Federal regulators are moving to tighten oversight of the relationships between community banks and their core service providers, aiming to increase transparency and address long-standing concerns about a highly concentrated market.
The Federal Reserve Board, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the National Credit Union Administration jointly proposed new guidelines for third-party relationship supervision on Friday morning. The guidance is specifically aimed at improving the dynamics between community banks and the core service providers that handle many of their most critical back-end functions.
What the Proposal Covers
Core service providers perform essential and technically complex operations for client banks, which are typically small- to medium-sized community banks and credit unions. These functions include account management, transaction processing, and loan servicing. According to the agencies, many small banks and credit unions have come to rely on these firms to remain competitive in a rapidly evolving market.
The proposal would give regulators more supervisory authority to examine transparency, contract structures, and technology components within these relationships. It calls for additional scrutiny of core services arrangements that provide limited transparency to community banks, as well as those that “unreasonably limit [banks’] ability to conduct due diligence and ongoing monitoring or to negotiate contract terms that address their business needs.”
The agencies also highlighted the highly concentrated nature of the core services sector, which leaves banks with few alternatives. The proposal seeks to address some of the competitive challenges that arise from such constrained market dynamics through risk-based examinations of these arrangements.
Because core servicers play a unique role in providing technology to community banks, the proposal also calls for closer oversight of their technology investments and capabilities.
A Principles-Based Approach
In a joint statement, the agencies said the proposed guidance reflects their supervisory experience and lessons learned from examining financial institutions’ third-party risk management practices. It is intended to help banks and credit unions better align and tailor their third-party risk management practices to the risks of individual third-party relationships.
The agencies noted that the guidance uses a “principles-based approach” and is not binding.
Separate Proposal for Traditional Community Banks
Alongside the broader core servicing proposal, the agencies issued a separate joint proposal specifically for so-called “traditional” community banks and their third-party service providers. This second proposal calls for less supervisory oversight of banks that do not engage in novel activities, such as fintech partnerships and digital asset services.
Fed Gov. Michael Barr dissented from the proposal, taking issue with the fact that the guidelines for the traditional community bank proposal were more specific than the broader third-party guidelines. He argued that community banks engaged in fintech partnerships and digital asset services would likely benefit from additional and more precise guidance on managing their third-party relationships.
“Experience suggests that many banks with complex business models are especially in need of guidance that better addresses their particular third-party risk management issues, which is not addressed in these proposals,” Barr said.
Barr also expressed concern that the proposals’ call for giving “due consideration to a banking organization’s reasonable decisions” could be interpreted as the agencies deferring to individual banks to set their own best-practice standards. He further flagged that neither proposal mentions consumer compliance standards, which could inadvertently remove oversight of such issues from the agencies’ guidelines if the proposal is adopted as is.
“A final rule could end up rescinding existing guidance, leaving a big gap in risk, or banks could end up needing to comply with two sets of guidance, sowing confusion and increasing burden,” he said.
Barr was the lone dissent on the Fed Board of Governors, which voted 6-1 to issue the proposed guidance.
Support for Responsible Innovation
Fed Gov. Lisa Cook issued a statement supporting the proposals as a needed step to facilitate responsible innovation within the community banking sector.
“It is important that the Board continue to foster responsible innovation and facilitate banks’ pursuit of third-party arrangements in a manner consistent with safe and sound practices and in compliance with applicable law, including those designed to protect consumers,” Cook said. “A principles-based and risk-focused approach may be helpful towards promoting these goals — especially for enabling innovation and competition for vendor services.”
The proposals will be open to public comment for 60 days following publication in the Federal Register.