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.

 

Does the Sharp Increase in Bank Stock Prices Create a Seller’s Dilemma?


stock-1-30-17.pngOh, what a difference a year can make. Or more to the point, what a difference just three months can make. At Bank Director’s Acquire or Be Acquired Conference last year, bank stocks were in the proverbial dumpster having been thoroughly trashed by declining oil prices, concerns about an economic slowdown in China and the slight chance that the slowly growing U.S. economy could be dragged into a recession in the second half of 2016.

Oil prices have since firmed up somewhat and the U.S. economy did not experience a downturn in the second half of the year, but all things considered, 2016 was a bumpy ride for bank stocks—until November 8, when Donald Trump’s surprise victory in the presidential election sent bank stock prices rocketing skyward. Valuations have been slowly recovering ever since the depths of the financial crisis in 2008, with some dips along the way. But since election day, stocks for banks above $250 million in assets have increased 21.2 percent to 24.8 percent, depending on their specific asset category, according to data provided by investment bank Keefe, Bruyette & Woods President and Chief Executive Officer Tom Michaud, who gave the lead presentation on the first day of the 2017 Acquire or Be Acquired Conference in Phoenix, Arizona.

What’s driving the surge in valuations is lots of promising talk about a possible cut in the corporate tax rate and various forms of deregulation, including the possible repeal of the Dodd-Frank Act and dismantling of the Consumer Financial Protection Bureau (CFPB). These tantalizing possibilities (at least from the perspective of many bankers), combined with the expectation that a series of interest rate increases by the Federal Reserve this year could ease the banking industry’s margin pressure and further boost profitability, has been like a liberal application of Miracle Grow to bank stock prices.

Michaud made the intriguing observation that investor optimism over what might happen in 2017 and 2018—but hasn’t happened yet—accounts for much of the jump in valuations since the election. “In my opinion, a lot of the good news is already in the stocks even though a lot of it hasn’t happened yet,” Michaud said. In fact, virtually none of it has happened yet. Investors have already priced in much of the increase in valuations resulting from a tax cut, higher interest rates and deregulation as if they have already occurred, which makes me wonder what will happen to valuations if any of these things don’t come through. I assume that valuations would then decline, although no one knows for sure, least of all me. But it should be acknowledged that the attainment of some of the already-priced-in-benefits of a Trump presidency, such as getting rid of Dodd-Frank and the CFPB, would have to overcome fierce opposition from Congressional Democrats while others, such as the combination of a corporate tax cut and a massive infrastructure spending program (which Trump has also talked about) would have to get past fiscally conservative Congressional Republicans. You’re probably familiar with the old saying that investors buy on the rumor and sell on the news. This could end up as an example of investors buying on the promise and selling on the disappointment.

Here’s the dilemma I think this sharp increase in valuations poses in terms of selling your bank or raising capital. If you’re an optimist, you probably will wait for another year or two in hopes of getting an even higher price for your franchise or stock. And if you’re a pessimist who worries about the sustainability of this industry-wide rise in valuations and the possibility that most of the upside from Trump’s election has already been priced into your stock, I think you’ll probably take the money and run.

Bank Regulatory Update: Three Things to Think About for 2017


regulation-1-18-17.pngSignificant regulatory changes continued to affect the banking industry in 2016. The industry generally has moved beyond implementing the requirements of the Dodd-Frank and Wall Street Reform and Consumer Protection Act, but regulatory expectations continue to rise, with increased emphasis on each institution’s ability to respond to and withstand adverse economic conditions. Regulatory supervision, often through oversight from multiple agencies, is becoming more focused on supporting compliance efforts with strong corporate cultures within the institution. Managing regulatory compliance risk for a financial institution has never been more complex.

Looking forward to 2017, regulators are expected to continue to ramp up expectations in several areas. Industry stakeholders undoubtedly will be watching closely as the new administration takes control of the White House. However, regulators are expected to continue to increase their emphasis on three areas: cybersecurity risk, consumer compliance and third-party risk management.

