Former Regulator Takes the Chairman’s Seat; Imaging Still Under Fire; The Changing Character of Tier 1 Capital; Spending Trends Point toward More Security

Former Regulator Takes the Chairman’s Seat

Ask William Isaac how his first board meeting as chairman of Fifth Third Bancorp went, and you’ll get a chuckle. “It’s a little unusual to walk into a boardroom that you haven’t been in before and chair a meeting,” he says. “But it went very well. By the end, I felt like I’d been around for five years.”

This appears to be new territory for the industry, as well. As chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, Isaac, 66, is among that small class of former regulatory heads whose resumes might seem tailor-made for today’s troubling times.

But the fact is that no other former regulatory head is running another bank board. The closest appears to be Don Powell, who ran the FDIC from 2001 to 2005, and joined Bank of America Corp.’s board in June 2009 as part of a board shakeup as the company grappled to address a host of crisis-related problems.

Fifth Third has had troubles of its own, having lost $2.1 billion in 2008, before rebounding with $737 million in net income last year. Isaac is the chairman of LECG Consulting, which was advising the company’s 12-member board on a number of governance and risk management issues. Among his suggestions: split the chairman and CEO roles to improve oversight.

CEO Kevin Kabat, 53, held both posts. The board also had a lead director, James Hackett, 53, CEO of Steelcase, Inc., a Grand Rapids, Michigan maker of office furniture.

The board resolved to split the jobs only if it could find the right person. Isaac suggested a half-dozen potential candidates, including Hackett. The lead director, however, said he was too busy with his day job to take the position. (Hackett remains lead director today.)

Eventually, the board approached Isaac, who had just lost a gig as lead director of Florida-based MPS Group, a staffing firm that in 2009 was sold to European rival Adecco SA. An Ohio native who had been consulting for Fifth Third for seven years, Isaac attended Miami University, just north of Cincinnati.

“It made some sense. I knew them, they knew me, and it was in Ohio,” Isaac says, adding: “I’ve got about 40 years in the business and a pretty good knowledge of what the regulators expect a bank to be doing.”

Those insights should come in handy as the industry faces greater scrutiny in the years ahead.

Imaging Still Under Fire

As if there wasn’t enough for bank boards and their attorneys to worry about nowadays, here’s another point of concern. In late March, a federal jury in Texas awarded tiny DataTreasury Corp. $27 million in damages, after finding that U.S. Bancorp and vendors Viewpointe Archive Services and Clearing House Payments Co. had infringed on its patents for check-imaging technology.

At press time, more than two months later, USB was still contemplating its options. “At this stage it would be inappropriate to comment,” said spokesman Steve Dale.

DataTreasury’s spokesman, Eric Wetzel, wasn’t showing the same restraint when asked what the boards of other banks should make of the verdict. “Any financial institution that’s taking advantage of check imaging and exchange without DataTreasury’s permission ought to be paying close attention to these findings,” he said.

Two similar cases are slated for the same Marshall, Texas courtroom later this year, including an October trial centered on Bank of America Corp., which faces up to $869 million in damages, according to court documents.

Legal observers say the jury’s findings have bolstered DataTreasury’s position in those trials. Indeed, the jurys’s verdict was enough to persuade at least one big defendant-Wells Fargo & Co., which faced up to $101 million in potential damages-to settle with the company in June.

DataTreasury’s story began in 1994, when founder Claudio Ballard set out to create a cheaper, less-paper-intensive way to process payments. He worked on some prototypes for a check-imaging system, and in 1997 filed for patents. While the patents were pending, he pitched his idea to the old Chase Manhattan Bank.

Chase walked away from the discussions and helped launch a rival vendor.

Today, check imaging is huge business, while DataTreasury, which once employed 100 people, now exists only as a patent holder that sues banks and related firms.

In 2005, JPMorgan Chase & Co. reached an out-of-court settlement with DataTreasury. Since then, a number of other large banks-Citigroup and UnionBanCal Corp. among them-have done likewise.

