Welcome to the Great Unknown

In early September, members of the compensation committee at Alliance Financial Corp. in Syracuse, New York gathered to begin educating themselves on the massive financial reform package that became law over the summer. They went through a summary of key pay-related provisions of the Dodd-Frank legislation and discussed what might need to go first on the committee’s to-do list.

“We realized more is unknown than known” about the law’s specifics, explains Lowell Seifter, 57, the committee’s chairman and a partner at Green & Seifter, a Syracuse law firm. “But what is known will be more than enough” to keep directors scrambling for the foreseeable future.

In next year’s proxy statement, $1.5 billion Alliance’s board must offer shareholders the chance to weigh in on executive compensation and decide how often they’ll hold such votes in the future. While the so-called “say-on-pay” resolution is nonbinding, no reasonable board member could ignore a thumbs down from a majority of the shares voted.

The committee also has begun compiling data for an anticipated requirement that the proxy include a comparison of Chairman and CEO Jack Webb’s pay with the median compensation of all Alliance employees.

The numbers in the so-called “internal equity ratio” won’t be all that bad-at least relative to most other banks. Webb got a 5.5% increase on his 2009 base salary, which puts him right at the 50th percentile versus 19 peer-group CEOs. With incentives, he could roughly double that total.

For the board, the real challenge lies with the time and costs involved in calculating the figures. “You have to go through [information on] all of the employees-not just their wages, but their life and health insurance, their dental plans, and cafeteria plans. How do you cost out all of that for all employees? And if someone works part-time, do we annualize that?” Seifter asks.

“It’s going to be a huge burden to figure all that out,” he adds. “But we don’t have any choice. We have to disclose it.”

These are just a couple of the many new tasks that await bank boards and managements in the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Passed in July as a response to a devastating financial crisis that persists today, the 2,300-page act represents a sweeping rewrite of the rulebook for American commerce in general and banks in particular.

Dodd-Frank’s primary goal is to foster greater system stability by increasing oversight and forcing banks to maintain fortress balance sheets. Institutions will need more regulatory capital than they’ve had in the past-common equity, please, no trust preferreds-and almost certainly will face tougher examinations and higher compliance costs. Certain businesses that are perceived as being too risky for banks to be involved in, such as private equity investments or proprietary trading, either face stiff limits or are altogether out.

At the same time, many other popular forms of fee income face stiff limits in the name of consumer protection. The underlying assumption is that banks are charging too much for such services as overdraft protection and need to be reined in.

The law is so complicated-and, critics say, so poorly thought out-that even regulatory attorneys can’t keep things straight. One reason is that so many of the actual rules have yet to be written.

According to an analysis by the Cleveland-based law firm Jones Day, Dodd-Frank explicitly calls for more than 240 rulemaking efforts and nearly 70 studies by 11 regulatory bodies. The rule of thumb in Washington is 10 pages of rules for each page of legislation, which means roughly 23,000 pages of new regulation to be churned out in the years ahead.

That uncertainty has bank directors understandably concerned. “Dodd-Frank is a correction for what went wrong in the financial sector. Everybody understands that the regulations weren’t effective and something needed to be done,” says Robert Goldstein, 69, a principal with CapGen Capital Advisors, a New York-based private equity firm that invests in banks. Goldstein is also a board member for three banks, including $8.8 billion F.N.B. Corp. in Hermitage, Pennsylvania and Seacoast Banking Corp. of Florida, a $2.2 billion company in Stuart, along the Sunshine state’s Atlantic coast.

“The problem is, nobody knows how it’s going to be executed,” Goldstein adds. “Once the rules and studies are done, what will banks have to do? Will it be too burdensome for community banks? That’s what has everybody worried.”

The law creates more than a dozen new government agencies, including an all-powerful Financial Stability Oversight Council, headed by the Treasury Secretary, that’s charged with identifying systemic threats and regulatory gaps.

Of particular concern to bankers is a new Consumer Financial Protection Bureau, which will have its own staff of examiners and the power to write consumer protection rules for banks with more than $10 billion in assets and nonbanks (mortgage brokers, payday lenders, student lenders, etc.).

