Recent Developments to Combat Redlining

Regulators have worked on a variety of anti-redlining proposals in recent months, including a joint initiative by the Department of Justice, the Consumer Financial Protection Bureau, and the Office of the Comptroller of the Currency.

These proposals come in tandem with recent initiatives from the Securities and Exchange Commission to increase the emphasis on ESG factors, a set of non-financial environmental, social and governance factors that publicly filed companies can use to identify material risks and growth opportunities.

Though anti-redlining legislation initially came into law when Congress enacted the Community Reinvestment Act in 1977, it has recently seen a refocus in the Combatting Redlining Initiative led by the DOJ Civil Rights Division’s Housing and Civil Enforcement Section. During Acting Comptroller Michael Hsu’s initial unveiling of this initiative, he highlighted the importance of providing “fair and equitable access to credit — to everyone” in order to build wealth among minority and underrepresented groups. He emphasized that modern redlining, as compared to its 20th century predecessor, is “often more subtle, harder to detect, and resource-intensive to find.”

Initial reactions to the initiative expected it to focus on the redlining seen in the Trustmark Corp. settlement, where the Jackson, Mississippi-based bank discriminated against Black and Hispanic neighborhoods by “deliberately not marketing, offering, or originating home loans to consumers in majority Black and Hispanic neighborhoods in the Memphis metropolitan area,” according to the CFPB. The $17.6 billion bank settled for a $5 million penalty.

But in recent weeks, though a final rule is not yet in place, the acting comptroller made it clear the focus is not only on direct discrimination, but also on indirect discrimination through climate redlining. Climate redlining occurs when certain minority communities are subject to heightened climate change risks based on where they are located; those heightened risks pose a disproportionate impact on minority groups.

Though official rules have yet to be proposed related to the policies, banks can take the following actions in preparation:

1. Review any neutral algorithms used in the lending process. Redlining is not always overt; it may be a byproduct of algorithms that appear neutral on the surface but disproportionately target minority communities based on targeting certain income brackets, risk factors or the demographic compensation of the surrounding area. Bankers should make time to carefully review the factors being input into their institution’s algorithms and consider whether those factors might create inadvertent bias.

2. Review any policies related to geographic filtering. Minority groups are disproportionately impacted by the effects of climate change; this disparate impact is expected to grow as the frequency of climate events increases. Rising water, more frequent fires and extreme weather events are all examples of events some banks might choose to geographically exclude in order to keep lending risk portfolios low. But by filtering out these events and impacts, banks may be inadvertently redlining. Banks should take the time to carefully examine any exclusions they make based on geography or weather history in preparation of any final rules, and compare them to demographic information on the bank’s lending practices.

3. Review branch locations. One of the reasons regulators found Trustmark to have engaged in redlining practices was its lack of branch locations in majority Black and Hispanic communities. This meant that not only were those residents not able to receive banking services, they also were not being marketed to when it came to potential lending opportunities. Banks should review the footprints of their branches relative to the demographics in the cities in which they are located to determine whether they are over- or under-represented in certain demographics.

4. Public bank holding companies should review ESG factors. With both proxy season and annual filing season upon publicly traded companies, now is a good time for publicly traded bank holding companies to evaluate their current treatment of environmental, social and governance risks. If a bank identifies that it may be inadvertently engaging in redlining, the affiliated bank holding company should carefully think through potential disclosures.

When to Form a Risk Committee

Should your board form a standing risk committee — and how will you know that the time is right?

Federal law requires all depository institutions to establish a standing board-level risk committee once they reach $50 billion in assets. The requirement dates back to the passage of the Dodd-Frank Act in 2010; the original asset threshold was set at $10 billion but raised to $50 billion when some of Dodd-Frank’s provisions were relaxed in 2018.

Not every bank waits until it reaches $50 billion to form a risk committee. Many boards make that decision when their bank is much smaller, generally in reaction to its growing size and complexity. In my experience, smaller banks tend to handle risk oversight through their audit committee. But as a bank grows by expanding geographically, adding new business lines or diversifying its loan portfolio — and sometimes doing all of these things at once — its risk profile changes. There is simply more to keep track of — more that can go wrong — and it becomes appropriate to assign the job of risk oversight to a dedicated committee.

