What Went Wrong?

For government regulators, however, Hamilton was a story of frustration and embarrassment. Through most of the early and mid-1990s, examiners from the Office of the Comptroller of the Currency assigned steadily rising safety-and-soundness ratings to Hamilton, even as it harbored numerous concerns about the bank’s safety and soundness. By 1997u00e2u20ac”the year its board took the company publicu00e2u20ac”Hamilton boasted straight “1”s in all six of the CAMELS categories, even though the company’s loan grading, reviews, and loss-reserving processes were questioned.

Less than five years later, Hamilton was shuttered by the OCC, doomed by deteriorating asset quality and capital levels and allegations of fraud. Efforts by the comptroller’s office to control and correct the bank’s activities wound up being too little, too late, according to a recent report by the Treasury Department’s Office of the Inspector General (OIG). Current estimated cost to the Bank Insurance Fund: $171.5 million.

The Monday-morning quarterbacking that followed has focused on several issues: the lending triangles, money laundering, and other fraudulent practices the bank allegedly used to bilk shareholders and the public; the weakness of a board that appeared to give senior management carte blanche without so much as a whisper; and the intransigence of managers who thumbed their noses at OCC corrective-action orders, regularly appealed any negative findings to the agency’s ombudsman, and even sued its primary regulator, alleging racial bias in its oversight of the bank.

For all that, one question seems to rise above the rest: How could the OCC have allowed the situation at Hamilton to get as bad as it did?

This is more than an academic curiosity. The past few years have witnessed the big-money failures of several small institutions, due to fraud or risky business strategies, and have usually featured high levels of “pushback” from bank managements against examiners.

The list of such institutions, which Bert Ely, an Arlington, Virginia regulatory consultant, calls “outliers,” includes:

NextBank, an online subprime credit-card lender with more than $1 billion in receivables, which was closed last year at a projected cost of more than $300 million after delinquencies climbed to 17%;

Superior Bank, a $2.3 billion Chicago-area thrift that was shut down in 2001 after it overdosed on residuals tied to subprime mortgage and auto loans it originated, at an estimated cost to the Savings Association Insurance Fund of $428 million (that after its former owners, Chicago’s wealthy Pritzker family, agreed to pay $460 million over 15 years);

The First National Bank of Keystone (West Virginia), a $1.1 billion subprime mortgage lender whose management-led fraud scheme resulted in a spectacular 1999 collapse, costing BIF an estimated $772 million;

And BestBank, a Boulder, Colorado subprime credit-card lender that was seized in 1998 after falsifying delinquency data, costing BIF $223 million.

Several smaller state-chartered banks, including Oakwood Deposit Bank Co. in Ohio (estimated cost: $73 million), Pacific Thrift & Loan in California ($50 million), and Iowa’s Hartford-Carlisle Savings Bank ($11 million), have similarly been seized by the FDIC after risky strategies or alleged frauds left them doomed.

Critics argue that there’s little excuse for regulators to regularly miss such obvious outliers, especially when it winds up costing the industry money. According to the Federal Deposit Insurance Corp., 11 banks and thrifts were closed last year, at an estimated cost of $628 million. That follows combined losses of about $1.5 billion in the previous four years. The vast majority of that tally has come from just a few institutions, which spent years in regulators’ sights before they were actually shuttered.

But L. William Seidman, FDIC chairman in the Reagan and Bush administrations, says regulators shouldn’t be judged too harshly. The industry turned in record profits of $105.4 billion in 2002, up 21% from the previous year, according to the FDIC, while BIF’s balance jumped $1.6 billion, to $32.1 billion, putting it at 1.27% of the $2.5 trillion in bank depositsu00e2u20ac”above the 1.25% level at which premium assessments kick in. SAIF’s balance rose to $11.7 billion, leaving it at 1.37% of the $860 billion in thrift deposits it insures.

Seidman notes that no really big failures have occurred since the passage of FIRREA and FDICIA more than a decade ago. In light of recent nonbank failures at the likes of Enron, WorldCom, and Global Crossing, the industry’s regulatory structure has proven its mettle. “To go through the stock-market drop we’ve had, 9/11, and everything else without a major banking problem shows the value of having someone looking over your shoulder,” Seidman says.

