How to Level the Playing Field Through Buy Now, Pay Later

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Buy now, pay later (BNPL) has exploded over the last few years and its momentum shows no signs of slowing. In fact, BNPL payments orders grew 85% and revenue increased 88% during Thanksgiving, Black Friday and Cyber Monday compared to the week before, according to Adobe Analytics. Not only is BNPL taking a growing share of lending from many community banks, BNPL platforms are now beginning to move into credit and debit card products too, potentially further eroding banks’ opportunities, and worse, the relationships with their current customers. Fortunately, several white-label solutions are now entering the market, enabling banks to meet the demands for BNPL and to better compete and retain market share of the customer’s wallet.

However, the increased usage and adoption of these solutions has also begun to highlight some of the problems this payment option can pose for both consumers and lenders alike. While it can present an easy way to buy items on credit, every purchase becomes multiple payments to manage and, unsurprisingly, 42% of BNPL users have missed a payment, with 33% of users overdrafting their checking accounts in just one month. As more of today’s borrowers take on an increasing number of BNPL payments, the chance for delinquencies will rise, especially for those customers living paycheck-to-paycheck. Keeping track of BNPL payments in addition to other expenses can get complicated quickly, and for many, one missed loan, credit card or bill payment could mean a long-term hit to their credit scores (and potentially a default for the lending bank).

With BNPL’s popularity and accessibility, it is unlikely to be going away anytime soon, so the question becomes how can banks make BNPL products better and safer for their customers while mitigating their risk? Luckily, banks have several advantages over pure-play fintechs they can leverage to deliver a superior BNPL experience.

  1. If limiting BNPL offerings to current customers, banks can use customer history to make ability-to-pay judgments prior to extending BNPL credit. Not only will this control potential losses, but it will also enable banks to make stronger offerings, whether providing more credit or as a tie-in with other products (e.g., bumped-up deposit account rates, reduced annual credit card fees, free overdraft protection).
  2. While banks can only encourage ACH autopay for BNPL payments, alternatively, they can require repayment through payroll-linked payments. This allows customers to simply “set it and forget it,” avoiding the need to manage multiple payment schedules for various purchases. It could also serve as an incentive to set up direct deposit for customers who are not already doing so (or to move their direct deposit).
  3. Banks can provide tracking tools for their BNPL customers. One key issue with BNPL is that the loans are not typically reported to credit bureaus (although some providers have started). This makes it impossible for lenders to know how many outstanding BNPL loans a customer has (referred to as “stacking” by the CFPB). It is also difficult for customers to track their payments, so banks can add real value by providing visibility, both for themselves as well as for their customers. Additionally, tracking provides greater insights to enhance future ability-to-pay decisions, allowing banks to continue improving their offerings.
  4. Banks should be fully transparent and go the extra mile for their disclosures. Per the Consumer Financial Protection Bureau, loans with four-or-less payments are not required to provide cost-of-credit disclosures, but doing so can be very useful for the customer. Clearly explaining that while BNPL is interest-free for them, the retailer is paying a fee in exchange for a sale, helps ensure customers better understand the process. Banks can even provide broad guidance on BNPL products for their customers, further enabling them to make good decisions about which payment method is best.
  5. Banks can create a big cross-selling opportunity by tying a debit card and, potentially, rewards points to a BNPL offering. This could be particularly effective with millennials and Gen Z customers who tend to be higher users of BNPL (and often lack or do not trust credit cards). While debit cards are not big money-makers for banks, they can act as effective relationship-builders that open the door for traditional deposit accounts and other products over time.

Consumer appetite for BNPL products is growing, as are the number of platforms available to meet that demand. In fact, many national banks are either in the process or have already rolled out their own BNPL offerings. While competition is increasing, the good news is that options like white-label solutions offer community banks the tools to become leaders in this popular market and can help level the playing field.

What’s more, as the CFPB introduces new regulations covering BNPL, banks’ competitive advantage versus pure-play BNPL players will likely increase, as most will be much better positioned to adapt and comply with future regulations. Today’s community banks should consider their options now and develop their BNPL strategies to both retain their existing customer relationships and compete for new ones in the future.

Overdraft Fees Are Getting a Much-Needed Overhaul

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Overdraft fees have been a significant source of noninterest income for the banking industry since they were first introduced in the 1990s. But these “deterrent” fees are on the chopping block at major financial institutions across the country, putting pressure on smaller banks to follow suit. 

Overdraft and non-sufficient funds (NSF) fees brought in an estimated $11 billion in revenue in 2021, according to the Financial Health Network, significantly down from $15.5 billion in fee revenue in 2019. As the industry responds to ongoing regulatory pressure on top of increased competition from neobanks and disruptive fintechs, that downward trend is expected to continue. 

