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.

Loans-chart.png

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.

 

Dealing With Nonbank Buyers


merger-1-16-19.pngMergers and acquisitions in the banking industry historically have been relatively straight forward, but things are beginning to change.

Typically, there’s a familiar pattern: Bank A wants to sell. Banks B, C and D bid, and the winner moves forward with a merger at the bank or holding company level.

Over the past few years, there have been more instances where the buyer is not a traditional bank. Investor groups, fintech entities, credit unions and other nontraditional bank acquirers are becoming more interested in acquiring banks. There may be specific regulatory or operational challenges when the buyer is not a traditional bank or bank holding company.

Here are some factors that sellers should keep in mind at the beginning of the process.

The acquirer and transaction will need approval from regulators. If a buyer is not already “known” to banking, regulators may scrutinize the transaction more than if a traditional bank were involved.

Individual investors may need to submit Interagency Biographical and Financial Reports, or IBFRs, and that process may be more invasive and time consuming than a person not familiar with the banking industry would expect. If the buyer is forming an entity that will eventually control the bank, then the Federal Reserve will need to approve it as a bank holding company in connection with the change in control.

Ensure the buyer is prepared for the process. The sophistication and deal experience of nontraditional buyers varies broadly. Working through the process with investor groups and credit unions is important. Regulators may expect to see a detailed business plan regarding how the buyer plans to operate the bank following the transaction.

A seller should carefully review the business plan prior to committing to a transaction to ensure it is viable and to be comfortable regulators will approve the plan. In many instances, it may be appropriate to have pre-transaction conferences with the regulators to get their preliminary indication on any strengths and weaknesses of the proposed acquirers and their business plan.

The seller’s management team may be required post-closing. Many nontraditional buyers will not have their own, full management team in place to run the organization after closing. In those situations, the buyer may have additional pressure to deliver management along with the transaction.

Sellers should ensure management is on board with the transaction and that appropriate compensation tools like change-in-control agreements and stay-bonus arrangements are in place at the start of the process. Additionally, both parties should work early in the process to lock in any post-transaction employment arrangements.

Understand and negotiate the transaction structure. In a bank-to-bank transaction, the buffet of possible deal structures is fairly limited. The menu may expand with a nontraditional buyer, if it does not already have a holding company or existing entity formed. Depending on the situation, particularly the desired tax treatment by both parties, transactions can be structured as a stock purchase or merger at either the holding company or bank level. It is important to plan the transaction structure early, as it will impact what regulatory and corporate approvals are needed to complete the transaction.

Be sure the board is aware of, and understands, alternative strategies. There is enhanced risk that it will be more difficult to obtain regulatory approval for a transaction with a nontraditional buyer, and it may take longer to close the transaction. Therefore, it is that much more important that the board understands the process. For a potential seller, the board should be aware of the alternatives, so the company can change gears and execute a different strategy if the nontraditional buyer ends up not being a viable partner.

Every potential bank deal should be approached with the realization that the process can be lengthy. When a nontraditional buyer is involved, both the buyer and seller should work closely with one another in the beginning to help ensure that it will go as smoothly as possible. Fully understanding in the beginning what the resulting entity will look like at the end of the transaction (financially, structurally and operationally) is critical to being able to properly plan the transaction and to receive regulatory approval.

Twelve Steps for Successful Acquisitions


acquisition-11-21-18.pngOftentimes bankers and research analysts espouse the track records of acquisitive banks by focusing on the outcomes of transactions, not the work that went into getting them announced. As you and your board consider growing your bank franchise via purchases of, or mergers with, other banks, consider these steps as a guideline to better outcomes:

