Regulatory Entanglement

regulatory-entanglement.pngThe increase in the number of regulations to which U.S. banks must comply can actually be measured in linear feet. Twenty-five years ago, if you had taken all of the laws and regulations that applied to banks and stacked them on the floor, they would have stood about a foot high. Today, that same pile would be about three feet high-a testament to how busy Congress and the federal regulators have been since the early 1990s.

“I would say that banking is more heavily regulated than any other industry,” says David Freeman Jr., a partner and head of the financial services practice group at the Washington-based law firm Arnold & Porter, who has actually done the measurement. “I don’t think the public has any idea. The industry is way more regulated than nuclear power.”

And if one were to drill into that three-foot high stack of do’s and don’ts, somewhat like a weather scientist taking a core sample from an Antarctic glacier, they could see all of the climate changes that have occurred in bank regulation in recent years. Buried in the regulatory ice is the Federal Deposit Insurance Corp. Improvement Act of 1991, which imposed new restrictions on the industry after a previous banking crisis. You would also find the Gramm-Leach-Bliley Act of 1999, which allowed commercial banks, insurance companies and investment banks to merge, but also imposed new privacy restrictions on banks, and of course the mother of all regulatory measures-the Dodd-Frank Act of 2010-which was spawned by a more recent financial crisis. Also to be found in this regulatory core sample are 15 other, lesser pieces of legislation that have imposed more requirements on the industry, not to mention rules that have been put in place by the regulatory agencies themselves, including the Federal Reserve and the Consumer Financial Protection Bureau (CFPB).

Unfortunately for the banking industry, few of these rules and regulations ever go away. Instead, they are laid down one upon the other like stratum that remain in perpetuity. True, the federal banking agencies are required by the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA) of 1996 to review and identify, within a 10-year period, any “outdated, unnecessary or unduly burdensome” regulations that have been imposed on banks and report that information to Congress. However, EGRPRA is the wrong tool to achieve broad scale relief-and the regulators are likely to be cautious anyway in the current political environment. “Nobody wants to be hauled up before Congress and be accused of being too easy on the banks,” says H. Rodgin Cohen, the senior chairman at Sullivan & Cromwell and one of the industry’s top lawyers. “The political pressure on these regulators is unprecedented. There are some regulatory relief measures they could do on their own, but the more fundamental changes really require Congress to act.”

Still, one former regulator thinks the three-foot high stack of rules that govern the industry should be given a thorough overhaul. Eugene Ludwig was Comptroller of the Currency from 1993 to 1998 before establishing his own Washington-based consulting firm, Promontory Financial Group, to work with banks and other financial services companies. He tells a story from his days as the comptroller, when he decided it would be a good idea to train young examiners by pairing them with more experienced examiners and sending them both into the well-run banks, with their cars parked in some bank locations. “I found out later that there were so many examiners being trained at some of the smaller banks that it almost made it impossible for the banks to operate when the training was going on,” Ludwig says. “We interrupted their business for almost a day or two. Once I found out, I stopped that. There are dozens and dozens of examples like that in the rule book. These rules and practices grow up like barnacles do on a ship, and if they’re not scrapped off from time-to-time, they’ll sink the ship.”

There are many bankers who would like to go even further. Working through its primary lobbying organizations-the American Bankers Association (ABA), the Independent Community Bankers of America (ICBA) and the Financial Services Roundtable (FSR)-the industry has tried unsuccessfully to persuade Congress to loosen or modify a number of regulations, particularly Dodd-Frank and its progeny, the CFPB. An ambitious regulatory relief measure failed to get through Congress last year, and even backfired on the industry when large banks were hit instead with what amounted to a new tax to help fund a major highway bill. Nor do the prospects for regulatory relief look any better in 2016, given the political cross-currents of a presidential election year.

At a deeper level, the principal roadblock that banks face when it comes to regulatory relief are all the frightening memories of the last financial crisis, which have been deeply etched into the national psyche, including Congress and the regulators. “The crisis was so devastating,” says Francis Creighton, executive vice president for governmental affairs at the Financial Services Roundtable, which represents large banks and nonbank financial companies. “So many people lost their jobs. People lost their homes. That memory is just hanging out there and it hasn’t gone away. I don’t know that it goes away for another 10 years.”

