A New Balance of Power

Wayne Cottle has worked closely over the years with state regulators to make sure all is in order with Dean Bank, a $217 million mutually owned financial institution in Franklin, Massachusetts. But for Cottle, president and chief executive officer at Dean, having the Massachusetts Division of Banks as a regulator may not be a realistic option down the road.

The Blueprint for a Modernized Financial Regulatory Structure, proposed by Treasury Secretary Henry M. Paulson Jr. earlier this year, calls for a long-term solution of one federal regulator of banks, which would likely make having a state charter unnecessary. Cottle worries this proposal would take away a special relationship he has had with state regulators, fostered by his 32-year tenure as chief executive.

u00e2u20acu0153There is a comfort level having a state charter,u00e2u20ac Cottle says. u00e2u20acu0153My state regulators know my institution. They know me. Their files reflect how I think and how my bank has traditionally operated. And they look at me as a positive resource in this community. That is what state banking departments are supposed to do.u00e2u20ac

Cottleu00e2u20acu2122s words are representative of community bankersu00e2u20acu2122 strong opposition to major parts of the Paulson blueprint, a sweeping proposal that aims to streamline the various regulatory agencies across financial industries. Since the proposal was released March 31, small banks, insurance agents, and credit unions have banded together to try to keep it from gaining momentum. That has most observers proclaiming the blueprint to be DOA on Capitol Hill, especially given the upcoming federal electionsu00e2u20ac”Congress seldom tackles ambitious legislation during election years. Yet community bankers, regulators, and interest groups worry that the plan may set the stage for changes in the years to come.

u00e2u20acu0153The plan itself, is it going to be implemented?u00e2u20ac asks Michael Stevens, senior vice president for the Conference of State Bank Supervisors, an advocate for state banks. u00e2u20acu0153No. But pieces of it will get traction and will get some attention, and we are going to have to live with this for some time. There are a lot of things than can be plucked from the blueprint and adopted.u00e2u20ac

The Treasuryu00e2u20acu2122s plan aims to shelve the current system of regulation over the next decade and replace it with three agencies that would oversee banking, market stability, and consumer and investor protection. Proponents argue the changes are needed since regulatory oversight has not kept up with financial innovation over the years.

u00e2u20acu0153If weu00e2u20acu2122re rational people, we will evolve to the point where all financial institutions, including insurance companies, are going to come under a federal safety and soundness regulator,u00e2u20ac says Christopher Whalen, cofounder of Institutional Risk Analytics, a Los Angeles consulting firm that provides financial analysis and valuation tools. That way, Whalen says, u00e2u20acu0153when you have problems, you know exactly who is responsible.u00e2u20ac

With regard to community banks, some of the most controversial provisions include folding the Office of Thrift Supervision into the Office of the Comptroller of the Currency, allowing companies to own banks, stripping the Federal Deposit Insurance Corp. of its examination role, and requiring all banks to have a federal charter.

u00e2u20acu0153The piece that affects the community banks the most is bringing all the banking regulatory bodies under one,u00e2u20ac says Jay Brew, chief banking strategist for m.rae resources inc., a consulting firm in Bethlehem, Pennsylvania. u00e2u20acu0153That I think is horrible if you want to call it a free-market system.u00e2u20ac

The Paulson plan also has rankled other interest groups, such as credit unions and smaller insurance companies. It proposes to do away with credit union charters and recommends insurance companies be given the choice to go with a national regulator, rather than state overseers.

For their part, state bank supervisors have also weighed in against the blueprint. The Treasury plan does not explicitly call for the end of state supervision of banks. But by proposing that financial institutions be required to have a federal bank charter to get federal deposit insurance, state regulators say they will all but lose the banks they oversee to the federal government. u00e2u20acu0153Itu00e2u20acu2122s a silent killer of state charters,u00e2u20ac Stevens says. u00e2u20acu0153If you want federal insurance, you have to have a federal charter. There is no reason to have a state charter.u00e2u20ac

Paulson has said publicly he does not expect the bulk of the proposal to be adopted during the current administration, and that Congress should not consider putting it into law until after the current credit and housing crisis has lifted. Nevertheless, community bankers are girding for the worst in the years to come, given a history of increasing regulatory burden over the last decade and the persistent attempts by powerful lobbying groups representing Wall Street and other industries to change the regulatory landscape.