1. Cybersecurity Risk
Cybersecurity is likely to remain a key supervisory focal point for regulators in 2017. Regulatory officials have stressed that cybersecurity vulnerabilities are not just a concern at larger financial institutions: small banks also are at risk. As such, financial institutions of all sizes need to improve their ability to more aptly identify, assess and mitigate risks in light of the increasing volume and sophistication of cyberthreats.

The Federal Financial Institutions Examination Council (FFIEC) agencies have established a comprehensive cybersecurity awareness website that serves as a central repository where financial services companies of all sizes can access valuable cybersecurity tools and resources. The website also houses an FFIEC cybersecurity self-assessment tool to help banks identify their risks and assess their cybersecurity preparedness. The voluntary assessment provides a repeatable and quantifiable process that measures a bank’s cybersecurity preparedness over time.

2. Consumer Compliance
The Consumer Financial Protection Bureau (CFPB)—now a more mature entity—is having a dramatic impact on the supervisory processes around consumer financial products. While the CFPB conducts on-site consumer exams for financial institutions with more than $10 billion in assets, it also has begun to work with regulators in consumer supervisory efforts in smaller banks. The CFPB also has issued a significant number of new and revised consumer regulations that apply to institutions of all sizes. Some of the more onerous requirements center on mortgage lending and truth-in-lending integrated disclosures (TRID).

The CFPB also continues to cast a wide net when it comes to gathering consumer complaints about financial products and services through its consumer complaint database. The latest snapshot shows the database contains information on more than one million complaints about mortgages, student loans, deposit accounts and services, other consumer loans, and credit cards.

CFPB examiners often use complaints received through the database as a channel for reviewing practices and identifying possible violations. This continued pressure has forced financial institutions to ensure their compliance management systems are supported by effective policies, procedures and governance. But keep in mind, it’s even more important now to adequately aggregate, analyze and report customer-level data, so your institution can identify and remediate problems before the regulators come after you, and so you don’t get accused of “abusive” practices under the Dodd-Frank Act.

3. Third-Party Risk Management
As a component of safety and soundness examinations, effective third-party risk management is regarded as an important indicator of a financial institution’s ability to manage its business. As a result, regulatory examinations consistently include an element of third-party risk management, and all of the federal bank regulators have issued some form of guidance related to third-party risk. The Federal Reserve’s (Fed’s) SR 13-19 applies to all financial services companies under Fed supervision. The Fed guidance focuses on outsourced activities that have a substantial impact on a bank’s financial condition or that are critical to ongoing operations for other reasons, such as sensitive customer information, new products or services, or activities that pose material compliance risk.

Guidance from the Office of the Comptroller of the Currency (OCC) on third-party risk (Bulletin 2013-29) generally is more comprehensive than the Fed guidance and requires rigorous oversight and management of third-party relationships that involve critical activities. The OCC bulletin specifically highlights third-party activities outside of traditional vendor relationships.

Outlook
The critical areas discussed here are just a few for which banks need to expect more regulatory scrutiny in 2017. While there are early indicators that some elements of Dodd-Frank and other regulatory requirements could be pared back as the new administration takes control of the White House, the industry will need to closely monitor any changes and adjust compliance efforts accordingly.

Is Trump Good for Fintech, or Bad?


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There has been an enormous sense of anticipation flooding through the community and regional banks since the election. President-elect Donald Trump’s opposition to the Dodd-Frank Act, which has created a stifling regulatory environment, is well known and bankers feel that relief is on the way. By contrast, the election results have produced a sense of consternation and concern among the financial technology companies that are trying to partner and compete with community and regional banks. The regulatory picture is much more confusing under a Trump Administration for these enterprises.

One reason for this is that fintech regulation was far from a settled issue before the election. The regulatory framework for fintech is not in place to any significant degree. In many cases, it will take new regulations to allow many of the fintech lenders and payment companies to expand their operations, and that’s a problem. Trump is opposed to new financial regulations of any sort, and it may be difficult to get the new framework in place during his term in office. Rather than pass new federal legislation, he is likely to leave the matter in the hands of the state legislatures and that will not benefit fintech companies.

