OCC Lacks Resources to Spot Problems Like JPMorgan's

Last week's Senate Banking Committee hearing on oversight of JPMorgan Chase's trading losses offers little explanation for the Office of the Comptroller of the Currency's role in this incident. Unfortunately, it is too easy to argue that the OCC simply failed to see this trade unraveling than to elevate the discussion to understanding the interplay between bank risk management and regulator and associated structural challenges at the OCC.

For both practical and philosophical reasons, the OCC relies heavily on bank management to have in place sound risk management practices and controls that identify and surface material risks proactively. 

Pragmatically, with an agency comprised of just over 3,700 staff overseeing 2,000-plus nationally-chartered banks and thrifts accounting for nearly $10 trillion in assets, the math simply does not support a regulatory model whereby examiners can possibly have real-time understanding of all aspects of a bank's risk-taking activities.

Over the next few years, this situation is likely to be exacerbated. By 2015 about one-third of the current OCC workforce will either be retiring or be eligible for retirement. Considering that the time it takes to become an experienced national bank examiner ranges from five to 15 years, it will be difficult for the OCC to replace seasoned examiners, particularly those with specialized expertise such as in capital markets. 

These statistics are even more alarming for the OCC's leadership corps where 59% of senior management will reach retirement age in the next few years. Compounding these workforce issues is the fact that the workload of the OCC and its sister regulatory agencies has ramped up sharply since 2009, both in terms of its supervisory responsibilities, but also its implementation of various postcrisis regulatory reforms.

For instance, about 100 OCC examiners have been dedicated to a horizontal review of mortgage practices across a number of banks. That is a big commitment when resources are already stretched in performing regular safety and soundness examinations. 

Moreover, looking at the JPMorgan example, the complexity of this transaction requires a level of capital markets and derivatives expertise that only a small number of OCC examiners possess. In this specific case, five examiners were assigned to the London office where those transactions were purportedly made. The reality is that the OCC cannot simply be expected to have a full line of sight into such transactions under the agency's current operating model. 

Obtaining the right balance in supervisory oversight has always been a challenge for bank regulatory agencies that face a host of political and market pressures. And yet the OCC in some respects bears a number of similarities to the Federal Aviation Administration in its oversight of airliner maintenance for thousands of different kinds of aircraft. 

The FAA employs more than 47,000 people. Among its many duties, it issues numerous bulletins regarding required maintenance on all aspects of airframe safety and performs periodic inspections against those requirements. In a similar way, the OCC issues an array of bulletins and guidance documents on various aspects of bank management for national banks and thrifts and performs regular and targeted exams against these supervisory requirements. 

With the lives of passengers literally at stake for the FAA, the level of oversight must be higher at FAA than at OCC, as must the airline regulator's staffing levels to ensure safety in the skies. This leaves the OCC heavily dependent on the competence and compliance of bank management with its guidance. 

Yes, there are areas where the OCC can certainly do more with its limited resources, such as in developing better data, risk identification and measurement infrastructures to support examination teams. But much of the responsibility for proactive risk identification falls on the shoulders of bank management to ensure it has established appropriate risk governance and controls over its activities.

 As it relates to derivatives transactions, for instance, accounting principles clearly establish a set of standards for what an effective hedge transaction should be. These include a well-articulated strategy regarding the nature of the underlying position being hedged, the derivatives employed in the hedge position and how the effectiveness of the hedge relationship will be measured on an ongoing basis in order to maintain eligibility for hedge accounting.

In the specific case of JPMorgan, such information should have been seen by the bank risk committee and made available to OCC examination staff well in advance of losses being incurred. Armed with that information, the OCC would have been in a position to have discussed the nature of the trading strategy and risk with bank management, leading to actions by the bank to reduce that risk if warranted. 

At this point we do not have sufficient information to know what was revealed to the OCC in the period leading up to the announcement of the trading losses. But as more details emerge on this incident, the OCC's effectiveness at handling this issue should be judged against the practical realities and philosophy of bank supervision and not on unrealistic and uninformed expectations.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.