In my opinion, once a bank becomes large and complex enough that risk oversight shouldn’t be juggled with audit committee issues like overseeing the external audit or ensuring the integrity of the bank’s financial statements (if it’s a public company), having a dedicated risk committee becomes a best practice.

“When the materials, when the content, when the conversations get more complex and more involved — that’s when I tend to see audit committees split apart into a pure audit committee and a board risk committee,” says Ryan Luttenton, a partner at the consulting firm Crowe LLP. “It’s when the complexities of the institution become a little more challenging to manage in the context of just one meeting. When you start to push things into consent agendas, and you’re approving things and the list starts to grow and grow, it becomes a question of, are we doing a disservice to the institution by not having more constructive discussions around risk and strategy in a risk committee?

BankNewport, a $2.3 billion mutual bank subsidiary of OceanPoint Financial Partners, opted to form a risk committee in 2016 when it was just $1.4 billion. According to risk committee chair James Wright, the Newport, Rhode Island-based bank was beginning to expand beyond Aquidneck Island, an island in Narragansett Bay that contains Newport and surrounding towns, to the rest of Rhode Island. The bank was also beginning to expand its lending focus to include commercial real estate, an inherently riskier asset class.

Previously, the BankNewport board had not assigned risk oversight to its audit committee, but instead handled it in a compliance and trust committee. The board ended up reconstituting that committee as a standing risk committee. “I think it was a variety of things that led us to doing that,” says Wright. “Our credit portfolio was shifting from more of a residential focus to more commercial. It wasn’t dramatic, but the balance was starting to shift. We were taking on more of a geographic footprint. It really was time to create a more enterprise-wide, strategically focused risk committee that would look at all risk as connected entities.”

There are seven members on the bank’s risk committee, including the board chair and CEO, and it meets quarterly. Around the same time that it created the committee, BankNewport also hired its first chief risk officer to build out a more comprehensive, enterprise-wide risk management process at the bank level. Wright believes the board’s decision to form a risk committee, combined with stronger risk management practices at the bank level, has greatly improved the quality of its risk oversight. “Now, there’s a more centralized place for everyone to go and say, ‘What are we doing about this? What are our protections? What are our proactive measure we’re taking on these things?’”

Another bank that made a decision to bring a sharper focus to risk governance is Glacier Bancorp, a $21.3 billion asset regional bank in Kalispell, Montana. According to committee chair Annie Goodwin, the bank had approximately $5 billion in assets when it formed a risk oversight committee in 2012. Obviously, this was well under the $10 billion threshold that had been established by Dodd-Frank, but the bank wanted to be ready when it got there.

Even though we’re not at the $50 billion asset threshold presently … our board has made the decision to maintain the risk oversight committee,” Goodwin says. Nine of Glacier’s 11 directors sit on the committee, and its risk oversight officer reports directly to the committee and provides it with monthly reports.

“The risk oversight committee provides a disciplined structure to ensure that we are conducting enterprise risk management in a comprehensive manner,” says Goodwin. “So many areas of the bank’s functions and operations are encompassed in the oversight of our committee that I don’t think our board could ever go back and not have a risk oversight process again.”

Although bank regulators rarely mandate that banks below the $50 billion threshold form a risk committee, they often begin to have conversations with banks under their supervision about adopting more robust enterprise risk management practices at the bank level when they approach the $5 billion mark, according to Luttenton. “And then, as you get to $8 billion, what I hear from my clients and feedback from some of the regulators is that they kind of come in and do a light touch,” he says. “They start to set some expectations around enterprise risk and things like model risk management and vendor management.” Regulation generally becomes tougher when a bank passes the $10 billion mark, and the regulators want a strong risk management program in place by then.

And if the bank is beefing up its risk management policies and practices at the bank level, it may make sense for the board to focus its risk governance efforts in a dedicated committee.

Goodman is a former regulator who served as Montana’s Commissioner of Banking and Financial Institutions from 2001 to 2010. She believes that even small community banks can benefit from bringing a more focused approach to risk governance by setting up a dedicated committee.