  1. Prepare your management team
    Does your team have any track record in courting, negotiating, closing and integrating a merger? If not, perhaps adding to your team is warranted.
  2. Prepare your board
    Understand what your financial goals and stress-points are, create a subcommittee to work with management on strategy, get educated about merger contracts and fiduciary obligations.
  3. Prepare your largest shareholders
    In many privately held banks there are large shareholders, families or individuals, who would have their ownership diluted if stock were used as currency to pay for another bank. It is important to get their support on your strategy as the value of their holdings will be impacted (hopefully positively) by your actions.
  4. Prepare your employees 
    While you cannot be specific about your targets until you need to broaden the “circle of trust,” let key employees know that their organization wants to grow via purchases. They will deal with the day-to-day reality of integration, get them excited that your organization is one they want to be with long-term.
  5. Prepare your counsel
    Just as some bankers focus on commercial or consumer loans, some law firms focus on regulatory matters, loan documents or corporate finance. Does your current counsel have demonstrated experience in merger processes? In addition, your counsel should help to educate your Board about the steps required to complete a transaction.
  6. Prepare the Street
    We have seen in recent months several large bank acquisitions announced where the market was unpleasantly surprised; a bank they viewed as a seller suddenly became a buyer. Some of these companies have since underperformed the broader bank market by 5 to 10 percent. If it has been several years between acquisitions, prep the market beforehand that you might resume the strategy. BB&T recently laid parameters for going back on the acquisition trail. And while their stock was down some on the news, it has since more than recovered.
  7. Prepare your IT providers 
    Most customers are lost when you close your transaction by the small annoyances that come with a systems conversion. Understand if your current core systems have additional capacity or begin to get systems in place that can grow as you grow.
  8. Prepare your regulator(s)
    Whether it is the state, the FDIC, OCC or the Fed, they generally do not like surprises. Get some soft guidance from them on their expectations for capital levels and growth rates. Before you formally announce any merger, with your counsel, give the regulators a courtesy heads-up.
  9. Prepare your rating agency
    If you are a rated bank, think about your debt holders as well as equity holders, especially if you need access to acquisition financing. Share with them the broad plan of growth and your tolerances for goodwill and other negative capital events.
  10. Prepare your financing sources
    Do you have a line-of-credit in place at the holding company that could be drawn to finance the cash portion of acquisition consideration? Have you demonstrated that you can fund in the senior or subordinated debt markets, perhaps by pre-funding capital? Are there large shareholders willing to commit more equity to your strategy?
  11. Prepare your targets
    If the Street does not know, and your shareholders do not know, and your bankers and lawyers do not know, then the targets you might have in mind also will not know you are a buyer. Courting another CEO is a time-consuming process, but completely necessary and should be started 12-18 months before you are in the position to pull the trigger. Your goal is to be on their “A” list of calls, and have the chance to compete, either exclusively or in a controlled auction process.
  12. Prepare to walk away 
    After you have done all this work, it is easy to get “deal fever” when that first process comes along. Sometimes you need to recognize it is a trial run for the real thing and be prepared to pack your bags and go home. The best deal most companies have ever done is the one they didn’t do.

Concentration Risk Management Remains an Exam Focus: Stress Tests are Vital


risk-9-4-18.pngMake no mistake about it: If your bank has concentrations that are at or above regulatory guidelines, examiners will expect to see a stress test that supports your concentration risk management plan.

Stress testing has never been mandated for community banks—but it is a tool examiners expect banks to use if they have concentration issues in their portfolio. And this isn’t going to change, no matter what Congress does to ease regulatory burden.

In the past year, many community banks have had regulators question their concentration risk management practices. Examiners have said the stress tests will be the primary focus, and in some cases the only focus, of the inquiry.

In several cases, regulators downgraded the bank’s CAMELS score for not having adequate stress testing in place. Regulators are most focused on the management’s command of the tests, and how they make real and critical decisions related to capital and strategic planning.

Banks with New Concentration Issues of Interest
Commercial real estate (CRE) concentration risk management is not a new issue, but regulators are especially targeting banks without a long history of managing CRE concentrations, and are growing their CRE book at excessive rates. 

A BankGenome™ analysis shows that 2,004 banks have grown their CRE portfolios by more than 50 percent in the last three years, a level that has regulators concerned. As of the first quarter of 2018, 293 banks were over the 100 percent construction threshold and 420 banks exceeded the 300 percent total CRE guidelines. Of banks exceeding the thresholds, 54 banks also had 50 percent or more growth within the last three years – a sure sign they will face increased scrutiny under current guidance.