It is indisputable that the industry is more strongly capitalized and more rigorously supervised by the federal banking agencies than before the crisis. And yet there are those in Congress and in the regulatory community itself who argue that the economy is still vulnerable to the systemic risk posed by the big financial institutions. Indeed, President Barack Obama was forced in March to publically defend the Dodd-Frank Act against progressives in his own party who argue that the law didn’t go far enough.

Seven years after the greatest economic downturn since the Great Depression, for which the industry has received most of the blame-unfairly perhaps, but not without some basis in fact-banking remains highly politicized. And it will be difficult to accomplish any meaningful regulatory relief for as long as that climate prevails in Washington. “I think 2016 is going to be a hard year,” says Ludwig. “We are hearing a lot of rhetoric. It’s natural in a political environment. You’ve got a lot of dissention here in Washington between the parties, which is unfortunate, but it’s real. I think I would be looking to 2017 and beyond for real change. I just don’t think it’s likely this year.”

For most bankers, the term “regulatory burden” has a number of connotations. It applies to the increased emphasis that has been placed on compliance with the Bank Secrecy Act since the New York terrorist attack on September 11, 2001. It encompasses the activities of the CFPB, which has authority for updating financial consumer protection rules and writing new ones, and is also responsible for examining banks over $10 billion in assets for compliance with those rules. It applies to the CFPB’s new qualifying mortgage rules that took effect last year, and which many bankers blame for making home loans more expensive for borrowers and driving many smaller banks out of the market. It applies to the cost of regulatory compliance, which many bankers claim has gone up substantially in recent years, and has become a significant burden for smaller banks.

And it applies to capital, of which the industry has a great deal more of thanks to the requirements of the Basel III Accord, which began taking effect last year. Many bankers worry that the heightened capital requirements have made them less attractive to investors. Bank of Marin Bancorp, a $2 billion asset community bank located in Novato, California, reported record profits in 2015, and in fact has reported record profits in five of the last seven years going back to 2009. President and Chief Executive Officer Russ Colombo says the company’s risk-based capital and return on equity (ROE) last year were 13.4 percent and 8.8 percent, respectively. Back in 2009, when its risk-based capital was 11.6 percent-which still implies a strong balance sheet-its ROE was 11.7 percent, or nearly 300 basis points higher.

The bank experienced very few difficulties during the crisis, according to Colombo. Its worst year saw a $100,000 decline in earnings, from $12.5 million to $12.4 million. In the 26 years that it has been in business, the bank has had net loan losses in commercial real estate-a cyclical asset class that has contributed to hundreds of bank failures since the early ’90s-of just $2.2 million. “I believe we have more than enough capital. This level of capital has a negative impact on shareholder returns and inhibits our ability to attract new capital in the future and new investors to buy our stock,” Colombo says.

Ludwig left the comptroller’s office nearly 20 years ago, but he is still passionate about the topic of bank regulation. “Almost all of our regulations were done with good attitude and in accordance with expert views,” he says. “But in almost every case they’ve never been reviewed from a highly academic or scientific perspective. We do not have measures or academically sound studies as to whether most of these rules are effective at all.” Ludwig points to the evolution that medicine went through in the middle of the last century when it began to adopt a more scientific approach to creating remedies and prescribing procedures. “Regulation in the banking area needs to do the same thing,” he says. “Otherwise we’ll just keep piling up well-intended thoughts, one on top of the other, and we’ll never get this right.”

As radical as it might sound, Ludwig advocates a thorough review of that three-foot stack of regulations unlike any that has ever been done before. “One really has to go through the rule book A to Z and ask ‘Does this rule matter? Does it make things safer? Is it important?’ And if it isn’t, it ought to be cut out. We might be able to cut the rule book in half without endangering safety and soundness. And in fact, efficiencies that would be created by that would make the system safer.”