“For all banks that are sitting on the sidelines with whether or not they should implement an enterprise risk management committee, my advice is to get started soon,” she says. “And even if it’s a very simple process, it’s always easier to implement a program when the bank is small, rather than waiting until it gets much larger in asset size and much more complex in its operations. I think even with a smaller community bank, enterprise risk management can get into the board’s DNA, their way of thinking that prepares them for the future and to help the bank with its long-term success.”

Brian Nappi, a senior manager at Crowe, says directors are often bogged down under the weight of too much information. “If I’m sitting on a risk committee and I have to look at more than nine pages to understand where we are, then we’re not good communicators,” he says. The first page should have four things, Nappi says: the risk appetite statement compared to the bank’s risk profile at the end of every quarter; the top three to five risks facing the bank; management’s response to those risks; and the top two or three emerging risks. The remaining eight pages should contain a variety of risk data if the committee members want to drill down deeper, he adds.

Generally speaking, risk committees should be forward-looking in their focus, while audit committees naturally look backward. This is why handling risk in the audit committee is something of a philosophical disconnect. When a bank forms a risk committee after its audit committee has been handling risk oversight, the audit committee still plays an important role in verifying that the bank’s various risk management policies are being followed.

“The focus for audit committees is on internal controls — which controls are working, and which ones are broken,” says Nappi. “Risk committees, their focus should be on what’s the highest residual risk [facing] the institution, and what [is] management’s response to those risks.”

You can view a sample risk committee charter here, part of our Board Structure Guidelines, which describe committee functions, structure and compensation, as well as board roles. These resources are available exclusively to Bank Services members.

Regulators Revive Efforts to Pass Dormant Compensation Rules

When it comes to incentive compensation, everything old is new again.

Financial regulators are expected to revive rulemaking on a number of compensation provisions that never went into effect but were mandated by the Dodd-Frank Act of 2010.

Some of the issues that bank and securities regulators could consider in the coming quarters include measures that will gauge executive pay against their performance, as well as mandate clawback provisions and enhanced reporting around incentive compensation structures, said Todd Leone, a partner and global head of compensation at consulting firm McLagan. He was speaking during Bank Director’s 2021 Bank Compensation & Talent Conference, held Nov. 8 to Nov. 10 in Dallas.

All banks with more than $1 billion in assets would need to comply with the final version of the enhanced incentive compensation requirements. Public companies, including banks, would need to comply with any final rules around clawbacks and pay versus performance. If the topics sound familiar, Leone reminded the crowd, it was because they were debated when the banking reform bill initially passed in 2010. Regulators considered rulemaking several years later. But the move to finally pass those rules could catch banks off-guard, especially when considering that rulemaking was essentially paused under the administration of President Donald Trump. Below is Leone’s overview of the proposed rules.

Clawbacks
Clawback provisions, or a company’s ability to take back previously awarded pay or bonuses after a triggering event such as a restatement of earnings, were a hotly debated topic of the post-crisis financial reform bill more than a decade ago. They also came into focus in the bank space after news broke about the Wells Fargo & Co. fake account scandal in late 2016. In 2017, the bank’s board announced it would seek $75 million in previously awarded compensation from two of the senior executives that it held accountable for the scandal. In response, a number of banks created clawback policies of their own.

In October 2021, the U.S. Securities and Exchange Commission, under Chair Gary Gensler, reopened the comment period for the clawback provision, or Section 954 of the act. Leone pointed out that the proposed rule defines a triggering event as an accounting restatement for a material error. A company has up to three years to claw back incentive pay linked to the financial information that is restated; potentially impacted employees include current or former executive officers. Leone expected a final rule by the second half of 2022 but recommended that audience members stand pat until something is published.

“Don’t touch existing policies, since it’s in flux,” he recommended for banks that created their own policies.

Pay For Performance
Pay for performance, or Section 953(a), is a proposed disclosure requirement for public companies, including banks, that would most likely appear as a table in the proxy statement. The disclosure compares total shareholder return for a company against a company-selected peer group, along with compensation figures of a company’s top executives. The company would need to state the principal executive’s reported total compensation for the current year and past four years, along with the average reported total compensation for other named executive officers over the current year and past four years.

