The last thing is the proposal, although it has been out there quite a bit, to raise capital reserves so that indeed the lenders will have more reserve against those particular loans so that, if they begin to fail in greater quantity, we will be protected against them. I worry about that because of what Representative Maloney had suggested, that if we are to drive some of the good lenders out of the business, we will have more of the unscrupulous lenders in there charging higher rates; causing far more problems, I think, to consumers, but perhaps not to the institutions.

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    Home Loan and Investment Bank out of Rhode Island is one of the good institutions that OTS has pointed out. Its capital reserve is in excess of 20 to 21 percent. Its loan/loss ratio last year and for most of the last four or five years has been less than 1 percent. Last year it was 0.52 percent. It is one of the good institutions that does good lending to sub-prime borrowers.

    I fear that some of the proposals that have been raised and geared more at the borrowers, rather than at the management of the institutions, that really needs to be fixed, whether it is auditing or coordination or cooperation, or whether it has to do with a number of different things on definitions and standards.

    I am looking for truly constructive ways of dealing with the issue, versus just coming forward and saying, let's raise our capital reserve from 8 to 16 percent, or other harsh things that will drive many good businesses out of the marketplace and bring the unscrupulous lenders into the marketplace, causing many people in the minority and low-income community to be negatively impacted by the situation rather than improved.

    I really look at this hearing, Mr. Chairman, as an opportunity for you to come back with a coordinated effort about what we should be doing rather than us fighting amongst ourselves, and particularly with regard to the lenders rather than the borrowers.

    Last, I might add, Mr. Chairman, is that we may look at a sub-prime borrower for a consumer loan and deny them; yet on the commercial side, approve them. Sometimes, many times, we have the same individual who will be denied a consumer loan, but they are given commercial loans.
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    I wonder how the proposed regulation will deal with the commercial side and whether we have to bring all institutions into this big tent that you are talking about, or is it just going to be some of the smaller institutions that deal with the sub-prime borrowers?

    I would be happy to hear any comments from any of the Members.

    Ms. SEIDMAN. Let me just say, yes, Home Loan and Investment is, in fact, a very responsible sub-prime lender. It, and a number of other institutions that are under OTS regulation that have been doing sub-prime mortgage lending for years, have been doing it well.

    This is a tension. And I am somebody who truly believes that if depository institutions don't serve these borrowers, unscrupulous people will.

    But we also need to be looking at it from the perspective that these are institutions that are backed by a federally insured depository system, which in fact allows them to hold less capital than their unregulated counterparts.

    Management is critical, pricing is critical, monitoring is critical. But capital is also important, and what we need to all be doing is to see how we get to the point where the capital is appropriately recognizing the risk, but not inappropriately creating a situation where people who should be able to get credit are not getting credit.

    Let me just say that I believe that we can reach that point.
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    Mr. WEYGAND. If I could say to you, I don't disagree with you about protecting FDIC, making sure there are the proper capital reserves to protect against losses; but each one of you today talked about not the borrowers being the problem, but lenders.

    Ms. SEIDMAN. That is why it is critically important that we focus heavily on the management issue and all the other issues that go into doing it badly or doing it well. Capital is one of those issues.

    Mr. WEYGAND. One of the solutions that you talked about is the capital reserve. I don't disagree when you have a very high ratio of sub-prime lending. The problem that I see is that no one is willing to take up the mantle about coordination, review auditing and better definitions and standards. I think you need to do that initially before you start looking at, well, we are going to raise the reserves just because we don't have any other way to counteract, we think, in the field.

    And I listened to Governor Meyer, and I couldn't disagree with him more about what you are saying it is balancing. But clearly I don't want to disadvantage the low-income, the minority borrowers who are out there which indeed will be disenfranchised because of some of the proposals.

    Mr. MEYER. Part of the balanced approach is that capital is only one of a very large number of elements that has to be taken into account.

    The agencies put out, on an interagency basis, guidance to consumers and to banks about sub-prime lending, and that is just one element in it; the rest is the normal due diligence process, making sure that the banks have the capacity and resources to handle this kind of activity.
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    It is a very different kind of activity. It takes different skills. It is much more labor intensive and more collection oriented.

    Mr. WEYGAND. Wasn't it the latter that led to the losses that we saw this last year?

    Mr. MEYER. Absolutely. I think you are absolutely right that those elements of improving management process are absolutely critical and in some sense go first. But I am a little cautious about this distinction, which is an interesting one, between the borrower and the management. The point I want to make is when management manages risk appropriately and prices risky loans appropriately and holds the appropriate amount of capital in relationship to higher risks, then those loans will be less available and there will be less access for borrowers than would be the case if management was negligent, didn't price for risk and didn't hold as much capital.

