In addition to better meeting the needs of consumers, technology’s promise often revolves around efficiency. Banks are clamoring to make the compliance function—a significant burden on the business that doesn’t directly drive revenue—less expensive. But the jury’s out on whether financial institutions are seeing greater profitability as a result of regtech solutions.
In Bank Director’s 2018 Risk Survey, 55 percent of directors, chief executive officers, chief risk officers and other senior executives of U.S. banks above $250 million in assets say that the introduction of technology to improve the compliance function has increased the bank’s compliance costs, forcing them to budget for higher expenses. Just 5 percent say that technology has decreased the compliance budget.
Regtech solutions to comply with the Bank Secrecy Act, vendor management and Know Your Customer rules are widely used, according to survey respondents.
Accounting and consulting firm Moss Adams LLP sponsored the 2018 Risk Survey, which was conducted in January 2018 and completed by 224 executives and board members. The survey examines the risk landscape for the banking industry, including cybersecurity, credit risk and the impact of rising interest rates.
Fifty-eight percent say that the fiscal year 2018 budget increased by less than 10 percent from the previous year, and 26 percent say the budget increased between 10 and 25 percent. Respondents report a median compliance budget in FY 2018 of $350,000.
Cybersecurity remains a top risk concern, for 84 percent of executives and directors, followed by compliance risk (49 percent) and strategic risk (38 percent).
Respondents report that banks budgeted a median of $200,000 for cybersecurity expenses, including personnel and technology.
Seventy-one percent say their bank employs a full-time chief information security officer.
Sixty-nine percent say the bank has an adequate level of in-house expertise to address cybersecurity.
All respondents say that their bank has an incident response plan in place to address a cyber incident, but 37 percent are unsure if that plan is effective. Sixty-nine percent say the bank conducted a table top exercise—essentially, a simulated cyberattack—in 2017.
If the Federal Reserve’s Federal Open Market Committee raises interest rates significantly—defined in the survey as a rise of 1 to 3 points—45 percent expect to lose some deposits, but don’t believe this will significantly affect the bank.
If rates rise significantly, 45 percent say their bank will be able to reprice between 25 and 50 percent of the loan portfolio. Twenty-eight percent indicate that the bank will be able to reprice less than 25 percent of its loan portfolio.
One-quarter of respondents are concerned that the bank’s loan portfolio is overly concentrated in certain types of loans, with 71 percent of those respondents concerned about commercial real estate concentrations.
To view the full results to the survey, click here.
Investor speculation in the cryptocurrency market hit a fever pitch in 2017, setting one record high after another over the course of the year. Bitcoin—the most prominent and highly valued cryptocurrency—was valued at $998 on January 1, 2017, according to the cryptocurrency news source CoinDesk. By mid-December, it was closing in on $20,000. Bitcoin fell to $13,860 at the end of the year, but these gains are still remarkable. Other cryptocurrencies—notably Ethereum and Litecoin—saw similar gains in 2017, albeit at a lower price point.
Alan Lane, the chief executive of Silvergate Bank, bought his first Bitcoin in 2013. The $1.2 billion asset bank based in La Jolla, California, was seeking deposit niches to fund its loan growth, and the more he explored the cryptocurrency space, the more he realized that these companies were flush with venture capital cash but lacked banks willing to provide deposit accounts to these companies. Early on, Lane brought in a potential client in the cryptocurrency space to speak with a few members of his team about how cryptocurrency works, and the challenges these firms face in establishing banking relationships. In 2014, the bank started building deposit relationships with cryptocurrency and other financial technology firms. “It’s become a major line of business for us,” Lane says.
The bank developed a program to build these deposits while staying in the right lanes for regulatory compliance. The bank established an early dialogue with its regulators. “We invited our regulators in to walk through how we were approaching this [and] the kinds of analysis we were doing in terms of vetting the appropriate [regulations] as related to a particular customer that we might choose to bank,” says Lane. “That early dialogue with the regulators has continued.” He dismisses concerns that cryptocurrency businesses are inherently dangerous. “There are regulations on the books, and it’s up to us to figure out how those regulations apply and how we can do things in a safe and sound manner,” he says.