The creation of a limited purpose national fintech charter as proposed by the Office of the Comptroller of the Currency is an attempt to make it easier for these companies to operate and not have to deal with regulatory agencies on a state-by-state basis. But in my opinion, there won’t be that many fintech companies that are willing and able to handle the responsibilities of a national charter, so this will provide limited relief to the industry. I also will not be shocked to see the concept of a limited purpose charter unwound early in a Trump Administration as bankers have been huge supporters of the incoming president and in my experience, the average bank is not shy about asking for favors.

Fintech firms are also big supporters of net neutrality since it gives them open and even access to bandwidth to offer services to users. Trump is not a supporter, and neither are the ranking members of the GOP in the Senate and the House of Representatives. Republican lawmakers have already put forth a bill to end net neutrality that I think will pass early in the next session of Congress and I expect Trump to sign it when it reaches his desk.

Immigration policies will also be a potential negative for fintech companies. Immigrants make up a significant percentage of the skilled workforce within the financial technology industry, and anything that makes to harder for them to get here and stay here is going to create a talent challenge for the companies in that space. Fintech companies that focus on payments could be hurt as well since many of the people that Trump wants to deport use these systems to send money to family back home, and that volume could drop substantially.

The biggest threat to fintech firms from the new administration will likely come from the repeal or reduction of Dodd-Frank. A lot of the opportunities that fintech companies are pursuing were created by the handcuffs placed on banks by that legislation. If the handcuffs come off under the Trump Administration, then fintech lenders and payment companies will find that they now have to go head to head with the likes of JP Morgan Chase & Co., Citigroup and Bank of America Corp., and that will be no easy task.

The regulatory environment for financial technology was murky before the election, and it is even more so today. While we can expect the combination of a Trump Presidency and GOP-controlled Congress to be pro-business, we can also expect them to be very pro-traditional banking. That will be a big negative for fintech companies that had hoped to compete with the banks in the future.

While many expect fintech to be a major disruptor of the banking industry and some even think it will replace banking, I don’t expect that to happen—especially if banks end up with a more favorable regulatory environment. The fintech firms that prosper under a Trump Administration will be those that can partner with a bank to offer financial products and services to bank customers in a more efficient and profitable manner.

Diversity Policies and Practices: Is Your Bank Ready for the New Rules?


diversity-12-5-16.pngWith the current overwhelming regulatory burden, many banks may not have given the issue of workplace diversity much, if any, consideration. However, the regulators have begun sending letters to banks across the country questioning whether the banks have, among other things, completed a diversity self-assessment and whether they want to report the results to their regulator. This letter has lead banks to scramble to get up to speed on this issue, so the purpose of this article is to explain the current guidance.

By way of background, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required each federal financial regulatory agency to establish an Office of Minority and Women Inclusion and instructed the office’s director at each agency to develop standards for assessing the diversity policies and practices of its regulated institutions. As a result, in June 2015, multiple regulators published a policy statement on assessing diversity policies.

Diversity assessments aren’t mandatory, but the policy statement shouldn’t be ignored. Instead, your bank should review its practices and decide how to address the policy statement. At a high level, the standards set forth in the policy statement address the following:

  • Organizational Commitment to Diversity and Inclusion: This describes how a bank promotes diversity and inclusion in both employment and contracting and how it fosters a corporate culture that embraces diversity and inclusion.
  • Workforce Profile and Employment Practices: This could include promoting the fair inclusion of minorities and women in the bank’s workforce by publicizing employment opportunities, creating relationships with minority and women professional organizations and educational institutions, creating a culture that values the contribution of all employees, and encouraging a focus on these objectives when evaluating the performance of managers.
  • Procurement and Business Practices—Supplier Diversity: This might involve expanding available third-party options by increasing outreach to minority-owned and women-owned businesses, including using metrics to identify the baseline of how much the bank spends procuring and contracting for goods and services, how much the bank spends with minority-owned and women-owned businesses, the availability of relevant minority-owned and women-owned businesses and how that may change periodically, as well as outreach to inform minority-owned and women-owned businesses of these opportunities.
  • Practices to Promote Transparency of Organizational Diversity and Inclusion: The bank might want to make public its commitment to diversity and inclusion through normal business methods, which include displaying information on the bank’s website, in the bank’s promotional materials, and in the bank’s annual report to shareholders, if applicable.
  • Self-Assessment: Banks can allocate time and resources to monitoring and evaluating performance under their diversity policies and practices on an ongoing basis.