Anticipate Exam Scrutiny
If you are one of these banks, the worst thing you can do is overlook your next safety and soundness exam. Regulators will come in guns blazing, and you should prepare yourself accordingly.

There will be findings and perhaps even formal Matters Requiring Attention (MRAs), no matter how prepared you are.

Make Minor Findings a Goal
However, the key is to manage those findings. You want only minor infractions, such as not having enough loans with Debt-Service Coverage Ratios (DSCRs) in your core, or having to deal with model risk and model validation. Those are easy to address, while allowing examiners to show their boss that they extracted blood from you. 

You do NOT want examiners to say management doesn’t understand or use the stress test. Those type of findings are far more serious and could lead to CAMELS rating downgrades or worse.

Regulators Expect Stress Tests
Examiners expect banks with CRE concentrations to conduct portfolio stress testing, so bank management and the board can determine the correct level of capital the bank needs. 

Banks with concentrations would be smart to follow the stress testing best practices outlined by the Federal Reserve Bank of Richmond’s Jennifer Burns. Those include:

  • Running multiple scenarios to understand potential vulnerabilities
  • Making sure assumptions for changes in borrower income and collateral values are severe enough
  • Varying assumptions for what could happen in a downturn instead of just relying on what happened to a bank’s charge-off rates during the recession
  • Using the stress test results for capital and strategic planning
  • Changing the stress test scenarios to stay in sync with the bank’s current strategic plan

Burns’ article also notes that one new area of concern is owner-occupied CRE loans, which for years were considered extremely safe.

Report Finds Increased Scrutiny and Risk
The Government Accountability Office issued a report in March that warned of increased risk from CRE loan performance, though still lower than levels associated with the 2008 financial crisis. The GAO found that banks with higher CRE concentration were subject to greater supervisory scrutiny. Of 41 exams at banks with CRE concentrations, examiners documented 15 CRE-related risk management weaknesses, most often involving board and management oversight, management information systems and stress testing.

Prudential regulators acknowledge that proper concentration risk management is a supervisory concern for 2018.
The Office of the Comptroller of the Currency’s latest semi-annual risk perspective noted that “midsize and community banks continued to experience strong loan growth, particularly in CRE and other commercial lending, which grew almost 9 percent in 2017. Such growth heightens the need for strong credit risk management and effective management of concentration risk.”

Are De Novos Making A Comeback?


de-novo-7-3-18.pngThere was a time, not long ago, when FDIC approved 237 applications in a single year. That was 2005. It’s unlikely there will be a return to similar activity levels, the de novo activity has grown from the post-recession single-digit levels to more than 20 open applications. That number that is anticipated to increase through 2018.

Among the de novos are geographically diverse groups involving non-traditional business models, online services, foreign nationals, ethnic/professional niches and minority ownership. Regulators have been open to applications that may have been deemed “non-starters” years ago.

Changes have been made to the FDIC application process that will benefit new community banks such as lessening the de novo period from seven to three years. The rescinding of the FDIC de novo period, the designation of de novo subject matter experts in the regional offices, and the issuance of supplemental guidance along with the FDIC’s “A Handbook for Organizer of De Novo Institutions” indicate a growing commitment by regulators to facilitate the process of establishing new community banks.

To ensure a smooth regulatory process and avoid significant cost outlays, groups should schedule and attend meetings with various regulatory agencies before pre-filing meetings to discuss the timeline and the likelihood of acceptance of an application. Federal and state regulators act in a timely manner, provide constructive feedback and can be easy to work with throughout the de novo process. Strong working relationship with the federal and state regulators, along with the collaboration between all parties highlight the importance of building the right team at the start.

The minimum opening capital requirement has been established at around $22 million. The caveat is that the capital must be in line with the risk profile of proposed bank, though more often than not $20 million or more of seed capital is almost always needed. Why is $22 million or more the magic number?

  • Start-up costs and initial operating losses of $1.5 to $3 million;
  • Profitability being achieved at between $175 to $225 million in assets;
  • Required Tier One Leverage ratio above 8 percent or more throughout the de novo period;
  • Creates an adequate loan-to-borrower limit.