Cross River Bank, with $877 million in assets in Teaneck, New Jersey, provides settlement and treasury management services for the cryptocurrency exchange Coinbase—an active business, given Bitcoin’s rise. “We have a strong appetite for those kinds of relationships,” says Cross River CEO Gilles Gade. Due diligence for these relationships is rigorous. Clients must have an executive on staff dedicated to BSA/AML, and systems equipped to comply with the Bank Secrecy Act and related rules. Cross River has the internal expertise to monitor these transactions as well, and Gade characterizes the bank’s risk limits as conservative.
Cross River Bank has developed APIs to facilitate cryptocurrency transactions, allowing the bank to quickly access the accounts of Coinbase users. “We never actually touch Bitcoin,” says Gade. Money is pulled from the Coinbase user’s bank account and deposited in a dedicated Coinbase account at Cross River. Coinbase then issues the desired cryptocurrency to the user. When the user wants to sell, the reverse of this process occurs, with the money in U.S. dollars landing in the user’s traditional bank account.
The banking industry has focused more attention on the potential of the underlying technology behind bitcoin—blockchain, a digital ledger by which participants can transfer assets without a centralized authority. “The underlying technology is where the real value is,” particularly for the banking industry, says Brent McCauley, a partner at the law firm Barack Ferrazzano. Blockchain could help the financial sector create efficiencies in several areas, from cross-border transactions to authenticating customer identities. And banks are actively testing concepts and working with the technology. “The blockchain is a technology which is a good technology. We actually use it. It will be useful in a lot of different things,” said Chase CEO Jamie Dimon last October, who has harshly criticized Bitcoin. “God bless the blockchain.”
Bitcoin has captured the attention of investors looking to cash in on the crypto-boom, but the volatility shown by Bitcoin and its crypto-brethren makes it an undesirable way pay for goods and services in the United States, or any other country with a stable currency. “The price has been skyrocketing, but for the most part, people are not using it for financial transactions,” says Jim Sinegal, an equity analyst with Morningstar. What seller wants to lose thousands of dollars if Bitcoin crashes, and what buyer is comfortable paying significantly more than an object is worth when the currency fluctuates?
As a result, few retailers accept Bitcoin as a method of payment. But as the payments landscape continues to evolve, bank boards and management teams would benefit from understanding cryptocurrency. Bitcoin transactions are public and traceable, for example. “Everybody can see the chain of title for Bitcoin, so it does provide some advantages that fungible currency doesn’t provide,” says McCauley. Central banks are exploring their own options for digital currency, and there are several cryptocurrency competitors to Bitcoin. Even if it doesn’t become a common form of currency in its own right, Bitcoin has blown the lid off the payments space. It would behoove directors serving on bank boards to consider what this means for their own institutions, and whether there’s a way to make a profit in this evolving space.
Disclosure: The writer owns a small stake in Bitcoin, Ethereum and Litecoin and manages her investment through her Coinbase account.
In the past five years, marijuana has become big business in the United States. There are now eight states with fully legalized recreational marijuana. Couple that with the other 20-plus states with legalized medical marijuana and we have two-thirds of Americans living in states with some form of legal access to marijuana. Many of the remaining states have decriminalized possession of small amounts of marijuana. Currently, it is estimated there are approximately 200,000 full-time and part-time workers in the cannabis industry, with legal marijuana and marijuana-related businesses (MRBs) anticipated to account for revenues in the $50 billion range over the next few years.
However, marijuana remains illegal at the federal level under the Controlled Substances Act. Marijuana continues to be classified as a Schedule I narcotic, which is the highest and most dangerous drug classification. Schedule I drugs are those that have no known medicinal value and the federal government considers to be illegal in all respects. Included with marijuana in this classification are heroin, ecstasy, methaqualone and peyote.
The inconsistency between state and federal laws has caused much confusion and consternation, particularly for financial institutions. In states where marijuana is legal, financial institutions have made many requests for federal guidance on banking MRBs. In 2014, the Department of Justice and Financial Crimes Enforcement Network, or FinCen, responded to such requests with the so-called Cole Memorandum and guidance titled “BSA Expectations Regarding Marijuana-Related Businesses,” respectively. The Cole Memorandum states the federal government will not prosecute within the cannabis industry so long as companies (including banks) obey local and state laws and regulations. The FinCen guidance provided a procedure for filing Suspicious Activity Reports for known MRB bank customers.