The policy statement makes several important points:

  • Completion of a self-assessment is voluntary.
  • The standards do not create new legal obligations. However, because of the increased focus on diversity policies in banks, the standards should not be ignored.
  • The agencies may use the information submitted to them to monitor progress and trends with regard to diversity and inclusion in employment and contracting activities.
  • Agencies are allowed to publish information disclosed to them in any form that does not identify a particular entity or individual or disclose confidential business information.

Based upon the agencies strong encouragement to perform a self-assessment, banks should consider assessing all aspects of their diversity policies and procedures to determine areas of success, and areas for growth. Most banks with 50 or more employees are required to have affirmative action plans, because they are considered federal contractors, as they serve as a depository of federal funds, or as an issuing and paying agency for U.S. savings bonds and notes in any amount; or are covered by deposit insurance. Banks with 100 or more employees are already subject to reporting under the Equal Employment Opportunity Commission’s EEO-1 filing.

The standards in many cases will outline similar mechanisms to ensure diversity and inclusion. Because Title VII of the Civil Rights Act applies to virtually all banks, it is a good idea to have diversity policies and a method by which to measure their effectiveness. Banks should consider consulting with their legal counsel regarding implementing affirmative action plans, putting together a self-assessment program and developing any necessary employment policies, or ensuring that current policies comply with federal, state, and local laws.

Do the Regulators Want Bigger Banks?


big-banks-12-2-16.pngOne of the more intriguing story lines of the banking industry’s consolidation since the financial crisis is the persistent belief that federal regulators privately want a more concentrated industry with fewer banks because it would be easier for them to supervise, and they signal their support for this laissez-faire policy every time they approve an acquisition.

Consider this comment from a respondent to our 2017 Bank M&A Survey: “Regulators are actively trying to reduce the number of charters, to reduce their workload and to give them control, with fewer institutions to supervise. While they do not openly admit it, every agency has admitted to me that they would prefer fewer institutions. This will cause more consolidation.” Implicit in this perception is the assumption of regulatory bias against the thousands of small banks that dot the industry landscape. The aforementioned respondent to our survey was a director at a bank with less than $500 million in assets.

Are the regulators really guiding the industry’s consolidation with a hidden hand? Looking back to the mid-1980s, I think it’s impossible to argue that the last five presidents and 11 secretaries of the Treasury (not to mention numerous federal regulators) were opposed to the idea of consolidation as the industry shrunk from 14,884 insured institutions in 1984 to 6,058 as of June 2016, according to the Federal Deposit Insurance Corp. The most intense period of consolidation was probably a 20-year period, beginning in 1984, where the industry shrank to just 7,842 insured institutions by the end of 2003—nearly a 50 percent reduction!

I found this observation in a 2005 article in FDIC Banking Review, entitled “Consolidation in the U.S. Banking Industry: Is the Long, Strange Trip About to End?” “Over the two decades 1984 to 2003, the structure of the U.S. banking industry indeed underwent an almost unprecedented transformation—one marked by a substantial decline in the number of commercial banks and savings institutions and by a growing concentration of industry assets among a few dozen extremely large financial institutions. This is not news.” And if it wasn’t news in 2005, it certainly shouldn’t be news today.

