A Cautionary Tale for Compensation Committee Members


committee-8-25-17.pngThe Office of the Comptroller of the Currency (OCC) recently took an enforcement action in the form of a consent order against a bank director that serves as a cautionary tale for the banking industry. The consent order, agreed to by and between the OCC and a director and former senior vice president of a small national bank in Wisconsin, reminds bank boards of directors of their fiduciary duties with respect to executive compensation and the consequences of breaching those duties. In particular, this action puts board compensation committee members on notice that they may be found liable for unsafe or unsound executive compensation practices that occur on their watch.

Enforcement Action Details
The consent order described that the director had a longstanding affiliation with the bank, serving in multiple operational positions throughout her tenure, culminating in her election to the bank’s board of directors in 2005. Despite these 32 years of service, the OCC’s findings in the consent order focused on the director’s relatively short period of service on the board’s executive compensation committee, where she served from 2010 to 2013.

During this period, it appears, based on a notice of charges issued in 2016 and a $1.6 million civil money penalty issued in 2017—both against the bank’s former chief executive officer (who also held the titles of president and chairman of the board)—that this individual abused his power and used it to reap excessive compensation from the bank. In particular, the notice of charges cited a report finding that the former CEO “was a dominant influence in all aspects of bank operations,” which ultimately led to insider abuse with respect to compensation and breaches of his fiduciary duties.

Based on such abuse and the resulting action against the former CEO, the OCC apparently then turned its attention to the director. Indeed, the consent order identified the director’s conduct during the period of 2012 to 2013 as the relevant period leading to the issuance or the consent order. During this time, the OCC said that the director failed to do the following:

  • Oversee or control the use of bank funds by its former CEO for his personal expenses despite knowing that he had previously used bank funds for personal expenses.
  • Ensure that disinterested and independent directors determined and approved the compensation of the bank’s former CEO, thereby allowing him to receive excessive compensation.
  • Recuse herself from voting on the bank’s former CEO compensation even though she had a conflict of interest because he was personally indebted to the director and her husband in an amount exceeding $2 million.

Based on these failures as a member of the board’s executive compensation committee, the OCC concluded that the director engaged in conduct satisfying 12 U.S.C. 1818(i) and ordered her to pay a civil money penalty in the amount of $5,000.

Takeaways for Bank Directors
As banks continue to report an uptick in regulatory inquiries and examination findings focusing on executive and incentive compensation, agency enforcement actions relating to compensation issues may become more common in the coming years. This is a trend that is developing even in the face of recent reports that some of the federal banking agencies are likely to postpone consideration of currently proposed regulations regarding incentive compensation required under the Dodd-Frank Act.

Boards should utilize this trend and the lessons learned from the consent order as a reminder to periodically review compensation arrangements and compensation standards at their bank to ensure they are adequately fulfilling their fiduciary duties. Such reviews should critically analyze executive and incentive compensation arrangements and seek to ensure that bank and board policies governing such arrangements meet regulatory expectations. In addition, boards should periodically inquire about and analyze any relationships board compensation committee members may have with senior management to be able to confirm the independence of the committee members.

The Long Drought in Small Business Lending


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Most Americans have moved on from the financial shocks that struck our economy almost a decade ago. Millions of new jobs have been created, wages are rising and companies have repaired their balance sheets. Yet one unfortunate legacy of the 2008 to 2010 meltdown remains: the tens of thousands of small businesses that still struggle to obtain a bank loan at reasonable cost, if at all.

A new studyby three Harvard Business School economists provides fresh insights into the pullback in small business lending, and its consequences. The researchers found that the nation’s four largest banks— Bank of America Corp., Citigroup, JPMorgan Chase & Co., and Wells Fargo & Co.—not only cut back more sharply than other lenders during the recession, but also showed far less interest in regaining lost ground as the economy picked up again.

According to the Harvard study, the four banks’ advances to small businesses hovered at only half of pre-crisis levels until 2014, even as rivals pushed up their lending to almost 80 percent of pre-crisis levels. All in all, lending by the big four was 30 percent lower than other banks included in a Community Reinvestment Act database.