For larger banks, those with more than $10 billion in assets, overdraft fee income has trended downward since 2015. Christopher Marinac, director of research at Janney Montgomery Scott, reported on this back in December 2021 after noting overdraft fees had declined for 23 quarters and expects this trend to continue into 2022. Despite the decline, regulators continue to focus on them, citing their role in the growth of wealth inequality. 

“[R]egulators have clearly sent a signal that they want those fees to either go away or be less emphasized,” Marinac says. “Like a lot of things in the regulatory world, this has been an area of focus and banks are going to find a way to make money elsewhere.”

For an industry that has evolved so rapidly over the last 10 years, overdraft fees represent a legacy banking service that has not adapted to today’s digital banking customer or the realistic cost to service this feature, says Darryl Knopp, senior director of portfolio marketing at the credit rating agency FICO. Knopp believes that an activities-based cost analysis would show just how mispriced these services actually are. It’s one reason why neobanks such as Chime have attracted customers boasting of lower fees. If banks were to think about overdrafts as access to short-term credit, that would change the pricing conversation to one of risk management. 

“Banks are way more efficient than they were 30 years ago, and they need to understand what the actual costs of these services are,’’ Knopp says. “The pricing has not changed since I got into banking, and that’s why [banks] are getting lapped by the fintechs.” 

Overdrafts aren’t going to disappear overnight, but some banks are getting ahead of the trend and taking action. Bank of America Corp., Wells Fargo & Co., and JPMorgan Chase & Co., which together brought in an estimated $2.8 billion in overdraft and NSF fee revenue in the first three quarters of 2021, recently announced reduced fees and implemented new grace periods, according to the Consumer Financial Protection Bureau. Capital One Financial Corp. announced the elimination of both overdraft and NSF fees back in December and Citigroup’s Citibank recently announced plans to eliminate overdraft fees, returned item fees, and overdraft protection fees. 

In April, $4.2 billion First Internet Bancorp of Fishers, Indiana, announced the removal of overdraft fees on personal and small business deposit accounts, but it continues to charge NSF fees when applicable. Nicole Lorch, president and chief operating officer at First Internet Bank, talked to Bank Director’s Vice President of Research Emily McCormick about the decision to make this change. She says overdrafts were not a key source of income for the bank and the executives wanted to emphasize their customer-centric approach to service. First Internet Bank’s internal data also found that overdraft fees tended toward accidental oversight by the customers, whereas NSF fees were more often the result of egregious behavior. 

“In the case of overdrafts,” says Lorch, “it felt like consumers could get themselves into the situation unintentionally, and we are not in this work to create hurdles for our customers.”

For banks that are grappling with the increased pressure to tackle this issue, there are other ways to get creative with overdraft and NSF fees. Last year, PNC Financial Services Group introduced its new “Low Cash Mode” offering, which comes with the Spend account inside of PNC’s Virtual Wallet. Low Cash Mode alerts customers to a low balance in their account. It gives customers the flexibility to choose which debits get processed, and provides a grace period of 24 hours or more to address an overdraft before charging a fee.

Banks that want to keep pace with the industry and are willing to take a proactive approach need to find ways to offer more personalized solutions. 

“The problem is not the overdraft fee,” says Ron Shevlin, chief research officer at Cornerstone Advisors. “It’s a liquidity management problem and it’s bigger than just overdrawing one’s account. Banks should see this as an opportunity to help customers with their specific liquidity management needs.” 

He says it’s time for the industry to move away from viewing overdrafts as a product and start thinking of it as a solutions-based service that can be personalized to a customer’s unique needs.

  • Bank Director Vice President of Research Emily McCormick contributed to this report.

What Does Today’s Community Banker Look Like?

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After more than a year of great uncertainty due to the coronavirus pandemic, the biggest driver of change for community banks now will likely come from customer behavior.

The shift towards digital banking that took off during the pandemic is expected to become permanent to some degree. Customers are most likely to use online or mobile channels to transact and they are becoming more involved in fraud prevention, with measures such as two-step verification. They are also performing an increasing number of routine administrative tasks remotely, like activating cards or managing limits. Branches are likely to endure but will need to rethink how to humanize digital delivery: The Financial Brand reports that 81% of bankers believe that banks will seek to differentiate on customer experience rather than products and location.

Digitalization is good news for community banks. It reduces pressure on the branch network and increases opportunities to develop the brand digitally to reach new customers. But it also creates an obligation to deliver a good digital experience that reduces customer effort and friction. In the digital age, customers face less costs of switching banks.