Once the formation bank reaches the minimum capital requirement and gains approval it can open the doors. Once open, the bank can continue raising capital until a higher or maximum level is reached. Additionally, the ability to use 401k accounts for investors is a necessity.

De novo formations bring value to their communities, their markets, shareholders, and the banking industry by filling a void created by the consolidation. With the loss of many key banks, organizers and local businesses feel that larger banks are not providing the level of service and credit desired by small- to medium-sized business owners.

Since the Great Recession, select areas of the country have rebounded more strongly than others. Texas, the Dakotas, Florida, the Carolinas, Washington, D.C., Utah and Washington state are among leaders in job creation and population growth. Given the growth, along with the opportunities to serve growing ethnic and minority populations, many geographies across the country offer attractive opportunities for de novo banking.

Returns for de novo investors can be attractive. There is a risk associated with the initial start-up expenses and a resulting decline in tangible book value. A de novo raises initial capital at tangible book value. While building a franchise, reaching profitability and creating a successful bank allows for multiple expansions and strategic options which can provide attractive returns for initial investors.

Creating a well-connected and qualified board, management team and investor group is proven to be the best recipe for success. Having these individuals and businesses as deposit and lending customers increase, the community’s confidence in the bank facilitates the business generation, along with the marketing and word of mouth publicity.

The proper de novo team is comprised of the founder team, a strategic consultant with regulatory expertise and legal counsel. Business plans now routinely surpass 250 pages and legal requirements continue to expand. When choosing these partners, it is important they have experience in submitting de novo applications in recent years as nuances continue to evolve. Further, ensure all the fees paid are “success based,” so applicable expenses are aligned to the accomplishment of specific milestones.

Regulatory changes, market opportunities and industry consolidations have created an environment in which a de novo bank can form and flourish. With the right founding group and partners, now is the time to explore being part of the next wave of de novo banking.

Regtech: Reaping the Rewards


regtech-4-24-18.pngAs it evolves, regtech is uniquely poised to save banks time and money in their compliance efforts, and has become a common topic for many in the banking industry. If you’re ready to realize the promise of regtech at your institution, here are a few key steps to take before you start parsing through providers or sending out requests for proposals.

Consider changes to your organizational structure that would place oversight of both legal and compliance transformations under one department. In Burnmark’s RegTech 2.0 report, Chee Kin Lam, the group head of legal, compliance and secretariat for DBS Bank, pointed to his authority over both legal and compliance functions and budgets as a key to the Singapore-based bank’s ability to work with regtech companies.

At first blush, a change to your bank’s internal structure seems like an extreme measure for a precursor to a technology pilot, but that perception misses the big-picture implications of implementing a new regtech solution. If a bank intends to engage meaningfully with regtech, Lam pointed out, there’s a need for an overarching framework for onboarding new technologies to make sure they “speak to each other at a legal/compliance level instead of at an individual function level—e.g. control room, trade surveillance, AML surveillance and so on.”

What’s more, legal and compliance functions are already tied closely together, and any regtech solution would likely impact both areas of the bank. Central management of these two functions can help ensure efficient regtech implementation.

Create a solid, detailed problem statement before you ever look for a solution. Lam suggests identifying the top legal and compliance risks your bank is facing, and working from there to identify pain points for your employees and customers when they interact with that risk area. One way to go about this process is to utilize design thinking, which looks at products and experiences from the point of view of the customers and employees who utilize them.

By seeking out pain points and working through the design-thinking process to find their root cause, bank leadership can identify specific, actionable areas for improvement. As tempting as it can be for an institution to attempt a total overhaul of its regulatory processes, banks should pursue modular regtech solutions to solve specific, defined problem statements instead. As Peter Lancos, CEO and co-founder of Exate Technology, points out in RegTech 2.0, “[f]ragmentation makes a regulatory strategy impossible—especially due to geographic spread and banks having separate teams set up to deal with individual regulations.”

Leverage outside expertise. The risks of implementing regtech can be daunting, so bank leaders need to use every tool in their arsenal to get deployment right. Banks should involve regulators in the conversation early on in the process of working with a regtech company. According to Jonathan Frieder of Accenture in The Growing Need for RegTech, “[r]egulators globally have continued to accept and, ultimately, to embrace regtech” making 2018 “a pivotal year.”