Unfortunately, neither of these governs the three prudential federal bank regulators, particularly in the enforcement of Bank Secrecy Act and anti-money laundering rules. As a result, most banks will not touch marijuana-related deposits, make loans to marijuana businesses or permit the use of credit cards on their payment systems. Banks that do provide services to MRBs are very quiet about it. They typically limit the deposits to certain dollar amounts, and if there is any whiff of concern, the accounts are quickly closed. It is estimated that in 2016, about 300 financial institutions in this country knowingly provided deposit accounts to MRBs. Many of these institutions have long standing relationships with their MRB customers and often require them to sign confidentiality agreements to keep the relationship quiet. There has been much speculation on how many banks are unknowingly banking marijuana customers, though it is certain that many are.
All of this legal uncertainty and risk has kept most banks out of the marijuana growing industry, leaving the business almost entirely cash-based. Many MRBs must find workarounds to deal with the cash they cannot deposit and the bills and taxes they must pay. Retailers have methods for hiding cash, including the purchase of armored cars and warehouses where cash can be stored. Many in the business have created their own security forces enlisting motorcycle gangs and former police or military personnel to protect their cash. Employees also are paid in cash, so pay day is staggered in order to prevent robberies. Taxes must be paid in person and are subject to penalties for cash payment. In addition, those who pay their taxes in cash are not eligible to take deductions, so they are paying taxes on gross revenue amounts, though it is difficult to determine (or audit) what those gross amounts really are. Many states are realizing this cash-based business is ripe for organized crime involvement.
With traditional banking mostly out of the picture, many entrepreneurs are working on technical alternative payment platforms as a way around old fashioned banking relationships. Some are using or developing crypto-currency platforms like Bitcoin and, more recently, Potcoin. These are only limited solutions to not having a deposit account or the ability to accept credit card payments. Others are trying to use stored value cards, cell phone apps and other mechanisms. Currently, no alternatives have caught on with the public or the industry. Alternative lenders, including individuals, private equity firms and loan sharks also have stepped in to provide expensive financing to the industry.
The Trump administration does not seem keen on legalizing marijuana, and Attorney General Jeff Sessions appears to be leaning toward increased enforcement. There are numerous bills in Congress to legalize marijuana and permit MRBs to be banked, but it is not clear whether any of these will pass. Until then, most banks will continue facing legal issues and continue avoiding the burgeoning and lucrative marijuana industry.
Fair lending compliance and community benefit plans are increasingly important factors in the merger and acquisition (M&A) approval process. In 2016 and the first quarter of 2017, the Board of Governors of the Federal Reserve System (Federal Reserve) approved 20 bank or bank holding company M&A applications. Fair lending compliance history was an essential element of the regulatory analysis in these cases. While the Federal Reserve focused on compliance issues beyond fair lending —such as the Bank Secrecy Act, overdraft policies, residential servicing, commercial real estate concentration, and enterprise risk management—fair lending was one of the hottest compliance issues that arose from the merger approval process. Regulators also are reviewing applicants’ combined compliance programs and controls to ensure that the resulting institution will be properly suited to protect against the new risks created through the transaction, particularly where the transaction will result in an acquirer crossing a key regulatory growth threshold. For example, the Bank of the Ozarks received regulatory approval for two M&A transactions in early 2016 and crossed the $10 billion asset threshold while both acquisition applications were pending. As evidenced by the Bank of the Ozarks approval order for the larger acquisition, fair lending compliance was a significant factor in the Federal Reserve’s evaluation of the transaction.
Moreover, many of the institutions that obtained Federal Reserve approval for an acquisition during this period demonstrated a commitment to fair lending compliance beyond receipt of a satisfactory or outstanding Community Reinvestment Act (CRA) rating. Nearly all approved applicants had a designated CRA officer and/or CRA committee, and several applicants described detailed plans for improving community lending in particular assessment areas.
Community Benefit Plans Emerge as Important Factor for Regulatory Approval The 2016 and 2017 M&A approvals also revealed the role of formal community benefit plans, as most clearly demonstrated in KeyCorp’s acquisition of First Niagara Financial Group, and Huntington Bancshares’ acquisition of FirstMerit Corporation. These two transactions received a considerable number of public comments focused on CRA and fair lending, and these large financial institutions used community benefit plans as an effective tool to demonstrate their commitment to fair lending compliance.