The lending drought has its origins in the big banks’ decision to focus on other, less risky sectors during the financial crisis. Among other drawbacks, small business loans carried higher capital requirements, and were hampered by inefficient automation of underwriting processes. Once the recession was over, the big four banks were constrained by stifling new regulations imposed by the 2010 Dodd-Frank Act and by the Federal Reserve, notably a large uptick in risk weightings for small business loans.

The pros and cons of the banks’ actions will be debated for years to come. What is beyond dispute is their painful consequences. A county-by-county examination by the Harvard researchers shows that in areas where the big four pulled back, business expansion slowed and job growth suffered, especially in communities where small businesses played an outsized role. Wages also grew more slowly. All these impacts were felt most strongly in sectors most dependent on outside funding, such as manufacturing.

The Harvard study acknowledges that other lenders, including an array of shadow bank start-ups, including online lenders, have largely filled the gaps left by the Big Four. Nonetheless, the cost of credit remains unusually high in the worst-affected areas and, while jobs have returned, wages continue to lag. “Our findings suggest that a large credit supply shock from a subset of lenders can have surprisingly long-lived effects on real activity,” the study concludes. It adds that “the cumulative effect of these factors could explain some of the reason why this recovery has been so weak compared to others in the post-war period.”

These findings are confirmed by the recent performance of the Thomson Reuters-PayNet small business lending index, which measures the volume of new commercial loans and leases to small businesses. Apart from a brief uptick after last November’s election, lending has been stuck in the doldrums for several years. The index has fallen, year-over-year, for 12 of the past 13 months. With a shortage of credit compounded by economic and political uncertainties, many small business owners remain reluctant to invest in new plant and equipment.

We at PayNet estimate that the small business credit gap costs the U.S. economy $108 billion in lost output and over 400,000 jobs a year. Some firms are forced to put operations on hold for two or three months while they wait for a bank to process their credit application.

According to our count, a typical commercial and industrial loan requires 28 separate tasks by the lending bank. It involves three departments— relationship manager, credit analyst, and credit committee—and takes between two and eight weeks to complete. The cost of processing each credit application runs at $4,000 to $6,000. The result? Few banks are able to turn a profit on this business unless the loan size exceeds $500,000, which is far more than most small businesses borrow. The time, paperwork and cost involved are pushing more and more small businesses away from traditional financing sources. We cannot allow such a key sector of our economy to fight with one hand behind its back. Lenders need to be more accepting of new kinds of financial data and fresh approaches to credit standards. Regulators must open the door to more innovative underwriting techniques and assessment processes.

A good place to start would be to examine what has gone wrong over the past decade. As the Harvard study puts it: “Going forward, it will be useful to better disentangle the causes of this shock. If regulation played an important role…then understanding the specific rules that contributed the most would be helpful from a policy perspective.”

Trump’s Big Chance to Remake Banking’s Regulatory Leadership


regulation-7-28-17.pngWhile the prospects for Congressional passage of a financial deregulation bill in 2017 are uncertain, that doesn’t mean bankers can’t look forward to a possible future loosening of the regulatory restrictions they’ve operated under since passage seven years ago of the Dodd-Frank Act.

On June 8, the Republican-controlled House of Representatives passed on a near party-line vote the Financial Choice Act, sponsored by Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee. The measure would repeal several key components of Dodd-Frank including restrictions against proprietary trading (known as the Volcker Act), while also drastically altering the structure and authority of the Consumer Financial Protection Agency (CFPB).

But the Financial Choice Act faces much tougher sledding in the Senate, which the Republicans control by just two seats. There, any financial deregulation bill would need 60 votes to pass and many Senate Democrats have voiced strong opposition to any significant unwinding of Dodd-Frank, which was enacted by a Democratic-controlled Congress following the financial crisis. Brian Gardner, a managing director and Washington research analyst at Keefe Bruyette & Woods, expects any relief measure coming out of the Senate to be modest in comparison to the House measure. “I don’t think there will be a bill on the president’s desk this year,” he adds.