The bureau’s duties include cracking down on predatory lending practices and playing the role of fee watchdog. It will be looking for signs that borrowers are being put into loans they either can’t afford or don’t understand. State attorneys general, not always a bank-friendly group, will enforce many of the rules.

“There’s great worry that those examiners will come in and be overly zealous about protecting consumers without any regard to the impact on the bank,” says Ralph Sharpe, a partner and head of financial services risk management and compliance at Venable LLP, a Washington, D.C., law firm. “Before, you’ve always had examiners who understood how the regulations fit with bottom lines and safety and soundness. That might not be the case now.”

The law also shuffles the deck on the scope and reach of existing bank regulatory agencies. The Office of Thrift Supervision is history, its authority folded mostly into the Office of the Comptroller of the Currency. (The thrift charter itself is preserved.)

In a nod to long-standing concern over institutions that are deemed “too big to fail,” the Federal Deposit Insurance Corp. gets additional authority to proactively unwind large failing financial firms. The agency recently launched two new divisions and has been hiring additional people to take on expanded supervisory powers.

Indeed, the Federal Reserve comes out the big winner in the power sweepstakes. It is charged, among other things, with setting tougher disclosure and capital and liquidity standards for banks and nonbank financial companies. It also gets oversight of bank and thrift holding companies with more than $50 billion in assets and will conduct regular stress tests on big banks.

To be sure, Dodd-Frank offers some faint silver linings, especially for well-run banks that have avoided the worst of the credit crisis. Nonbank financial firms and foreign-owned banks will be subject to greater regulation, for instance, leveling the competitive playing field, while a permanent bump of deposit insurance to $250,000 could presumably help attract more low-cost funding.

For the first time, banks can buy branches across state lines in states, such as Florida, that have not allowed this before. For the strongest institutions, tougher regulation of rivals could fuel organic growth and present some attractive merger opportunities.

Importantly, the law provides a permanent exemption from the auditor attestation requirement for public firms with capitalization of less than $75 million-a big cost savings for many small lenders.

Even so, for directors, the pros are outweighed by the cons. New regulations will likely mean greater workloads and more scrutiny from shareholders, customers, examiners, and everyone else. Their decisions on matters such as executive pay will likely be more visible. And their institutions will make less money: Analysts say the combination of fee limits and higher compliance costs could dent the average bank’s per-share earnings by as much as 11%.

The law also is likely to heighten directors’ personal risks. Evan Rosenberg, a senior vice president and global specialty lines manager with Chubb Specialty Insurance in Warren, New Jersey, says premiums for director and officer liability insurance have risen by 50% for some bank boards since, late 2007 and could jump more due to Dodd-Frank. “It’s…the unintended consequences of passing new legislation. It presents more hooks for plantiffs’ attorneys to come up with new theories of liability,” he explains.

“Nobody is pushing the panic button just yet, because we don’t know how the rules will end up,” Rosenberg adds. “But we’ve seen this before, with Sarbanes-Oxley. As a director, you have more folks looking at you, more rules to comply with, more opportunities for mistakes, and more parties who can bring action against you.”

To blunt the ill effects, smart boards will need to learn the law’s nuances, follow its evolution, and identify their own institutions’ vulnerabilities. They’ll also have to figure out if they can still earn a decent return while absorbing higher compliance costs, and meeting greater capital requirements. Some may find they need to alter their business models or shrink their balance sheets.

More than a few critics fret that a bill meant to stabilize the system and right some perceived pricing injustices could actually make for a weaker, less-effective banking industry-one that’s too risk-averse and lacks the lending capacity and financial wherewithal to fuel an economic recovery.

“The big question is, ‘Has Congress created more instability in the industry by constraining noninterest income sources in the name of consumer protection?’” says Ralph (Chip) MacDonald III, a partner in Jones Day’s Atlanta office. “In order to survive, banks have to attract capital; in order to attract capital, they need to be able to make money. Some banks will have trouble with that.”