Banks that assume they will be the sole supplier of a customer’s financial services or that a relationship will endure for a lifetime do so at their own risk. President Joseph Biden’s administration is promoting greater competition in the bank space through an executive order asking the Consumer Financial Protection Bureau (CFPB) to issue rules that give consumers full control of their financial data, making it easier for customers to switch banks. Several countries have already implemented account switching services that guarantee a safe transfer. How should community banks respond so they are winners, not losers, with these changes?

With their familiar brands, community banks are well positioned for success, but there are things they must do to increase customer engagement and build loyalty. Continuing to invest in digital remains crucial to delivering a digital brand experience that’s aligns with the branch. Such investment will be well rewarded — not only in retaining customers but also attracting new ones, particularly the younger generation of “digital natives” who expect a digital-first approach to banking. The challenge will be migrating the trust that customers have in the branch to the app, offering customers choice while maintaining a similar look and feel.

The branch will continue being a mainstay of community banking. Customers are returning to their branches, but its use is changing and transactions are declining. Customers tend to visit a branch to receive financial advice or to discuss specific financial products, such as loans, mortgages or retirement products. Some banks already acknowledge this shift and are repurposing branches as advice centers, with coffee shops where customers can meet bankers in a relaxed atmosphere. In turn, bankers can go paperless and use tablets to guide the conversation and demonstrate financial tools, using technology augmented by a personal touch.

Community banks can play a crucial role in promoting financial literacy and wellness among the unbanked. As many as 6% of Americans are unbanked and rely on alternative financial services, such as payday loans, pawnshops or check cashing services to take care of their finances. According to a 2019 report by the Federal Reserve, being unbanked costs an individual an average of $3,000 annually. By increasing financial inclusion, community banks can cultivate the customers of tomorrow and benefit the wider community.

Cryptocurrencies are the next stage of the digital revolution and are becoming more mainstream. Although community banks are unlikely to lose many customers in the short term over cryptocurrency functionality, these digital assets appeal to younger customers and may become more widely accepted as a payment type in a decade. Every bank needs a strategy for digital assets.

The shift to digital banking means bank customers expect the same experience they get from non-financial services. Application program interfaces (APIs) have ushered in a new era of collaboration and integration for banks, their partners and customers. APIs empower banks to do more with data to help customers reduce effort, from automating onboarding to access to funds and loans immediately. At a time when community banks and their customers are getting more involved with technology, every bank needs an API strategy that is clearly communicated to all stakeholders, including partners and customers. Although APIs cannot mitigate uncertainty, they do empower a bank to embrace change and harness the power of data. Banks without an APIs strategy should speak to their technology partners and discover how to find out how APIs can boost innovation and increase customer engagement.

Former CFPB Head on a Post-Pandemic Banking Industry

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Banks across the country have been frontline responders in the unfolding economic crisis.

Many are offering forbearance and modifications to borrowers facing health emergencies or financial hardship. But they should take care not to assume business will get back to normal for their consumers, even as states reopen and economic activity thaws, says former CFPB Director Richard Cordray.

Cordray, the former Ohio Attorney General, headed up the Consumer Financial Protection Bureau after its inception in the passage of the Dodd-Frank Act until his resignation in 2017. The sometimes-controversial agency focuses on consumers’ financial rights and protections; its jurisdiction extends to institutions above $10 billion in assets.

Bank Director recently spoke with Cordray after a COMPLY Summit Series webinar that he participated in about how banks can navigate customer relationships during and after the pandemic.

BD: This pandemic has led banks to roll out consumer-friendly policies, like waiving or suspending overdraft or late fees. Do you think these changes are permanent, or do you see them coming back?
RC: The fees have been put on hiatus at certain banks, but they’re still out there. It has been better practice for banks, during this crisis, to be very consumer friendly —  recognizing that, through what is clearly no fault of their own, many of their customers have been required to stay at home, their businesses have been shuttered and they don’t have income coming in — and give them a break.

BD: What should guide banks as they decide how to help consumers?
RC: At this point, I think the pressure on banks is mostly reputational. If banks are not perceived as serving their customers in involuntary distress well, they end up in trouble as a matter of public branding. There’s a certain normative effect on banks now, in the depths this crisis, that has nothing to do with what they’re legally allowed or not allowed to do.

If bank customers are going regain their footing in the future, shoving them into bankruptcy or financial ruin is not helpful and it’s not in the bank’s own interest. Reputational risk is a real and significant thing that banks have to think about. All you have to do is think about Wells Fargo and how their reputation has been damaged in recent years. Banks do not want to take on the brand of being a company that’s not sensitive to their customers.

