Winds of Change

These are truly challenging times for banks, and for bank directors. A weak U.S. economy has made it difficult for most institutions to find enough good lending opportunities to go around. Commercial real restate loan portfolios are bleeding red ink like a harpooned whale. And depressed stock prices have limited much of the industry to a grind-it-out growth strategy, which is darn tough to do when you don’t have the wind of a strong economy at your back.

It also seems undeniable that we are entering an era of heightened oversight from Washington. As I write this column in early January, the regulatory reform drama in Congress is still unfolding and it’s far from clear what the new regulatory architecture for financial services will look like-although a profound change of some kind seems inevitable. In fact, it’s already occurring. Consider what the Federal Reserve has wrought in just the last few months. In September, the central bank proposed a new rule whereby Fed examiners would review annually the compensation practices of the banks under their supervision with the authority to amend any plan that, in their judgment, poses a risk to the institution involved. And in November, the Fed released a final rule that prohibits all banks, thrifts, and credit unions from charging overdraft fees on ATM and debit card transactions unless a consumer has voluntarily enrolled in an overdraft protection program.

The nature of bank regulation is going to change significantly in 2010-and for some institutions, the changes could be drastic. The sheriffs down in Washington allowed a few bad outlaws get away with murder a few years ago and ordinary citizens are angry (as they should be), so they’re cracking down on everyone. And they’re going to pass some new ordinances that everyone’s going to have to live by.

With all this in mind, I believe there are three issues that all bank directors should be focusing on in the year ahead.

Understand the new rules of the game. Some or all institutions could end up with a new regulator under various reform proposals floating around Congress at this writing. But even if the current regulatory structure remains intact, the level of oversight has clearly become more stringent, and it’s crucial that bank and thrift boards understand their regulator’s expectations, beginning with a desire to see more strongly capitalized balance sheets. It has ever been thus, because banking has always been a highly regulated industry, but it’s a little more ‘thus’ now, than in the recent past.

Go to school on risk management. I’ve always thought that having strong risk management practices (and for community banks, that primarily means having a strong credit culture) was most important when the economy is roaring because that’s when lending excesses generally occur. The Great Recession and the damage it has inflicted on banks has reminded everyone that they are creatures of the economy and can fail if there aren’t strong risk control measures in place. Boards can’t delegate this activity to their management teams, even though management is responsible for monitoring risk on a day-to-day basis. It’s the board’s job to set the overall risk parameters for the institution and to assess whether management is staying within those limits. But how can the board discharge that duty effectively if directors can’t speak the language of risk management and don’t have a strong working knowledge of its precepts?

Focus on your institution’s business model. The imperative for directors to understand how their banks make money and how that might be impacted by regulatory and/or market forces is truer today than any time I can think of in the last 20 years. For example, the Fed’s new rule on overdraft fees will reduce an important revenue source for banks at a time when revenue is hard to come by. But legislation has been introduced in both houses of Congress that’s even more restrictive, and all banks will have to have a plan for how they will replace that additional missing revenue if either measure (or an amalgamation of the two) becomes law.

Bank directors who come from outside the financial services industry have a unique challenge compared to their peers in other less specialized corporate sectors. Banking is a complex business and it takes time for outsiders to fully understand its intricacies. This is not necessarily a bad thing, because a board comprised only of ex-bankers might be too insular, and putting together a group of smart people with diverse backgrounds usually leads to better governance. But in the face of a difficult economy and the likelihood of big changes coming out of Washington, it’s time for all bank directors to focus on what really matters.