New Rule Settles a Vexing Problem for Bank Exams

One of the most contentious aspects of post-financial crisis bank examinations under the administration of President Barack Obama just got resolved.

A new set of rules implemented this year confirm a rather simple and straightforward idea: Supervisory guidance and bank regulations are different. It attempts to address concerns from banking trade groups that the regulators sometimes used supervisory guidance in place of a formal rule in examination feedback — in short, that supervisory guidance effectively substituted as a rule — and has implications for how supervisory guidance should be used going forward.

“I think there was a growing concern that [regulators] were using the soft guidance as a means of enforcing hard requirements,” says Charles Horn, a regulatory and transaction attorney at Morgan Lewis. He cites the supervisory guidance around leveraged lending as one example of guidance that created concern and confusion for the banking industry.

The Rule
The rules, which build on a 2018 interagency statement, were passed by the individual bank regulatory agencies — the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Consumer Financial Protection Bureau and the Federal Reserve — at different times but feature similar language. They specify that supervisory guidance does not establish rules that have the force and effect of law, in contrast to rules that undergo the rulemaking process that includes notice and comment periods, according to notice from the law firm Covington. A regulator’s examination staff cannot use supervisory guidance as the basis for issuing the dreaded report known as a “Matter Requiring Attention” or for any other enforcement action or report of noncompliance.

Both the Fed’s and OCC’s rules state that its examiners will not base supervisory criticisms or enforcement actions on a “violation” of or “non-compliance with” supervisory guidance, and will limit the use of thresholds or other “bright-lines” included in supervisory guidance expectations.

Unlike a law or regulation, supervisory guidance does not have the force and effect of law,” stated the OCC in January 2021 and the Federal Reserve in March of the same year. “Rather, guidance outlines expectations and priorities, or articulates views regarding appropriate practices for a specific subject.”

There are several reasons why regulators issue supervisory guidance. Guidance can educate and inform the agency’s examiners, and could be shared with banks so that both groups are on the same page. Regulators may also issue guidance on issues that are too timely or trivial to merit rulemaking. Sometimes, banks ask regulators to provide guidance or insights on an issue. It can come in many shapes and forms: bank bulletins, frequently asked questions and circulars, among others. Most pieces of supervisory guidance are not issued with a notice and comment period.

“It’s remarkable how much guidance the agencies have issued over the years,” says Greg Baer, president and CEO of the Bank Policy Institute, a research organization whose membership includes some of the biggest banks in the country. The BPI was one of the groups that formally petitioned the agencies to turn the 2018 interagency statement into a rule.

Unlike rules, supervisory guidance wasn’t supposed to be binding. But if a bank examiner treated it as binding, it could pressure bank executives to adopt the same approach. Bank trade groups became concerned that examiners could cite situations where the bank was not following supervisory guidance as the reason for issuing an MRA. MRAs fall below the seriousness of enforcement actions like consent orders, but examiners still expect banks to respond to and address them. Failure to address an MRA can generate subsequent MRAs or contribute to more formal administrative actions.

Of course, a rule on the paper could be different than a rule that is applied and enforced during an exam. It may be too soon to know if the rule has made an impact on exams. The impetus for the new rules began under the administration of President Donald Trump, although many of the rules were finalized at the start of President Joe Biden’s administration. The change in administrations and continued regulatory adjustments made in response to the coronavirus pandemic means that the agencies could still be in an adjustment period. It may take some time for the edict to trickle down from the agency heads to the front-line examiners. Bank executives and boards may also need time to learn about the rule and how it might apply to feedback they’ve received from examiners.

Bank examinations are famously secret. And while bankers and directors may have more leeway to ask for clarification on examination feedbacks or even appeal the findings of the report, especially if feedback cites supervisory guidance, they may not feel comfortable doing so to maintain good relationships with their regulators and examiners. Horn, for his part, expects banks to be cautious about challenging examination actions even with this new rule.

“Banks do value good relationships with the regulators, and there are a number of banks that don’t want to take the risk of pushing back against regulatory criticism unless they think it’s important,” he says. “Personally I think [the rule] can be helpful, but we don’t know how helpful it will be until we can see how this plays out over the coming months and, frankly, the coming years.”

Strengthening Stress Tests After Covid-19

Banks below $50 billion in assets aren’t required to conduct an annual stress test, following regulatory relief passed by Congress in May 2018. But most banks still conduct one or more annual tests, according to Bank Director’s 2021 Risk Survey.

A stress test determines whether a bank would have adequate capital or liquidity to survive an adverse event, based on historical or hypothetical scenarios. Financial institutions found value in the practice through the Covid-19 pandemic and related economic events, which created significant uncertainty around credit — particularly around commercial real estate loans and loans made to the hospitality sector, which includes hotels and restaurants.

“It gives you a peace of mind that we are prepared for some pretty big disasters,” says Craig Dwight, chair and CEO at $5.9 billion Horizon Bancorp, based in Michigan City, Indiana. Horizon disclosed its stress test results in third quarter 2020 to reassure its investors, as well as regulators, customers and its communities, about the safety and soundness of the bank. “We were well-capitalized, even under two-times the worst-case scenario,” he says. “[T]hat was an important message to deliver.”