BD: There have also been consumer-friendly practices coming out of the CARES act and different edicts from state government for moratoriums on evictions. How can financial institutions aid in these efforts?
RC: To the extent that banks hold car loans or mortgages [that aren’t subject to CARES Act relief], they have a judgment to make: Are they going to afford similar relief to their customers? Some are, some aren’t. If you’re holding auto loans, you can dictate that there will be no auto repossessions during this period. I think that would be by far the better practice.

BD: We’ve seen announcements from regulators encouraging banks to work with customers. Is there anything regulators or banks could be doing more of?
RC: I think it would make sense for mortgages holders to give forbearance to their customers, whether or not its mandated by the CARES Act. Foreclosure is a last resort. If we have a rash of foreclosures, they’re going to get tied up in the courts and it’ll be difficult for mortgage holders to foreclose quickly. They will start to suffer the loss of the abandoned and vacant houses that we saw during the last crisis, and that’s something to be avoided at all costs for them.

BD: Once we return to a more normal operating environment, I imagine many of these types of forbearance relief will go away. Do you have any thoughts about how banks can help customers through this transition?
RC: The wrong way to do this would be to say that debts accumulated over the course of the emergency orders need to be repaid all at once. That is not realistic and is not going to be successful. If people couldn’t make those payments during this period, they’re not going to have all that money suddenly to pay it just because we came to the end of this period. The result will be foreclosures, evictions and repossessions. The right thing to do is have that amount be repayable over time or put it on the back end of the loan.

The Latest Look at the “New CFPB”

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CFPB-5-28-19.pngOn April 17, Consumer Financial Protection Bureau Director Kathleen Kraninger delivered her first policy speech at the Bipartisan Policy Center. She touched rule promulgation, supervision and enforcement, previewing of the tone and direction of the CFPB under her leadership.

Rule Pomulgation
One important concern for banks will be rule promulgation at the agency, or how the bureau proposes, enacts and enforces regulations. In the speech, Kraninger said that the bureau will release proposed rules to implement the Fair Debt Collection Practices Act in the coming weeks.

The promulgation of these rules has been in the CFPB’s pipeline since the Dodd-Frank Act transferred rulemaking authority related to the state exemptions under the Fair Debt Collection Practices Act to the bureau. We saw proposed rulemaking in 2013, followed by various pushes under the tenure of former Director Richard Cordray. Through these pushes in between 2011 and 2017, we learned that the CFPB’s efforts in the Fair Debt Collection Practices Act space were broad and, the industry argued, unduly burdensome on creditors. These efforts included rules to address litigation disclosures, information integrity and associated liability, time-barred debt and, possibly, first-party collector liability.

In contrast, Kraninger focused on how the new rules will provide clear, bright-line limits on the number of calls consumers may receive and how to communicate using newer technology such as email or text messages—issues the industry has sought guidance on. It will be interesting to contrast the proposed actions outlined under Cordray’s tenure to the rules issued under Kraninger.

As Kraninger made clear in her speech, “[b]ecause rules are general standards, they are not best articulated on a case-by-case basis through enforcement actions.” Rather, she said they should be developed through transparent rulemaking that allows stakeholders to submit comments and include “rigorous” economic and market analysis as well as judicial review.

Supervision
In her speech, Kraninger reiterated that “supervision is the heart of this agency–particularly demonstrated by the percentage of our personnel and resources dedicated to conducting exams.”

Though she shares this sentiment with Cordray, she pointed out that “the bureau is not the only government regulator supervising any given entity” and that it must “ensure that we do not impose unmanageable burdens while performing our duties.”

This may be the clearest demarcation between the two directors. Cordray’s leadership did not seem to consider the “burden” of supervision experienced by a supervised entity; that regime was solely focused on consumer protection.

While the industry has yet to see a substantial shift in the approach to supervision, Kraninger’s remarks hint that we will see some relief as the CFPB considers its approach to exams. The agency could make changes in the prioritization and frequency of exams, the size of the exam teams, the number days spent on-site, the supporting systems and job aids, the time it takes to complete an exam and deliver a report and how the bureau empowers examiners to provide input on the process.

Enforcement
Kraninger also stated that “enforcement is an essential tool Congress gave the bureau,” another echo to Cordray’s leadership. However, she diverged by adding that “purposeful enforcement is about utilizing robust resources most effectively to focus on the right cases to reinforce clear rules of the road.”

Kraninger’s use of the phrase “clear rules of the road” is interesting. Justice Brett Kavanaugh, then on the U.S. Court of Appeals for the District of Columbia Circuit, used similar imagery when he criticized the lack of due process in the CFPB’s “regulation through enforcement” approach with regards to their PHH enforcement action.