Like the clawback proposal, this provision was first debated by the SEC in 2015; it is in “final rule stage,” according to the agency, and Leone believed it could go into effect in the second half of 2022. The rule could create a “fair bit more work” for companies to comply with, he said. But he believed it will have a similar impact on the industry as the CEO pay ratio disclosure, which compares the pay of the CEO to that of the company’s median employee and has yet to lead to significant changes in pay for either group.

Incentive Compensation Rules
Similar to the other two proposals, the enhanced incentive compensation rule, or Section 956, has come up again. The SEC included it as a proposed rule in its agency rules list for spring 2021. Leone joked that he had used the same presentation slide on the enhanced incentive compensation rule a decade ago. The rule has been proposed by regulators twice since the passage of Dodd-Frank: It was 70 pages when it was first proposed in 2011 but had grown to 700 pages when it was re-proposed in 2016, he said.

Leone believed this rule will come up again in the spring of 2022, and that rulemaking will take some time because a number of regulators will need to collaborate on it. It would apply to all banks with more than $1 billion in assets, along with other financial institutions such as credit unions and broker dealers. The requirements would vary based on asset size, with the biggest firms facing the most stringent rules around their incentive compensation agreements. Under previous iterations of the rule, financial institutions would need to include provisions to adjust incentive compensation downward under certain circumstances, outline when deferred incentive compensation could be forfeited and build in a clawback period of seven years.

In the end, Leone recommends banks be proactive when it comes to changing compensation rules.

Expect more, not less regulation,” he said.

Once Stagnated, Banks Are Refreshing Checking Accounts to Compete

Once a staid and basic product offering, banks are reinvigorating consumer checking accounts.

A number of banks, taking a page from the challenger bank playbook, are adding features to their accounts to please consumers: early access to a direct-deposited paycheck, free overdraft and short-term loans. These changes attempt to match the offerings from financial technology platforms such as Chime and Current, which have been growing exponentially and attracting billions in venture capital funding.

The default consumer checking account is easy to take for granted. Most banks offer them without cost to customers in exchange for a deeper relationship such as a monthly direct deposit or a minimum balance. The hope is that a customer is profitable through noninterest fee income such as debit card interchange fees or through other products the bank can cross-sell to the customer.

But the Durbin amendment, part of the 2010 Dodd-Frank Act, reduced interchange income for banks with more than $10 billion in assets. The Durbin amendment made checking accounts less profitable while digital account opening made it easier for consumers to open an account with a competitor. Checking accounts stagnated, says Alex Johnson, director of fintech research at Cornerstone Advisors. Joining the fray were online-only neobanks like Chime, Digit and Varo Bank, N.A., a fintech that received approval for a bank charter in July 2020 and now has $403 million in assets. They customized their checking accounts with valuable features to gain new customers — including customers willing to pay for some features.

Investments in digital are not the same as investments in deposits, but they were treated as the same a lot of times,” Johnson says. “Banks said ‘We’re keeping pace, we let people open up these accounts on their phone.’ That’s great, but … are you doing anything new to improve the value proposition there? The answer is no.”

Now, a number of banks are reconsidering their deposit offerings to drum up interest from new customers and deepen relationships with existing ones. Many of them leverage technology, require direct deposit information and are consumer friendly, helping customers avoid overdraft fees. Capital One Financial Corp. and SoFi Technologies— a fintech that has applied to acquire a community bank — offer access to direct deposits paychecks two days in advance, following Chime’s lead. Pittsburgh-based PNC Financial Services Group launched a feature called “Low Cash Mode” within its digital wallet in April; Columbus, Ohio-based Huntington Bancshares rolled out a cash advance product in June for checking account customers with a history of monthly deposits. The offering from the $125.8 billion bank takes a page from Varo’s Varo Advance product and is addition to the bank’s overdraft grace period. Ally Financial, which has $181.9 billion in assets, did away with overdraft fees altogether.

The intense focus on reinvesting in deposit products relates directly to the importance of primacy. Consumers define their primary bank as the institution that holds their checking account, versus the institution with the car loan or mortgage, says Mike Branton, a partner at StrategyCorps.* StrategyCorps works with banks to add services to checking accounts using a subscription model.