Unfortunately, it’s seems unlikely that Congress would sanction a regulatory overhaul of this magnitude in the current environment. And while the federal banking agencies are required by law to review the rule book once every 10 years, and do have considerable discretion to make changes, it’s unlikely that they would be willing to get out in front of Congress in this regard. “Anything that reeks of helping banks, including even small banks, is very toxic right now,” says Brian Gardner, a senior vice president and public policy analyst at Keefe, Bruyette & Woods. As for the mandated review under EGRPRA, “I think it’s nice as far as it goes, but it’s more window dressing than anything else,” Gardner says. (The three federal banking agencies-the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp.-all declined interviews for this story.)

It’s not surprising that the prudential regulators cracked down hard on the industry after the financial crisis, but it is surprising that seven years later they are still playing the role of the tough cop. Cohen at Sullivan & Cromwell describes the regulatory environment today as being “extraordinarily difficult.” “I think it is much more comprehensive, much more intensive and much more enforcement oriented,” he adds.

Ludwig worries that the banking regulators are expecting a level of compliance that approaches perfection. “Every examiner recognizes that there’s going to be a loan that goes bad,” he says. “That’s just part of running the bank. There is going to be a recurrent stream of judgment calls on loans that end up being mistaken. That’s the way it is. But on the compliance side right now, it truly is kind of a zero tolerance environment. And zero tolerance is not achievable-if at all-without enormous cost to the institution and to the system. And that’s an area that needs very close scrutiny by the regulatory community and all of the policy makers.”

There is no shortage of ideas from within the industry on how to reduce the regulatory burden, and many of them were incorporated in a bill introduced last year by Senator Richard Shelby, R-Alabama, chairman of the Senate Banking Committee. The bill had a laundry list of provisions, including raising the automatic asset threshold to be considered a Systemically Important Financial Institution (SIFI), which brings with it a higher level of supervision and additional regulation, from $50 billion to $500 billion; raising the threshold of CFPB consumer compliance examinations from $10 billion to $50 billion; and measures that would make it easier for small banks to underwrite home mortgages. But the bill barely made it out of the committee by a 10-to-8 party line vote, and then stalled in the Senate. Critics of the bill claimed it was a stalking horse for the big banks that wanted to gut the Dodd-Frank Act, even though it was supported by all three trade associations, including the ICBA, which represents small institutions.

“It couldn’t even get bipartisan support in the Senate banking committee, let alone the full Senate,” says a banker active in the ABA, William “Billy” Beale, president and CEO of Union Bankshares Corp., a $7.7 billion asset bank in Richmond, Virginia.

The best that industry lobbyists could do was get some of the Shelby bill’s provisions attached to a $305 billion highway bill that was signed into law last December by Obama. The examination cycles for banks under $1 billion in assets were extended from 12 to 18 months, and certain privacy notification requirements were dropped, but if the industry asked for a loaf of bread it received a few crumbs in return.

And worse yet, banks over $10 billion in assets were forced to help pay for the highway bill. It was an unexpected reversal that still rankles. “I think the struggle was that the Senate majority [i.e. the Republicans] really needed to pass the highway bill, and they needed to do it without raising the gas tax,” recalls the FSR’s Creighton. Banks that are members of the Federal Reserve System are paid a 6 percent dividend on stock they are required to keep at the central bank, and apparently someone at the Senate Finance Committee thought to expropriate that source of money to help fund the highway bill. The original proposal would have cut the dividend to just 1.5 percent for all banks, although institutions under $10 billion were eventually excluded from the measure, and instead of cutting the dividend to 1.5 percent, the highway bill used a floating rate set to the 10-year U.S. Treasury Bill. Still, the Senate took money from the banks to pay for roads. “The fact that [the Senate] ended up in a place where they essentially put a new tax on banks was a surprise,” says Creighton. “It was a real surprise.”

The industry is preparing to try again in 2016 to push its regulatory relief agenda through Congress. The Shelby bill will carry over from last year, and there are several other bills that have been introduced including one that would create a short-form call report that banks could fill out every first and third quarter, another that would amend the Sarbanes-Oxley Act of 2002 to exempt banks under $1 billion in assets from performing mandated assessments of internal controls, and a third that would require federal agencies (including the banking agencies) to only promulgate rules that are required by law, or made necessary by a compelling public need.