    Mr. WEYGAND. In the case I pointed out, Rhode Island's Home Loan and Investment Bank, does just that. They would not be impacted by the proposal that is before us, because they exceed all of the guidelines that have been proposed, but I am concerned that there will be other people who truly do a wonderful job for low-income minority neighborhoods that will in fact pull out of the marketplace, will in fact disenfranchise so many different people that would love to have the opportunity to be in a borrowing situation and they will not be in the future.

    Chairman LEACH. Mr. Baker.
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    Mr. BAKER. Thank you, Mr. Chairman.

    Mr. Hawke, has there been to your institutional memory a time when the Comptroller of the Currency has refused cooperation of the FDIC in an inquiring institution other than the Keystone matter, which I acknowledge was reversed administratively very quickly? Maybe cast a little tighter loop around it, has there been a vote of the Board where a majority has voted with the Comptroller to deny the FDIC access to a request?

    Mr. HAWKE. I am not aware of any instance where FDIC participation has been denied in a bank that was either in the lower-rated categories or that presented a situation of deterioration, which is what I think the backup authority was primarily designed to addressed. What happened in the early 1990's really related to a somewhat different approach to the backup authority. At that time, the Director of OTS and the Comptroller of the Currency, two of three members on the Board, did take a position that was restrictive of the FDIC's ability to do examinations of banks, but that was not focusing on problem banks or troubled banks.

    Mr. BAKER. I note in your testimony that although you say banking conditions today appear to be very stable with very high levels of capital, you have a couple of concerns. Apparently you view underwriting standards to be slipping slightly while at the same time you have some concern about the low loan loss reserves that are now held by banks. I recall not long ago the SEC promulgated some criticism of banks for holding a too high level of loan loss reserve. Has there been some shift in the industry? Has the SEC comment had some impact? What is going on with the loan loss reserve question?
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    Mr. HAWKE. I can't say that the position that the SEC was taking a year or more ago has had an impact on the level of bank reserves. I think what has affected bank reserves probably more than anything is the continuous striving of the industry to maintain high levels of earnings and high returns on equity. There is a natural disinclination to add to the provision for loan losses, which tends to reduce profitability.

    I should say with respect to the relationships with the SEC that the interagency group has been working very constructively with the SEC for many months looking toward the development of an agreed-upon set of procedures and documentation requirements and disclosure requirements with respect to the loan loss reserve. I hope that process will reach fruition in the near future.

    Mr. BAKER. I wouldn't want to bring up FASB either again or anything they might be doing. It seems to me if we are going to do legislative relations between agencies, we ought to have the SEC in this bucket.

    With regard to the frequency of audit, I have a different concern. I think it is great to have auditors with bedrooms in the bank so they can stay as long as they like, but I think there ought to be a limit, because those things come at some cost to somebody. When you have multiple agencies, I worry about cost to the industry and as best reflected by the comments of many of the colleagues on the other side of the aisle about the impact of higher capital standards, higher underwriting criteria for sub-prime credit requests. These individuals may not necessarily be somebody just with the delinquency on payment history. You could have someone just out of school with no assets and a part-time job trying to get credit to go to school and get their MBA. There are a lot of people who fit into the sub-prime category, and I am very concerned that unless the regulators as a panel have some view that there is a nationwide problem with current lending practices by institution to sub-prime borrowers, that we move very cautiously in implementing new standards because of the adverse impact it could have on the market.
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    I would say a decade makes a great difference. It was only in the early 1990's when this committee was having hearings, traveling around screaming about the credit crunch. There were terribly difficult economic times, and banks internally, not because of Government mandate, I recall, were upgrading their credit criteria, and people who had historically gotten their notes renewed were being told no. Now in extraordinarily good economic times, banks facing unusual pressures, albeit with higher capital in their bank account, and looking for new ways to try to make a dollar. The sub-prime market I think perhaps is now being better served than ever. Unless there is a problem regulators want to bring before the attention of this committee that warrants some decisive action, tell me why we should take any further actions today based on the few number of problems that appear to be related to this matter as opposed to fraud or misconduct.

    Mr. HAWKE. We are not proposing any legislative action with respect to sub-prime lending. A number of actions have been taken by the regulators over the past year addressing supervisory concerns about sub-prime lending, basically the need for appropriate risk management systems and for proper pricing. Governor Meyer very articulately described what the balance of considerations was in that regard.