KeyCorp worked closely with various community organizations to develop a community benefit plan that was announced in March 2016, prior to KeyCorp’s receipt of regulatory approval for its merger. Under the KeyCorp plan, KeyCorp committed to lending $16.5 billion to low- and moderate-income communities over a five-year period, with up to 35 percent of the total commitment targeted at the areas where KeyCorp and First Niagara overlapped in New York, and to maintaining a vital branch and administrative footprint in western New York. Similarly, after submitting its merger application, Huntington adopted a community benefit plan committing to invest $16.1 billion in its communities, including low- and moderate-income communities, over a five-year period.
Notwithstanding the Federal Reserve’s reliance on the KeyCorp and Huntington community benefit plans in concluding that the relevant institutions are meeting the credit needs of the communities they serve, the Federal Reserve noted in the Huntington approval order that “neither the CRA nor the federal banking agencies’ CRA regulations require banks to make pledges or enter into commitments or agreements with any organization.” Accordingly, the Federal Reserve likely will not require a bank to make any community investment pledge to any organization in the absence of significant negative comments or, more importantly, adverse examination findings or a pending enforcement action. Nevertheless, given their apparent benefits, both for Federal Reserve applications and for general community and regulator relations, community benefit plans likely will remain a factor in the approval process for bank mergers that attract community groups’ attention—and likely will help expedite the approval process in the face of adverse community group comments.
Outlook The 2016 and early 2017 merger approvals make clear that a comprehensive fair lending strategy, which may or may not include a community benefit plan, is likely to be well received by the regulators and considered in applicable approval analyses. We expect the regulatory staff of each of the federal banking regulators to continue to focus on fair lending compliance and that community groups will continue to comment actively on the fair lending compliance issues of bank M&A acquirers and attempt to influence their activities.
The Office of the Comptroller of the Currency (OCC) recently announced it would move forward with a plan to grant special purpose national bank charters to qualifying financial technology companies. The OCC has solicited comments on the proposal, which it will evaluate to determine whether to formally adopt the process for granting fintech charters. If adopted, companies granted such a charter would become national banks regulated by the OCC, with the attendant regulatory obligations and oversight, and would no longer need to partner with traditional banks to take advantage of preemption of certain state laws. As noted by the OCC Chief Counsel Amy Friend, the first charter may be granted in the first half of 2017.
General Requirements Under the proposed rule, for a company to qualify for a fintech charter, it must have the appropriate corporate structure, engage solely in bank-permissible activities and adhere to certain regulatory requirements.
Generally, national bank charters subject their holders to specific standards and federal oversight such that the firm can conduct business nationally. Because the proposed fintech charter would be granted under the National Bank Act (NBA), fintech companies would need to adhere to the statute’s governance requirements. For example, a fintech firm chartered by the OCC would need to have a minimum of five board members.
In addition, fintech charter holders only would be permitted to engage in activities authorized by OCC regulations and associated interpretations. These activities can include, among others, lending money, issuing debit cards and facilitating payments, but also investment advisory services and certain brokerage activities. If a given activity is not clearly permitted by the OCC, the firm could seek permission from the OCC, which grants approval of new activities on a case-by-case basis. Beyond OCC regulations, the new charter would impose other laws on a chartered fintech firm, such as the Bank Secrecy Act and related anti-money laundering laws, as well as certain enhanced prudential standards under the Dodd-Frank Act if applicable.
Moreover, a fintech charter holder will be required to meet various supervisory requirements, including that it maintain a business plan documenting its activities, such as with respect to financial inclusion; have a governance structure that reflects the expertise, financial acumen and risk management necessary in light of the proposed business lines; effectively manage compliance risks, such as consumer protection and anti-money laundering; and address potential recovery and resolution. In addition, a fintech firm would need to maintain capital and liquidity commensurate with the risk and complexity of the proposed businesses, including any off-balance sheet activities.
Despite the many requirements the OCC is likely to impose when granting a fintech charter, fintech-chartered companies would have the advantage of no longer being required to register with or become licensed in each state where they conduct business. As enjoyed by national banks, the fintech charter generally would give a company the benefit of preemption under the NBA. Among other features, this would allow the exportation of interest rates from a bank’s home state to other states regardless of the home state’s usury restrictions.
Various stakeholders have reacted to the proposal with differing views. For example, the New York Department of Financial Services submitted a comment letter opposing the proposal and arguing that state regulators are the best equipped to regulate the fintech industry. Others in the industry have voiced their support.
Considerations for Existing Banks Banks may see fewer partnerships with fintech companies as a result of the fintech charter because NBA preemption means that fintech firms no longer need a bank to obtain the advantage of state law preemption.