In addition to getting regulators on board, banks should consider enlisting outside assistance from consultants or other regulatory experts. Such experts provide assistance with assessing problem statements or potential regtech vendors. Lancos states that he feels “it is essential for banks to have regulatory expertise support to actually write the rules that go into the rules engine of regtech solutions.”

Regtech implementation is a lot more involved than an average plug-and-play fintech product. However, when a bank considers the cost efficiencies, improved compliance record and decreased customer and employee frustration, the upside of regtech can be well worth the planning it requires.

Are You Overlooking a Major M&A Obstacle?


merger-1-1-18.pngPeople often think about the Herfindahl-Hirschman Index (HHI) in relation to its effect on large, public transactions. However, as smaller community banks look to merge with other small banks in their markets or in adjacent communities, the HHI is increasingly becoming an issue. This often overlooked component of a merger could cause significant regulatory impacts on the structure and success of a transaction. For example, one small community bank recently had to withdraw from a bid process because of insurmountable HHI concerns cited by the federal regulators.

What is the HHI?
The HHI is a commonly accepted measure of market concentration that is generally used when evaluating business combinations. It is calculated by squaring the market share of each bank competing in a given market and then summing the resulting numbers. As the number of banks in a market decreases or the disparity in size increases, the HHI will increase proportionately. A moderately concentrated market has an HHI of 1,500 to 2,500 points, and anything greater than 2,500 is considered heavily concentrated. Generally, if an acquisition will increase the HHI by more than 200 points, it will be heavily scrutinized by the federal regulators and may ultimately be rejected.

How Can You Assess Your Bank’s HHI Market?
The U.S. Department of Justice and the Federal Reserve created the Competitive Analysis and Structure Source Instrument for Depository Institutions (CASSIDI) to allow financial institutions to easily determine the effect that a proposed merger would have on the market’s HHI. It is a simple tool that allows anyone to run the HHI calculation on the financial institution of his or her choosing. The CASSIDI calculation can help bank management teams determine the necessary steps they may have to undertake in order to get a deal approved.

As explained above, the HHI calculation takes into account all banks in a certain market. CASSIDI allows users to search the markets to determine which market that a deal would fall into. However, the DOJ and the Federal Reserve have the ability to amend the market to include a larger or smaller area in the HHI calculation. Therefore, while CASSIDI may be very helpful, it can be an imperfect indicator of the validity of your transaction under the HHI calculation. It is important to contact your local regulator to determine the exact market that would be used for your proposed transaction. Your regulator will be able to assist you in running a more exact calculation if you suspect your proposed transaction may increase the HHI by over 200 points.

Are Credit Unions Included in the HHI?
At this time, the CASSIDI calculation does not include any market share held by credit unions. However, regulators may consider including credit unions in the structural concentration calculations in the event an application exceeds the delegation criteria in a given market. Generally, credit unions may be included in these calculations if two conditions are met: first, the field of membership includes all, or almost all, of the market population, and second, the credit union’s branches are easily accessible to the general public. In such instances and at the regulator’s discretion, a credit union’s deposits will be given 50 percent weight. If a credit union has a significant commercial lending presence and staff available for small business services, then its deposits may be eligible for 100 percent weighting, though such an outcome is very rare.

How Can You Fix an HHI Issue?
If you perform an HHI calculation and find that your proposed transaction will exceed the 200 point threshold, there are a few options to consider. You can assert that there are mitigating factors at play, or that a broader market should be considered. Another common solution is to divest certain legacy or acquired assets. For example, financial institutions will sometimes sell a branch in markets where the two parties compete directly in order to complete a merger. Over the past 40 years, divestiture has become an important antitrust remedy for parties looking to complete their deals. That being said, divestiture may not always be practical in a merger of two small banks with limited branch locations.

Financial institutions continue to see a large volume of merger activity. The current costs of operating a bank indicate that this activity will continue to grow. While the HHI is an obvious concern for large deals, it should be on the radar of small community banks as well. Your bank’s board and management team should analyze the anti-competitive effects of any proposed transaction early in the negotiation process.