    I think it is a little bit unfortunate that the FDIC draft proposal, which is being discussed on a confidential basis among the regulatory agencies, has leaked into the public domain, because that tends to affect the way the interagency process is carried on. We need to complete the process of having a free and frank exchange of views among the regulators on the FDIC proposal, which stirs a lot of thought and requires very serious consideration, before we address questions like whether any legislation is needed on sub-prime lending.
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    Mr. BAKER. I meant to go a bit further than just legislation. I meant even regulatory action unless there is clear evidence that there are practices in the market which are unwarranted. Everything we do, to ''protect'' people means that the ultimate rate that that borrower will pay, or whether he or she qualifies at all, becomes a more difficult hurdle to jump, and I think we have to be very careful about.

    Thank you.

    Chairman LEACH. Thank you, Mr. Baker.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman. I apologize for being late. I was held up in the Budget Committee where we were having a hearing with the Director of OMB.

    I have a couple of questions, and I have gone through some of your testimony. One that you haven't addressed and it may be something that you can address that I have been concerned about as it relates to sub-prime lending, if you followed any of the debate on bankruptcy reform as it has gone through the House last year and the Senate just recently, some have argued that Congress shouldn't focus so much on the debtor as much as they might focus on the creditor and the amount of access—the amount of credit that is being extended to borrowers, that perhaps that we have gone too far. Now, I think Governor Meyer raised the issue of tension between credit quality and access to credit and it wasn't too long ago that a lot of people in the consumer activist world were arguing that lower-income Americans didn't have fair access to credit or any access to credit, consumer credit in particular, and now it would appear they have a great deal of access to credit at a certain price. The concern—I will say that I think that that is a little bit apples and oranges to the issue of bankruptcy reform, but my question is whether or not you as regulators have begun to look at lenders' extension of consumer credit in the same way as you would corporate lending to whether or not a bank or a thrift or a financial institution is properly evaluating the creditworthiness of their borrower. You certainly have done that in the past. You did that in the 1980's when you looked at loan portfolios, primarily commercial loan portfolios, to determine whether or not the lenders were extending themselves too far, and it may be that in the consumer credit market, it is too voluminous, but when you do hear stories about credit being extended to people that are apparently way over their head and if they were a commercial entity would never happen, is there a way that the regulators can look at the banks and how they are doing this?
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    The second thing I would ask is on the question of residual valuation. Has the problem been that the lenders are using too risky of assumptions as to what the value of the residual will be for purposes of assets?

    And the third question with respect to the Chairman's bill, beyond the question of a turf battle or not, is this something that if you were to give this authority to the chair of the FDIC, would we be in any way taxing the FDIC's resources against its other obligations that it has?

    And I would appreciate your comments on those three questions.

    Ms. SEIDMAN. Let me try to go through them quickly. On the issue of the quality of borrowers, this is underwriting. And, yes, our examiners do look at underwriting standards and where we see lax underwriting standards, we take action to encourage the institution to improve those underwriting standards. As you know, I come from the home mortgage business and of course the industry that OTS regulates is still 50 percent home mortgages. I think home mortgage lenders have learned a very important lesson. That is, the things we thought measured credit quality don't always measure credit quality. It is therefore very important to take advantage of all of the technological tools we have at our disposal, and frankly a little bit of judgment, a lot of judgment actually, to make certain that people are not denied credit for reasons that have relatively little to do with their creditworthiness, such as the color of their skin, their age and a number of other factors.

    So, yes, underwriting on the consumer side is very important and it is something that we look at.
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    On the issue of residuals, there is a wide range of assumptions that must be made in valuing a residual. Where you have a residual that is not easily marketable, and most of them are not, those assumptions can make a very, very big difference in the value of that residual on the balance sheet. It is an issue that we addressed in guidance on an interagency basis in December. It is one that we are continuing to work on. The assumptions are just simply so variable that it reduces the residual's reliability as capital.

    And finally on the third issue, since, as we have testified, the OCC and the OTS and the Fed invite the FDIC and welcome them in these circumstances, no, I don't think this would tax the FDIC's resources. I do think there are some very serious issues related to the role of the Board at the FDIC which Comptroller Hawke talked about earlier.

    Mr. MEYER. I would just add one thing on residual valuations. Part of the problem sometimes is bad assumptions. But part of the problem is sometimes that the underlying risk factors can be very volatile, and therefore there can be dramatic changes in the contribution to capital from these residuals, so that makes it another factor in addition to the fact that sometimes the assumptions that are used are very poor.