The fintech charter holders would not have a material competitive advantage with respect to banks because they are subject to the full panoply of OCC regulation and supervision.
Banks may consider seeking their own fintech charter, perhaps through an affiliate, if particular business lines might benefit or if they are currently chartered in one or only a few states in order to expand their national presence.
Banks across the country are complaining about the costs of compliance, especially community banks, which have fewer resources.
Now, the Federal Reserve has done a detailed analysis of what those costs actually are. Taking a look at responses from more than 400 financial institutions surveyed in 2015 by the Conference of State Bank Supervisors, researchers Drew Dahl, Andrew Meyer and Michelle Clark Neely at the Federal Reserve Bank of St. Louis recently published findings that banks with less than $100 million in assets are spending roughly three times more relative to their expenses than banks from $1 billion to $10 billion in assets.
Those super-small banks spend roughly 8.7 percent of their noninterest expenses on compliance; while banks from $1 billion to $10 billion in assets spend 2.9 percent on average, the study found.
2014 Mean Compliance Expenses
Asset Size Categories
$100M to $250M
$250M to $500M
$500M to $1B
$1B to $10B
Data Processing Expense
Number of Banks
Source: Federal Reserve. NOTES: The sample consists of 469 commercial banks with assets under $10 billion that responded to the Conference of State Bank Supervisors’ survey in 2015 on operations in 2014 and for which complete data are available. Dollar amounts, expressed in thousands, represent means for banks in varying categories. Percentages are means within a category of the ratios of dollar amounts to overall noninterest expenses.
Arthur Johnson, chairman of United Bank in Grand Rapids, Michigan, says the notion that regulations are scalable based on the size of the institution “just isn’t true.” His bank, which has $560 million in assets, is contending with new mortgage disclosures and regulations put forth by the Consumer Financial Protection Bureau as part of the Dodd-Frank Act. People getting a residential mortgage these days have to look at paperwork that’s a quarter of an inch thick. Mortgage is a big part of the bank’s business model, so giving up on it is not an option, he says. Households want a checking account and they want a residential mortgage. “If we can have those two relationships we can feel we will be the primary institution for that household,’’ he says.
For the most part, mortgage activity has not been curtailed. A recent GAO report found that while banks say new regulations coming out of the Dodd-Frank Act have negatively impacted their banks, and their ability to offer some products such as nonqualified mortgages, the level of mortgage lending is actually on the increase.
“The results of surveys we reviewed suggest that there have been moderate to minimal initial reductions in the availability of credit among those responding to the various surveys and regulatory data to date have not confirmed a negative impact on mortgage lending,” the report said.
Paul Schaus, president and CEO of CCG Catalyst, a consulting group, says banks tell him frequently that they are spending more money on compliance than years past. Ten years ago, a community bank might have one compliance officer and a $200,000 budget for compliance. Now, it has five to six employees and a $1 million budget, even though nothing else has changed about the bank.
Some of the biggest compliance headaches involve the Bank Secrecy Act, he says. Even though the law is the same as it has been for many years, enforcement has become tougher, he says. Banks are buying monitoring systems to track transactions, which when first installed, trigger an avalanche of activity that must be analyzed by employees.
He thinks the costs of compliance are among several issues leading to more consolidation among banks. A bank with $400 million in assets can merge with another bank and become one with $800 million in assets that combines its compliance functions.
Another solution short of merging is to narrow the bank’s focus and cut costs that way. A lot of small, community banks still are trying to be everything to everyone, and that’s not going to cut it, Schaus says. “You need to differentiate yourself,’’ he says.
Johnson says his bank is looking at its options to grow to become more efficient, which might mean buying another bank. With five full-time employees working on compliance, two of them lawyers, the cost of compliance has become quite high. “I’ve been here for 45 years and I never thought we’d be big enough to hire our own in-house lawyer,’’ he says.
Julie Stackhouse, the executive vice president for banking supervision at the St. Louis Fed, says she hears all the time that community banks are struggling under the weight of compliance, but they have other problems too, including low interest rates and slow growth in many of the small communities where they do business.
“The costs clearly are being attributed to consumer compliance laws and regulations, and there have been several new ones; and the ongoing costs of BSA and anti-money laundering legislation, which has been here for some time,” she says. She says banks are spending more on computer systems to help with compliance and BSA.