Horizon Bancorp has been stress testing for years now. The two-times worst case scenario he mentions refers to loss history data from the Office of the Comptroller of the Currency; the bank examines the worst losses in that data, and then doubles those losses in a separate analysis. Horizon also looks at its own loan loss history.

The bank includes other data sets, as well. Dwight’s a big fan of the national and Midwest leading indicators provided by the Federal Reserve Bank of Chicago; each of those include roughly 18 indicators. “It takes into consideration unemployment, bankruptcy trends, the money supply and the velocity of money,” he says.

It’s a credit to the widespread adoption of stress testing in the years following the financial crisis of 2008-09. “All the infrastructure’s in place, so [bank management teams] can turn on their thinking fairly quickly, and [they] aren’t disconnected [from] what’s happening in the world,” says Steve Turner, managing director at Empyrean Solutions, a technology provider focused on financial risk management.

However, Covid-19 revealed the deficiencies of an exercise that relies on historical data and economic models that didn’t have the unexpected — like a global pandemic — in mind. In response, 60% of survey respondents whose bank conducts an annual stress test say they’ve expanded the quantity and/or depth of economic scenarios examined in this analysis.

“We have tested pandemics, but we really haven’t tested a shutdown of the economy,” says Dwight. “This pandemic was unforeseen by us.”

Getting Granular
The specific pain points felt by the pandemic — which injured some industries and left others thriving — had banks getting more granular about their loan portfolios. This should continue, says Craig Sanders, a partner at Moss Adams LLP. Moss Adams sponsored Bank Director’s 2021 Risk Survey.

Sanders and Turner offer several suggestions of how to strengthen stress testing in the wake of the pandemic. “[D]issect the portfolio … and understand where the risks are based on lending type or lending category,” says Sanders. “It’s going to require the banks to partner a little more closely with their clients and understand their business, and be an advisor to them and apply some data analytics to the client’s business model.” How will shifting behaviors affect the viability of the business? How does the business need to adjust in response?

He recommends an annual analysis of the entire portfolio, but then stratifying it based on the level of risk. High risk areas should be examined more frequently. “You’re focusing that time, energy and capital on the higher-risk areas of the bank,” says Sanders.

The survey finds two-thirds of respondents concerned about overconcentrations in their bank’s loan portfolio, and 43% of respondents worried specifically about commercial real estate loan concentrations. This represents a sharp — but expected — increase from the prior year, which found 78% expressing no concerns about portfolio concentrations.

We’re still not out of the woods yet. Many companies are now discussing what their workplace looks like in the new environment, which could have them reducing office spaces to accommodate remote workers. If a bank’s client has a loan on an office space, which they then rent to other businesses, will they be able to fill the building with new tenants?

If this leads to defaults in 2021-22, then banks need to understand the value of any loan collateral, says Sanders. “Is the collateral still worth what we think it was worth when we wrote the loan?”

It’s hard to predict the future, but Sanders says executives and boards need to evaluate and discuss other long-term effects of the pandemic on the loan portfolio. Today’s underlying issues may rise to the surface in the next couple of years.

Knowing What Will Break Your Bank
Stress testing doesn’t tend to focus on low-probability events — like the pandemic, which (we hope) will prove to be a once-in-a-lifetime occurrence. Turners says bank leaders need to bring a broader, more strategic focus to events that could “break” their bank. That could have been the pandemic, without the passage of government support like the CARES Act.

It’s a practice called reverse stress testing.

Reverse stress testing helps to explore so-called ‘break the bank’ situations, allowing a banking organization to set aside the issue of estimating the likelihood of severe events and to focus more on what kinds of events could threaten the viability of the banking organization,” according to guidance issued by the Federal Reserve, Federal Deposit Insurance Corp. and OCC in 2012. The practice “helps a banking organization evaluate the combined effect of several types of extreme events and circumstances that might threaten the survival of the banking organization, even if in isolation each of the effects might be manageable.”

Statistical models that rely on historical norms are less useful in an unforeseen event, says Turner. “[I]f someone told you in February of 2020 that you should be running a stress test where the entire economy shuts down, you’d say, ‘Nah!’” he says. “What are the events, what are the scenarios that could happen that will break me? And that way I don’t have to rely on my statistical models to explore that space.”

Testing for black swan events that are rare but can have devastating consequences adds another layer to a bank’s stress testing approach, says Turner. These discussions deal in hypotheticals, but they should be data driven. And they shouldn’t replace statistical modeling around the impact of more statistically normal events on the balance sheet. “It’s not, ‘what do we replace,’” says Turner, “but, ‘what do we add?’”

With stress testing, less isn’t more. “My advice is to run multiple scenarios, not just one stress test. For me, it’s gotta be the worst-case stress test,” says Dwight. And stress testing can’t simply check a box. “Can you sleep at night with that worst case scenario, or do you have a plan?”

Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP, 188 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $50 billion in assets. The survey was conducted in January 2021, and focuses on the key risks facing the industry today and how banks will emerge from the pandemic environment.