“Imagine that a police officer tells a pedestrian that the pedestrian can lawfully cross the street at a certain place. The pedestrian carefully and precisely follows the officer’s direction. After the pedestrian arrives at the other side of the street, however, the officer hands the pedestrian a $1,000 jaywalking ticket. No one would seriously contend that the officer had acted fairly or in a manner consistent with basic due process in that situation,” he wrote in the 2016 decision for PHH Corp. v. CFPB. “Yet that’s precisely this case.”

While only time can tell, it appears that the industry can expect clear guidance and that rules that redefine industry standards will proceed related enforcement efforts.

The more activity from the “New CFPB,” the more observers will be able to gauge how it interacts with institutions. The shift occurring under the agency’s new leadership will most likely impact those companies that push regulatory boundaries. We continue to see a deep review of institutions’ core compliance management systems and associated controls. If your bank is wading into an unsettled regulatory area, you would best served in documenting the decision-making process, including considerations of the existing regulatory framework.

How Risk Culture Drives a Sound Third-Party Risk Management Program

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risk-10-1-18.pngRisk culture plays a role in every conversation and decision within a financial institution, and it is the key determinant as to whether a bank performs in a manner consistent with its mission and core values. Risk culture is a set of encouraged, acceptable behaviors, discussions, decisions and attitudes toward taking and managing risk.

Third-party risk management (TPRM) is a fairly new discipline that has evolved over the past few years from legacy processes of vendor or supplier management functions previously used by companies to manage processes or functions outsourced to third parties. A “third-party” now refers to any business arrangement between two organizations.

The interagency regulatory guidance (The Federal Reserve Board, OCC, FFIEC and CFPB) says a bank cannot outsource the responsibility for managing risk to a third-party especially when additional risks are created. These risks may relate to executing the process or managing the relationship.

The recent Center for Financial Professionals (CFP) Third Party Risk Management survey “Third Party Risk: A Journey Towards Maturity” underpinned the issue around risk culture given the resourcing dilemma that most organizations face. Getting top-down support and buy-in was an issue posed by respondents in the survey. One respondent stated, “The greatest challenge ahead is to incorporate third party risk management goals into the goals of the first line of defense.” Another respondent stated, “Challenges will be to embed this into the organization, including [the] establishment of roles and responsibilities.” In particular, TPRM teams found it challenging to get buy-in from the first line of defense for the management of cyber risk and concentration risk.

Effective TPRM can only be achieved when there is a risk-centric tone, at the top, middle and bottom, across all layers of the company. Clear lines of authority within a three-lines-of-defense model are critical to achieving the appropriate level of embeddedness, where accountabilities and preferred risk management behaviors are clearly defined and reinforced.

Root cause analyses on third-party incidents and risk events (inclusive of near-misses) should be better used by organizations to reinforce training and lessons learned as it relates to duties performed by the third party. Risk event reporting and root cause analysis allows leadership to identify and understand why a third party incident occurred, identifies trends with non-performance of service-level agreements with the third party, and ensures appropriate action is taken to prevent repeat occurrences as it relates to training, education or communication deficiencies.

Risk culture is paramount to achieving benefits from the value proposition of an effective and sustainable TPRM program, and also satisfies regulators’ use test benchmarks.

Roles and responsibilities must be clearly defined and integrated within a “hub and spoke” model for the second-line TPRM function, the first line third-party relationship managers and its risk partners. Clearly, there is a need for financial institutions to (1) implement a robust training and communication plan to socialize TPRM program standards, and (2) ensure first-line relationships and business owners have been provided training.

Risk culture mechanisms that facilitate clear, concise communication are fundamental components for a successful TPRM program – empowering all parties to fulfill responsibilities in an efficient, effective fashion. The challenge of managing cultural and personnel change components cannot be underestimated. As a result, the involvement of human resources, as a risk partner, is critical to a successful resource model. With respect to cultural change, a bank should observe and assess behaviors with current third-party arrangements. The levels of professionalism and responsibility exhibited by key stakeholders in existing third-party arrangements may indicate how much TPRM orientation or realignment is required.

Key success factors to build a robust risk culture across TPRM include:

  • Clear roles and responsibilities across the three lines of defense and risk partners within the “hub and spoke” model for risk oversight.
  • Greater consistency of practices with regards to treatment of third parties. Eliminate silos.
  • Increase understanding of TPRM activities and policy requirements across the relationship owners and risk partners.

Indicators of a sound TPRM culture and program include:

  • Tone from the top, middle and bottom – the board and senior management set the core values and expectations for the company around effective TPRM processes from the top down; and front-line business relationship manager behavior is consistent from the bottom-up with those values and expectations. 
  • Accountability and ownership – all stakeholders know and understand core values and expectations, as well as enforcement implications for misconduct. 
  • Credible and effective challenge – logic check for overall TPRM framework elements, whereby (1) decision-makers consider a range of views, (2) practices are tested and (3) open discussion is encouraged.
  • Incentives – rewarding behaviors that support the core values and expectations.