But does that mean bankers can’t expect any regulatory relief in Washington where Republicans control both houses of Congress and the White House? Not necessarily, because the Trump Administration has the opportunity to appoint new—and perhaps friendlier—leadership at several key bank regulatory agencies.

The administration has already nominated former banker Joseph Otting to head up the Office of the Comptroller of the Currency, which supervises nationally chartered banks. Otting would replace former Comptroller Thomas Curry, an Obama Administration appointee whose five-year term expired earlier this year. Otting, who was chief executive officer at OneWest Bank from 2010 to 2015, might be expected to take a more sympathetic view of the regulatory burden that banks operate in—much of it related to Dodd-Frank. Curry, by contrast, was a career regulator who had never run a bank.

The Trump Administration also has the opportunity to appoint an entirely new slate of directors to the Federal Deposit Insurance Corp.’s five-member board over the next year and a half, including a replacement for Chairman Martin Gruenberg, whose five-year term as chairman expires in November. President Trump nominated former congressional staffer James Clinger to replace Gruenberg, but Clinger has since withdrawn his name from consideration, citing family concerns. Gruenberg was a Senate staffer and trade association president before coming to the FDIC.

The FDIC board consists of three independent directors appointed by the president, as well as the comptroller of the currency and director of the CFPB. Richard Cordray’s five-year term as CFPB director runs through July 2018. A piñata for Republican criticism in Washington almost from the day he took the job, Cordray most certainly will not be reappointed by Trump, and it has been reported that he may run for governor in his home state of Ohio next year.

There are also three open seats on the Fed’s seven-member board of governors, including someone to serve as the Fed’s point person on financial regulation. Former Fed Governor Daniel Tarullo had played that role during the Obama Administration, and was known for taking a tough regulatory stance on the country’s largest banks, stepped down from the board in April. His place would be taken by Randal Quarles, a former Treasury department official under George Bush who has been nominated to serve as vice chairman for supervision. Quarles said in his prepared remarks before the Senate Banking Committee this week that post-crisis bank rules need some “refinements.”

But the most important regulatory position of all belongs to Fed Chair Janet Yellen, whose term ends in February 2018. Not only is the Fed considered to be first among equals of the regulatory agencies, but Yellen also controls the agenda at the Fed—including what gets talked about at meetings, Gardner says. Yellen was an Obama appointee and has largely been supportive of the past administration’s regulatory philosophy. Gardner says that historically most Fed chairs get two terms, although Trump has been noncommittal about reappointing Yellen. While it would be unusual for Yellen not to be reappointed, Trump has shown that he’s not a slave to convention. Asked what he thinks the president will do, Gardner, laughing, says “I have absolutely no idea.”

Keeping an Eye on the Red Line: Avoiding Fair Lending Regulations


fair-lending-6-19-17.pngNot long after the November election results became official, politicians, lobbyists and bankers began discussing the topic of bank regulatory reform. With a Republican in the White House, the Republican-controlled Congress vowed to push through its long-desired and promised reform of Dodd-Frank. While it is a decent bet some form of bank regulatory reform will emerge, it is unlikely reform will extend to the area of fair lending compliance. It seems most likely vigorous fair lending examination and enforcement are here to stay.

Each year, the Consumer Financial Protection Bureau prepares and issues a report specifically addressing its efforts in the area of fair lending supervision and enforcement. After touting its work from the previous year, CFPB specifically stated in its April 2017 Fair Lending Report that it will “continue to enforce existing fair lending laws at a steady and vigorous pace.” Furthermore, in a blog post from December 2016, Patrice Ficklin, director of CFPB’s Office of Fair Lending and Equal Opportunity, similarly indicated that the bureau’s work was far from over when it comes to stamping out lending discrimination.

The CFPB’s 2016 annual report identified three specific fair lending priorities for 2017, including redlining, mortgage and student loan servicing, and small business lending. While each of these priorities is important, redlining seems to be the hottest of the three in regulators’ eyes and deserves particular attention.