Critics of the firm say its patents merely describe a common business practice, and aren’t patentable. The jury’s verdict would seem to contradict that stance.

“Anyone who claims that DataTreasury’s technology is unoriginal simply hasn’t been following the case close enough,” Wetzel says.
-John R. Engen

The Changing Character of Tier 1 Capital

Bankers fighting the crises of the last few years probably have not had time to notice a new fire that is smoldering in a consultative document released by the Basel Committee on Banking Supervision entitled “Strengthening the Resilience of the Banking Sector.” One of the primary focuses of this proposal is the definition of Tier 1 capital.

The document, issued in December 2009, heavily emphasizes that common shares and retained earnings (net of regulatory adjustments) will be the predominant form of Tier 1 capital. Common shares will have to be “subordinated, have fully discretionary non-cumulative dividends or coupons, and neither have a maturity date nor an incentive to redeem.” To be eligible to be included in Tier 1 capital as common shares, instruments will need to meet a series of tests, among them:

u2022 be the most subordinated claim in liquidation

u2022 be perpetual without being able to be repaid apart from liquidation (other than certain discretionary repurchases to reduce capital in a manner that may be permitted by applicable law)

u2022 at issuance have no expectation of repayment and contain no contractual terms that provide any feature that might give rise to an expectation of repayment

u2022 have the paid-in amount recognized as equity for purposes of determining balance-sheet insolvency instead of as a liability

u2022 have the paid-in amount classified as equity under applicable accounting standards

u2022 be directly issued and paid up

u2022 be clearly and separately disclosed on the balance sheet

u2022 not be secured or covered by a guarantee of the issuer or a related entity or subject to any other arrangement that would enhance the seniority of the claim

u2022 have distributions that are paid only after all legal and contractual obligations have been met.

The proposal also requires goodwill and other intangibles to be deducted from the common equity account.

As a result, the new rules will phase out instruments like trust preferred securities and other “[innovative] hybrid capital instruments with an incentive to redeem through features like step-up clauses.” A capital buffer requirement was also proposed. If adopted, not only will banks be required to maintain specific minimum capital thresholds, but they also will be required to maintain capital above the minimum threshold. If the buffer were to decline, the bank would be required to rebuild the buffer by reducing or eliminating dividends and stock buy-backs and by reducing or eliminating staff bonuses.

The Basel Committee expects to develop a “fully calibrated set of standards” by the end of 2010 and desires to have implementation by the end of 2012, subject to a phase-in and grandfathering of yet-to-be described instruments. Banks already considering capital raises in 2010 or 2011 and banks that have not yet decided whether to raise new capital should monitor the committee’s progress and, if necessary, consider whether additional common equity will need to be issued to prepare for implementation of higher common equity requirements.

-Annette Tripp, partner, Sutherland Askill Brennan

Spending Trends Point toward More Security

According to Deloitte’s seventh annual survey of financial services security spending and priorities, more than half of the senior security executives surveyed, from some of the world’s largest financial institutions, say their information security budget has increased, appearing to buck the current trend of cost-cutting.

And-following a number of high-profile cases involving thefts of computer code thefts-the executives surveyed are now making it a priority to invest in tools that restrict user access to critical information. Among 19 different types of initiatives, 44% of survey respondents listed this as a top initiative.

Some of the other findings:

u2022 Data loss prevention has taken on a greater urgency. Data loss is caused by inadvertent action on the part of an organization’s people. When asked to characterize their ability to thwart internal breaches, only 34% of respondents are “very confident” but that response rises to 56% when respondents are asked about their ability to thwart external breaches. Respondents indicate that, after encryption, data loss prevention will be the most piloted technology in the next 12 months.

u2022 Regulatory compliance is a key priority for financial institutions. Financial institutions are expecting more regulatory pressure. Respondents to the survey included regulatory and legislative compliance as one of their top five initiatives and are hiring more internal auditors to resolve internal and external audit findings.

u2022 For the first time, organizations appear eager to embrace emerging technologies to combat threats. Organizations are now proactively embracing new technologies as “early majority adopters.”

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