Dodd-Frank “is a disaster for the financial system and the country. It does not address the major issues that led to the last crisis and will not prevent the next one,” declares William Isaac, 66, chairman of consultant LECG’s global financial services practice, based in Devon, Pennsylvania, and non-executive chairman of $113 billion Fifth Third Bancorp in Cincinnati.

“If I were president, I would propose … [the] repeal of Dodd-Frank,” adds Isaac, a former FDIC chairman. “We need to start over.” (See pg 32 for Bank Director’s oneu2013on oneu2013interview with Isaac.)

A repeal is not likely to happen. Instead, many boards are working overtime to educate themselves on the law’s impact. They’re identifying their institutions’ vulnerabilities and opportunities, with an eye to avoiding regulatory trouble and perhaps turning Dodd-Frank to their own advantage.

“The danger is that compliance overtakes business development as a priority,” says Bob Calvert, a bank board consultant in Alford, Florida. “The regulators are pushing in a lot of different directions, but you have to make sure to keep your eye on the ball” in terms of growing the business amid the compliance onslaught.

Many boards and committees are planning strategic retreats or sessions with management and the bank’s compliance staff or business-line heads to get a jump on things.

As much as anything, these early efforts are aimed at coming up with an orderly process and structure for assessing the impact of the post-crisis regulatory avalanche. “Boards need to deal with this in a focused, organized way,” MacDonald says. “If you think about 2,300 pages and spend your time bouncing from title to title, you’ll get fatigued before you come up with a good strategy for dealing with it.”

There’s plenty of help to be found. Regulatory and compensation consultants, law firms, risk management firms, auditors, investment bankers, and more are doing a booming business providing advice.

At this stage, a good pair of reading glasses, and perhaps a hearing aid, helps. There’s no shortage of 100-plus-page white papers to be found online that provide solid overviews of the law’s key provisions. F.N.B.’s board members are “reading everything that comes out,” Goldstein says. “We have directors attending seminars and listening to speakers, trying to figure out exactly how it will affect individual banks.”

Ron Glancz, chairman of Venable’s financial services group, Washington, D.C., recommends that boards hire an outside law firm to conduct an initial “legal audit” of the bank and its practices to learn what regulatory and governance holes might need filling in Dodd-Frank’s wake. “There are a lot of changes here, and compliance is very important,” he says.

Board members, Glancz adds, should also request compliance updates at every meeting going forward. “I would make it a permanent part of the agenda, so directors can ensure that management is on top of things.”

The law’s impact will be different for different institutions, and some directors will have more to worry about than others. Boards of federally chartered thrifts, for instance, will have a new regulator, the OCC, which has a reputation for tougher enforcement than the OTS.

“Depending on your perspective, it’s either a more rigorous examination, or more arbitrary,” says David Baris, a partner with BuckleySandler LLC, a Washington, D.C. law firm, and executive director of the American Association of Bank Directors. “It’s important to learn about those differences sooner, rather than later.”

Generally speaking, the bigger a bank is, the more scrutiny its board will endure. The collapses or forced sales of large banks, such as Washington Mutual Inc., Wachovia Corp., and National City Corp.-all top 10 institutions that were burned by real estate problems-rocked the entire system.

In addition to stress testing, big banks also must devise their own “living wills” that provide regulators a road map for how best to unwind their operations in the event of a failure. The provision poses legal risks for bank boards, which could be forced to pick winners and losers among equity holders and creditors.

And since most boards have no intention-and show no signs-of getting into trouble, the entire exercise is likely to be viewed as just another costly distraction. Glancz calls it window dressing. “If you get into real crisis mode, would anyone really have the luxury to follow the plan in an orderly fashion?” he asks.

Regulators also are empowered to be more proactive in enforcement. Expect closer scrutiny of the basics-capital levels, loan-loss reserves, loan-quality metrics and concentrations, as well as incentive structures. Loan and business diversity will be more important than ever.

The rules say that seizure proceedings against a large financial institution can begin if Treasury, the Fed, and FDIC agree that an institution’s circumstances pose a “grave threat” to system stability. If the company’s board resists, the courts can appoint the FDIC as receiver.