Measuring primacy — the number of households or customers that genuinely consider an institution to be their primary one — is hard for banks. Branton says many banks don’t have a set definition or use a definition based solely on banking behavior, such as account balance or debit card swipes; others look at the sheer number of other accounts linked to a checking account. StrategyCorps uses a financial definition for primacy that considers banking behavior and account activity in terms of revenue generation: Primary customers generate $350 or more a year for their bank.

That kind of revenue can be a tall order when banks have offered free checking for decades. Results from cross-selling may prove elusive. But free doesn’t have to be a showcased feature of checking accounts, especially if customers think the services and benefits are valuable. Digit, a fintech that helps customers save money by analyzing their spending and automatically moving funds when they can afford it, charges $5 a month. The fintech Current charges $4.99 per month for a premium account, which includes up to $100 in overdrafts and early access to direct deposits such as paychecks, a benefit for low- and moderate-income Americans who are living paycheck-to-paycheck.

“Products are more important than ever,” Branton says. “I think what banks are learning from the pandemic is that because people are not coming in the branch and experiencing the human touch as frequently, but are interacting with the banking product, they must make their products better than ever.”

*Bank Director founder Bill King is also a founding partner of StrategyCorps.

The Coming Buyback Frenzy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Recalibrating Bank Stress Tests to a New Reality

Any bank that stress tested its loan portfolios prior to the Covid-19 pandemic probably used a worst-case scenario that wasn’t nearly as bad as the economic reality of the last five months.

Stress tests are an analysis of a bank’s loans or revenue stream against a variety of adverse computer-generated scenarios. The results help management teams and their boards of directors gauge whether the bank has adequate reserves and capital to withstand loan losses of various magnitudes. One challenge for banks today that incorporate stress tests into their risk management approach is the lack of relevant historical data. There is little modern precedent for what has befallen the U.S. economy since March, when most of the country went into lockdown to try to flatten the pandemic’s infection rate. The shutdowns tipped the U.S. economy into its steepest decline since the Great Depression.

Does stress testing still have value as a risk management tool, given that we’re navigating in uncharted economic waters?

“I would argue absolutely,” says Jay Gallagher, deputy comptroller for systemic risk identification support and specialty supervision at the Office of the Comptroller of the Currency. “It is not meant to be an exercise in perfection. It’s meant to say within the realm of possibility, these are the scenarios or variables we want to test against. Could we live with what the outcome is?”

The Dodd-Frank Act required banks with assets of $10 billion or greater to run annual stress tests, known as DFAST tests, and report the results to their primary federal regulator. The requirement threshold was raised to $100 billion in 2018, although Gallagher believes that most nationally chartered banks supervised by the OCC still do some form of stress testing.

They see value in the exercise and not having the regulatory framework around it makes it even more nimble for them to focus on what’s really important to them as opposed to checking all the boxes from a regulatory exercise,” says Gallagher. “We still see a lot of banks that used to have to do DFAST still use a lot of the key tenets in their risk management programs.”

Amalgamated Bank, a $5.8 billion state chartered bank headquartered in New York, has been stress testing its loan portfolios on an individual and macro level for several years even though it sits well below the regulatory threshold. For the first time ever, the bank decided to bring in an outside firm to do its own analysis, including peer comparisons.

President and CEO Keith Mestrich says it is as much a business planning tool as much as it is a risk mitigation tool. It gives executives insight into its loan mix and plays an important role in decisions that Amalgamated makes about credit and capital.

It tells you, are you going to have enough capital to withstand a storm if the worst case scenario comes true and we see these loss rates,” he says. “And if not, do you need to go out and raise additional capital or take some other measures to get some risk off the balance sheet, even if you take a pretty significant haircut on it?”

Banks that stress test have been forced to recalibrate and update their economic assumptions in the face of the economy’s sharp decline, as well as the government’s response. The unemployment rate spiked to 14.7% in April before dropping to 11.1% in June when the economy began to reopen, according to the Bureau of Labor Statistics. But the number of Covid-19 cases in the U.S. has surged past 3 million and several Western and Southern states are experiencing big increases in their infection rates, raising the possibility that unemployment might spike again if businesses are forced to close for a second time.