I think a more interesting question is whether the collective governmental brainpower seriously considered the systemic ramifications of a more concentrated industry—especially the creation of megabanks like JPMorgan Chase & Co., Wells Fargo & Co. and Bank of America Corp. Those three institutions, along with Citigroup, rank as the four largest U.S. banks and collectively held 40 percent of the industry’s total deposits and 42 percent of its total assets as of September 2016, according to S&P Global Market Intelligence.

It was the fear that a large bank would fail during the financial crisis, worsening the situation even further, that led to the controversial and much criticized industry bailout and provided the emotional fuel in Congress to pass the Dodd-Frank Act. Even today, approximately seven years after the crisis passed, we are still debating whether another unofficial governmental policy from years past—too big to fail—could be deployed in times of emergency despite the efforts of the framers of Dodd-Frank to kill it once and for all. I would say that Washington ended up getting exactly what it had wanted over the last three decades—a more concentrated industry with fewer banks—but doesn’t seem to be very comfortable with the outcome.

Another interesting question is when will consolidation end? It’s taken as gospel that the four megabanks will not be allowed to do any more acquisitions because they’re already too large, and most of the M&A activity in recent years has been in the community bank sector, where individual banks do not pose a systemic threat to the economy. But is there a number at which point the regulators, Congress or some future presidential administration would say enough? A more concentrated industry poses systemic risks of its own, so does Washington reverse its laissez-faire policy when we reach 5,000 banks, or 3,500, or even 2,000?

If anyone in Washington has an answer to that question, I’d love to hear it. Then again, President-Elect Trump fits the description of a laissez-faire capitalist as well as anyone, so maybe he’ll let the banking industry seek its own final number.

Contingent Hedging Plans: How Community Banks Can Approach Hedging


A contingent hedging plan should be unique to every bank and developed in concert with internal modeling and management’s rate expectations. Like a captain adding ballast to a ship to provide a smoother ride, hedging allows a bank to reduce volatility and limit the impact of sudden interest rate changes. (See BMO’s previous article on this topic.) The goal is not to eliminate risk, but proactively mitigate or control risk at a suitable cost.

Derivative use among community banks has increased over the last several years. The graphs below illustrate the growth in the number of banks with swap and gross balances. Interestingly, after the Dodd Frank Act was enacted in 2012, at a time when using derivatives was expected to be more onerous, the year-over-year growth in derivative use among community banks has accelerated rather than declined.Swap chart.PNG

One possible explanation with the migration of bankers from larger institutions to smaller community banks is they bring with them an understanding of derivatives and their benefits. The sustained flat curve and low rate environment may have compelled banks to evaluate and use derivatives.

How To Create a Contingent Hedging Plan
Regulators require banks to establish contingent funding plans. Developing a contingent hedging plan could follow the same approach. The plan can include description of roles, responsibilities and action plans where applicable. It should also allow management to act quickly when rate assumptions change. Among the items one can include:

Determine Economic Goals with Quantitative Guidance: What are the economic risks the bank is trying to mitigate? The more quantifiable the risk, the more specific you can be with your dealer and the more targeted the recommended solution.

List of Approved Transaction Types: Keep definitions broad enough to allow management to act opportunistically without waiting for approval at the monthly board meeting. Learn the basic mechanics of these trades today, so when you look to execute in a volatile market you will already have some understanding on which trades are most suitable for the risk.

Cost and Timing: There is usually a trade off or “cost” to do a hedge–nothing is for free. Get on someone’s rate sheet distribution, remain aware of current hedge levels and determine a range of acceptable cost. When one waits too long to trade, the hedge cost may become prohibitively expensive.

Understand Accounting Treatment: Derivatives are subject to FAS133 / ASC815 accounting treatment. Develop a familiarity of which accounting model is required and under which hedging circumstance.

Transaction Mechanics: Know who to call and how to execute a trade. Develop familiarity with terminology and swap nomenclature in order to accurately communicate intent.

Counterparty Selection: This may be the most important ingredient. Without access to a dealer counterparty to help provide solutions, creating a contingent hedging plan could be a moot point.