Highly Rated Banks Don’t Spend More Further, researchers analyzed whether banks who spend more on compliance have better management ratings on regulatory exams than banks who spend less. Apparently, that wasn’t the case. Other factors, such as the ability of management, the audit committee and auditors to work together to properly focus oversight attention, may better determine management ratings than the sheer number of dollars you spend on compliance, the researchers found.
In fact, for very highly rated banks under $100 million in assets, which received a “1” rating on their management score, the spend was about 6.8 percent of noninterest expenses, compared to 9.1 percent on average for everybody else in their size category.
There are obviously problems comparing your banks with others in your asset class. Some banks may have relatively high expenses because they do business in expensive cities such as San Francisco, or because they have expensive but highly profitable business models, so it doesn’t always make sense to compare your bank with an average.
Overall, though, Stackhouse thinks the study will be very useful. “Having research that supports analysis of the issues is going to be very useful for us going forward,’’ she says.
I was having a discussion about the future of banking with some fellow investors recently and one of my younger and more tech savvy associates opined that fintech companies would soon make traditional branch banking obsolete. It is a provocative idea but I am pretty sure he is wrong. Two decades from now it will still be fairly easy to find a bank branch a short drive away even if it is in a driverless car. Bankers will adapt and banking will become more mobile and more digital, but there will always be a place for banks and their branches in the economy.
Bankers are not sitting in their offices waiting to be replaced. They are finding ways to use new technology advancements to make their business faster, more efficient-and most importantly, less expensive. This is particularly true in one of the highest cost centers in the bank-regulatory compliance-where the automation of that detail intensive process is providing huge cost benefits. Compliance costs have been spiraling upward since the financial crisis led to an avalanche of new regulations, and technology might be the industry’s best hope of bringing those costs back down.
Bankers are starting to see the advantages of big data and analytics-based solutions when they are applied to the compliance challenge. “Although still in the early stages, banks are applying big data and advanced analytics across customer-facing channels, up and down the supply chain, and in risk and compliance functions,” said Bank of the West Chairman Michael Shepherd in a recent interview with the Reuters news service. For example, a growing number of banks are using new technology to automate the enormous data collection and management processes needed to file the proper compliance reports, particularly in areas like the Bank Secrecy Act. This new technology can help regional and community banks address data gathering and reporting challenges for regulatory compliance.
Smaller banks in particular are looking to partner with companies that can help build a data driven approach to compliance management. More than 80 percent of community banks have reported that compliance costs have risen by at least 5 percent as a result of the passage of the Dodd-Frank Act and the expense is causing many of the smallest institutions to seek merger partners. In fact, two of the biggest drivers of my investment process in the community bank stock sector is to identify banks where compliance costs are too high, and where there is a need to spend an enormous amount of money to bring their technology up to date. Odds are that those banks will be looking for a merger partner sooner rather than later.
While banks are looking to make the compliance process quicker, easier and cheaper, they also need to be aware that the regulators are developing a higher level of interest in the industry’s data collection and management systems as well. A recent report from consulting firm Deloitte noted that “[In] recent years regulatory reporting problems across the banking industry have more broadly called into question the credibility of data used for capital distributions and other key decisions. The [Federal Reserve Board] in particular is requesting specific details on the data quality controls and reconciliation processes that firms are using to determine the accuracy of their regulatory reports and capital plan submissions.”
The Consumer Financial Protection Bureau is also monitoring the compliance management process very closely. An assistant director there was quoted recently as saying that the bureau is increasingly focusing its supervisory work on the third-party compliance systems that both banks and nonbanks sometimes rely on. This is the behind-the-scenes technology that drives and supports the compliance process.
There is a developing opportunity for fintech companies to focus their efforts on providing regtech solutions to regional and community banks. The cost of compliance is excessive for many of these institutions and, for some, place their very survival into question. Regtech firms that develop compliance systems that are faster, more efficient and can help cut compliance costs significantly in a manner acceptable to the regulatory agencies will find a large and fast growing market for their services.
Reverse due diligence in the context of bank mergers and acquisitions has become more relevant in the current regulatory environment. Bank regulators are more closely scrutinizing transactions and taking a stricter approach to supervisory and regulatory matters. This may generally extend processing timeframes and increase risk to not only the buyer, but also the seller. Therefore, a seller should develop a fairly comprehensive understanding of the regulatory condition of a proposed suitor as early as possible, even in an all-cash deal.