Redlining is a form of unlawful lending discrimination under the Equal Credit Opportunity Act (ECOA). It is defined as providing unequal access to credit, or unequal terms of credit, because of the race, color, national origin, or other prohibited characteristic, of the residents of a particular geographic area seeking credit. The unlawfulness of such practices is not new, but as with many consumer compliance issues, this one seems to go in and out of favor over time. It just so happens now it is back in favor.

The federal regulatory agencies take a risk-based approach to compliance examination, especially fair lending compliance examination. To determine the depth and breadth of the examination, the regulators evaluate and analyze the fair lending risk in the bank’s products and services. The results of this risk factor analysis affect the determination of whether, and to what extent, further examination is needed.

To identify redlining risk at a particular bank, the regulators may look at some or all of the following described risk factors:

CRA assessment area: The bank’s Community Reinvestment Act assessment area indicates where the bank expects to make loans. In assessing this risk factor, the examiner looks for exclusion (or non-inclusion) of geographic areas with high concentrations of minority race or ethnic residents.

Branch and loan production offices: Similar to the bank’s CRA assessment area, the location of the bank’s branches and loan production offices indicates from where it expects to attract loan customers. In assessing this risk factor, the regulators look for an unwarranted absence of locations in predominantly minority race or ethnic communities. Regulators look for so-called donut holes in the bank’s branch network?minority areas without a branch surrounded by majority areas containing branches.

Marketing and outreach: An effective marketing campaign attracts the customers the bank wishes to attract. In assessing the redlining risk attendant to the bank’s marketing efforts, the examiner looks to see whether the bank’s efforts expressly exclude, or will not include, racial and ethnic minority consumers. They consider to what zip codes or neighborhoods direct mail campaigns are sent and which real estate brokers are targeted for referral business. They also consider whether the bank makes affirmative efforts to reach out to racial and ethnic minority consumers as potential customers.

Complaints: Sometimes the most obvious indication of a problem is someone telling you there is a problem. Complaints about potential redlining may come directly to the bank by way of direct communication from an individual or advocacy group. But it is just as likely a complaint will be lodged on social media or in the press. In any case, the compliance examiner reviews complaints, including those received by regulatory authorities, in order to determine the existence and level of redlining risk.

Identifying and correcting unlawful redlining is a regulatory priority for 2017. Boards and senior management teams of banks of all sizes and geographies would be wise to redouble their efforts on making sure their bank’s policies, processes and procedures keep an eye out for that red line.

Fifth Third CEO Says Pace of Bank Industry Change Is Fastest He’s Ever Seen


growth-6-14-17.pngWhile the audience was largely optimistic at Bank Director’s Bank Audit & Risk Committees Conference in Chicago yesterday, many of the speakers, including Fifth Third Bancorp President and CEO Greg Carmichael, hit a note of caution in a sea of smiles.

During an audience poll, 51 percent said the nation will see a period of economic growth ahead but 28 percent said the nation has hit a high point economically. Bank stock prices soared following the presidential election. Credit metrics are in good shape and profitability is up. Capital levels are higher than they’ve been in decades. And political power in Washington has turned against bank regulation, as evidenced by the U.S. Treasury Department’s recent report on rolling back the Dodd-Frank Act.

“It’s unlikely we will have increasing regulatory burdens and instead, we’ll go regulatory light,” said Steve Hovde, an investment banker and chairman and CEO of Hovde Group.

Although there’s a sense that bank stocks may be overvalued at this point, or “cantilevered over a pillar of hope,’’ as Comerica Chief Economist Robert Dye put it, the economy itself is resilient. “We’ll have another recession and we’ll get through it fine,” he said.

But financial technology is transforming the industry and creating entirely new business models, said Carmichael. That won’t be a problem for banks as long as they adapt to the change. “The volume and pace of what’s emerging is amazing,’’ he said. “I’ve never seen it before in our industry.”

Carmichael, who has an unusual background as a bank CEO—he was originally hired by the bank in 2003 to serve as its chief information officer—is working hard to transform Fifth Third.

Sixty percent of the bank’s transactions are now processed through digital channels, such as mobile banking. Forty-six percent of all deposits are handled digitally. And the bank has seen an increase of 17 percent in mobile banking usage year-over-year.