Executives would likely be on the hook for a failure, with the FDIC empowered to recover up to two years’ worth of compensation from senior executives if a failure occurs on their watch.

Oh, and to shield taxpayers from the costs, the tab for a large-bank failure will be borne by the industry through fees imposed on financial firms with more than $50 billion in assets (another cost).

Governance-wise, there’s plenty to digest. Boards of banks with more than $10 billion in assets are now required to have a separate risk committee, which must include at least one “risk expert”-similar to the financial expert requirements for audit committees under Sarbanes-Oxley.

The committee is expected to identify and prioritize risks within the organization, ensure that the board is receiving good information, and oversee risk management efforts. That includes everything from ensuring the loan portfolio is balanced by type and geography to setting new policies, limits, and controls in such areas as incentive compensation and product pricing.

The law also requires all public companies to have fully independent compensation committees (someone with some pay-related experience would help) and codifies the need for clawbacks, holding periods, and other means of recapturing incentive pay if the numbers behind those rewards don’t stand the test of time.

Many boards should plan on spending more time recruiting new directors with the skills and independence needed to meet the new standards.

The say-on-pay provision, meanwhile, is likely to increase the importance-and length-of the compensation discussion and analysis portion of proxy statements. Susan O’Donnell, a managing director in the Boston office of Pearl Meyer & Partners, a compensation consulting firm, tells her clients that more is usually better. “You have to sell the story behind the package,” she explains. “Don’t assume that investors know anything.”

O’Donnell offers the example of a recent proxy issued by one struggling mid-sized bank. The board is pursuing a turnaround strategy and recently lured several sharp executives from another bank with some bigger long-term incentives. The investment is expected to pay dividends, but hasn’t yet.

“By the numbers alone, I wouldn’t have supported it,” she says. But the beginning of the CD&A featured an executive summary “that laid out the context behind the board’s thinking wonderfully.… With that context, you understood what they were doing.” The package was supported by a majority of shareholders.

On paper, smaller banks don’t face the same amount of rigor as their larger kin. In practice, they’re likely to face many of the same requirements. “Any time you start with the larger institutions, it usually doesn’t take too long for examiners to begin applying the same principles and rules to the smaller banks,” Baris says.

Regional and large community banks should be prepared to conduct their own stress tests, for instance, and report the results to their primary regulators. Many community bank boards have already embraced the concept of a risk committee as a best practice, and in anticipation that they’ll eventually need one.

O’Donnell says that while small banks with relatively simple pay packages don’t need to make abrupt changes in their compensation practices, they nonetheless should begin looking at the regulatory guidance that is being applied to bigger banks.

“Generally speaking, when the regulator comes in the door next time, you want to be able to say, ‘Here’s what we’re doing, here’s what we’ve reviewed, here’s our assessment of the situation, and where we are in the process,’” she explains.

This is no time to be sheepish about what’s happening on the governance or business development fronts. “Directors need to question management sharply on what it’s doing to respond to these changes,” says Charles Wendel, president of Financial Institutions Consulting in New York. “And they need to be very skeptical. In some cases, it’s going to be the board’s responsibility to say ‘This isn’t working. We need to try something else.’”

While it’s not required, MacDonald says some bank boards are adding capital planning or strategy committees, and with good reason. The biggest challenges posed by the new law lie at the messy intersection of compliance, revenues, profits, and capital levels.

Dodd-Frank takes away or limits some important revenue-generating opportunities. The so-called “Volcker Rule,” named for the former Fed chairman, bans financial institutions from engaging in proprietary trading. Banks’ investments in private-equity and hedge funds are limited to 3% of Tier 1 capital and 3% of a fund’s capital.

The law bans the underwriting of asset-backed securities that result in conflicts of interest. It also prohibits any acquisitions that would leave a company with more than 10% of the system’s total deposits.

Under the “Durbin amendment” the Fed is charged with ensuring that the interchange fees banks charge merchants for debit-card transactions are “reasonable and proportional.”