Reasons for Reverse Due Diligence The purpose of a seller’s due diligence investigation of a buyer is to obtain sufficient data to allow the board of directors to make well-informed strategic decisions in accordance with its fiduciary duties. Such an investigation is important not only in transactions in which seller’s shareholders receive the buyer’s securities, but also in transactions in which the consideration is paid entirely in cash. A regulatory issue affecting the buyer can delay processing and lead to adverse consequences regardless of the form of consideration.
Recently, several transactions have been halted indefinitely as a result of regulatory concerns regarding the buyer, including fair lending practices, Bank Secrecy Act compliance and anti-money laundering protections. Under these circumstances, regulators may require remediation of the issues before resuming their review, which further extends the transaction timeframe. There are also recent examples of regulators staying review until satisfactory remediation is confirmed by the institution’s next full-scope examination. Furthermore, publication of regulatory delays may prompt public comments on the application, which could further delay approval.
A material delay in a pending transaction presents potential risks to a seller. If a definitive agreement provides a stand-still covenant, the seller is generally unable to pursue other transactions until a termination right becomes available (which may be several months down the road). A seller runs the risk of having to forego other strategic opportunities during any extended immobilization. Moreover, unanticipated delays may expose a seller to instability and disruption in its operations as a result of diverting personnel from ordinary banking duties, additional transaction costs and professional fees, criticism from investors and reputational risk.
Scope of Reverse Due Diligence While the scope of the investigation will depend on the nature and size of the institutions involved, a seller should at a minimum evaluate the following items:
the two or three most recent year-end financial statements (audited, if available) of the buyer;
sources of the buyer’s funding for the proposed transaction;
the status of any capital raising transactions or incurrence of indebtedness of the buyer;
anticipated capital requirements necessary for the buyer to fund the proposed transaction and execute its strategic plan;
buyer’s shareholder composition, including outstanding capital commitments; and
material pending or threatened litigation involving the buyer or its affiliates.
Ideally, a seller also should be satisfied with the buyer’s regulatory condition and should be aware of any regulatory enforcement actions. A seller should also be aware of the timing of the buyer’s next examination and whether it will occur during the anticipated application period.
However, reverse due diligence is challenged by legal restrictions on disclosing confidential supervisory information, including examination reports, to third parties, which could prevent a seller from obtaining reasonable comfort in the buyer’s ability to obtain regulatory approval. In such case, a seller may consult its legal advisor regarding alternative methods for completing its review of the buyer. Furthermore, there may be conditions affecting the buyer that do not become material until after the definitive agreement is signed and applications are filed.
Depending on the results of reverse due diligence, a seller may consider negotiating contractual protections, including representations and warranties related to the buyer’s compliance with laws and regulatory condition, limitations on the buyer’s ability to terminate for burdensome regulatory conditions, and acceleration of seller’s termination right in the event of delays in obtaining regulatory approval. In addition, a seller may consider negotiating reverse break-up fee arrangements or purchase price adjustments related to delays in obtaining regulatory approval.
Conclusion Bank regulators are taking a more authoritative approach to supervisory and regulatory matters in the context of bank mergers and acquisitions. Accordingly, sellers should plan fairly comprehensive reverse due diligence in all potential transactions. While reverse due diligence will not eliminate all of seller’s transaction risk, it can better the position seller in making strategic decisions and negotiating contractual safeguards that are commensurate with the anticipated risk.
There were more than 900 attendees at Bank Director’s Acquire or Be Acquired Conference in Phoenix this week, and zero bank regulators. So it wasn’t much of a surprise that the crowd of mostly bank directors and bank CEOs frequently bashed regulation and its enormous cost burdens. In the wake of the financial crisis and the ensuing Dodd-Frank Act, banks are ramping up their compliance departments and facing an onslaught of fines, as well as an increased focus on consumer rights and the Bank Secrecy Act.
This added burden has been most difficult for the smallest banks to handle, because they have fewer resources. I talked to one bank CEO, Joe Stewart, who owns a series of small banks in Missouri, and has sold two of them since 2013, each below $200 million in assets. He said the banks couldn’t afford to add a second compliance person to a staff of one. He pointed in particular to increased reporting requirements and disclosure standards for residential mortgage loans. “Unless you can get some regulatory relief, we can’t survive,’’ he said.
