The unchecked power of federal bank regulators

The Federal Deposit Insurance Corporation (FDIC) has neutered its system of independent review for the material supervisory decisions it makes concerning banks’ activities. That is a problem. Why? Because the FDIC is, perhaps surprisingly, one of the more powerful agencies in the federal government with an almost unlimited regulatory oversight over banking.

One tool the FDIC uses in this oversight role is supervision, where it monitors banks to detect and preempt threats to their safety. While most supervision is no doubt done competently, there are times when mistakes are made, or when legitimate differences of opinion arise between banker and supervisor. Further, this process is often opaque and, unfortunately, is sometimes abused in attempts by FDIC officials to control industries engaged in legal-but-disfavored activities. In the past, this has led to lawsuits and some uncomfortable acknowledgments that the FDIC failed to uphold its policies.

What makes supervision so powerful, and so fraught, is how little process and oversight is involved. FDIC officials can reference vague federal agency guidance language, rather than a legal statute or binding rule, to discourage banks from engaging in disfavored activities. Banks know that if they don’t comply, the FDIC can make matters difficult without formal action that could be challenged in court. Banks also recognize the importance of having a good relationship with their supervisors, including the FDIC, and rarely challenge the agency.

Cognizant of the challenges posed by bank supervision, Congress mandated in 1994 that the federal banking regulators, including the FDIC, establish internal independent appeals processes where banks could appeal what examiners judged to be material supervisory findings. From 1995 to 2019, the FDIC used, in various configurations, the Supervisory Appeals Review Committee (SARC). The SARC was staffed by one of the FDIC’s three inside directors, who served as chair and representative of the other two. If there were vacancies, the chair could appoint others to fill the gap.

This arrangement still presented a problem. While the officials reviewing the supervisory decisions were usually in a different reporting chain than those doing the supervising, they were still dependent on maintaining relationships with the other staff. Further, to the extent that the dispute implicated the regulatory or supervisory agenda of FDIC leadership, the officials on the SARC may find themselves judging their own policies. Finally, in a situation like we are currently in, where there is only one inside director at the FDIC, that director would be able to choose who else sat on the SARC.

To address this, in 2021 the FDIC established the Office of Supervisory Appeals (OSA), which was to be a truly independent office staffed by former government employees with bank supervisory experience. Unfortunately, in March of this year, the FDIC announced an about-face, returning to the SARC structure. It did not even solicit public comment before making the change, though it did open up a short comment period after the change was made.

We, among others, opposed this change and how it was done. The change made the appeals process less independent and credible, which is vital to the FDIC’s ability to properly do its important job. The process prevented meaningful feedback. Perhaps to address the obvious weakness of returning to the SARC arrangement, the FDIC recently announced that it would make some additional minor changes and opened up another short comment period.

While the newest proposal is a slight improvement over the FDIC’s initial regression, it remains inadequate. Gone is a truly independent office, replaced with the problematic old system. While the latest proposal adds the FDIC’s ombudsman (as a non-voting member), the ombudsman is not empowered to act and reports to the chair, who is the most senior management over supervision. Thus, there is little reason to assume this will bring needed independence to the appeals process.

The FDIC’s work is too important to have its decisions languish under a cloud of suspicion. It needs to maintain credibility, which is best accomplished using an appeals process that is truly independent and staffed by knowledgeable, but neutral, officials. Restoring the OSA would benefit the FDIC and the banks it supervises, and it will improve the reliability of the review process and credibility of the institution.

Brian Knight is the director of innovation and governance and a senior research fellow at the Mercatus Center at George Mason University. Thomas Hoenig is a Mercatus Center distinguished senior fellow, a former vice chairman with the Federal Deposit Insurance Corporation (FDIC) and a former president and CEO of the Federal Reserve Bank of Kansas City.