    Ms. TANOUE. On the last issue, I would just add that if you look at the record of the FDIC in requesting participation in special insurance examinations, I think you will find that FDIC has been very judicious in the number of instances in which it has asked for that authority. And second, I would emphasize that when we do go in and do the backup examinations, we certainly do not seek to duplicate the work that is being conducted by the primary supervisor.
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    Mr. BENTSEN. When you go in to do backup exams, and my time is up and you can answer for the record if you want, do you look at sub-prime portfolios and credit card portfolios, do you actually crack down on lenders in saying that you are extending credit to people who may have too much credit at this point in time and it is creating risk?

    Ms. TANOUE. Looking at sub-prime lenders is not necessarily in the context of the backups, but let me just say that when we look at these lenders, we are looking at whether they have appropriate safeguards in place, and certainly there are many, many sub-prime lenders that do. In trying to develop a proposal, we were trying to focus on those sub-prime lenders that do not have appropriate safeguards, whether it is an appropriate underwriting program, sufficient allowances for loan losses, and again, capital.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Mr. Bentsen.

    Mr. Royce.

    Mr. ROYCE. Thank you, Mr. Chairman.

    I have a couple of questions, and one would be why would the OCC ever consider refusing FDIC access to a national bank that is considered a problem, considering that the FDIC is the steward of the insurance fund and yet since 1994, the prior OCC access agreement with the FDIC has been shelved? My other observation would be as to response to the statement that Keystone was an aberration. Maybe it was an aberration, but it is still three-quarters of a billion dollar aberration, it is the reason we are here, it is over 95 percent of the loss to the fund. And the OCC reports that an audit of the Keystone Bank not long before its collapse revealed no significant deficiencies. This would seem to call into question the reliability of these audits as a tool for detecting fraud, so are audit guidelines and standards adequate? Are auditors performing the necessary procedures to determine the risk of fraud? And do you believe examiners are placing undue reliance on audits completed by the bank's external auditor? Those would be my questions for the panel.
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    Mr. HAWKE. Those are excellent questions, Mr. Royce. On the first one, the answer is we would not and have not denied the FDIC access to any bank that has any semblance of a problem, and we will not do that in the future.

    Mr. ROYCE. Then why not just change back to the agreement prior to 1994?

    Mr. HAWKE. Essentially, that is where we are. I would be happy to brief you personally on the situation in Keystone. But let me say that that situation related to the unique and unprecedented facts and the conditions that our examiners faced in the Keystone situation.

    With respect to the audit, one of the supervisory actions that we took in Keystone was the imposition on the bank of a formal written agreement that required them to engage a national auditing firm that had experience in securitizations. Our agreement specified a whole list of tasks that those auditors were to perform. In November of 1998, the auditors told our people on-site that they had reconciled all of the major accounts of the bank and that the bank's balance sheet had not been in such good condition for ages. It was shortly after that that they issued an unqualified opinion and it was four months after that that we discovered a $500 million hole in the bank's balance sheet.

    I think your point about reliance on audits is extremely well taken. That was a situation where we were not just dealing with a run-of-the-mill audit, but an audit that was being conducted under specific ground rules and guidelines that we had laid down, and even then the underlying conditions were not discovered. So tightening up on audits and being much more cautious about our reliance on external audits are things we have to give very serious consideration to.
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    Mr. ROYCE. I think we really need a postmortem on this case. We really need to look at what went wrong because of the magnitude of it.

    Mr. HAWKE. We would be happy to brief you on it.

    Mr. ROYCE. I would appreciate it. Thank you. Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Mr. Royce.

    Ms. Schakowsky.

    Ms. SCHAKOWSKY. Thank you, Mr. Chairman.

    I heard what you said, Chairman Tanoue, about this being an early stage kind of proposal, and even some suggestions, Mr. Hawke, that this discussion is really premature and perhaps inappropriate, but I want to thank the Chairman very much for this hearing and an opportunity for me at least to be able to listen to the issues that are under discussion and to at this early stage offer again what seemed to be a clear suggestion from a number of people, a number of my colleagues. And I would also like to say that I think that everything that has been said has been very constructive and I hope helpful in the development of these proposals. But certainly the concern over the proposed increases in capital requirements and the effect that that might have in some of the sub-prime lending, I was looking at an article, the Bureau of National Affairs and some quotes from the Director of Regulatory and Trust Affairs at the American Bankers Association and the Regulatory Council for America's Community Bankers where they raised those concerns. The ABA spokesperson, Jim McLaughlin said, ''I am afraid there will be some level of stifling effect that this proposal may have unless the regulators are very careful about it and they get the word out that there are some low- to moderate-income buyers who may have a problem. And that America's Community Bankers spokesperson pointed to an example given in the appendix of the draft proposal that classifies auto loans as prime or sub-prime according to their credit scores and it says that it is a very arbitrary cutoff—there was actually a number given—a very arbitrary cutoff. A person can have a credit score below 620 just because they missed a few payments on a utility bill.
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    So, Mr. Meyer, when you say that we need to have a more systematic approach to risk mitigation and not just a case-by-case, I think that there is some history here that says that some low- and moderate-income borrowers, because risk mitigation has been narrowly defined, have historically sometimes been denied loans, even when they are in fact pretty good borrowers. So I think that the caution that has been suggested here has been really important.

