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. 

The Powerful Force Driving Bank Consolidation


margins-8-16-19.pngA decades-old trend that has helped drive consolidation in the banking industry can be summarized in a single chart.

In 1995, the industry’s net interest margin, or NIM, was 4.25%, according to the Federal Reserve Bank of St. Louis. (NIM reflects the difference between a bank’s cost of funds and what it earns on its assets, primarily loans.) Twenty years later, the margin dropped to a historic low of 2.98%, before gradually recovering to 3.30% last year.

NIM-chart.png

The vast majority of banks in this county are spread lenders, making most of their money off the difference between what they pay for deposits and what they charge for loans. When this spread narrows, as it has since the mid-1990s, it pinches their profitability.

The decision by the Federal Reserve’s Federal Open Market Committee to reduce the target range for the federal funds rate by 25 basis points in August will likely exacerbate this by reducing the rates that banks can charge on loans.

“For most banks, net interest income [accounts for] the majority of their revenue,” says Allen Tischler, senior vice president at Moody’s Investor Service. “A reduction in [it] obviously undermines their ability to generate incremental earnings.”

There have been two recessions since the mid-1990s: a brief one in 2001 and the Great Recession in 2007 to 2009. The Federal Reserve cut interest rates in both instances. (Over time, lower rates depress margins, although banks may initially benefit if their deposit costs drop faster that their loan pricing.)

Inflation has also remained low since the mid-1990s — particularly since 2012, when it never rose above 2.4%. This is why the Fed has been able to keep rates so low.

Other factors contributing to the sustained decline in NIMs include intermittent periods of intense competition and rate cutting between banks, as well as the emergence of fintech lenders. Changes over time in a bank’s the mix of loans and securities, and among different loan categories, can impact NIMs, too.

The Dodd-Frank Act has exacerbated the downward trend in NIMs by requiring large banks to carry a higher share of low-yielding liquid assets on their balance sheets, which depresses their margins. This is why large banks have contributed disproportionally to the industry’s declining average margin – though, these institutions can more easily offset the compression because upwards of half their net revenue comes from fees.

Community banks haven’t experienced as much compression because they allocate a larger portion of their balance sheets to loans and do most of their lending in less-competitive markets. But smaller institutions are also less equipped to combat the compression, since fees make up only 11% of the net operating revenue at banks with less than $1 billion in assets, according to the Office of the Comptroller of the Currency.

The industry’s profitability has nevertheless held up, in part, because of improvements to operating efficiency, particularly at large banks. The corporate tax cut that went into effect in 2018 plays into this as well.

“If you recall how banking was done in 1995 versus today … there’s just [greater] efficiency across the board, when you think about what computer technology in particular has done in all service industries, not just banking,” says Norm Williams, deputy comptroller for economic and policy analysis at the OCC.

The Fed’s latest rate cut, combined with concerns about additional cuts if the escalating trade war with China weakens the U.S. economy, raises the specter that the industry’s margin could nosedive yet again.

Tischler at Moody’s believes that sustained margin pressure has been a factor in the industry’s consolidation since the mid-1990s. “That downward trend does undermine its profitability, and is part of the reason why the industry has consolidated as much as it has,” he says.

If the industry’s margin takes another plunge, it could drive further consolidation. “The industry has been consolidating for decades … and there’s no reason why that won’t continue,” says Tischler. “This just adds to the pressure.”

There were 11,971 U.S. banks and thrifts in 1995. Today there are 5,362. Given the direction of NIMs, it seems like we may still have too many.

2019 Mid-Year Bank M&A Outlook


merger-8-5-19.pngWhat might the second half of 2019 bring for bank mergers and acquisitions (M&A)?

The favorable drivers in the first half of 2019 — the regulatory landscape, enhanced earnings as a result of tax reform, desire for scale and efficiency, and the search for digital capabilities — will likely continue to be the catalysts for bank M&A activity in the second half of 2019. While the market has not seen a spike in the bank M&A deal volume, overall deal values continue to rise because of a few large transactions, including mergers with price tags of a $28 billion and a $3.6 billion. The following trends and drivers are expected to continue to have an impact on banking M&A activity in the second half of 2019 and beyond.

Intensifying Battle for Secured Customer Deposit Bases
U.S. banks’ deposit costs rose far more quickly than loan yields in the first quarter of 2019; further increases in deposit costs may prevent net interest margins from expanding in 2019. As the competition for deposits intensifies, buyers are increasingly looking for banks with a secured deposit base, especially those with a significant percentage. Moreover, as deposit betas accelerate — even as the Federal Open Market Committee slows rate hikes — it becomes more difficult for banks to grow deposits.

With the largest banks attempting to grow their deposit market share via organic customer growth, the regional and super regional banks are trying to develop similar presences through acquisitions. Banks that can navigate this rate environment ably should emerge as better-positioned acquirers via their stock currency, or sellers through the attractiveness of their funding base.