“We have over 50 bills teed up on regulatory relief, and many of them are bipartisan bills,” says Paul Merski, the ICBA’s executive vice president for congressional relations. ICBA banks tend to be quite small. Most of them are privately held, and and many are located in rural communities. Merski says there is strong support in Congress among Republicans and Democrats alike for providing some measure of regulatory relief for these kinds of institutions. The problem, he says, is when their agenda is coupled to things the big banks want in a single proposal. Although he didn’t mention the Shelby bill by name, he says that measure included benefits for large banks that helped doom it in 2015. “You could pick up the phone and randomly call any House or Senate office and ask for their opinion on community bank relief and they will be genuinely supportive,” says Merski. “It’s when you mix in broader relief [for larger banks] that it becomes more difficult.”

For the most part, the three trade associations-which represent the full spectrum of banks based on asset size-have worked together on regulatory relief initiatives. And yet the concern that many lawmakers in Washington express about the safety of the country’s largest banks probably dooms any relief bill that is perceived as weakening the Dodd-Frank Act, like raising the threshold to be considered a SIFI from $50 billion to $500 billion. Small banks might do better if they lobbied Congress on their own, but thus far the industry groups have maintained a united front.

One big, complicating factor in the industry’s legislative strategy is that 2016 is a presidential election year. “Presidential election years are always difficult to get things done in,” says James Ballentine, executive vice president for congressional relations and political affairs at the ABA. “The time frames are much shorter in terms of pursuing legislation.” Congress will recess in July, then come back briefly in September before scattering again until after the election. “You have to be strategic in trying to move bills independently, or attach them to other measures,” he says. “We’ll look for any measure [to attach a relief bill to], but also seek them independently.”

The prospects for regulatory relief in 2016 would appear to be bleak, despite the determination of lobbyists to move something through Congress. “I think the window has closed,” says KBW’s Gardner. Beale at Union Bankshares agrees. “A third of the Senate is up for re-election,” he says. “I don’t think any of them are going to want to [take a stand] on an issue such as this. I think the House will probably take the same approach.”

Indeed, the banking industry continues to be a lightning rod in Washington. There have been repeated calls in recent years to break up the country’s largest banks, most recently by Neel Kashkari, president of the Federal Reserve Bank of Minneapolis and a former Treasury Department official who oversaw the Troubled Asset Relief Program. Democratic Sen. Elizabeth Warren, D-Massachusetts, has introduced legislation that would reinstate the separation of commercial and investment banking, co-sponsored by Democratic presidential candidate Bernie Sanders, who also believes that the large U.S. banks should be broken up. Sanders’ principal rival for the Democratic nomination, former Secretary of State Hillary Clinton, has also said she would push for additional financial regulation if elected president.

The Republicans currently hold an eight seat majority in the Senate, but 34 seats are up for grabs in November-of which the party holds 24. If the Democrats succeed in recapturing the Senate in what could be a challenging year for the Republican candidates, given the growing possibility in late March that Donald Trump would become the party’s presidential candidate, that could make it even more difficult to achieve regulatory relief in 2017 and beyond.

Beale, who currently serves as treasurer of the ABA, laments that his industry “doesn’t have enough muscularity in D.C. right now where we are either feared or respected. My sense is probably the best thing we can do is, one, figure out how to improve our image and two, develop some political muscularity and hope we can create some change in either one of the two chambers-especially the Senate-to where we would have more of our friends there.”

That might seem like a fool’s errand given the mood in Congress, but Beale says it’s dangerous not to try. He points to the outcome of the highway bill, where Congress expropriated the Fed dividends to pay for something that had nothing to do with banking. “I think as long as we continue to try to push the political process on a grassroots basis, and continue to work the political process, hopefully it won’t get worse,” he says. “I think if we just say, ‘Oh well’ and walk away, it will get worse because they’ll see us as being more weakened than we are today, and they’ll take advantage of it.”


Jack Milligan


Jack Milligan is editor-at-large of Bank Director magazine, a position to which he brings over 40 years of experience in financial journalism organizations. Mr. Milligan directs Bank Director’s editorial coverage and leads its director training efforts. He has a master’s degree in Journalism from The Ohio State University.

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