To meet the needs of its customers, Fifth Third recently announced it had joined the person-to-person payments network Zelle, an initiative of several large banks. It has a partnership with GreenSky, which will quickly qualify consumers for small dollar loans, and which Fifth Third invested $50 million into last year. Consumers can walk into a retailer such as Home Depot, order $17,000 worth of windows, and find out on the spot if they qualify for a loan.

Fifth Third is gradually reducing its branch count, and new branches are smaller, with fewer staff that can handle more tasks. Carmichael is trying to make the organization more agile, with less bureaucracy, and less cumbersome documentation.

Automation will allow the bank to automate processes “and allow us to better service our customers instead of focusing on processes that don’t add value,” he said.

Banks that are going to do better are those that can use the data they have on their customers to better serve them, he said. But when it comes to housing enormous amounts of personal and financial data on their customers, the biggest worry for bank CEOs is cybersecurity risk, Carmichael said–not the traditional commercial banking risk, which is credit.

When he was a chief information officer, executives often asked how the bank could make its network secure, and his completely honest response was, “when you turn it off.”

Adding to the cybersecurity challenge, returns on capital are low for the industry compared to other, more profitable sectors, and measures of reputation are middling for banks compared to more popular companies such as Apple, Nordstrom, Netflix and Netflix.

Carmichael encouraged banks not to get mired in pessimism.

“There’s a lot of change but we can step up and embrace it and leverage it to better serve our customers and create more value for our shareholders and contribute to the success of our communities,” he said.

What Are the Prospects for Regulatory Reform?


regulation-6-7-17.pngEditor’s note: The House passed the CHOICE Act Thursday 233-186 but it isn’t expected to earn enough votes in the Senate to become law.

Financial regulatory reform is a priority for President Donald Trump and his administration, which views burdensome and costly regulation as a significant impediment to lending and economic growth. However, more than 100 days into the Trump presidency, neither the president nor Congress has taken meaningful action on financial regulatory reform. While it is impossible to predict what the administration’s legacy will ultimately be on regulatory reform, its actions thus far with respect to regulation generally, proposals introduced in Congress by Republicans, and the president’s power to appoint agency officials may offer some clues of what’s to come.

Financial CHOICE Act
The Financial CHOICE Act, which House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has called a blueprint for financial regulatory reform, passed the House Financial Services Committee on a party line vote on May 4. The current version of the CHOICE Act would, among other things:

  • Transform the Consumer Financial Protection Bureau (CFPB) from an independent agency to an executive agency, subject to Congressional oversight and the Congressional appropriations process, with its director removable at will by the president.
  • Make the CFPB an enforcement agency without a bank supervisory function.
  • Eliminate the CFPB’s authority to enforce unfair, deceptive or abusive acts and practices.
  • Provide regulatory relief to community banks and those engaged in residential mortgage lending.
  • Repeal the Volcker rule, which prohibits banks from proprietary trading.
  • Provide regulatory relief for banks that maintain a 10 percent leverage ratio.
  • Overturn the U.S. Second Circuit Court of Appeals’ decision in Madden v. Midland Funding.

While the CHOICE Act is likely to pass the House in some form, its chances of passage are remote in the Senate since 60 votes are required to overcome a filibuster. Nevertheless, some targeted reforms, including regulatory relief for community-based institutions, could be enacted.

Executive Orders
With material changes to the Dodd-Frank Act likely to die in the Senate, President Trump’s executive orders may form the basis of the administration’s regulatory reform strategy. President Trump has signed six executive orders impacting the financial services industry. Among other things, these executive orders:

  • direct the Treasury secretary to consult with the nine member agencies of the Financial Stability Oversight Committee and draft a report to the president analyzing current laws and regulations for their consistency with the seven so-called core principles of financial regulation;
  • require each agency to repeal two regulations for each new regulation implemented;
  • require a cost/benefit analysis before new regulations are adopted; and
  • require agencies to establish regulatory reform task forces and appoint regulatory reform officers whose job will be to identify burdensome regulations and evaluate their consistency with the core principles.