One provision of the Paulson plan supports an idea that has persisted in Washington: a call for allowing companies to own banks, much like in Japan and Germany. u00e2u20acu0153This is just another huge prescription for a further-concentrated financial and economic system where your largest retailers like Wal-Mart and Home Depot [can] buy banks and open up banking facilities in all of their stores,u00e2u20ac says Kenneth Guenther, a former assistant to the board of governors of the Federal Reserve and former head of the Independent Community Bankers of America, a Washington, D.C. industry group. u00e2u20acu0153Thatu00e2u20acu2122s been a Wall Street idea ever since I can remember. Itu00e2u20acu2122s not a Main Street idea.u00e2u20ac

Yet banks have been battling the concept for some time, going up against a powerful argument that consumers would ultimately benefit. u00e2u20acu0153Nothing would have been more pro-consumer [than] to allow Wal-Mart to enter into the world of banking and provide banking services,u00e2u20ac argues James Rockett, a partner at law firm Bingham McCutchenu00e2u20acu2122s San Francisco office. u00e2u20acu0153I donu00e2u20acu2122t think there is any justification from a policy standpoint for not allowing competition to take place in the world of banking and to allow companies that believe they can deliver better products to deliver them.u00e2u20ac To be sure, the Paulson plan has put small financial institutions on guard. u00e2u20acu0153There is precious little in this proposal for community banks,u00e2u20ac says Camden Fine, president and chief executive officer of the ICBA. u00e2u20acu0153In some ways I would read the Treasury blueprint as a death knell for community banking and the community banking system as we know it. Community bankers should be very concerned. In the next administration and the next Congress, I think at least elements of the blueprint will be taken up for consideration.u00e2u20ac

Likely action

In the near term, there are a few recommendations that are expected to come to fruition. Treasury is working on an executive order that would increase membership of the Presidentu00e2u20acu2122s Working Group on Financial Markets. The group was originally created in 1988, in the aftermath of the 1987 market crash. The group has served as an interagency coordinator for financial market regulation and policy issues, headed by the Treasury secretary. It includes top officials from the Federal Reserve, Securities and Exchange Commission, and Commodity Futures Trading Commission. Under the blueprint, the group would be expanded to oversee the entire financial sector, rather than just financial markets. To that end, the group would also include heads of the OCC and FDIC, as well as the OTS, the agency the Treasury proposal would eliminate in the long-term. Treasury also seeks to expand the powers of the group in order to enhance financial market integrity and promote consumer and investor protection, the blueprint says.

Despite strong opposition to the Treasury plan as a whole, there are a few parts that community banks support. One is expanding the regulatory authority of the Federal Reserve over nonbanks, especially those given access to the discount window when they need liquidity. The near collapse of Bear Stearns & Co. brought this issue to the fore recently.

Community banks are also behind Treasuryu00e2u20acu2122s short-term suggestion to create a federal Mortgage Origination Commission. The commission would establish minimum conduct and competency standards for mortgage originators. It would also require information to evaluate each stateu00e2u20acu2122s mortgage compliance standards to increase transparency in the securitization process. Other short-term recommendations include an information-sharing agreement between the Federal Reserve and the Securities and Exchange Commission and the creation of an Office of Insurance Oversight at the Treasury.

Looking further down the road, Treasury has characterized the rest of the proposal as a starting point for debate (the agency declined to comment for this article). u00e2u20acu0153Beyond these steps, the Blueprintu00e2u20acu2122s recommendations are intended to provoke thoughtful discussion that will ultimately lead to change,u00e2u20ac Paulson said in a May 16 speech. u00e2u20acu0153And we must begin that discussion now, because these changes are important to the long-term strength and effectiveness of our capital markets.u00e2u20ac

No doubt the discussion has gotten off to a rocky start, given that Treasuryu00e2u20acu2122s recommendations for the intermediate and long-term have irked community bankers. In the intermediate termu00e2u20ac”over the next few yearsu00e2u20ac”the plan calls for

• phasing out the federal thrift charter over a two-year period. The OTS would be closed and the OCC would assume its operations;
• bank examination responsibilities for state-chartered banks to fall completely under the supervision of the Fed or the FDIC;
• creation of a federal charter for all the various major payment and settlement systems, with the Fed as overseer;
• creation of an Office of Insurance Oversight at the Treasury, giving insurance companies the option of having a federal regulator rather than the states;
• combining the Securities and Exchange Commission and the Commodities Futures Trading Commission.