    I am also concerned, and let me end with this question, on predatory lenders in the sub-prime market and that there have been exorbitant high cost loans to senior citizens, and so forth, and I am wondering if this proposal addresses that in some way or if there are measures currently at your—and I say ''your'' broadly—disposal to stop this kind of predatory lending that increasingly in urban areas we are seeing?

    Ms. TANOUE. The proposal is designed to be a safety and soundness proposal, so it does not really address predatory lending practices and any types of consumer protections that might be necessary. Certainly the subject of predatory lending is one that concerns everyone. We cannot condone such practices. We do have a panoply of laws that are at our disposal so that we can keep a watch on those types of practices.

    Ms. SEIDMAN. Let me add I think there are some safety and soundness issues involved with predatory lending in addition to the consumer issues. I think we have to deal with both of them, and we are moving ahead on an individual supervisory basis. I think there are also some things that we need to look at with respect to both unregulated and regulated institutions and how the laws are playing off each other in a manner that may facilitate predatory lending. It is something we are focusing on at OTS.
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    Mr. MEYER. The first part of your question goes to the heart of defining sub-prime lending. After all, it is supposed to be defined—it is defined—we generally define it as lending to borrowers who have higher default probabilities. It is not that easy necessarily to determine that, which I think is the point of your question. So where we have methodologies that we think are reliable, where there are systematic relationships between debt-to-income ratios and blemished histories and default probabilities, then we have to take that into account. We also have to be careful—we have to do a careful job of it so as not to either deny credit or impose higher cost of credit on those for whom the borrowing isn't really any more risky.

    Mrs. SCHAKOWSKY. Thank you.

    Chairman LEACH. Thank you very much.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you, Mr. Chairman.

    The only thing with which I am concerned, particularly in Keystone, is that they use the title ''Keystone'', because it does not necessarily reflect West Virginia. It reflects Pennsylvania. So we can make it very clear it was not a Pennsylvania bank that was involved.

    Chairman LEACH. Would the gentleman yield? I am embarrassed to tell you one of the failures was an Iowa bank, but it is the only bad bank in Iowa. No, I am kidding.
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    Mr. KANJORSKI. Why did it take four years for the regulators who had suspicions and were looking to find this problem? It seems to me an inordinate amount of time. If I were running a business and fraud was occurring in my business, I would suspect that in four years all my equity would be gone. It seems to me when you see there is something that may be happening incorrectly, there must be a way, particularly considering the modern age of computers, to identify it more quickly. A simple thought of mine is that if you do suspect fraud going on in a bank, why cannot there be a system that puts the bank on an instantaneous monitoring device in order to view their transactions as they occur, thereby correlating transactions to see if there is a security being pledged for six loans. This way, it can be determined whether a security does not, in fact, exist or it is double-counted. Implementing such a program is not a very difficult thing to do.

    Mr. HAWKE. Mr. Kanjorski, I may have said this before you came in, that we are a little bit limited in what we can say publicly because of the pending indictments, but I think I can address your question.

    There was no suspicion of fraud at Keystone until very late in the game. We were addressing in the earlier years the deficiencies that were obvious. There was a lack of internal controls. There were management system problems. There were questions of accuracy of call reports. Those questions were all addressed. Remedial actions were taken. At a subsequent point in time, we became concerned about the way residual values were being calculated in connection with the securitizations. Those issues were addressed. We put a written agreement on the bank in May of 1998 that required the engagement of a national auditing firm that had experience in securitizations, and we gave them a whole laundry list of things to look at. They came back with a completely clean audit and assurances to us that the bank's balance sheet had never been in better shape. They said that after saying that they had reviewed and reconciled all the major accounts in the bank. It wasn't until we and the FDIC went back in, in 1999, that irregularities caused us to push very hard for certain information that we were not being given access to and when we persevered in that, we got the information that eventually revealed the circumstances that caused us to close the bank. So this was a process of dealing with issues as they were coming up, getting remedial action, and then going on to the next set of issues as they arose.
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    Mr. KANJORSKI. What was the size and population of the community in which Keystone conducted its business?

