Mester addresses economy, supervision at CBAO convention

The renewed health of the banking industry means the time is ripe to reconsider post-crisis regulatory changes, said Cleveland Fed President Loretta Mester.

Loretta Mester

Community banks are vital to the economic health of the nation, said Loretta Mester, president of the Federal Reserve Bank of Cleveland. She addressed the forty-third annual convention of the Community Bankers Association of Ohio in Cincinnati last week. Mester also spoke on economic expansion, normalization of the Fed’s balance sheet and regulatory oversight.

She opened her remarks with a complimentary view of the institutions represented by the bankers in attendance. “Community banks play a vital role in the economic health of their communities, providing creditworthy businesses the wherewithal to prosper and households the ability to improve their financial standing and quality of life,” Mester said. “Because of their important work, community bankers are among the most knowledgeable about changes in conditions on the ground in local areas.”

She also expressed appreciation for the candor with which many bankers have approached her. They offer information which often takes much longer to show up in official statistical reports. Speaking with bankers provides a key component of “the mosaic of information” Mester uses to inform her views on appropriate monetary policy, she said.

Not surprisingly, bankers also mention banking supervision and regulatory burden when talking to Mester. “I am grateful to the bankers who willingly discuss both the economy and regulation with me, and today I would like to return the favor and provide you with some of my perspectives on both,” she said, moving on to address economic expansion, the Fed’s balance sheet and regulatory oversight.

Recovery

The expansion, one of the longest on record, is now eight years old, Mester began. “The sustainability of the expansion through various economic shocks is a testament to the U.S. economy’s resiliency, and I believe the underlying fundamentals supporting the economic expansion remain sound,” she said. Output growth has maintained a moderate rate of just over two percent on average and she expects that to continue.

Last year, the economy added more than 2.2 million jobs. While 2017 has not kept that pace, the economy has added about 180,000 jobs per month, well above estimates of 75,000 to 120,000 per month. The trend employment growth has slowed in recent decades, but the recent stability of the participation rate signals strength in the market, Mester said.

Meanwhile unemployment, which peaked at 10 percent during the Great Recession, was at 4.4 percent in June 2017, matching the lowest level reached in the previous expansion. Other indicators, such as the number of part-time workers seeking full-time employment, have also fallen significantly in that time. Mester, however, expects unemployment to rise to about 4.75 percent over the next year.

Mester then changed her focus to inflation, which continues to run below the Fed’s goal of 2 percent. But she believes that conditions are ripe for it to gradually return over the next year to that goal.

Based on the economic outlook, the Fed has begun to remove some of the “extraordinary accommodation” necessary in the wake of the financial crisis. That includes return to a more normal balance sheet, which has grown to $4.5 trillion from $900 billion in 2007.

While the balance sheet is unlikely to return to its pre-crisis size, Mester expects it to be considerably smaller than it is today.

“I view the steps the FOMC is taking to normalize monetary policy — both the fed funds rate and the balance sheet — as a welcome acknowledgment that the economy is transitioning back to normal after being in the abyss of the financial crisis and Great Recession,” she said.

Reg relief?

That crisis also helped identify gaps in the regulatory architecture, Mester said, and the resulting supervisory changes have strengthened the country’s financial system.

The improved health of the banking industry, however, makes this an opportune time to reconsider the effectiveness of some of those supervisory changes. “I won’t keep you in too much suspense: the Federal Reserve and the other financial regulatory agencies are already taking steps to improve the effectiveness of their supervision,” she said.

“Community banks generally don’t impose costs on the rest of the financial system or create the kinds of contagion that can put the entire financial system at risk, so their oversight should differ from that of systemically important institutions,” Mester said. “Aligning oversight with risk helps to ensure that institutions aren’t burdened by rules that make it more costly for them to serve their customers but that do little to further the goal of a healthy and resilient financial system.”

Mester supports exempting community banks from the Volcker rule and said the Fed already is working on other regulation simplifications.

Federal banking agencies recently completed their 10-year review of banking regulations to identify unnecessary or outdated provisions. As a result of the review, 78 guidance letters were deemed out-of-date and were eliminated, and the data-reporting requirements for small community banks were reduced and simplified, resulting in a shorter Call Report.

Additionally exam frequency has been reduced for many institutions. Eighty-three percent of all insured depository institutions qualify to be examined every 18 months rather than every 12 months. A provision in the 2015 Fixing America’s Surface Transportation Act raised the asset threshold from $500 million to $1 billion.

The agencies are also working to develop a simplified capital framework for community bank organizations.

Mester also said the Fed is working to close compliance examination findings “in a reasonable period of time.”

While public opinion of the banking industry in general is low, with only a quarter of Americans say they trust financial institutions. However, nearly 60 percent of the people polled said they trusted their local bank, Mester said. “This is an encouraging sign that by focusing on safety, soundness, resiliency, and customer service, we can create a financial system that the public views as beneficial, and one that truly is.”