Comptroller Dugan Tells Bankers That Supervisory Process Must Support a Competitive, Safe and Sound Banking Industry

CHICAGO – Comptroller of the Currency John C. Dugan said today that the supervisory process must support a competitive banking industry that takes risks and innovates, while also ensuring a safe and sound system that avoids excessive risks.

For example, proposed regulatory guidance on nontraditional mortgage products "is not intended to ban innovative mortgage products," he said in a speech to the Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago.

"We believe that financial innovation is vital to promote the national goal of homeownership, and we encourage it," he added. "What our proposed guidance seeks to do instead is to ensure that all nontraditional mortgage products are properly underwritten and disclosed. We believe this will help promote sound and sane practices in the mortgage market and thus serve the interests of the banking system and the general public."

Mr. Dugan said supervision works best when it helps banks in the identification of emerging and growing risks – a process that encourages banks to develop advanced tools and techniques to manage those risks, for their own account and for their customers. Both the proposed real estate guidance and a separate proposal on commercial real estate reflect that approach.

"Neither is intended to restrict the availability of credit to finance commercial real estate or home sales," Mr. Dugan said of the two proposals. "To the contrary, each is intended to address concerns early, effectively, and without undue disruption. This, in turn, is intended to foster a climate of stability in which credit remains available on reasonable terms to support developers and homebuyers alike."

Mr. Dugan said the business environment that banks operate in has seen much change since he last addressed the Chicago Fed conference, as Deputy Assistant Treasury Secretary 15 years ago. Not very long ago, he said, most business transactions were fundamentally local, but today even small businesses have global ties.

"Their involvement in global markets has produced growing exposure to fluctuations in commodity prices and foreign exchanges rates," Mr. Dugan said. "And that, in turn, has increased reliance on more comprehensive and integrated analysis of risk and the most sophisticated risk management tools."

There have been two types of responses to the new competitive environment—one from banks that seek new opportunities in evolving markets, and another from those that choose to specialize in markets where they have particular expertise and experience, he said.

"Banks in the first group – typically larger institutions – have responded by diversifying their revenue streams, developing new products and services, and enhancing the features of existing offerings," Mr. Dugan said. "They have embraced the world of multiple risks as a way of cushioning themselves against excessive exposure to any one risk."

The members of the second group, often midsize and community banks, have concluded that their competitive advantage lies in superior knowledge, service and efficiency, and therefore narrowed their focus to regional geographies and to specific products and services, he said.

"Larger banks – the ‘diversifiers,’ as I have termed them – have come to dominate the national market for home mortgages, while smaller banks have increasingly focused their attention on the localized market for commercial real estate loans," Mr. Dugan said. These two very different approaches to real estate lending have resulted in two very different types of risk.

Commercial real estate markets are inherently cyclical, which adds risk to lending in this field. Although loan quality has risen as risk management techniques have improved, the concern today is growing concentrations and how they are managed.

"I should emphasize that, while concentrations pose a known risk to safety and soundness, this risk can be effectively addressed if properly recognized and actively managed," Mr. Dugan said. "Of course, banks with real estate lending concentrations must also have adequate capital to address the increased risk, as most of these smaller banks already do."

Although traditional home mortgage lending has posed far less credit risk for banks than commercial real estate lending, the increased use of interest-only and payment-option mortgages as a tool to make mortgages more affordable has increased bank exposure to both credit and reputation risk, he said.

"But what happens if rates rise, or house prices fall, or both occur?" Mr. Dugan asked. "A borrower could easily be stuck with a mortgage that exceeds the value of his or her home, making it very difficult to refinance or sell the home."

This could lead to default and foreclosures, and expose the lender with a portfolio of such loans to a much higher credit risk than would be the case with traditional mortgages, with possible implications for their capital and earnings, he said.

Even if negative economic factors become a reality, this cluster of concerns with nontraditional mortgage products might not result in the failure of a single bank, Mr. Dugan said. "But in combination they nevertheless have the potential to impair an institution’s earnings and capital; sully its reputation; impair its relationship with consumers; and impede its ability to fulfill the public’s future need for home loans."

"Knowing when to intervene in business of the banking system – and to what degree – will always demand the exercise of subjective judgment," Mr. Dugan said. "The OCC brings long and specialized experience to this critical mission, and we will continue to work hard to strike the right balance in our guidance on real estate lending."

Related Links

• Speech Text (PDF)
• Comptroller John C. Dugan