“I feel like the unemployment numbers are probably the most important ones, but they’re always set off by how the Covid cases go,” says Rick Childs, a partner at the consulting firm Crowe. “To the extent that we don’t get [the virus] back under control, and it takes longer to develop a vaccine and/or effective treatment options for it, I think they’ll always be in competition with each other.”

Another significant difference between the Great Recession and the current situation is the unparalleled level of fiscal support the U.S. Congress has provided to businesses, local governments and individuals through the $2 trillion CARES Act. It is unclear another round of fiscal support will be forthcoming later this year, which could also drive up the unemployment rate and lead to more business failures. These and other variables complicate the process of trying to construct a stress test model, since there aren’t clear precedents to rely on in modern economic history.

Stress testing clearly still has value despite these challenges, but Childs says it’s also important that banks stay close to their borrowers. “Knowing what’s happening with your customer base is probably going to be more important in terms of helping you make decisions,” he says.

Former CFPB Head on a Post-Pandemic Banking Industry

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.

2020 Risk Survey Results: “Don’t Panic. Just Fly the Airplane.”

It wasn’t uncommon in the latter half of 2019 for bank executives to note the margin pressure faced by the industry, brought on by an inhospitable interest rate environment. And rates dropped even lower in early 2020, with the Federal Reserve cutting rates to zero.

“In spite of the Fed’s yo-yo interest rate, we have a responsibility to manage our assets in a manner that is in the best interest[s] of our shareholders and communities we serve. The key is not to panic, but [to] hold the course,” said John Allison, CEO of Conway, Arkansas-based Home Bancshares, in the $15 billion bank’s second quarter 2019 earnings call. “At the end of the day, your management’s trying to operate profitably in the middle of this chaos. They say when you’re piloting an airplane and there’s a major problem, like an engine going out: ‘Don’t panic. Just fly the airplane.’”

Allison’s advice to “just fly the airplane” seems an appropriate way to frame the risks facing the banking industry, which Bank Director explored again in its 2020 Risk Survey, sponsored by Moss Adams. Conducted in January, it includes the views of more than 200 independent directors, CEOs, risk officers and other senior executives of U.S. banks below $50 billion in assets.

A majority of these industry leaders say they’re more worried about interest rate risk amid a competitive environment for deposit growth — 25% report their bank lost deposit share in 2019, and 34% report gains in this area. Looking ahead to 2020, most (73%) say their bank will leverage personal relationships to attract deposits from other institutions. Less than half will leverage digital channels, a strategy that skews toward — but is not exclusive to — larger banks.

In the survey, almost 60% cite increased concerns around credit risk, consistent with the Federal Reserve’s Senior Loan Officer Opinion Survey from January, which reports dampened demand for commercial loans and expectations that credit quality will moderately deteriorate.

Interestingly, Bank Director’s 2020 Risk Survey finds respondents almost unanimously reporting that their bank’s loan standards have remained consistent over the past year. However, the majority (67%) also believe that competing banks and credit unions have eased their underwriting standards over the same time period.

 

Key Findings

  • Scaling Back on Stress Tests. The Economic Growth, Regulatory Relief and Consumer Protection Act, passed in May 2018, freed banks between $10 billion and $50 billion in assets from the Dodd-Frank Act (DFAST) stress test requirements. While last year’s survey found that 60% of respondents at these banks planned to keep their stress test practices in place, participants this year reveal they have scaled back (7%) or modified (67%) these procedures.
  • Ready for CECL. More than half of survey respondents say their bank is prepared to comply with the current expected credit loss (CECL) standards; 43% indicate they will be prepared when the standards take effect for their institution.
  • Cyber Anxiety Rising. Eighty-seven percent of respondents say their concerns about cybersecurity threats have risen over the past year. This is the top risk facing the banking industry, according to executives and directors. Further, 77% say their bank has significantly increased its oversight of cybersecurity and data privacy.
  • Board Oversight. Most boards review cybersecurity regularly — either quarterly (46%) or at every board meeting (24%). How the board handles cybersecurity governance varies: 28% handle it within a technology committee, 26% within the risk committee and 19% as a full board. Just one-third have a director with cybersecurity expertise.
  • Climate Change Overlooked. Despite rising attention from regulators, proxy advisors and shareholders, just 11% say their bank’s board discusses climate change at least annually as part of its analysis and understanding of the risks facing the organization. Just 9% say an executive reports to the board annually about the risks and opportunities presented by climate change. More than 20% of respondents say their bank has been impacted by a natural disaster in the past two years.