However, executive orders can accomplish only so much. Just as President Obama could not unilaterally repeal legislation, President Trump will not be able to roll back statutory provisions of Dodd-Frank without acts of Congress. Further, while it may be possible to soften the impact of certain Dodd-Frank regulations, the Administrative Procedures Act generally requires that any regulations implemented through a notice and comment process go through a similar process before they can be repealed.

Appointments
President Trump’s broadest impact on financial regulatory policy may come from his appointments to federal agencies. Treasury Secretary Steven Mnuchin has been confirmed. Three vacancies currently exist on the seven-member Federal Reserve Board of Governors. Former Treasury Undersecretary Randy Quarles is expected to be appointed as the first vice-chair of supervision, filling one of these vacancies. When the terms of Chair Janet Yellen and Vice-Chair Stanley Fischer expire in February 2018, the president will have the opportunity to reshape the central bank. Likewise, the comptroller of the currency has been replaced on an acting basis by banking attorney Keith Noreika and may be replaced by former One West CEO Joseph Otting on a permanent basis. If CFPB Director Richard Cordray is removed or leaves of his own accord later this year to run for Governor of Ohio, as many suspect he may, the president would have the ability to appoint a new CFPB director. Further, there is currently a vacancy on the Federal Deposit Insurance Corp. board and current chair Martin Gruenberg’s term as director will end in November. Since the comptroller of the currency and the director of the CFPB also sit on the FDIC’s board, the president soon will have an opportunity to appoint four of the FDIC board’s five members.

While the president can’t order officials at these agencies to take particular actions, and his ability to remove agency officials may be limited, his appointees will likely exercise a more restrained approach to regulation than Obama-era appointees. Over time, we expect a tangible difference in how banking agencies approach supervision and enforcement. At the end of the day, the president’s appointment power may be the most effective tool in his tool box.

Can We Say Goodbye to Fair Lending Cases?


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

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

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

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

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

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

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

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

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

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

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

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

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

A Modest Yet Welcome Thaw for Banking M&A and Financial Stability


mergers-4-18-17.pngAs part of approving the merger of $40.6 billion asset People’s United Financial Inc., with $2 billion asset Suffolk Bancorp, the Federal Reserve stated that, “[t]he [Federal Reserve] Board’s experience has shown that proposals involving an acquisition of less than $10 billion in assets, or that result in a firm with less than $100 billion in total assets, are generally not likely to create institutions that pose systemic risks” and that the Federal Reserve Board now presumes that such a proposal does not create material financial stability concerns, “absent evidence that the transaction would result in a significant increase in interconnectedness, complexity, cross-border activities, or other risk factors.”

Before the recent action, the Federal Reserve had since 2012 imposed very low thresholds under which it would presume no financial stability concerns exist. It only exempted acquisitions of less than $2 billion in assets or where the resulting firm would have less than $25 billion in total assets. Only a small number of transactions met these thresholds. The Federal Reserve reiterated its position, however, that it maintains the authority to review the financial stability implications of any proposal, specifically noting any acquisition regardless of size involving a global systemically important bank.

Through this action, the Federal Reserve has not only liberalized the key asset thresholds it previously established in 2012 for its evaluation of the financial stability factor in banking M&A, but also delegated authority to approve applications and notices that meet the newly revised thresholds to the Federal Reserve Banks. This revision has obvious parallels to recent statements from Chair Janet Yellen, Governor Tarullo and other Federal Reserve officials over the past few years (including as recently as December 2016) that the current $50 billion threshold for designation of a financial company as a systemically important financial institution (SIFI) may be too low. We believe that the delegation of authority to the Federal Reserve Banks could be at least as important, if not more important, as revisions to the financial stability thresholds because delegation should increase the chance that M&A transactions would proceed without the long delays that have recently been the norm in Federal Reserve Board reviews. Of course, all of the other requirements for delegation would also have to be met.