Whether regulators are to blame or not, the recent failures certainly demonstrate the limits of regulation. The agencies are hindered by a variety of factorsu00e2u20ac”personalities, politics, evermore-complex strategies, cost considerations, and their own structuresu00e2u20ac”from being as aggressive as some would like.

This is an important issue for bank directors, many of whom take quietu00e2u20ac”and perhaps misguidedu00e2u20ac”comfort knowing that seasoned examiner eyes are looking over management’s shoulders to keep the institution on the straight and narrow. The ostensibly tight regulation seems especially beneficial at a time when board practices are being put under the Sarbanes-Oxley microscope. When a bank fails, however, it’s not the regulator that’s most likely to get skewered, but the institution’s board and officers. True, critical reports are issued by government agencies, followed by the occasional congressional hearing. But no examiner in recent memory has lost a job because of a failure on his or her watch, Ely says.

In contrast, executives and directors of both Superior and Keystone faced both civil litigation and civil money penalties, (from those same regulator agencies), despite their pleas of ignorance. As of September, the Keystone case alone had resulted in 88 years of prison sentences, 32 years of probation, and $1.3 billion in fines and court-ordered restitution, according to Gaston Gianni Jr., the FDIC’s inspector general.

Given the risks, says Bob Calvert, a bank-board consultant from Roswell, Georgia, it’s a mistake to rely on regulators to catch outlier behaviors. Rather, directors should educate themselves, be vigilant and ensure that key oversight functions are vigorous, and up-to-date. “Regulators don’t have the time, money, or knowledge to unearth frauds or risky strategies,” he says. “The primary responsibility lies with the board to make sure something bad doesn’t happen. And if you miss it, you’ll wind up in trouble.”

Like its outlier kin, Hamilton appears to have gotten some subtle help from regulators along the road to infamy. The company’s roots stretched back to 1983, with the founding of Alliance National Bank. Five years later, Alliance failed, and a group of investors bought the $22 million company, changing its name to Hamilton.

Management initially focused on cleaning up its inherited mess, and apparently did a good job. The bank, with eight branches in Miami and another in Puerto Rico, specialized in Latin American trade finance, a business that generates plenty of fee income. It was also a business that regulators considered relatively low risk, because developing nations place high importance on maintaining access to capital.

Beneath the surface, however, things weren’t quite as bright. According to the OIG report, the OCC raised significant concerns about risk management capabilities, deteriorating asset quality, poor recordkeeping, insider transactions, lending-limit violations, loan concentrations, and loan-underwriting and loss- reserve practices between 1991 and 1995.

But while they once threatened to impose civil money penalties, examiners never followed through, instead giving the bank improving marks for safety and soundness. “It is not clear from the examination files why stronger action was not taken against Hamilton,” the report states, adding that “more forceful supervision and enforcement” might have kept the bank afloat.

In 1996, examiners found abnormally high risk concentrations in emerging markets, poor internal review processes, and poor management of correspondent banking relationships. The bank had a reputation for making loans that “quickly migrated to the loss category,” the OIG report states, and had “poor management, workout, and disposition strategies” to deal with those loans.

Similar problems were outlined in 1997. Even so, the OCC assigned straight “1”s in all six CAMELS categories a year later, lauding Hamilton’s “good risk management processes” and “high-quality growth.” That same year, Hamilton went public, raising $38 million in an IPO. According to the OCC, management’s plan called for annual growth of 15%. Yet almost immediately, it began to wildly exceed those projections. By the end of 1998, assets had ballooned by 125%. The stock price soared, too, hitting the low-$40s that yearu00e2u20ac”more than double its IPO price.

More troubling than the growth was its manner. Being public brought pressure to boost earnings, altering management’s “mission and credit philosophy,” the OIG report says. Hamilton took on more obligations in markets like Panama and Guatemala, accelerated its correspondent lending programs with at-risk banks, and moved from merely facilitating trade finance to higher-risk wire transfers. It also began lending to buyers, sellers, and intermediaries in the same transaction, the report states, and allegedly created companies to hide bad loans, while accepting “pouches” of cash from customers outside the countryu00e2u20ac”often considered a red flag for money-laundering schemes.