To view the full results of the survey, click here.

3 Ways a Democratic Presidency Could Impact Executive Compensation

Sen. Elizabeth Warren, D-Mass., recently wrote, “Almost ten years ago, Congress directed federal regulators to impose new rules to address the flawed executive compensation incentives at big financial firms. But regulators still haven’t finalized (let alone implemented) a number of those key rules, including one that would claw back bonuses from bankers if their bets went bad in the long run. As President, I will appoint regulators who will actually do their job and finish these rules.”

Warren is referring to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was introduced in 2010 as a response to the 2008 financial crisis. The act contained over 2,300 pages of provisions, including a number that impact executive compensation, to be implemented over several years. A few provisions — like management say-on-pay, say-on-golden-parachutes, CEO pay ratio — have been implemented, while others like incentive-based compensation arrangements (§ 956), clawbacks (§ 954) and pay-versus-performance (§ 953(a)) remain in limbo.

In any Democratic presidency, incentive-based compensation (§ 956) may be the easiest provision to finalize. The 2016 proposal creates a general restriction for banks with more than $1 billion in assets on incentive compensation arrangements that encourage inappropriate risks caused by a covered person receiving excessive compensation that could lead to a material financial loss. As proposed, it is very prescriptive for banks with assets of $50 billion or more, requiring mandatory deferrals, a minimum clawback periods, ability for downward adjustments and forfeiture.

The final rules for § 956 were re-proposed in 2016, but regulators’ interest in the topic has been muted during President Donald Trump’s administration. There are other ways that executive compensation programs could be impacted by a Democratic president, of which Warren is one contender for the nomination. While not exhaustive, we see three potential changes — beyond § 956 — that could impact  executive compensation programs.

1. Increased Regulatory Oversight
In almost all scenarios, a Democratic presidency will be accompanied by an increase in regulation. The 2016 sales practices scandal at Wells Fargo & Co. brought incentives into the spotlight. The Federal Reserve Board has stressed the importance of firms having appropriate governance of incentive plan design and administration, and have audited the process and structure in place at banks. One key thing that firms can and should be doing, even if the party in power does not change, is implement a documented and thorough incentive compensation risk review process as part of a robust internal control structure. Having a process in place will be key in the event of regulatory scrutiny of your compensation programs.

2. Mandatory Deferrals
Warren re-introduced and expanded the concept of mandatory deferrals through her Accountable Capitalism Act of 2018. This proposed legislation restricts the sales of company shares by the directors and officers of U.S. corporations within five years of receiving them or within three years of a company stock buyback. Deferred compensation gives the bank the ability to adjust or eliminate compensation over time in the event of material financial restatements or fraudulent activity, and is sure to be a topic that will come up with a Democratic presidency.

While the concept is different from deferred compensation, many firms have introduced holding periods in their long-term incentive programs for executives. This strengthens the retentive qualities of the executive incentive program and provides some accounting benefits for the organization, making it something to consider adding to stock-based incentive plans.

3. Focus On More Than The Shareholder
The environmental, social and governance (ESG) framework has been a very hot topic in investment communities, with heavy-hitting institutional investors introducing policies relating to ESG topics. For example, BlackRock is removing companies generating more than 25% of revenues from thermal coal production from its discretionary active investment portfolios, and State Street Corp. announced that it will vote against board members for “consistently underperforming” in the firm’s ESG performance scoring system. Warren believes that companies should focus on “the long-term interests of all of their stakeholders — including workers — rather than on the short-term financial interests of Wall Street investors.” It remains to be seen exactly what future compensation plans for banking executives will look like, though the myopic focus on total shareholder return may become a thing of the past.

Many potential incentive compensation changes that are likely to occur under a Democratic presidency already exist in the marketplace, including holding periods for long-term incentive plans; incentive compensation risk review, including the internal control structure; mandatory deferrals and clawbacks; and aligning incentive plans with the long-term strategy of the organization. Directors should evaluate their bank’s current plans and processes and identify ways to tweak the programs to ensure their practices are sound, no matter who takes office in 2021.