Bank Director has published several recent articles and videos about stress testing, including an Online Training Series unit on stress testing. You may also consider reading “Recalibrating Bank Stress Tests to a New Reality.”

The Coming Buyback Frenzy

Capital planning is examined as part of Bank Director’s Inspired By Acquire or Be Acquired. Click here to access the content on BankDirector.com.

The banking industry hasn’t been this well capitalized in a long time. In fact, you have to go back to the 1940s — almost 80 years ago — before you find a time in history when the tangible common equity ratio was this high, says Tom Michaud, president and CEO of investment bank Keefe, Bruyette & Woods, during a presentation for Bank Director’s Inspired By Acquire or Be Acquired platform.

That ratio for FDIC-insured banks has nearly doubled since 2008, he says, reaching 8.5% as of Sept. 30, 2020, says Michaud.

A big part of the industry’s high levels of capital goes back to the passage of the Dodd-Frank Act in 2010, the Congressional response to the financial crisis of 2008-09. Because of that law, banks must maintain new regulatory capital and liquidity ratios that vary based on their size and complexity.

During the pandemic, banks were in much better shape. You can see the impact by looking at the capital ratios of just a handful of big banks. Citigroup, for example, had a tangible common equity ratio in the third quarter of 2020 that was nearly four times what it was in 2008, Michaud says.

With a deluge of government aid and loans such as the Paycheck Protection Program, the industry’s losses during the pandemic have been minimal so far. The Federal Deposit Insurance Corp. has closed just four banks, far fewer than the deluge of failures that took place during the financial crisis. So far, financial institutions have maintained their profitability. Almost no banks that pay a dividend cut theirs last year.

Meanwhile, regulators required many of the large banks, which face extra scrutiny and stress testing compared to smaller banks, to halt share repurchases and cap dividends last year, further pumping up capital levels.

That means that banks have a lot of capital on their books. Analysts predict a wave of share repurchases in the months ahead as banks return capital to shareholders.

“The banking industry continues to make money,” said Al Laufenberg, a managing director at KBW, during another Bank Director session. “The large, publicly traded companies are coming out with statements saying, ‘We have too much capital.’”

Investors have begun to ask more questions about what banks are doing with their capital. “We see investors getting a little bit more aggressive in terms of questions,” he says. “‘What are you going to do for me?”

Bank of America Corp. already has announced a $2.9 billion share repurchase in the first quarter of 2021. In fact, KBW expects all of the nation’s universal and large regional banks to repurchase shares this year, according to research by analysts Christopher McGratty and Kelly Motta. They estimate the universal banks will buy back 7.3% of shares in 2021, while large regionals will buy back 3.5% of shares on average. On Dec. 18, 2020, the Federal Reserve announced those banks would again be allowed to buy back shares after easing earlier restrictions.

Regulators didn’t place as many restrictions during the pandemic on small- and medium-sized banks, so about one-third of them already bought their own stock in the fourth quarter of 2020, according to McGratty.

In terms of planning, banks that announce share repurchases don’t have to do them all at once, Laufenberg says. They can announce a program and then buy back stock when they determine the pricing is right.

Shareholders can benefit when banks buy back stock because that can reduce outstanding shares, increasing the value of individual shares, as long as banks don’t buy back stock when the stock is overvalued. Although bank stock prices compared to tangible book value and earnings have returned to pre-Covid levels, the KBW Regional Banking Index (KRX) has underperformed broader market indices during the past year, making an argument in favor of more repurchases.

Robert Fleetwood, a partner and co-chair of the financial institutions group at the law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP, who spoke on the Bank Director session with Laufenberg, cautions bank executives to find out if their regulators require pre-approval. Every Federal Reserve region is different. Regulators want banks to have as much capital as possible, but Fleetwood says they understand that banks may be overcapitalized at the moment.

High levels of capital will help banks grow in the future, invest in technology, add loans and consolidate. For the short term, though, investors in bank stocks may be the immediate winners.

When it Comes to Loan Quality, Who Knows?

Seven months into the Covid-19 pandemic, which has flipped the U.S. economy into a deep recession, it’s still difficult to make an accurate assessment of the banking industry’s loan quality.

When states locked down their economies and imposed shelter-in-place restrictions last spring, the impact on a wide range of companies and businesses was both immediate and profound. Federal bank regulators encouraged banks to offer troubled borrowers temporary loan forbearance deferring payments for 90 days or more.

The water was further muddied by passage of the $2.2 trillion CARES Act, which included the Paycheck Protection Program – aimed at a broad range of small business borrowers – as well as weekly $600 supplemental unemployment payments, which enabled individuals to continuing making their consumer loan repayments. The stimulus made it hard to discriminate between borrowers capable of weathering the storm on their own and those kept afloat by the federal government.

The CARES Act undoubtedly kept the recession from being even worse, but most of its benefits have expired, including the PPP and supplemental unemployment payments. Neither Congress nor President Donald Trump’s administration have been able to agree on another aid package, despite statements by Federal Reserve Chairman Jerome Powell and many economists that the economy will suffer even more damage without additional relief. And with the presidential election just two months away, it may be expecting too much for such a contentious issue to be resolved by then.