In 1998, Hamilton’s adversely classified assets had jumped fivefold from 1996 levels, representing 21% of the bank’s capital. The OCC lowered its composite CAMELS rating to “2,” and demanded that Hamilton reduce its foreign exposure. Several other Miami banks received similar orders, the OIG says, but “Hamilton was the only one that did not reduce its concentration.”

The bank’s capital position continued to deteriorate. In late 1998, the board injected $15 million in capital into the banku00e2u20ac”$12.6 million from a trust-preferred stock offeringu00e2u20ac”and followed that with another $8.6 million a year later. In 1999, the OCC gave it just a “3” for capital adequacy, and began to seek enforcement actions against the bank’s managementu00e2u20ac”moves the OCC asserts were “willfully” resisted by the bank.

But even then, the report notes, examiners failed in several key instances to conduct the rigorous on-site compliance assessments required by OCC policies after enforcement actions have been ordered. This allowed management, which bucked increasingly harder against its regulator at every turn, to dig itself into deeper fraud and asset-quality troubles.

In 2000, Hamilton’s “country risk exposure” ranked among the top 10 nationally in dollar volumeu00e2u20ac”a dubiously lofty rating for a $1.7 billion bank. Worse were the allegations of fraud and money laundering. In court documents, the OCC alleged that the bank took in nearly $2 billion in cash deposits from Latin America during the year. It also alleged that the bank issued about $80 million in loans to individuals that “appeared to have no legitimate business purpose” and to “shell companies to pay off or finance the purchase of other delinquent or poorly underwritten loans, and thereby disguise the true financial condition of the bank.”

Hamilton’s attorneys at Hunton & Williams declined to comment for this story, and attempts to contact management were unsuccessful. But the company denied the fraud allegations, asserting that all of its transactions were legitimate. It sued the OCC, charging the agency with “arbitrary, capricious, and discriminatory conduct” motivated by racial bias. But it was too little, too late.

In early 2002, the FDIC took over Hamilton. A subsequent auction of 1,091 of the bank’s loans by the FDIC yielded $244 millionu00e2u20ac”a loss of $170 million, or $32.5 million more than its loss reserves and capital combined. In essence, observers say, the bank was insolvent before its closure. Several key Hamilton executives, including its chairman, are the subject of at least one class-action shareholder suit, not to mention potential regulatory action.

An OCC spokesman says that the agency took “aggressive action” with Hamilton, noting that the bank was closed while it still had risk-based capital levels above 7%. “We feel we did everything we should have done,” the spokesman says.
But Ely argues that Hamilton looked so much like the earlier failures of Keystone and Superior that regulators should have been alert to impending trouble. All witnessed astoundingly rapid asset growthu00e2u20ac”often fueled by out-of-market lendingu00e2u20ac”and bore weak or costly deposit franchises. “If you don’t have a viable business plan on both sides of the balance sheet, there’s going to be trouble, and the regulatory agencies should see that,” he says.

They also boasted overbearing managements that seemed to have cowed their own boards and engaged in significant pushback against examiners in the form of regular appeals to ombudsmen, court challenges, and even physical intimidation.

OCC examiners and Keystone officials battled for years over the diligence of examinations and how to value residuals from the bank’s securitizations. Things got so tense that examiners received U.S. marshal escorts for bank visits. “The relationship was about as bad as I’ve ever seen it,” recalls Robert Clarke, a former comptroller and now a partner at Bracewell & Patterson in Houston, who tried to mediate several disputes. In the Superior case, Gianni’s investigation noted that the board was dominated by its chairmanu00e2u20ac” something he called a “high-risk indicator.”

Similarly, OCC officials have said their ability to confront Hamilton’s problems was blocked by an ineffective board and recalcitrant management, which filed numerous challenges to OCC rulingsu00e2u20ac”including two cease-and-desist ordersu00e2u20ac”and confronted the agency’s requirements for stricter capital requirements in court. In court papers, OCC lawyers wrote that Hamilton engaged in “continuous, apparently deliberate, activity to ‘hide the ball,’” leaving examiners “wholly unable to determine with any degree of certainty the true financial condition of the bank.”