Setting a proper risk culture across the company is indeed the foundation to building a sound TPRM program. In other words, you need to walk before you can run.

Dodd-Frank Reform Creates New Strategic Considerations For Community Banks

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regulation-9-14-18.pngIn May, President Donald Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Growth Act”), which provided long-awaited—and in some cases modest—regulatory relief to financial institutions of all sizes. Due to the adjustment of certain assets thresholds that subject banks to various regulatory burdens, the biggest winners from the regulatory reform are community banks with assets below $10 billion and regional banks with total assets above the $10 billion threshold and aspirations for future significant growth. As a result, it is incumbent upon these institutions to include in their strategic planning a new set of issues, examples of which are provided below.

Congress Eases Regulatory Environment for Community Banks
For community banks under $10 billion in total consolidated assets, the Growth Act repealed or modified several important provisions of the Dodd-Frank Act. In particular, the Growth Act:

  • Increases the total asset threshold from $2 billion to $10 billion at which banks may deem certain loans originated and held in portfolio as “qualified mortgages” for purposes of the CFPB’s ability-to-repay rule;
  • Requires the federal banking agencies to develop a Community Bank Leverage Ratio of not less than 8 percent and not more than 10 percent, under which any qualifying community banks under $10 billion in total assets that exceeds such ratio would be considered to have met the existing risk-based capital rules and be deemed “well capitalized;” and
  • Amends the Bank Holding Company Act to exempt from the Volcker Rule banks with total assets of $10 billion or less and which have total trading assets and trading liabilities of 5 percent or less of their total consolidated assets.
  • It is expected that these changes will have a significant effect on the operations of community banks. As an example, qualifying banks under the Community Bank Leverage Ratio will be relieved from the more stringent international capital standards and, as a result, may be better able to deploy capital.

Crossing the $10 Billion Threshold is Now a Lot Less Ominous, but There is Still a Price to be Paid
The revisions to asset thresholds are not limited to those affecting smaller institutions and offer significant regulatory relief to institutions with greater than $10 billion in assets and less than $100 billion in assets. Such relief changes the calculus of whether to exceed the $10 billion threshold.

On the plus side, the $10 billion threshold at which financial institutions were previously required to conduct annual company-run stress tests, known as DFAST, has been moved to $250 billion in assets. In addition, publicly traded bank holding companies no longer have a regulatory requirement to establish risk committees for the oversight of the enterprise-wide risk management practices of the institution until they reach $50 billion in assets. We anticipate, however, that most if not all institutions near or exceeding $10 billion in assets will continue to maintain board risk committees and will be conducting modified forms of stress testing for safety and soundness purposes.

On the downside, and perhaps most important, is what the Growth Act did not change: financial institutions with assets over $10 billion in assets continue to be subject to the Durbin Amendment, the Volcker Rule and the supervision and examination of the CFPB. In addition, the regulatory benefits the Growth Act newly provides to community banks will be lost when the $10 billion asset threshold is crossed.

New Strategic Issues To Consider
Based on the changes described above, senior executives and boards of directors should continue to carefully consider the regulatory impact of growing (or possibly shrinking) their institution’s balance sheet. Such considerations may include:

  • How will the institution’s capital position change under the simplified capital rules applicable to qualifying community banks?
  • Will compliance with the Community Bank Leverage Ratio rule ultimately result in a more efficient capital structure, or result in a need for more capital, compared to compliance with the current multi-faceted capital requirements?
  • Will near term compliance with a simplified Community Bank Leverage Ratio be outweighed by the cost of transitioning back to the existing regime once $10 billion is assets is achieved?
  • Given the institution’s loan portfolio and target market, would the institution benefit from the automatic qualified mortgage status now afforded to institutions under $10 billion?
  • Will the institution meaningfully benefit under the revised provisions of the Volcker Rule, and how might that affect the institution’s financial position?
  • Will the new benefits of being under $10 billion alter an institution’s strategic plan to grow over $10 billion, or is the relief from the company-run stress test and risk committee requirements enough to outweigh the regulatory relief provided to institutions under $10 billion?

Three Themes Are at the Top of Bankers’ Minds Right Now

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risk-6-14-18.pngIf one looks at the bank industry as a whole, it’s easy to agree with Jamie Dimon, the chairman and CEO of JPMorgan Chase & Co., the nation’s biggest bank by assets, that we are in the midst of a “golden age of banking.”