    Mr. HAWKE. It was a tiny community. Our examiners had to go to the next town to have lunch because they didn't have a restaurant in the town.

    Mr. KANJORSKI. I live in a small town, too. If a small town bank started conducting a billion dollars worth of work, I would certainly hear about it, and I would be awfully suspicious as to where that activity is.

    Mr. HAWKE. The activity came from the business of securitizing Title I FHA loans that the bank had embarked on in 1993. That, plus a change in the accounting rules caused them to book very large residual values as assets on the balance sheet, which contributed to the bank's growth. There is no question that kind of growth gave us concerns. It gave us concerns about the bank's capacity to handle that kind of business, about the systems and controls that they had in place, and about their methodology for valuing the residuals and those were all things that we bore down on during those earlier years.

    Mr. KANJORSKI. It reminds me of an insurance fraud scandal, and I hate to mention a name, but Equitable is in the title. About ten years ago, about 2,700 people involved with the organization in New York were going out to lunch and making up fictitious names to write life insurance policies. They actually had entered into their computers about $5 billion worth of policies that did not exist, and the only way these transgressions were caught was by having the auditors come in during off-hours and evaluate the policies. Other than that, it was a self-sustaining operation. Well, this sounds to me like Keystone acquired a copy of this case study and figured out just how to similarly manipulate the system while aparently the regulators did not read a copy of it due to Keystone's initial success. I am just wondering, whenever there is something of a high turnover of an extraordinary nature occurring within in a bank, particularly a small community bank, is there a computer program available in regular monitoring to indicate and identify improper transactions?
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    Mr. HAWKE. I am not sure the detection of fraud can be reduced to a computer program. It requires a high degree of specialized training of our examiners. We are doing that. Chairman Tanoue made the point earlier in the hearing that one of the most telling signs that should alert examiners to the possibility of fraud is the resistance of management to providing information that the examiners think is necessary. Both of our agencies, and I think the others as well, have put out very strong statements to our examining forces on that subject.

    Mr. KANJORSKI. Thank you, Mr. Chairman.

    Chairman LEACH. Mr. Sherman.

    Mr. SHERMAN. Thank you, Mr. Chairman.

    It would appear that the losses can occur in three ways. You can have bad business decisions or stupidity in the lending decisions of the bank, and I don't know if there is a way to catch that until you go in and look. There is fraud, which I don't think can be discovered until you go in and look. But the third is that a bank simply has chosen to engage in a high risk strategy, one that might be in an appropriate profit making enterprise, but one that because of FDIC insurance, the high risk upside accrues to the shareholders and the downside accrues inappropriately to the FDIC. Do you have a mechanism for just looking at the yield that a financial institution is earning and do you then automatically question when this yield seems to be 4 points, 6 points, 8 points higher than the cost of funds in a relevant area or some other measure of what rate of return can be earned on SAIF loans?

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    Ms. SEIDMAN. I think all of us have systems in place that have hits, such as excessive growth, and excessive yield. There are a whole lot of monitoring devices that we use. I am reminded, however, that we just explained in our directors' seminar, one of the responsibilities of the board of directors is that when their bank is earning too much money, they have got to find out why.

    Mr. SHERMAN. But do you have a way of knowing—let's say a bank embarks on a high risk strategy tomorrow and half their assets are invested in very high yield investments within three weeks. When would you know about that? Is there a weekly or monthly reporting system where they tell you what their average yield is?

    Mr. HAWKE. I think it depends on the size and nature of the bank. In the thirty largest banks that we supervise, we have resident examination teams and they would probably learn about a significant change in the bank's business profile very quickly. Those are really not the banks we are concerned about. We are much more concerned about the smaller banks that don't have the capacity to manage or control a significant new line of business. We would normally pick that up in our quarterly reviews of the banks. We are not in those banks every day. They are not subject to daily or weekly or monthly reporting requirements. We examine them on a twelve-month or eighteen-month schedule, but we have detailed quarterly reviews of those banks, and the examiner in charge of each one of those mid-size and community banks keeps in touch in that way.