“If, as an examiner, you really believe that your position is strong, and you’re getting pushback from management, it’s reason to be suspicious,” Clarke says. “You have to wonder why, in these cases, the agencies weren’t more aggressive.”
George Benston, an accounting and economics professor at Emory University who has studied bank failures, says there are only so many ways to defraud a bank, and that experienced regulators should be able to recognize the signs. Some of these indicators include pushback, lifestyle changes for senior officers, the types and recipients of loans being made, or a business mix that is too concentrated in one area.

But defenders say it’s not that simple. Regulators aren’t auditors, Seidman points out. Rather, they rely on the information supplied by bank auditors. Either way, frauds involving top management are so difficult to catch that it’s neither practical, nor desirable, for regulators to set out to uncover them all. “You’d have to check every transaction at every bank, and the costs to the industry would quickly exceed the benefits,” he says.

Nor is confronting a risky strategy a piece of cake. In a 1999 speech, Comptroller John Hawke complained that examiners had difficulty getting bankers and directors in those boom times to rein in “loans based on dubious business assumptions … [or] with equity-like features and risk characteristics.” Bankers, he said, were under pressure to meet unrealistically high profit expectations. While good regulation can limit “the scope and cost of bank failures,” it also faces many practical limitations, including proper predictive tools and individual bankers’ own risk tolerances.

Because of banks’ central role in funding the economy, regulators also must walk a political tightrope between action and overreaction. In a more recent California speech, Hawke noted that “repressive supervision … runs the risk of causing bankers to retreat from good credits”u00e2u20ac”hardly a recipe for economic growth.

Benton Gup, a banking professor at the University of Alabama and author of several books on regulation and fraud, says the industry’s evolution is outpacing regulators’ abilities to keep up. Subprime lending, derivative activities, the steady emergence of unregulated competition, and the like are pushing institutions to pursue more risks. Regulators, he adds, shouldn’t be expected to intervene just because something looks risky.

Gup notes that J.P. Morgan Chase & Co. and Bank of America combined presently control about two-thirds of all derivatives on bank balance sheets. If the market for those contracts collapsed, it could result in a massive failure and lead to plenty of second-guessing. “It’s a high-risk situation, but what can the regulators do? Tell J.P. Morgan to get out of the business?” Gup asks. “I don’t think that’s desirable or politically feasible.”

Structure also affects regulator effectiveness. The OCC oversees national banks; the Office of Thrift Supervision handles thrifts; and various state banking departments regulate state-chartered institutions. A handful of banks are monitored by the Federal Reserve Bank, as are bank holding companies. The FDIC, administrator of the industry-funded BIF and SAIF, serves as a backstop regulator that sometimes conducts its own examinations of banksu00e2u20ac”if, that is, the primary regulator allows it.

Built over time, this patchwork system has served the industry well. But since banksu00e2u20ac”not the regulatory agenciesu00e2u20ac”pay the costs of failures through deposit insurance premiums, the agencies charged with ensuring safety and soundness have little directly at risk, Ely says. Indeed, such agencies are funded largely by the fees they charge banks for exams. They jealously guard their turfsu00e2u20ac”in both the Superior and Keystone cases, the primary regulator squabbled with the FDIC over who should conduct examinationsu00e2u20ac”and have a subtle incentive to look the other way when signs of trouble arise. “There’s a desire in these chartering agencies to give management too much time to turn things around, because they don’t want to lose the charter and the fee income that goes with it,” Ely says.

And then there’s human nature. Examiners like to see their charges succeed, which encourages them to ride with a troubled institution longer than they should. And while some individual examiners are strict, others are prone to intimidation or simply “don’t want to be confrontational,” Benston says. “The way things are set up, it’s tough to blame them.”

It might be that bankers are merely getting what they asked for, in the form of a kinder, gentler regulatory scheme that inevitably lets some institutions fall through the cracks. The early 1990s witnessed a sharp industry backlash against an OCC that was viewed as too aggressive in its oversight following the savings-and-loan crisis. In response to the outcry, the OIG report notes, the “demeanor of the OCC” during the mid-1990s focused on “establishing a good relationship with the banks and reducing the regulatory burden.”