We expect charge-offs to increase rapidly as borrowers leave forbearance and government stimulus programs [end],” says Andrea Usai, associate managing director at Moody’s Investors Service and co-author of the recent report, “High Volume of Payment Deferrals Clouds a True Assessment of Credit Quality.”

Usai reasons that if there’s not a CARES Act II in the offing, banks will become more selective in granting loan forbearance to their business borrowers. Initially, banks were strongly encouraged by their regulators to offer these temporary accommodations to soften the blow to the economy. “And the impression that we have is that the lenders were quite generous in granting some short-term relief because of the very, very acute challenges that households and other borrowers were facing,” Usai says.

But without another fiscal relief package to help keep some of these businesses from failing, banks may start cutting their losses. That doesn’t necessarily mean the end of loan forbearance. “They will continue to do that, but will be a little more careful about which clients they are going to further grant this type of concessions to,” he says.

For analysts like Usai, getting a true fix on a bank’s asset quality is complicated by the differences in disclosure and forbearance activity from one institution to another.  “Disclosure varies widely, further limiting direct comparisons of practices and risk,” the report explains. “Disclosure of consumer forbearance levels was more comprehensive than that of commercial forbearance levels, but some banks reported by number of accounts and others by balance. Also, some lenders reported cumulative levels versus the current level as of the end of the quarter.”

Usai cites Ally Financial, which reported that 21% of its auto loans were in forbearance in the second quarter, compared to 12.7% for PNC Financial Services Group and 10% for Wells Fargo & Co. Usai says that Ally was very proactive in reaching out to its borrowers and offering them forbearance, which could partially explain its higher percentage.

“The difference could reflect a different credit quality of the loan book,” he says. “But also, this approach might have helped them materially increase the percentage of loans in forbearance.” Without being able to compare how aggressively the other banks offered their borrowers loan forbearance, it’s impossible to know whether you’re comparing apples to apples — or apples to oranges.

If loan charge-offs do begin to rise in the third and fourth quarters of this year, it doesn’t necessarily mean that bank profits will decline as a result. The impact to profitability occurs when a bank establishes a loss reserve. When a charge-off occurs, a debit is made against that reserve.

But a change in accounting for loss reserves has further clouded the asset quality picture for banks. Many larger institutions opted to adopt the new current expected credit losses (CECL) methodology at the beginning of the year. Under the previous approach, banks would establish a reserve after a loan had become non-performing and there was a reasonable expectation that a loss would occur. Under CECL, banks must establish a reserve when a loan is first made. This forces them to estimate ahead of time the likelihood of a loss based on a reasonable and supportable future forecast and historical data.

Unfortunately, banks that implemented CECL this year made their estimates just when the U.S. economy was experiencing its sharpest decline since the Great Depression and there was little historical data on loan performance to rely upon. “If their assumptions about the future are much more pessimistic then they were in the previous quarter, you might have additional [loan loss] provisions being taken,” Usai says.

And that could mean that bank profitability will take additional hits in coming quarters.

Evolving Considerations in the CECL Countdown


CECL-7-23-19.pngExecutives gearing up for the transition to the new loan loss accounting standard need to understand their methodologies and be prepared to explain them.

Many banks are well underway in their transition to the current expected credit loss methodology, or CECL, and coming up with a preliminary allowance estimate under the new standard. CECL will require banks to book their allowance based on expected credit losses for the life of their assets, rather than when the loss has been incurred.

The standard goes into effect for some institutions in 2020, which is slightly more than six months away. To prepare, executives are reviewing their bank’s initial CECL allowance, beginning to operationalize their process and preparing the documentation around their decision-making and approach. As they do this, they will need to keep in mind the following key considerations:

Bankers will need time to review their bank’s preliminary results and make adjustments as appropriate. Banks may be surprised by their initial allowance adjustments under CECL. Some banks with shorter-term portfolios have disclosed that they expect a decrease of their allowance under CECL, compared to the incurred loss estimate.

Some firms may find that they do not have the data needed to segment assets at the level they initially intended or to use certain loan loss methodologies. These findings will require a bank to spend more time evaluating different options, such as identifying simpler methodologies or switching to a segmentation approach that is less granular.

These preliminary CECL results may take longer to analyze and understand. Executives will need to understand how the assumptions the bank made influence the allowance. These assumptions include the periods from which the bank gathered its historical loss information for each segment, the reasonable and supportable forecast period, the reversion period, its prepayment assumptions, the contractual life of its loans—and how these interact. Bankers need to leave enough time for their institutions to iterate through this process and become comfortable with their results.

Incorporate less material or non-mainline loan asset classes into the overall process. Many banks spent last year determining and analyzing various loan loss methodologies and how those approaches would potentially impact their larger and more material asset classes. They should now broaden their focus to include less material or non-mainline asset classes as well.

Banks may be able to use a simplified methodology for these assets, but they will still need to be integrated into the bank’s core CECL process to satisfy internal controls and management and financial reporting.

Own the model and calculations. Executives will need to support their methodology elections and model calculations. This means they will need to explain the data and detailed calculations they used to develop their bank’s CECL estimate. It includes documenting why they decided that certain models or methodologies were the most appropriate for their institution and for specific portfolios, how they came to agree upon their key assumptions and what internal processes they use to validate and monitor their model’s performance.