    Mr. SHERMAN. Let me suggest that you have a requirement to file a form on a monthly basis if a bank is earning yields above what conservative practices could at that time achieve, not that these banks might not be very sound. They might have a lot of capital, appropriately capitalized so the shareholders assume the risks or they may be engaged in an activity where yes, it is high yield, but the yield is high not because there is high risk, but because there is high service cost where they are making a lot of $3,000 loans or $2,000 loans, but where there is high yield without high cost in a capitalist well-run market system, you would expect that is because there is high risk and if there was an extra reporting requirement or system that you had for detecting that rather than waiting on a quarterly basis, it might.
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    Moving on, I see that there are certain types of practices that you are thinking of prohibiting and I think that might make some sense, but I would not underestimate the ability of my former profession, the lawyers, to come up with new ways to design high risk instruments and even if you are able to say, well, you can't make this kind of loan or that kind of loan, if a financial institution wants to play this game of well, either we are all going to be millionaires or the bank goes broke and FDIC picks it up, it may be necessary not only to define certain instruments, but to monitor certain yields.

    My time is almost over, but I may have time for one more comment and question and that is, high risk loans can be too high risk consumer loans, but you can kind of monitor what is happening there. You have thousands and thousands of loans. They can be high risk loans because it is a big house or it could be a high risk loan because it is a small business. From a national policy perspective, I am more interested in seeing capital flow to small businesses than people who want to buy $3 million homes with 10 percent down which is not uncommon in my district. Is there anything in your rules that encourages banks to loan $2 million to a small business rather than that same $2 million to someone who wants to live in a particular large home that they can't necessarily afford?

    Mr. MEYER. I want to address the earlier part of your question because I think it is extremely important. It has to do with the flow of information. We are trying to deal with all the ways we as supervisors could deal with higher risk lending, and I think you pointed out one additional item other than on-site examinations, looking at management processes, transaction testing. It is a flow of information to supervisors, particularly in between their on-site examinations.
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    I want to stress that because we hear a variety of conflicting points of view, often from committees like this who worry about regulatory burden as we increase reporting requirements. I just wanted to give you forewarning in advance that we have been hard at work on trying to reduce the number of reporting items in the core report, which I am sure this committee and other committees have stressed very strongly. What I want to forewarn you about in the process of worrying about some of these new activities like sub-prime lending and securitization, we have come up with additional reporting items which we think are very important to give us adequate and timely information that can help us prevent problems such as have occurred.

    So I hope you will give that careful consideration as we move in that direction. Whether or not we should get information on an even more timely basis, as opposed to the quarterly call reports, and go to something that is even on a shorter duration, I think we will have to consider what the regulatory burden of that is.

    Mr. SHERMAN. I want to emphasize I am talking about a report that would be filed only by a few institutions around the country. If you look at the average cost of funds, and I don't know the terminology, so I am kind of inventing, there is a certain spread that the average financial institution has so if the average cost of funds is 6 percent, the average institution might have its money lent out at 10 percent and that would be a 4 percent spread. If you have a financial institution whose average spread on their portfolio is double or triple national averages, if you have a financial institution today whose average loan is at 16 or 18 percent on real estate loans, 20 percent on business loans, I think that would be so few institutions that it wouldn't be a burden on the entire industry. Most community bankers want to do regular banking, but you ought to have a means of noting when some bank has taken a major part of its portfolio way outside the mainstream.
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    Mr. Chairman, thank you very much.

    Chairman LEACH. Thank you very much.

    Let me just conclude with a couple of observations. As the panel understands, you get mixed signals from Congress about too much regulation, too little regulation. When there is a problem you get hit with one. When there are good times, you get hit with the other. So it is a difficult line to walk.

    With regard to the largest failure, which is Keystone, there does appear to be some imperfections. I want to go back over a timeframe. 1993 was a bellwether year. Under a prior Comptroller there was an insistence that arrangements be changed. Then-Chairman of the committee, Henry Gonzalez, and I, as the Ranking Member, wrote a very definitive letter to the FDIC objecting to the changes that were underway. Some of this is psychological, some of this is substantive—psychological in the sense, what is the FDIC? Is it the chairman and the institution or is it the board? And basically Congress set up a board which presumably had some independent authority to serve as the FDIC and so the board made a legal change. On the other prior procedures which had the effect of weakening the FDIC chairman and the FDIC itself and so you have a psychological issue that then developed. Psychologically the FDIC, as we have been able to develop in talking with a number within the institution, feel they got chilled from some of their independence and they feel that a circumstance developed in which they partly were at war with the OCC in terms of their independence. Now, subsequently under Comptroller Hawke there has been a movement toward a greater collegiality with the FDIC and certain steps have been made, but I don't think it is correct to say that there were no imperfections on the Keystone issue as we review the circumstance, and it has been reflected here that there has been coordination from beginning to end. However, in July of 1997, the OCC gave the bank a 3 rating, the FDIC a 4. In February the FDIC requested three FDIC examiners. This request was initially denied by the OCC. Subsequently, two FDIC examiners were allowed in the third quarter of 1998 to examine Keystone. But in the first quarter of 1999, despite the statement about beginning to end cooperation, there was a very critical meeting between the OCC and Keystone's accountants regarding the valuation of residual assets and the development of a residual valuation model of which the FDIC was not allowed to take part, was not informed of.
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    Mr. HAWKE. I believe that meeting wasn't held, Mr. Chairman, but I may be wrong. Let me say this, that the FDIC participated in the 1996 examination. There was constant communication between our field staff and the FDIC field staff. They were fully informed about the 1997 examination, which they did not request participation in. In the case of the 1998 examination, we frankly made a mistake in initially turning that request down, but it was totally without prejudice to the FDIC's interest. Chairman Tanoue has made clear that the ultimate result would not have been changed by that, and, as a matter of fact, the examination was accelerated. After that decision was corrected and——