This is true on multiple fronts. Dimon’s comments were directed specifically at the easing of the regulatory burden on banks, an evolution that has been going on since the change in administration at the beginning of last year. The lighter touch is most evident at the Consumer Financial Protection Bureau, which has taken a more passive approach to enforcement actions under its current acting director, Mick Mulvaney. The broadest base of regulatory relief culminated last month, when federal legislation was signed into law that eased the compliance burden on smaller banks in particular.

Banks are also reaping benefits from the cut last year in the corporate income tax rate from 35 percent down to 21 percent. The change led to a surge in profits and profitability.

These events highlight a trio of themes that emerged from this year’s Bank Audit & Risk Committees Conference hosted by Bank Director in Chicago. Each theme is unique, but the common denominator is that bank boards face an evolving landscape when it comes to the macroeconomic environment, cyber security threats and the means through which a bank can navigate this landscape.

Profitability is a point that Steve Hovde, chairman and CEO of Hovde Group, stressed in a presentation on the current and future state of banking. Banks earned a record $56 billion in the first quarter of the year, which amounted to 28 percent growth over the same quarter of 2017. And while the industry has yet to report a return on assets above 1 percent on an annual basis since the financial crisis a decade ago, the average bank eclipsed that figure in the first three months of the year.

And banks aren’t just more profitable, they’re also arguably safer, former Comptroller of the Currency Thomas Curry noted in a conversation with Bank Director magazine Editor in Chief Jack Milligan. Curry pointed to the fact that banks have more capital than they’ve had in decades.

Yet, as Hovde noted, many of these positive performance trends are not being experienced equally across the industry, with the lion’s share going to the biggest banks. The return on average assets of banks with between $10 billion and $50 billion in assets is 1.27 percent compared to 0.72 percent for banks with less than $1 billion in assets. This is also reflected in bank valuations, with big banks trading on average for more than two times tangible book value compared to 1.4 percent for smaller banks.

This gap is projected to grow with time, in part because of a second theme that coursed through conversations at this year’s Bank Audit & Risk Committees Conference: trends in technology and cyber threats, which large banks have deeper pockets to address. Of all the things that concern bank officers and directors right now, especially those tasked with audit- and risk-related duties, the need to defend against cyber threats is at the top of the list.

There are approximately 20 million hostile cyber events every day, with an estimated 200,000 of these targeted at financial institutions, noted Alex Hernandez, vice president of DefenseStorm, a cybersecurity defense firm. Seventy-three percent are perpetrated by people outside the organization compared to 28 percent by insiders. It isn’t just criminals who pose a threat, as nation-state actors are behind 12 percent of hostile cyber events, with their timing tending to coincide with elections.

The solution, Hernandez notes, is to double down on the fundamentals of cyber defense. “The most effective way to address cyber threats isn’t to focus on the latest shiny object like artificial intelligence, it’s about educating your staff and securing your network.” To this point, most threats come through unsophisticated channels, be it an email phishing scheme or malware delivered by way of a thumb drive.

One challenge in addressing these threats is simply recruiting the right expertise—not only on the bank level, but also on the board. Finding and retaining the right talent in not only information security but elsewhere was also a recurring theme. Most board members in attendance acknowledge they don’t know enough about technology to ask the right questions. But recruiting people who do is easier said than done, especially for banks in rural communities, who often try to tap into nearby metro areas for talent, or offer creative compensation plans to mitigate risk and retain younger officers.

There are certainly reasons to suggest big banks are experiencing a golden age, but smaller and mid-size banks shouldn’t use this recent change in fortune as an excuse to rest on their laurels. It remains incumbent on bank officers and directors to stay vigilant against ever-evolving cybersecurity risks and focused on recruiting the talent and designing effective governance structures to address them.

The Deregulation Promise Beginning to Bear Fruit

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regulation-5-14-18.pngEd Mills, a Washington policy analyst at Raymond James, answers some of the most frequent questions swirling around the deregulation discussion working its way through Congress, the changing face of the Fed and other hot-button issues within the banking industry.

Q: You see the policy stars aligning for financials – what do you mean?
The bank deregulatory process anticipated following the 2016 election is underway. The key personnel atop the federal banking regulators are being replaced, the Board of Governors at the Federal Reserve is undergoing a near total transformation, and Congress is set to make the most significant changes to the Dodd-Frank Wall Street Reform Act since its passage. This deregulatory push, combined with the recently enacted tax changes, will likely result in increased profitability, capital return, and M&A activity for many financial services companies.

Perhaps no regulator has been more impactful on the implementation of the post-crisis regulatory infrastructure than the Federal Reserve. As six of seven seats on the board of governors change hands, this represents a sea change for bank regulation.

We are also anticipating action on a bipartisan Senate legislation to increase the threshold that determines if an institution is systemically important – or a SIFI institution – on bank holding companies from $50 billion to $250 billion, among other reforms.