Is there a way to make the system more effective? Numerous regulatory fixes have been proposed. Ely advocates privatizing the system, which he says would strengthen enforcement by eliminating the “regulatory moral hazard” that results when a regulator doesn’t pay the bills for a failure. He also thinks examiners should lose their jobs when a big failure occurs, figuring that one job lost for every $250 million in deposit insurance losses is about right.

The regulators themselves have proposed structural remedies. FDIC Chairman Don Powell noted in a recent speech at Washington’s Exchequer Club that, while the banking industry has evolved over the years, “the regulatory community is still mired in a confusing web of competing jurisdictions, overlapping responsibilities, and cumbersome procedures.” The system, he says, creates “dysfunctional turf wars” between agencies and jeopardizes safety and soundness. He thinks the industry should have one big banking regulator.

Similarly, Hawke advocates changing the system’s funding. The present system, he says, amounts to a charters “bazaar,” in which factors like “examination quality and the scope of permissible activities” take a second seat to cost. Better to use the deposit insurance funds to bankroll regulation, he says.

These initiatives face a tough uphill battle. By Powell’s count, there have been 25 attempts at overhauling the regulatory system since the 1930s, with little success. And others say no big changes are required. Clarke, who as comptroller from 1985 to 1992 earned a reputation as the “regulator from hell,” says the present system can work just fine, provided examiners follow through. Over time, some banks in a free-market system will naturally fail, due to flawed business strategies, a lack of capital, or poor management. But the main point of bank supervision is to protect the depositors and the industry from big losses.

To achieve that end, examiners employ the CAMELS rating system to assess an institution’s risk profile in six areasu00e2u20ac”capital adequacy, asset quality, management administration, earnings, liquidity, and sensitivity to market risks. They have the ability to substantially alter business strategies, for instance, by requiring higher capital levels or limiting concentrations of certain types of loans. In the worst cases, they can require a bank to devise solutions for problematic situations or impose cease-and-desist orders, whether the institution likes it or not. “Regulators have tremendous poweru00e2u20ac”some would say too much poweru00e2u20ac”to take action,” Clarke says.

The agencies also are expected to learn from their mistakes. Following the Keystone collapse, for instance, new guidelines for securitizations were issued. The OIG’s report on Hamilton, meanwhile, includes recommendations to improve “early warning tools” for emerging problem banks and to enhance communications between OCC examiners, lawyers, and bankers.

Calvert, who looks at several examination reports a week, says the agencies use their powers wellu00e2u20ac”and in most cases, are plenty assertive. He tells of a recent examination of a bank client in Minneapolis. “These guys were extremely tough,” Calvert recalls. “They went the extra mile in uncovering every single error and mistake.” Clarke, who regularly represents banks involved in disputes with regulators, says, “You won’t find many people who say the regulators are going easy on them.”

Where does this leave bank directors? Gup says that because the agencies have had trouble keeping up with the latest trends, they’ve begun to shift the focus of their examinations from line-by-line details to the broader risk management processes a bank has in place. In essence, this means they’re handing off more oversight responsibility to bank boards.

“The financial world has become so complex, [regulators] have determined they can’t examine everything,” he explains.
With that kind of pressure, Calvert says that boardsu00e2u20ac”which, after all, have the most at stakeu00e2u20ac”must be on guard for management fraud and risky behaviors. One key, he says, is maintaining a strong internal audit function. Several of his clients have caught frauds well before regulators had any inkling of trouble, thanks to internal auditors who received regular training updates and reported directly to the audit committee. The charter of the audit committee should lay out the line of reporting, so that the auditors know to whom they owe their primary allegiance.

“Particularly in light of Sarbanes-Oxley, the board should insist that the internal audit staff has a big enough budget to mind things, and ensure it has the proper policies and procedures down in writing,” Calvert says. “If there’s a hole in your oversight system, it’s the directors who will ultimately pay the price.”

Such clearly was the case at Hamilton. While the OCC could have been more aggressive, it was the board and management’s “unwillingness to recognize problems, patterns of resistance, and failure to comply with laws and regulations” that helped trigger the bank’s demise, the OIG report states. Those same people will ultimately pay a price for the bank’s failure.