Favorable Regulatory Environment
Dodd-Frank regulations have eased over the past 12 months, increasing the threshold for added oversight and scrutiny from $50 billion in assets to $250 billion. Easing bank regulations and tax reforms that create surplus capital could continue driving regional and super regional consolidation. Moreover, banks with $250 billion to $700 billion in assets may continue to benefit in the second half of 2019 from a more-favorable regulatory landscape.

MOE’s Potential Change on the Competitive Landscape
There were a couple of mergers of equals (MOE) in the first half of 2019 that were welcomed by investors — an indication that the industry could be likely to see a rise in the volume of larger transactions in 2019. Regional banks that miss the MOE wave in the near term may soon find themselves without a “partner” after the initial wave of acquisitions occurs.

As the banks pressure-test their MOE strategy, the key may be to find a partner with strategic overlap to drive the synergies and justify the purchase price premium yet also provide an opportunity for growth and geographic footprint. Furthermore, unlike smaller tuck-ins, MOE requires additional strategic diligence and capabilities. This includes the ability to successfully integrate and scale capabilities, the ability to cross-sell to newly acquired segments, the ability to consolidate branches in overlapping markets and integrating divergent management processes and culture.

The Hunt for Digital Capabilities
Evolving consumer wants and the table stake needed to provide an integrated digital ecosystem are compelling many bank executives to differentiate themselves via technology and digital channels growth. Investors typically place a premium on digital-forward banks, driving up multiples for banks with efficient ecosystems of digital capabilities. The hunt for digital capabilities may provide an opportunity to not only add scale, but also transform legacy banks into agile, digital-first banks of the future.

Bank boards and executives should remain cognizant of above trends as they progress through their strategic M&A planning. Their resulting decisions — to be buyer, seller or an observer on the sidelines — may shape bank M&A activity in the second half of 2019 and into 2020.

Moreover, while the banks continue to assess the potential impact of the current expected credit loss (CECL) standard, the general market consensus is CECL may require a capital charge. As such, M&A credit due diligence should be treated as an investment in reducing future losses, even though the loan quality is currently viewed as benign. Successfully driving value from acquisitions while mitigating risks requires a focused lens on M&A strategy with the right set of tools, teams and processes to perform due diligence, execute and integrate as needed.

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. In the United States, Deloitte refers to one or more of the US member firms of DTTL, their related entities that operate using the “Deloitte” name in the United States and their respective affiliates. Certain services may not be available to attest clients under the rules and regulations of public accounting. Please see www.deloitte.com/about to learn more about our global network of member firms.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

Copyright © 2019 Deloitte Development LLC. All rights reserved.

The Latest Look at the “New CFPB”


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.

Community Banks and Derivatives: Debunking the Four Biggest Myths


derivatives-4-8-19.pngThose of us who were in banking when Ronald Reagan entered the White House remember the interest rate rollercoaster ride brought about by the Federal Reserve when it aggressively tightened the money supply to tame inflation. It was during this era of unprecedented volatility that interest rate swaps, caps and floors were introduced to help financial institutions keep their books in balance. But over the years, opaque pricing, unnecessary complexity and misuse by speculators led Richard Syron, former chairman of the American Stock Exchange, to observe, “Derivative. That’s the 11-letter four-letter word.”

As community banks bought into Syron’s “D-word” conclusion and resolved to avoid their use altogether, several providers fed these fears and designed programs that promise a derivative-free balance sheet. But many banks are beginning to question the effectiveness of these solutions.

Today, as commercial borrowers seek long-term, fixed-rate funding for 10 years and longer, risk-averse community banks want to know how to solve this term mismatch problem in a responsible and sustainable manner. The fact that Syron voiced his opinion on derivatives in 1995 suggests that now might be a good time to examine the roots of “derivative-phobia,” by considering what has changed in the past quarter-century and challenging four frequently heard biases against community banks using swaps.

1. None of my community bank peers use interest rate derivatives.
If you are not hedging with swaps, and your total assets are between $500 million and $1 billion, then you are in good company: More than nine out of ten of your peers have also avoided their use.

5m-1b-assets-chart.png

But if your bank is larger, or your growth plans anticipate crossing the $1 billion asset level, more than one in four of your new peers use swaps.

1-2b-assets-chart.png

Once your bank crosses the $2 billion mark, more than half of your peers manage interest rate risk with derivatives, and institutions not using swaps become a shrinking minority.

2-5-b-assets-chart.png

Community banks should consider their growth path and the best practices of their expected peer group before dismissing out-of-hand the use of derivatives.

2. The derivatives market is a big casino, and swaps are always a bet.
While some firms (AIG in 2008, for example) have used complex derivatives to speculate, a vanilla swap designed to neutralize a bank’s natural risks operates as a hedge. Post-crisis, the Dodd-Frank Act brought more transparency to swap pricing, as swap dealers are now required to disclose the wholesale cost of the swap to their customers. In addition, most dealers are now willing to operate on a bilateral secured basis, removing most of the counterparty risk that the trading partners of Lehman Brothers experienced firsthand when that company collapsed. These changes in market practices have made it much more practical for community banks to execute simple hedging transactions at fair prices with manageable credit risk.