In the longer term, the Paulson plan proposes to restructure the regulatory system to focus the goals of regulation in terms of addressing particular market failures. Currently the system is divided into historical industry segments: banking, insurance, securities, and futures. The Treasury proposes a system like that found in Australia and the Netherlands, with a focus on three goals:

• market stability regulation, addressing overall conditions of financial market stability. The Federal Reserve would assume this responsibility.
• prudential financial regulation to address issues of limited market discipline caused by government guarantees. The financial regulator would monitor requirements similar to those for insured depository institutions today, including oversight of capital adequacy requirements, investment limits, activity limits, along with direct, on-site risk management supervision. This agency would assume the roles of current prudential regulators such as the OCC and OTS.
• business conduct regulation (linked to consumer protection regulation) to address standards for business practices. Business conduct regulation would include key aspects of consumer protection such as disclosures, business practices, and chartering and licensing of certain types of financial firms. The business conduct regulator would set standards for firms to be able to enter the financial services industry.

Genesis of the blueprint

The Treasury blueprint to revise the current regulatory framework was initiated more than a year ago in response to the conclusion that U.S. financial markets and companies are up against regulatory burdens that undermine their global competitiveness. It is an attempt to address the shortcomings of the Gramm-Leach-Bliley Financial Services Modernization Act passed in 1999.

With the passage of Gramm-Leach-Bliley, commercial banks and insurance companies were allowed to consolidate, to the benefit of large entities such as Citibank, which had merged with Travelers Group in 1998. But the law did not address the tougher task of moving toward an umbrella regulator for complex organizations, and it failed to delineate the responsibilities of state and federal governments in certain markets. These shortcomings had become increasingly evident in recent years as mortgage lenders loosened underwriting standards, setting the stage for the subprime crisis.

Subprime loans were packaged by investment banks into mortgage-backed securities, which were in turn repackaged into collateralized debt obligations and sold to institutional investors around the world. While some community banks have been burned, the collapse has remained largely outside their domain.

To no surprise, community bankers see the Treasury department using the current crisis as a way to advance the idea of consolidated regulation. But they are bitter, saying the system that works well for smaller financial institutions shouldnu00e2u20acu2122t be mothballed to rein in the mortgage banking industry and the risky practices of global financial institutions, the likes of which have recently received capital infusions from shareholders and sovereign wealth funds.

u00e2u20acu0153We need to go after the people who are really the culprits,u00e2u20ac says Rusty Cloutier, president and chief executive officer of MidSouth Bank, a $936 million publicly traded financial institution in Lafayette, Louisiana. u00e2u20acu0153When are the guilty going to have to pay the price? The answer may be never.u00e2u20ac

Overall, community bankers place blame for todayu00e2u20acu2122s problems squarely on large commercial and investment banks. Fine of the ICBA argues that over the last 15 years, the Federal Reserveu00e2u20ac”and to a lesser extent the OCC, FDIC, and OTSu00e2u20ac”has allowed the concentration of financial assets, most of which now rest in the hands of a half-dozen players. u00e2u20acu0153They are so enormous, they are too big to regulate and too big to fail,u00e2u20ac Fine says. u00e2u20acu0153Essentially the regulators have had regulations on the books to prevent much of whatu00e2u20acu2122s happened. [The problem is] these entities have become much bigger than the regulators themselves, and the regulators canu00e2u20acu2122t get their arms around them. So when the big guys stumble, the regulatory authorities have no choice but to treat them differently than they would all other banks.u00e2u20ac

Meanwhile, community banks insist they, too, end up paying the price when the government attempts to regulate large financial companies. The Citigroup merger was the catalyst for Gramm-Leach-Bliley, yet it added more regulation for community banks, such as the Financial Privacy Rule, which requires financial institutions to provide consumers with annual privacy notices, and the Safeguards Rule, which requires financial institutions to have a written information security plan detailing how the company is prepared to protect nonpublic customer data. Similarly, community banks have been hit with additional regulations as a result of the adoption of Sarbanes-Oxley, which was passed in the wake of corporate and accounting scandals such as Enron and Worldcom. The laws have u00e2u20acu0153made for a very unlevel playing field,u00e2u20ac Cloutier says.