Q: Can you expand on why Congress is changing these rules?
Under existing law, banks are subject to escalating levels of regulation based upon their asset size. Key thresholds include banks at $1 billion, $10 billion, $50 billion and $250 billion in assets. These asset sizes may seem like really large numbers, but are only a fraction of the $1 trillion-plus held by top banks. There have been concerns in recent years that these thresholds are too low and have held back community and regional banks from lending to small businesses, and have slowed economic growth.

Responding to these concerns, a bipartisan group in the Senate is advocating a bill that would raise the threshold for when a bank is considered systemically important and subjected to increased regulations. The hope among the bill’s advocates is that community and regional banks would see a reduction in regulatory cost, greater flexibility on business activity, increased lending, and a boost to economic growth.

The bill recently cleared the Senate on a 67-31 vote, and is now waiting for the House to pass the bill and the two chambers to then strike a deal that sends it to the president’s desk.

Q: What changes do you expect on the regulatory side with leadership transitions?
In the coming year, we expect continued changes to the stress testing process for the largest banks (Comprehensive Capital Analysis and Review, known as CCAR), greater ability for banks to increase dividends, and changes to capital, leverage and liquidity rules.

We expect the Fed will shift away from regulation to normalization of the fed funds rate. This could represent a multi-pronged win for the banking industry: normalized interest rates, expanded regulatory relief, increased business activity and lower regulatory expenses.

Another key regulator we’re watching is the CFPB (Consumer Financial Protection Bureau), which under Director Richard Cordray pursued an aggressive regulatory agenda for banks. With White House Office of Management and Budget Director Mick Mulvaney assuming interim leadership, the bureau is re-evaluating its enforcement mechanisms. Additionally, Dodd-Frank requires review of all major rules within five years of their effective dates, providing an opportunity for the Trump-appointed director to make major revisions.

Q: We often hear concerns that the rollback of financial regulations put in place to prevent a repeat of one financial crisis will lead to the next. Are we sowing the seeds of the next collapse?
There is little doubt the lack of proper regulation and enforcement played a strong role in the financial crisis. The regulatory infrastructure put in place post-crisis has undoubtedly made the banking industry sounder. Fed Chairman Jerome Powell recently testified before Congress that the deregulatory bill being considered will not impact that soundness.

Q: In your view, what kind of political developments will have effects on markets?
We are keeping our eyes on the results of the increase in trade-related actions and the November midterms. The recent announcement on tariffs raises concerns of a trade war and presents a potentially significant headwind for the economy. The market may grow nervous over a potential changeover in the House and or Senate majorities, but it could also sow optimism on the ability to see a breakthrough on other legislative priorities.

Be Careful Cheering On Mick Mulvaney Too Much

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CFPB-5-4-18.pngThe Consumer Financial Protection Bureau has been a thorn in the side of the banking industry since its creation by the Dodd-Frank Act of 2010. The bureau’s authority to rewrite consumer regulations impacts even those banks below the $10 billion asset threshold it doesn’t supervise directly, so we imagine that many bankers are cheering on Interim Director Mick Mulvaney while his hawkish style bears fruit, or doesn’t, depending on your perspective.

But here’s the rub: These changes are occurring in a highly charged political atmosphere in Washington, D.C. So it was in 2010, and so it is today. The CFPB (and Dodd-Frank generally) was and remains a politically divisive issue in Washington.

Mulvaney is a former Republican congressman from South Carolina, and while he may truly believe that the changes he has wrought at the bureau are in the banking industry’s best interests, it’s hard not to see them as hawkish political cannon fodder boosting up an agenda that has drawn mixed reviews. So what happens if the White House flips to the Democrats in 2020? Will a new director reverse course and undo what Mulvaney has undone? In a couple years, will we rinse and repeat this all again?

Or, considering Mulvaney is still technically in an interim role, how much would his style and decisions shift if a different, less boisterous leader were put in place?

Bankers might not like regulation—and certainly the industry is obsessively regulated—but generally they accept the rules that are in place so long as they know what they are and have confidence they don’t dramatically change overnight.

Bankers generally favor less regulation for very good reasons—it costs a lot of time and money, which could arguably be better spent improving their products, performance, or the experience for their customers and shareholders. So a bipartisan review of the CFPB’s mission and methods would probably be a good thing.

But banks also function best in stable, predictable environments. And when a regulatory body is the target of political promises and potentially sweeping reform every two years, it creates uncertainty. And uncertainty doesn’t serve this industry well.

It’s impossible to know completely what the political landscape will look like a year, two or four down the road, but banks will remain, and regulators will remain, and the relationship between the two will remain. It only makes sense to keep those relationships stable.