In support of this liberalization, the Federal Reserve cited its approval of a number of transactions over the past two years, including several transactions where the acquirer and/or resulting firm were over $100 billion or where the firm being acquired was over $10 billion and thus exceeded the newly revised financial stability thresholds. The increased thresholds and the delegation of authority to Federal Reserve Banks to process filings are welcome developments, especially for regional and community banking organizations that may be looking to acquire or be acquired. We would not, however, read the Federal Reserve’s actions as a strong signal that it expects or desires increased financial industry acquisitions or consolidation. The financial stability factor is only one of many that must be evaluated and questions will persist over how Community Reinvestment Act or fair lending concerns, anti-money laundering compliance, competition, general supervisory issues or public comment may affect a particular transaction. This action may, however, represent more formal support from the Federal Reserve for efforts to raise the $50 billion thresholds for SIFI designation and other purposes with a financial stability component under the Dodd-Frank Act.

Note: Another version of this article was initially published as a blog post on the Davis Polk FinRegReform blog on March 18, 2017.

OCC Fintech Charter: Considerations for Banks


fintech-4-12-17.pngThe Office of the Comptroller of the Currency (OCC) recently announced it would move forward with a plan to grant special purpose national bank charters to qualifying financial technology companies. The OCC has solicited comments on the proposal, which it will evaluate to determine whether to formally adopt the process for granting fintech charters. If adopted, companies granted such a charter would become national banks regulated by the OCC, with the attendant regulatory obligations and oversight, and would no longer need to partner with traditional banks to take advantage of preemption of certain state laws. As noted by the OCC Chief Counsel Amy Friend, the first charter may be granted in the first half of 2017.

General Requirements
Under the proposed rule, for a company to qualify for a fintech charter, it must have the appropriate corporate structure, engage solely in bank-permissible activities and adhere to certain regulatory requirements.

Generally, national bank charters subject their holders to specific standards and federal oversight such that the firm can conduct business nationally. Because the proposed fintech charter would be granted under the National Bank Act (NBA), fintech companies would need to adhere to the statute’s governance requirements. For example, a fintech firm chartered by the OCC would need to have a minimum of five board members.

In addition, fintech charter holders only would be permitted to engage in activities authorized by OCC regulations and associated interpretations. These activities can include, among others, lending money, issuing debit cards and facilitating payments, but also investment advisory services and certain brokerage activities. If a given activity is not clearly permitted by the OCC, the firm could seek permission from the OCC, which grants approval of new activities on a case-by-case basis. Beyond OCC regulations, the new charter would impose other laws on a chartered fintech firm, such as the Bank Secrecy Act and related anti-money laundering laws, as well as certain enhanced prudential standards under the Dodd-Frank Act if applicable.

Moreover, a fintech charter holder will be required to meet various supervisory requirements, including that it maintain a business plan documenting its activities, such as with respect to financial inclusion; have a governance structure that reflects the expertise, financial acumen and risk management necessary in light of the proposed business lines; effectively manage compliance risks, such as consumer protection and anti-money laundering; and address potential recovery and resolution. In addition, a fintech firm would need to maintain capital and liquidity commensurate with the risk and complexity of the proposed businesses, including any off-balance sheet activities.

Despite the many requirements the OCC is likely to impose when granting a fintech charter, fintech-chartered companies would have the advantage of no longer being required to register with or become licensed in each state where they conduct business. As enjoyed by national banks, the fintech charter generally would give a company the benefit of preemption under the NBA. Among other features, this would allow the exportation of interest rates from a bank’s home state to other states regardless of the home state’s usury restrictions.

Various stakeholders have reacted to the proposal with differing views. For example, the New York Department of Financial Services submitted a comment letter opposing the proposal and arguing that state regulators are the best equipped to regulate the fintech industry. Others in the industry have voiced their support.

Considerations for Existing Banks
Banks may see fewer partnerships with fintech companies as a result of the fintech charter because NBA preemption means that fintech firms no longer need a bank to obtain the advantage of state law preemption.

The fintech charter holders would not have a material competitive advantage with respect to banks because they are subject to the full panoply of OCC regulation and supervision.

Banks may consider seeking their own fintech charter, perhaps through an affiliate, if particular business lines might benefit or if they are currently chartered in one or only a few states in order to expand their national presence.