    Chairman LEACH. I appreciate what the gentleman is saying. I am trying to conclude and I was going to come back and say despite all of this, I do not think that this issue has been totally central to the Keystone failure. That is the point I would like to stress. I have received the impression in subsequent months that it isn't the Government's fault that fraud occurred and that there was inadequate attention to some of the issues of fraud related to seeking an independent auditor's accountability for reporting. I just want to make a point that this is a responsibility of the Government, not simply an independent auditor. It is bizarre and I would say one of the single failures of the FDIC and the OCC appears to be not checking on whether certain instruments actually existed and then arguing that a bank that put its bet on not having the validity of these kinds of instruments checked by the Government regulator, whether it be the OCC or FDIC. Again, this appears to me to be the single greatest failure in oversight of this particular bank. But having said that, when it comes to this issue of cooperation, and I believe it is an issue of cooperation between the OCC and the FDIC and also between the OCC and larger banks and increasingly the Federal Reserve, it would be the expectation that there would be cooperation that would not involve any implicit chilling at the FDIC. It is my view that based upon the assertions of the Comptroller, you are moving appropriately in that direction. So I think that this minor issue, although it is almost a billion dollar issue, so one can't define it as too minor, but it has raised some concerns that are being addressed institutionally.
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    Now, whether or not you need legislation is an awkward thing. It was the view of Chairman Gonzalez and myself, as explicitly framed in a letter in 1993, that prior statute envisioned the full independence of the FDIC. Now, one of the questions with the arrangement that the prior Comptroller made, which was clearly made with an effort to limit the FDIC's independence, was a direction that is in compliance with the FDI act. I think it probably was. Whether it was perfectly wise, I think it probably was not. So it could be that we don't need a legislative shift, we simply need an attitudinal shift. But it will be very important to me as we look forward in the next several months what sense I get from the FDIC and whether or not they feel they are being chilled, which is a psychological issue, not a legal issue and likewise I think in other regulatory circumstances.

    In any regard, and I am sorry we devoted no time to the Iowa bank failure, which has a number of implications, particularly relating to public deposits which are very interesting, and a State law that has other banks in the State pick up the non-insured public deposits. But whether there is adequate covering of this and other State laws is something that is of interest to me. I think as embarrassing as the failure was in Iowa, the good news in Iowa is the other banks are under law picking up the public deposits, and that is very important for the system.

    In any regard, I would just return to the theme that is the crucial one and that is we have had what I believe is a very embarrassingly sized several failures in exceptionally good economic times involving extremely small banks and that should raise very real concerns about what happens in more difficult times with larger institutions. The only concluding point I would make is it certainly would be the hope of all of us that cooperation is the mainstay arrangement.
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    I am concerned about some issues that haven't been raised that were slightly touched on in Governor Meyer's testimony about the question of whether we can have adequately trained regulators given the new kinds of instruments that are fast developing and whether the training can be of a nature that keeps up with the pace of change in the industry. But I think those are issues that all of you are going to have to look at together.

    Having said that, again, I would stress the big picture is the American regulatory system is quite healthy. It is extremely well intended and we have a system in place that I think serves the public in largest measure well. There has been no loss of public funds, but there has been a loss of private sector resources that have gone into the deposit insurance system and if mistakes mushroom, you can have a public sector liability.

    In any regard, does anyone want to make a closing statement? If not, I want to thank you all and we appreciate your testimony. The hearing is adjourned.

    [Whereupon, at 2:55 p.m., the hearing was adjourned.]