Key Considerations with the Community Bank Leverage Ratio

Banking regulators have adopted a final rule offering community banks the ability to opt in to a new, simplified community bank leverage ratio. The CBLR is intended to eliminate the burden associated with risk-based capital ratios, and became effective on Jan. 1, 2020.

Congress amended provisions of the Dodd-Frank Act to provide community banks with regulatory relief from the complexities and burdens of the risk-based capital rules. Agencies including the Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp. were directed to promulgate rules providing for a CBLR between 8% and 10% for qualifying community banking organizations (QCBO). These banks may opt-in to the framework by completing a CBLR reporting schedule in their call reports or Form FR Y-9Cs.

In response to public comments, the final rule includes a few important changes from the proposed one, including:

  • The adoption of Tier 1 capital, instead of tangible equity, as the leverage ratio numerator.
  • A provision allowing a bank that elects the CBLR framework to continue to be considered “well capitalized” for prompt corrective action (PCA) purposes during a two-quarter grace period, if its leverage ratio is 9% or less but greater than 8%. At the end of the grace period, the bank must return to compliance with the QCBO criteria to qualify for the CBLR framework; otherwise, it must comply with and report under the generally applicable capital rules.

To be eligible, a QCBO cannot have elected to be treated as an advanced approaches banking organization. It must have: (1) a leverage ratio (equal to Tier 1 capital divided by average total consolidated assets) greater than 9%; (2) total consolidated assets of less than $10 billion; (3) total off-balance sheet exposures of 25% or less of total consolidated assets; and (4) a sum of total trading assets and trading liabilities 5% or less of total consolidated assets.

If a QCBO maintains a leverage ratio of greater than 9%, it will be considered to have satisfied the generally applicable risk-based and leverage capital requirements, the “well capitalized” ratio requirements for purposes of the PCA rules and any other capital or leverage requirements applicable to the institution.

QCBOs may subsequently opt-out of the CBLR framework by completing their call report or Form FR Y-9C and reporting the capital ratios required under the generally applicable capital rules. A QCBO that has opted out of the leverage ratio framework can opt back in by meeting the discussed qualifying criteria discussed above.

The leverage ratio provides significant regulatory relief to QCBOs that would otherwise report under the risk-based capital rules. Opting-in to the CBLR allows a qualifying bank to be considered “well capitalized” under the PCA rules through one simple calculation (assuming the organization is not also subject to any written agreement, order, capital directive or PCA directive). Additionally, calculating the community bank leverage ratio involves a measure already used by banks for calculating leverage: Tier 1 capital.

The cost of adoption is low as well. If qualified, a bank simply has to adopt the new leverage ratio in its call reports or Form FR Y-9C. And the two-quarter grace period offers further flexibility. For instance, if a QCBO engages in a major transaction or has an unexpected event that impacts the 9% leverage ratio, the bank will be able to reestablish compliance with the CBLR without having to revert to the generally applicable risk-based capital rules. Since the CBLR is voluntary, it is within each qualifying bank’s discretion whether the benefits are sufficient enough to adopt the new rule.

Qualifying banks should be aware that opting in to the community bank leverage ratio essentially raises its well-capitalized leverage ratio requirements under the PCA rules from 5% to 9%. These banks must ensure their leverage ratios are above 9% or find themselves attempting to comply with both the CBLR and the risk-based capital rules.

It has been suggested that the CBLR may create a de facto expectation from the agencies that a properly capitalized qualifying bank should have a leverage ratio greater than 9%. Though the agencies emphasized that the CBLR is voluntary, community banks eligible to adopt the rule should be thoughtful in their decision to use it. While qualifying banks can opt in and out of the new leverage ratio, the agencies noted that they expect such changes to be rare and typically driven by significant changes, such as an acquisition or divestiture of a business. The agencies further indicated that a bank electing to opt out of the CBLR framework may need to provide a rationale for opting out, if requested.

While the community bank leverage ratio will be useful in reducing regulatory burdens for qualifying community banking organizations, its adoption does not come without risk.