The Banking Themes of 2017: What to Expect


bank-trends-2-3-17.pngAfter the anemic economic growth and overregulation of the past decade, what banking themes can we expect in 2017 amid current market optimism?

Rates
For an immediate impact, Trump and the Republican Congress need to lower the corporate tax rate first. Other policy agendas will have long-term effects. The true unemployment rate is over 10 percent, not 4.6 percent, when factoring in a normal labor participation rate, which is currently close to a 40-year low. Almost all employment growth from 2005 to 2015 is part-time, temporary or contract work. The economy is still not well, yet inflation continues to build, for example, with rising healthcare costs, government services and education costs. Most assets are overpriced with artificially low rates contributing to a torrid stock market and average price/earnings ratios at a 20-year high. This should keep rate hikes to 1 or 2 percentage points versus the 3 or 4 percentage points most are predicting. Rate hikes will create a nominal positive effect on net interest margin for banks of 5 to 10 basis points.

Credit
Corporate debt ratios are higher, particularly those with high yield. Most banks have thankfully chased high grade customers and credit since the crash. However, many are at or over the 300 percent real estate or 100 percent construction and development loan thresholds. Expect a real estate pullback. If the stock market retreats 5 to 10 percent, a mild recession may result. We are due for a credit correction over the next 6 to 18 months. It will hurt non-bank lenders more than banks. Loan growth should remain steady and provisions need to increase.

Capital
If bank stock prices can stay above 16 times earnings, expect more initial public offerings (IPOs) due to pent-up demand from 2016. Many banks are trading at 20 times price to earnings or more, and banks are in favor with investors. Bank stocks have been a greed and fear trade since 2008 with a near 100 percent correlation. Consumer and investor confidence is running high presently. Optimism abounds about interest rates, the economy, tax cuts and deregulation. While it all seems to be priced into bank stocks right now, investing in government optimism versus company fundamentals feels a bit awkward at best. Expect a pullback, but for the sector to remain strong with good, core earnings growth of 15 percent or more and with more IPOs in quarters two through four. There has been an increasing interest from yield-starved investors in bank stock loans, subordinated debt and preferred stock. Expect that to continue.

M&A
The volatility in the markets in 2016 were driven by China, energy, and Brexit, so renewed confidence could be a good thing for M&A. Do prospective sellers, frustrated with lackluster returns and burdensome regulations, have newfound optimism and upward price exit expectations? Perhaps, but there is room to run here. Volume was down 10 percent in 2016 with 242 deals. But there was an increase in exits or restructuring, as private equity investments matured and investor activists pressured banks to sell. Confidence and high buyer currency should lead to increased volume in 2017, especially given the seller expectations being average to below average, while buyer currencies are at 20-year highs. But if volatility and fear get too high, then M&A will slow.

Deposits
One or two rate hikes shouldn’t be an issue as bankers will wait to raise rates on deposits. At some point, depositors will gain confidence in the market and push for higher returns. This will be interesting as many bankers think they have core deposits, even though they don’t, and will realize they have a liquidity problem when the deposits run.

Regulatory
Complaints about the Dodd Frank Act are still rampant industry wide, but bankers will be found thinking, “Hey, I’ve spent the money and adjusted. I need certainty, not uncertainty.” While there are still parts of Dodd-Frank that haven’t been implemented, deregulation could be the developing theme. Also, what happens to the Consumer Financial Protection Bureau? This is an entity which basically usurped power from the other regulatory agencies, and plenty of senators and representatives would like to curtail its power.

Customers
Lastly, banks will have to work on improving customers’ experience. Take note of the retail industry. After a robust Christmas shopping season, Macy’s is closing 59 stores and Sears even more. If your product is clothing at a good price, then online retailers have stolen your product. Retail needs to provide an experience to differentiate. Some banks are already delivering a coffee shop or networking experience. Amid the fake news perpetuated online, and failed deliverables from Wall Street, the country is desperate for a trusted refuge and harbor of safety they can believe in. Perhaps, banks that deliver an experience anchored in a theme of trust will do well.