3. Derivatives accounting always results in unwanted surprises and volatility.
Derivatives missteps led to FAS 133—regarding the measurement of derivative instruments and hedging activities—being issued in 1998, bringing the fair value of derivatives out of the footnotes and onto the balance sheet for the first time. But the standard (now ASC 815) proved difficult to apply, leading to some notable financial restatements in the early 2000s. Fast forward nearly twenty years, and the Financial Accounting Standards Board has issued an overhaul to hedge accounting (ASU 2017-12) that is a game-changer for community banks. With mandatory adoption in 2019, there are more viable ways to solve the age-old mismatch facing banks. And the addition of fallback provisions, combined with improvements to “the shortcut method,” greatly reduces the risk of unexpected earnings volatility.

4. ISDA documents should always be avoided.
While admittedly lengthy, the Master Agreement published by the International Swaps and Derivatives Association was designed to protect both parties to a derivative contract and is the industry standard for properly documenting an interest rate swap. Many community banks seeking an ISDA-free solution for their customers are actually placing the borrower into a lightly-documented derivative with an unknown third-party. If a borrower is not sophisticated enough to read and sign the ISDA Master Agreement, they have no business executing a swap in the first place. A simpler solution is to make a fixed-rate loan and execute a swap behind the scenes to neutralize the interest rate risk. This keeps the swap and the agreement between two banks, and removes the borrower from the derivative altogether.

For community banks that have been trying to solve their mismatch problem in a manner that is derivative-free, it is worth re-examining the factors that have led to pursuing a derivatives-avoidance strategy, and counting the costs and hidden exposures involved in doing so.

2019 Risk Survey: Cybersecurity Oversight


risk-3-25-19.pngBank leaders are more worried than ever about cybersecurity: Eighty-three percent of the chief risk officers, chief executives, independent directors and other senior executives of U.S. banks responding to Bank Director’s 2019 Risk Survey say their concerns about cybersecurity have increased over the past year. Executives and directors have listed cybersecurity as their top risk concern in five prior versions of this survey, so finding that they’re more—rather than less—worried could be indicative of the industry’s struggles to wrap their hands around the issue.

The survey, sponsored by Moss Adams, was conducted in January 2019. It reveals the views of 180 bank leaders, representing banks ranging from $250 million to $50 billion in assets, about today’s risk landscape, including risk governance, the impact of regulatory relief on risk practices, the potential effect of rising interest rates and the use of technology to enhance compliance.

The survey also examines how banks oversee cybersecurity risk.

More banks are hiring chief information security officers: The percentage indicating their bank employs a CISO ticked up by seven points from last year’s survey and by 17 points from 2017. This year, Bank Director delved deeper to uncover whether the CISO holds additional responsibilities at the bank (49 percent) or focuses exclusively on cybersecurity (30 percent)—a practice more common at banks above $10 billion in assets.

How bank boards adapt their governance structures to effectively oversee cybersecurity remains a mixed bag. Cybersecurity may be addressed within the risk committee (27 percent), the technology committee (25 percent) or the audit committee (19 percent). Eight percent of respondents report their board has a board-level cybersecurity committee. Twenty percent address cybersecurity as a full board rather than delegating it to a committee.

A little more than one-third indicate one director is a cybersecurity expert, suggesting a skill gap some boards may seek to address.

Additional Findings

  • Three-quarters of respondents reveal enhanced concerns around interest rate risk.
  • Fifty-eight percent expect to lose deposits if the Federal Reserve raises interest rates by more than one hundred basis points (1 percentage point) over the next 18 months. Thirty-one percent lost deposit share in 2018 as a result of rate competition.
  • The regulatory relief package, passed in 2018, freed banks between $10 billion and $50 billion in assets from stress test requirements. Yet, 60 percent of respondents in this asset class reveal they are keeping the Dodd-Frank Act (DFAST) stress test practices in place.
  • For smaller banks, more than three-quarters of those surveyed say they conduct an annual stress test.
  • When asked how their bank’s capital position would be affected in a severe economic downturn, more than half foresee a moderate impact on capital, with the bank’s capital ratio dropping to a range of 7 to 9.9 percent. Thirty-four percent believe their capital position would remain strong.
  • Following a statement issued by federal regulators late last year, 71 percent indicate they have implemented or plan to implement more innovative technology in 2019 to better comply with Bank Secrecy Act/anti-money laundering (BSA/AML) rules. Another 10 percent will work toward implementation in 2020.
  • Despite buzz around artificial intelligence, 63 percent indicate their bank hasn’t explored using AI technology to better comply with the myriad rules and regulations banks face.

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