Auditors and regulators expect the same level of scrutiny from executives whether the bank uses an internally developed model, engages with a vendor or purchases peer data. Executives may need specialized resources or additional internal governance and oversight to aid this process.

Know the qualitative adjustments. Qualitative adjustments may shift in the transition from an incurred loss approach to an expected lifetime one. Executives will need a deep understanding of the bank’s portfolios and how their concentration of risk has changed over time. They will also need to have an in-depth knowledge of the models and calculations their bank uses to determine the CECL allowance, so they can understand which credit characteristics and macro-economic variables are contemplated in the models. This knowledge will inform the need for additional qualitative adjustments.

Anticipate stakeholder questions. CECL adoption will require most banks to take a one-time capital charge to adjust the allowance. Executives will need to explain this charge to internal and external stakeholders. Moving from a rate versus volume attribution to a more complex set of drivers of the allowance estimate, including the incorporation of forecasted conditions, will require the production of additional analytics to properly assess and report on the change. Executives will need ensure their bank has proper reporting framework and structure to produce analytics at the portfolio, segment and, ultimately, loan level.

A Former Regulator Shares His Advice for Boards


regulator-6-13-19.pngDeveloping a positive relationship with regulators is important for any bank. How can banks foster this?

There’s no one better to answer this question than a former regulator.

Charles Yi served as general counsel of the Federal Deposit Insurance Corp. from 2015 to 2019, where he focused on policy initiatives and legislation, as well as the implementation of related rulemaking. He also served on the FDIC’s fintech steering committee.

In this interview, Yi talks about today’s deregulatory environment and shares his advice for banks looking to improve this critical relationship. He also explains the importance of a strong compliance culture and what boards should know about key technology-related risks.

Yi, now a partner at the law firm Arnold & Porter, in Washington, D.C., spoke to these issues at Bank Director’s Bank Audit & Risk Committees Conference. You can access event materials here.

BD: You worked at the FDIC during a time of significant change, given a new administration and the passage of regulatory relief for the industry. In your view, what do bank boards need to know about the changes underway in today’s regulatory environment?
CY: While it is true that we are in a deregulatory environment in the short term, bank boards should focus on prudent risk management, and safe and sound banking practices for the long term. Good fundamentals are good fundamentals, whether the environment is deregulatory or otherwise.

BD: What hasn’t changed?
CY: What has not changed is the cyclical nature of both the economy and the regulatory environment. Just as housing prices will not always go up, [a] deregulatory environment will not last forever.

BD: From your perspective, what issues are top of mind for bank examiners today?
CY: It seems likely that we are at, or near, the peak of the current economic cycle. The banking industry as a whole has been setting new records recently in terms of profitability, as reported by the FDIC in its quarterly banking profiles. If I [were] a bank examiner, I would be thinking through and examining for how the next phase of the economic cycle would impact a bank’s operations going forward.

BD: Do you have any advice for boards that seek to improve their bank’s relationship with their examiners?
CY: [The] same thing I would say to an examiner, which is to put yourself in the shoes of the other person. Try to understand that person’s incentives, pressures—both internal and external—and objectives. Always be cordial, and keep discussions civil, even if there is disagreement.

BD: What are some of the biggest mistakes you see banks make when it comes to their relationship with their examiner?
CY: Even if there is disagreement with an examiner, it should never become personal. The examiner is simply there to do a job, which is to review a bank’s policies and practices with the goal of promoting safety and soundness as well as consumer protection. If you disagree with an examiner, simply make your case in a cordial manner, and document the disagreement if it cannot be resolved.

BD: In your presentation at the Bank Audit & Risk Committees Conference, you talked about the importance of projecting a culture of compliance. How should boards ensure their bank is building this type of culture?
CY: Culture of compliance must be a focus of the board and the management, and that focus has to be communicated to the employees throughout the organization. The incentive structure also has to be aligned with this type of culture.

Strong compliance culture starts at the top. The board has to set the tone for the management, and the management has to be the example for all employees to follow. Everyone in the organization has to understand and buy into the principle that we do not sacrifice long-term fundamentals for short-term gain—which in some cases could end up being [a] long-term loss.

(Editor’s note: You can learn more about building a strong culture through Bank Director’s Online Training Series, Unit 16: Building a Strong Compliance Culture.)

BD: You served on the FDIC’s fintech steering committee, which—in a broad sense—examined technology trends and risks, and evaluated the potential impact to the banking system. Banks are working more frequently with technology partners to enhance their products, services and capabilities. What’s important for boards to know about the opportunities and risks here?
CY: Fintech is the next frontier for banking, and banks are rightly focused on incorporating technology into their mix of products and services. One thing to keep in mind as banks increasingly partner with technology service providers is that the regulators will hold the bank responsible for what the technology service provider does or fails to do with regard to banking functions that have been outsourced.