Sarbanes-Oxley costs MidSouth Bank about $600,000 to $700,000 a year in compliance, representing as much as 8% of revenues, estimates Cloutier. The extra expenses include fees for consulting, reporting, and accounting and the hiring of additional staff. u00e2u20acu0153Iu00e2u20acu2122m sure with new bills coming out of Congress, there are going to be a lot of law changes for me,u00e2u20ac Cloutier says. u00e2u20acu0153And Iu00e2u20acu2122m not guilty of anything. I know I havenu00e2u20acu2122t made any subprime loans.u00e2u20ac

In fact, community banks are already paying for the risky subprime lending of others, says Fine of ICBA. Regulators across the board are coming into banks with a much more adversarial attitude. In some cases, regulators are making banks reappraise properties, regardless of whether the loan is performing. u00e2u20acu0153Unfortunately the guys they should have stomped on are the Wall Street mega firms who have been playing fast and loose for the last five to seven years,u00e2u20ac Fine says.

Charter choice

Bankers and regulators argue that revamping the regulatory system is unnecessary since it already works as it is. One of the biggest perks of the current framework is allowing financial institutions to select the type of charter they want to operate under. Proponents say this method fosters competition among agencies, and allows financial institutions to pick a regulator best suited to their needs. u00e2u20acu0153Regulatory choice is like choice in any other facet of our lives,u00e2u20ac says John Reich, director of the OTS. u00e2u20acu0153We consider competition and choice to be desirable virtues and that applies to regulation, too. One cookie cutter doesnu00e2u20acu2122t necessarily serve the best interest of the financial services community.u00e2u20ac

u00e2u20acu0153The FDIC, in my experience, tends to be the most business friendly, whereas the OCC tends to be a stricter-type agency,u00e2u20ac says Brew of m.rae resources. The OCC, which oversees banks with federal charters, is better suited for larger financial institutions, he notes. u00e2u20acu0153If you are sitting there and not happy with one, you have choices to go to other ones.u00e2u20ac

For example, 26 institutions have converted to a thrift charter over the last three calendar years, 2005 to 2007, while 22 have switched to another charter over the same period, according to the OTS. Meanwhile, de novos have a choice of charter to meet their needs. An organizing group has the u00e2u20acu0153opportunity to form a financial institution to serve needs they identify,u00e2u20ac Reich says.

Collaborative approach

Regulators also point out that the system is already used collaboratively to set joint policy goals through the Federal Financial Institutions Examination Council, a interagency body charged with developing uniform regulatory standards. The body consists of officials from the Fed, OCC, FDIC, OTS, and the National Credit Union Administration. The agency also coordinates with state regulators such as the Conference of State Bank Supervisors. Over time, the framework has allowed the agencies to collaborate on a broad set of issues, ranging from Basel II capital rules to the Community Reinvestment Act to the Bank Secrecy Act. The agencies are currently working on a uniform regulation to address unfair and deceptive practices by credit card companies, with a final rule expected by the end of the year. u00e2u20acu0153One of the primary benefits of having several regulatory bodies is that there are several people at the policymaking table, rather than one dominating individual or voice that would exist if you [were to] have one primary regulatory agency doing prudential supervision,u00e2u20ac Reich warns.

Whether the regulatory landscape changes much in the coming years is anyoneu00e2u20acu2122s guess, but advocates of the status quo point to the unruly task of forming the Department of Homeland Security after 9/11, which folded the Federal Emergency Management Agencyu00e2u20ac”once an independent bodyu00e2u20ac”under its wing. FEMA was roundly criticized later for not responding adequately to hurricanes Katrina and Rita in 2005.

Still, Whalen of Institutional Risk Analytics sees a hybrid of the blueprint emerging in the years to come. For example, thrift charters could remain an option. The Paulson plan u00e2u20acu0153doesnu00e2u20acu2122t mean you have to do away with the diversity of charters,u00e2u20ac Whalen says. u00e2u20acu0153There is no reason why you canu00e2u20acu2122t have thrifts.u00e2u20ac

Yet community bankers and their advocates will still resist consolidation. u00e2u20acu0153A lot of parts of our financial system that relate to community banks arenu00e2u20acu2122t broke,u00e2u20ac says Ron Glancz, a partner at law firm Venableu00e2u20acu2122s Washington, D.C. office. u00e2u20acu0153And so I think if you are satisfied right now, if you are a national bank, and you know you have good relationships with your district office, why do you have to change things? The first rule is, u00e2u20acu02dcIf it ainu00e2u20acu2122t broke, donu00e2u20acu2122t fix it.u00e2u20acu2122