Can We Say Goodbye to Fair Lending Cases?


lawsuit-6-2-17.pngOne of the potential impacts of a new administration in Washington, D.C., is a lot less fair lending enforcement. For a number of banks, that would be a very good thing. Banks have been hit with fines, bad press and enforcement actions in the last few years, as the Justice Department and the Consumer Financial Protection Bureau have brought cases alleging everything from indirect auto loan discrimination to redlining, the practice of carving out minority neighborhoods to exclude from loans.

Institutions such as Fifth Third Bank and Ally Bank have been hit with the auto finance accusations, and Tupelo, Mississippi-based BancorpSouth Bank last year paid $10.58 million in fines and restitution to settle a case accusing it of redlining in Memphis. The $13.9 billion asset bank said it had taken several steps to improve its commitment to affordable lending products in low and moderate income and minority areas.

Many of the accusations have relied on the disparate impact theory, which has been upheld by the Supreme Court. The idea behind it is that no intentional discrimination has to occur for a violation of the law. Bank managers, as a result, must stay vigilant not only on their own lending policies and staff training, but they have to research lending patterns and loan terms to make sure that a disproportionate number of minorities aren’t stuck with loans on worse terms than non-Hispanic whites. If they are, there has to be a justifiable reason why this was so. Marketing efforts can’t exclude minority neighborhoods.

The most recent case was when the U.S. Department of Justice sued KleinBank, a small community bank in the suburbs of Minneapolis, accusing it of redlining. The bank’s CEO said the lawsuit had no basis in fact, and challenged the idea that the $1.9 billion asset bank has a duty to serve the urban areas of Minneapolis and St. Paul.

One of the odd aspects of the case is that it was filed on Jan. 13, 2017, right before President Donald Trump was inaugurated. Now, the new attorney general, Jeff Sessions, is in an excellent position to influence the case and whether it moves forward at all.

I would expect fair lending cases to be less a priority under Jeff Sessions,’’ says Christopher Willis, a fair lending attorney and partner at Ballad Spahr. “And the cases that would be brought would be less eager to explore new ground.”

John Geiringer, a partner at the law firm Barack Ferrazzano in Chicago, agreed. “Presumably, under the Trump administration, fair lending is not going to be on the front burner as much as it was in the Obama administration.”

But that’s not a pass-go card, not quite yet. The Consumer Financial Protection Bureau (CFPB) is moving ahead with plans to implement an expansion of the requirements for mortgage data under the Dodd-Frank Act. Basically, there are 25 new data points banks must send to the bureau, starting January 2018, on everything from the borrower’s credit score, to the parcel number of the property, to a unique identifier for the loan originator who originated the loan, according to the American Bankers Association, which has argued the rule should be repealed because of increased cost to banks and data security concerns. The Home Mortgage Disclosure Act already mandates 23 data points, the association says.

The fear is that the data will be used to initiate even more fair lending cases against banks, although regulators have said the data could be used to weed out unnecessary fair lending reviews. The CFPB and the Justice Department did not respond to a request to comment.

So far, it’s not clear that the rule will be thrown out, despite the change at the White House. The CFPB is led by Director Richard Cordray, whose term doesn’t end until 2018.

For now, bankers must assume that regulations due to go into effect will indeed do so. Fair lending enforcement won’t go away under the Trump Administration. It’s not just that the CFPB’s leadership is still in place. The agency’s goal from the Fair Lending Report for 2016, published in April, 2017, is to increase “our focus on markets or products where we see significant or emerging fair lending risk to consumers, including redlining, mortgage loan servicing, student loan servicing, and small business lending.” The banking agencies also can continue to pursue enforcement actions, even if the Justice Department doesn’t.

But the tone has changed. The former head of the Justice Department’s civil right division, Vanita Gupta, told The New York Times in January 2017 that “the project of civil rights has always demanded creativity… It requires being bold. Often that means going against the grain of current-day popular thinking. Or it requires going to the more expansive reading of the law to ensure we are actually ensuring equal protection for everyone.”

There’s a good chance that the creativity Gupta described is gone.