BD: On a final note: In your view, what are the top risks facing the industry today?
CY: I mentioned already the risks facing the industry as we contemplate the downhill side of the current economic cycle. One other issue that I know the regulators are and have been spending quite a lot of time thinking about is cybersecurity. What is often said is that a cyber event is not a question of if, but when. We can devote volumes of literature [to] talking about this issue, but suffice for now to say that it is and will continue to be a focus of the regulators.

Arnold & Porter was a sponsor of Bank Director’s Bank Audit & Risk Committees Conference.

Your Bank’s Answer to the Cannabis Conundrum


strategy-5-30-19.pngBanks should not wait on lawmakers taking action on the myriad of proposed cannabis banking bills to make important strategic decisions about servicing marijuana-related business.

It is unclear if any of the proposed cannabis banking bills will gain enough traction and support in Washington to pass through Congress. Despite the inaction, a growing number of financial institutions are choosing to provide banking services to the cannabis industry. Banks considering doing business with cannabis companies need to determine if it fits within the institution’s overall strategy and risk appetite. To determine whether the business fits, a board should ask and answer the following four questions:

To be or not to be a cannabis bank? Every board needs to ask itself this question. Even if your bank does not actively seek out cannabis business customers, it is likely your bank has been or will be approached by a customer in the business who is seeking banking services.

The vast majority of banks in the U.S. have marijuana-related or hemp businesses in their market areas, now that more than three-fifths of the country permit some sort of legal cannabis production and use–medical, recreational or industrial hemp. It is quite possible your bank is unwittingly providing banking services to a customer who is at least tangentially related to the business. It is important for your board to definitively establish where your institution stands on this business line and communicate that to the business development, sales and other customer-facing personnel. Are you in or out? Not having a stance risks being flat-footed when an opportunity or a threat arises.

What is a marijuana-related business? The Financial Crimes Enforcement Network, or FinCEN, issued guidance in 2014 on how financial institutions can provide services to marijuana-related businesses in a manner consistent with their Bank Secrecy Act obligations. But neither FinCEN nor any bank regulator has defined the term “marijuana-related business,” or MRBs.

As a result, it is not always clear if your bank is doing business with an MRB. Certainly, those firms that physically handle the plant are MRBs: cultivators, processors, testing facilities, packagers, transporters and dispensaries. If they are required to have a state license, they are an MRB. Your bank should follow the FinCEN guidance regarding suspicious activity report filings when transacting with these companies.

But what about other individuals or companies that are indirectly connected to marijuana-related businesses, such as equipment suppliers, payment processors, consultants, landlords and advisors? There is no simple answer. If a significant portion of the customer’s revenue is dependent on the industry, it could be considered an MRB.

If your bank decides to offer banking services to cannabis businesses, the board and executives must establish a method to determine which indirectly related businesses are MRBs and prepare for revisions to the method if regulators provide further guidance.

Develop in-house compliance programs or engage a consultant? FinCEN is clear that a bank working with marijuana-related businesses must have a robust customer due diligence process. Shortcomings in the diligence process could lead to mistakes and missteps when it comes to compliance with the Bank Secrecy Act and anti-money laundering laws and lead to serious adverse outcomes.

Bank boards must determine whether their institutions have sufficient internal staff to develop and implement customer diligence and other compliance programs, or if they will outsource these functions. Any compliance function will require the board and management to provide appropriate oversight and monitoring of the cannabis-related compliance program.

Will your institution bank marijuana, hemp, or both? Recent changes in the Farm Bill made this a legitimate and important question for bank boards. Before the new Farm Bill was signed into law, the processes and procedures for dealing with hemp businesses were the same as cannabis businesses, because they were treated the same under the Controlled Substance Act.

The 2018 Farm Bill amended the Controlled Substance Act, including removing hemp from the definition of marijuana as long as it contains not more than 0.3% tetrahydrocannabinol, or THC. The bill also allowed states to establish programs for the licensure and regulation of cultivation, production, processing and sale of hemp products.

The Farm Bill changes mean it might become less difficult for banks to work with hemp-related customers from an operational and compliance standpoint. But neither the FinCEN nor federal bank regulators have issued updated guidance on working with hemp businesses following this change.

As federal policy on cannabis continues to evolve, banks will be well-served by internal evaluations and aligning their positions toward this industry sooner rather than later. Those four questions should assist any bank board in establishing their strategy for cannabis-related business.

77 Percent of Bank Boards Approve Loans. Is That a Mistake?


loans-5-17-19.pngBank directors face a myriad of expectations from regulators to ensure that their institutions are safe and sound. But there’s one thing directors do that regulators don’t actually ask them to do.

“There’s no requirement or even suggestion, that I’m aware of, from any regulators that says, ‘Hey, we want the board involved at the loan-approval level,’” says Patrick Hanchey, a partner at the law firm Alston & Bird. The one exception is Regulation O, which requires boards to review and approve insider loans.

Instead, the board is tasked with implementing policies and procedures for the bank, and hiring a management team to execute on that strategy, Hanchey explains.

“If all that’s done, then you’re making good loans, and there’s no issue.”

Yet, 77 percent of executives and directors say their board or a board-level loan committee plays a role in approving credits, according to Bank Director’s 2019 Risk Survey.