No doubt, for very small banks, regulatory costs are a much greater burden than they are for larger banks. But other factors are at play, too. When asked what factors are driving M&A in the marketplace, an audience poll revealed regulatory cost was the no. 4 most popular answer, after such factors as shareholders looking for liquidity, being too small to compete with bigger banks, and retiring leadership.
When I asked the CEO of BNC Bancorp, the parent company of Bank of North Carolina, Rick Callicutt, who has purchased eight banks in five years, what is driving banks to sell, he thought regulatory costs were part of the equation. But he also thinks banks are looking at their balance sheets and realizing they are going to make less money in a few years than they make today, and are not satisfied with that future. Some have realized that their loan portfolios are filled with fixed rate loans at seven-, 10-, and 15-year terms, and they are not going to be in a good position.
Mark Kanaly, an attorney at Alston & Bird, doesn’t think compliance costs are a huge factor in consolidation. “It’s not the determinant,’’ he said. Most often, bank leadership teams take a look at what they can realistically achieve, and don’t like what they see.
Another clue to what’s driving recent bank acquisitions is to look at the industry’s profitability as a whole. The median return on equity was just 8.7 percent in the third quarter of 2015, according to a Keefe, Bruyette & Woods analysis of the banks in their coverage universe. The average return on assets was .91 percent. Interests rates are likely to stay low for some time, continuing pressure on bank profitability.
A lot of banks simply aren’t doing that well. Regulators may be partly to blame for increased consolidation, but they aren’t the whole story.
With the first prime time Republican primary debate of the 2016 election cycle in the rear view mirror, we have all gotten an inkling of what the candidates think about the banking industry. I did take particular note of Senator Marco Rubio when he stressed the importance of repealing the Dodd-Frank Act. As Commerce Street Holdings’ CEO shared in an article on BankDirector.com, “many bankers feel that given the legislative and regulatory environment coupled with low rates, low margins, low loan demand and high competition, growth is very difficult.” So repealing Dodd-Frank is a dream for many officers and directors, and Rubio is echoing their concerns.
Senator Rubio’s comments build on those of former Texas Governor Rick Perry, who recently laid out a sweeping financial reform agenda earlier. He believes the biggest banks need to hold even more capital—or Congress should possibly reinstitute elements of the Glass-Steagall Act. While his campaign appears to be winding down, I do agree with his call for government to work harder to “level the playing field” between Wall Street banks and community institutions.
With so much political scrutiny already placed on banks, it is interesting to think of the pressures being placed on institutions to grow today. On one side, you have politicians weighing in on how banking should operate. On the other, regulatory and investor expectations are higher now than in recent years. Buckle up, because I believe the coming election will only further encourage politicians with opinions, but little in the way of detailed plans, about “revitalizing” the economy.
Against this political backdrop, today’s business environment offers promising opportunity for bold, innovative and disciplined executives to transform their franchises. But I believe regulatory hurdles are making it tougher to do deals. Indeed, the recently approved merger of CIT Group and OneWest Bank creates a SIFI [Systemically Important Financial Institution] which will have to submit to increased regulation and scrutiny. However, when the deal was first announced, CIT’s CEO, John Thain, suggested that his purchase of OneWest could spur other big banks to become buyers. A year later and such activity has yet to be seen.
I see the absence of bigger deals reflecting a reality where any transaction comes with increased compliance and regulatory hurdles. For CIT, going over the $50 billion hurdle meant annual stress tests will now be dictated by the government, as opposed to run by the bank. The institution will have to maintain higher capital levels. Thain seems to think that those added costs and burdens are worth it. By the lack of action, other banks haven’t yet agreed.
Without a doubt, regulatory focus has impacted strategic options within our industry. For instance, we learn about CRA [Community Reinvestment Act] impacting deals and also find fair lending concerns and/or the Bank Secrecy Act delaying or ending potential mergers. Consequently, deals are more difficult to complete. As much as a bank like CIT can add cost savings with scalability to become more efficient, you can understand why banks in certain parts of the country need to debate whether it is better to sell today or to grow the bank’s earnings and sell in three to five years.
The evidence is clear that big banks are not doing deals. Maybe a GOP victory in the next election will thaw certain icebergs, creating a regulatory environment more friendly to banks. While regulators have to comply with existing laws, the leadership of regulatory institutions is appointed by the president and the tone at the top is critical in interpreting those laws. Until we see real action replace cheap talk, I’m looking at CIT as an outlier and simply hoping that political rhetoric doesn’t give false hope to those looking to grow through M&A.