The exact limits haven’t been set yet, but Bank of America alone has projected a loss of around $2 billion annually from the provision. Throw in the new credit card rules and total lost revenues for the nation’s biggest bank are estimated at between $7 billion and $10 billion. Dodd-Frank “is going to cause a significant reduction in revenue in the future,” CEO Brian Moynihan told analysts in his second-quarter conference call.

The consumer bureau also is expected to place caps on the revenues banks can make on the retail side. One of the first tangible signs of the new law was the requirement that banks ask customers to “opt in” on overdraft protection by Aug. 15. Fees for all sorts of services must be more clearly disclosed-and often must be reduced.

“Revenue generation will be tougher. And because of the new regulations, you’re going to need more and better people in areas like compliance and risk management,” says Goldstein, the F.N.B and Seacoast director. “When you add all that up, it’s going to be more difficult to generate good returns.”

That’s clearly not the best recipe for attracting new capital from investors, yet Dodd-Frank demands that, as well. While the exact levels have yet to be determined, experts predict that many banks could be required to maintain Tier 1 capital levels equal to 12% or more of assets, compared to 6% a few years back. Some banks have recently been asked to come up with Tier 1 ratios of 14%, attorneys say.

Making matters worse, the money will have to be raised without the benefit of trust-preferred securities-a popular hybrid form of capital that’s been attractive to investors and carries tax benefits for the company.

Trust preferreds no longer will count as Tier 1 capital for banks with more than $500 million in assets. (Existing trust preferreds will be grandfathered for banks with less than $15 billion in assets.) The primary reason: liquidity of the investment. “They used to say, ‘Capital is king,’” Sharpe, the Venable attorney, explains. “Now, it’s cash that’s king.”

It all means that, on top of the regulatory headaches, boards must also consider how to replace revenues that might be lost. Boards will “really need to roll up their sleeves and debate corporate strategy” to figure out how to replace lost revenue, says Jim McCormick, president of First Manhattan Consulting Group in New York.

MacDonald says one of his clients is attacking the review task at a grass-roots level, asking the head of each business line, “How does the law affect your pricing and profitability and the capital needed for your business?”

The questions include, “What might need to change, in terms of fee structures, products, and the like, going forward? Do we want to stay in all of those businesses? And what sort of investments might be needed in other areas, such as customer segmentation, to replace those lost earnings?” he says.

From there, the board can weigh potential risk-adjusted returns and make some dispassionate decisions about how to proceed. “If a business is below the threshold, you might conclude it isn’t worth being in anymore,” McCormick says.

Some banks could be forced to morph their business models in response to the fee crackdown. While initial reports of consumers opting in on overdraft protection, for instance, have been stronger than many expected-consultants peg the figure at above 80% for the industry-the idea of providing free accounts to the masses that are subsidized by a small percentage of heavy overdrafters will likely no longer fly with regulators.

In 2009, the banking industry captured $38 billion in overdraft fees alone, according to Moebs Services, an economic research firm in Lake Bluff, Illinois.

“I think we’re going to see the end of free checking,” says McCormick. Instead, look for the return of monthly fees on checking accounts, charges for statements, and perhaps even branch visits, and a heavier emphasis on traditional deposit gathering and lending.

Whether all of Dodd-Frank’s anticipated, negative effects come to pass remains to be seen. A “corrections bill” that adjusts some of the law’s provisions is expected to come out of Congress later this year. Many bankers, meanwhile, are lobbying regulators to soften the actual rules that emerge.

“The real battle now will be the rule-making process,” says Sharpe. “The comment period is critical. This is a bank’s opportunity to let the regulators hear what you think.”

Either way, it seems likely the industry will have fewer participants going forward. Caught between the capital demands of regulators, the profit requirements of investors, and the growing workload, more than a few boards will likely conclude that Dodd-Frank is the final nail in the coffin and that shareholders’ interests-not to mention their own health and sanity-are best served by a sale.

“I think we’ll see a lot of them say, ‘Our revenues are down and we’re not big enough to absorb all of these additional costs. We’re tired of the pressures; maybe a bigger bank can handle all of this better,’” MacDonald says. “More consolidation is inevitable.” |BD|