Boards at smaller banks are more likely to approve loans than their larger peers. This is despite the spate of loan-related lawsuits filed by the Federal Deposit Insurance Corp. against directors in the wake of the recent financial crisis.

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The board at Mayfield, Kentucky-based First Kentucky Bank approves five to seven loans a month, says Ann Hale Mills, who serves on the board. These are either large loans or loans extended to businesses or individuals who already have a large line of credit at the bank, which is the $442 million asset subsidiary of Exchange Bancshares.

Yet, the fact that directors often lack formal credit expertise leads some to question whether they should be directly involved in the process.

“Inserting themselves into that decision-making process is putting [directors] in a place that they’re not necessarily trained to be in,” says James Stevens, a partner at the law firm Troutman Sanders.

What’s more, focusing on loan approvals may take directors’ eyes off the big picture, says David Ruffin, a director at the accounting firm Dixon Hughes Goodman LLP.

“It, primarily, deflects them from the more important role of understanding and overseeing the macro performance of the credit portfolio,” he says. “[Regulators would] much rather have directors focused on the macro performance of the credit portfolio, and understanding the risk tolerances and risk appetite.”

Ruffin believes that boards should focus instead on getting the right information about the bank’s loan portfolio, including trend analyses around loan concentrations.

“That’s where a good board member should be highly sensitized and, frankly, treat that as their priority—not individual loan approvals,” says Ruffin.

It all boils down to effective risk management.

“That’s one of [the board’s] main jobs, in my mind. Is the institution taking the right risk, and is the institution taking enough risk, and then how is that risk allocated across capital lines?” says Chris Nichols, the chief strategy officer at Winter Haven, Florida-based CenterState Bank Corp. CenterState has $12.6 billion in assets, which includes a national correspondent banking division. “That’s exactly where the board should be: [Defining] ‘this is the risk we want to take’ and looking at the process to make sure they’re taking the right risk.”

Directors can still contribute their expertise without taking on the liability of approving individual loans, adds Stevens.

“[Directors] have information to contribute to loan decisions, and there’s nothing that says that they can’t attend officer loan committee meetings or share what they know about borrowers or credits that are being considered,” he says.

But Mills disagrees, as do many community bank directors. She believes the board has a vital role to play in approving loans.

First Kentucky Bank’s board examines quantitative metrics—including credit history, repayment terms and the loan-to-value ratio—and qualitative factors, such as the customer’s relationship with the bank and how changes in the local economy could impact repayment.

“We are very well informed with data, local economic insight and competitive dynamics when we approve a loan,” she says.

And community bank directors and executives are looking at the bigger picture for their community, beyond the bank’s credit portfolio.

“We are more likely to accept risk for loans we see in the best interest of the overall community … an external effect that is hard to quantify using only traditional credit metrics,” she says.

Regardless of how a particular bank approaches this process, however, the one thing most people can agree on is that the value of such bespoke expertise diminishes as a bank grows and expands into far-flung markets.

“You could argue that in a very small bank, that the directors are often seasoned business men and women who understand how to run a business, and do have an intuitive credit sense about them, and they do add value,” says Ruffin. “Where it loses its efficacy, in my opinion, is where you start adding markets that they have no understanding of or awareness of the key personalities—that’s where it starts breaking apart.”

Here’s How to Address CECL’s Biggest Question


CECL-4-26-19.pngA debate is raging right now as to whether the new loan loss accounting standard, soon to go into effect, will aggravate or alleviate the notoriously abrupt cycles of the banking industry.

Regulators and modelers say the Current Expected Credit Loss model, or CECL, will alleviate cyclicality, while at least two regional banks and an industry group argue otherwise. Who’s right? The answer, it seems, will come down to the choices bankers make when implementing CECL and their view of the future.

CECL requires banks to record losses on assets at origination, rather than waiting until losses become probable. The hope is that, by doing so, banks will be able to prepare more proactively for a downturn.

This debate comes as banks are busy implementing CECL, which goes into effect for some institutions as early as 2020.

Last year, internal analyses conducted by BB&T Corp. and Zions Bancorp. indicated that CECL will make cycles worse compared to the existing framework, which requires banks to record losses only once they become probable.

Both banks found that CECL will force a bank with an adequate allowance to unnecessarily increase it during a downturn. Their concern is that this could make lending at the bottom of a cycle less attractive.

The increase in provisions would “directly and adversely impact retained earnings,” wrote Zions Chief Financial Officer Paul Burdiss in an August 2018 letter, without changing the institution’s ability to absorb losses. BB&T said that adjusting its existing reserves early in a recession, as called for under CECL, would deplete capital “more severely” than the current practice.

BB&T declined to comment, while Zions did not return requests for comment.

The Bank Policy Institute, an industry group representing the nation’s leading banks, said in a July 2018 study that the standard “will make the next recession worse.” CECL’s lifetime approach forces a bank to add reserves every time it makes a loan, which will increase existing reserves during a recession, the group argued.

“The impact on loan allowances due to a change in the macroeconomic forecasts is much higher under CECL,” the study says.

And in Congressional testimony on April 10, JPMorgan Chase & Co. Chairman and CEO Jamie Dimon said CECL could impact community banks’ ability to lend in a recession.

“I do think it’s going to put smaller banks in a position where, when a crisis hits, they’ll virtually have to stop lending because putting up those reserves would be too much at precisely the wrong time,” he said.

Those results are at odds with research conducted by the Federal Reserve and firms like Moody’s Analytics and Prescient Models. Some of the differences can be chalked up to modeling approach and choices; other disagreements center on the very definition of ‘procyclicality.’

Moody’s Analytics believes that CECL will result in “easier underwriting and more lending in recessions, and tighter underwriting and less lending in boom times,” according to a December 2018 paper. The Federal Reserve similarly found that CECL should generally reduce procyclical lending and reserving compared to the current method, according to a March 2018 study.

Yet, both the Fed and Moody’s Analytics concluded that CECL’s ability to temper the credit cycle will vary based on the forecasts and assumptions employed by banks under the framework.

“The most important conclusion is that CECL’s cyclicality is going to depend heavily on how it’s implemented,” says Moody’s Analytics’ deputy chief economist Cristian deRitis. “You can … make choices in your implementation that either make it more or less procyclical.”

DeRitis says the “most important” variable in a model’s cyclicality is the collection of future economic forecasts, and that running multiple scenarios could provide banks a baseline loss scenario as well as an upside and downside loss range if the environment changes.

The model and methodology that banks select during CECL implementation could also play a major role in how proactively a bank will be able to build reserves, says Prescient Models’ CEO Joseph Breeden, who looked at how different loan loss methods impact an economic cycle in an August 2018 paper.

A well-designed model, he says, should allow bankers to reserve for losses years in advance of a downturn.

“With a good model, you should pay attention to the trends. If you do CECL right, you will be able to see increasing demands for loss reserves,” he says. “Don’t worry about predicting the peak, just pay attention to the trends—up or down—because that’s how you’re going to manage your business.”

In the final analysis, then, the answer to the question of whether CECL will alleviate or aggravate the cyclical nature of banking will seemingly come down to the sum total of bankers’ choices during implementation and execution.

12 Questions Directors Should Ask About New Bank Activities

A bank’s board of directors must answer to a variety of constituencies, including shareholders, regulatory agencies, customers and employees. At times those constituencies may have competing interests or priorities. Other times, what may appear to be competing interests are actually variations of aligned interests.

One area where this is particularly true is the board’s responsibility to strike the right balance between driving revenues and ensuring the bank adheres to its risk appetite established as part of its enterprise risk management framework.

The failure to strike this proper balance can be devastating to the institution, and if widespread, could result in consequences across the entire industry, such as the 2008 financial crisis. As technology and innovation accelerate the pace of change in the banking industry, that balance will become more critical and difficult to manage. And as banks explore ways to increase profits and remain competitive, especially with respect to noninterest income, bank directors will need to remain diligent in their oversight of new bank activities.

Regulators have offered guidance to bank boards on the subject. For example, the Office of the Comptroller of the Currency (OCC) issued a bulletin in 2017 that defines “new activities” to include new, modified, and/or expanded products and services and provide guidance related to risk management systems for new activities. While it is management’s role to execute strategy and operate within the established risk appetite on a day-to-day basis, the board’s role is to oversee and evaluate management’s actions, and the board should understand the impact and risks associated with any new activities of the bank.

To exercise this responsibility, directors should challenge plans for new activities by posing the following questions to help them determine if the proper risk approach has been taken. Questions may include:

  • Does the activity align with the bank’s strategic objectives?
  • Was a thorough review of the activity conducted? If so what were the results of that review and, specifically, what new or increased risks are associated with the activity, the controls, and the residual risk the bank will be assuming?
  • Is the associated residual risk acceptable given the bank’s established risk appetite?
  • Is the bank’s infrastructure sufficient to support the new activity?
  • Are the right people in place for the activity to be successful (both the number of people required and any specific expertise)?
  • Are there any new or special incentives being offered for employees? If so, are they encouraging the correct behavior and, just as importantly, discouraging the wrong behavior?
  • What are the specific controls in place to address any risks created?
  • How will success be measured? What reporting mechanism is in place to track success?
  • Will there be any impact on current customers? Or in the case of consumers, will there be any disparate impact or unfair or deceptive acts or practices (UDAAP) implications?
  • What third parties are required for successful implementation?
  • What limits on the amount of new business (concentration limits) should be established?
  • Are the applicable regulators aware of the bank’s plans, and what is their position/guidance?

These threshold questions will assist directors in becoming fully informed about the proposed new activities, and the answers should encourage follow up questions and discussions. For example, if third parties are necessary, then the focus would shift to the bank’s vendor management policies and procedures. Discussions around these questions should be properly documented in the meeting minutes to evidence the debate and decision-making that should be necessary steps in approving any new bank activity.

If these questions had been posed by every bank board contemplating the subprime lending business as a new activity, it may have averted the challenges faced by individual banks during the financial crisis and lessened the impact on the entire industry.

In the future, if boards seek the answers to these questions, the following discussions will help ensure directors will give thoughtful consideration to new activities while properly balancing the interests of all of their constituencies.