The Dodd-Frank Act provides advantages for hedgers if they transact with a registered swap dealer (RSD). The act defines swap dealers as entities who “hold themselves out as dealers in swaps; make a market in swaps; regularly enter into swaps with counterparties in the ordinary course of business for their own accounts; or engage in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.”

These entities are required to register with the Commodity Futures Trading Commission and are held to higher business conduct standards. A list of provisionally registered swap dealers can be found here

Hedgers Can Expect the Following Benefits From RSDs
Price transparency: The act requires all RSDs to quote mid + bid/offer spread on every trade. The hedger knows exactly what the dealer is making.

Liquidity / Cost: By trading directly with a market maker, the hedger crosses one bid or offer spread rather than two which normally happens when going through an intermediary.

Fair Credit Terms: You get fair credit terms with bi-lateral collateral posting for uncleared trades.

Expertise: RSDs can provide direct market color, trade recommendations and regulatory guidance. The level of expertise will be much higher given the critical mass and scale required to be a market maker in this regulatory environment.

Hedgers should consider that the regulatory burden on RSDs is significant, so dealers have responded by recalibrating business lines. While there are still RSDs willing to face small banks, many other dealers have exited the community bank space entirely. When evaluating a swap partner, you may want to ask about their commitment to your asset class.

Busting the Logjam in Small Business Lending


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With reports touting the health of the economy and the officials at the Federal Reserve talking about raising interest rates again, the lending environment must be good for small business owners, right? Wrong.

According to Babson’s 2016 State of Small Business in America report, obtaining capital is a challenge that frustrated SMB owners continue to face. Even those receiving a loan from a traditional lender obtain less than half the amount they applied for. What’s standing in the way of entrepreneurs borrowing from a traditional bank?

Lingering fear from the Great Recession: From 2008 to 2013, small businesses benefited from loosened lending restrictions. But in the past couple of years, fears about SMB lending has shifted thinking and brought about a tightening of standards–leading banks to provide available loan opportunities only to bigger businesses, which they view as less risky.

Fallout from Dodd-Frank: Post-2008 recession, new regulations created paperwork headaches for large lenders and small community banks alike. But the annoyances aren’t just isolated to a potential borrower being required to fill out a couple of additional forms. Compliance increased the cost of originating loans, so much so that it’s no longer fiscally responsible for lenders to issue lots of small loans.

In fact, Oliver Wyman research (PDF) indicates underwriting these loans costs a marginal $1,600 to $3,200 per loan. Compare these costs to the annual revenue smaller loans generate—$700 to $3,500 on average—and they’re clearly unprofitable.

Fewer lending options: It has also become very expensive to raise capital to open new community banks due to heightened regulatory requirements since the financial crisis. These local financial institutions are a great lending option for small business owners when big banks tighten their lending requirements. But with fewer local banks, SMB owners are left with fewer borrowing options than ever.

The stimulus encouraged banks to stockpile reserves: Prior to 2008, the U.S. economic structure encouraged financial institutions with large amounts of cash to lend it to other banks in need of liquidity. The federal stimulus pact reduced this cash flow, and large banks began sitting on their significant reserves–reducing the amount of available capital to smaller lenders, which in turn would be passed on to small business owners in their form of much needed credit.

Despite these obstacles, traditional lenders can and should break the SMB lending logjam. According to Barlow Research’s 2016 Small Business Annual Report, SMB loan demand is trending down slightly in a year-over-year comparison—off 9 percent between 2010 and 2016. However, this downward trend applies only to the traditional-lender space. New digital marketplace lenders are helping SMB borrowers to get around this credit logjam–and capturing more and more SMB lending business that used to go to banks.

According to one report by Morgan Stanley, loan origination at alternative lenders has doubled every year since 2010, reaching $12 billion in 2014. While banks are still the dominate credit source for small businesses, last year SMBs sought 22 percent of their financing from alternative lenders. That’s hardly a trend that benefits small businesses. Marketplace lenders do offer SMB borrowers fast, convenient loans–but that speed and convenience comes at a steep price, with expensive and often opaque lending terms that have attracted increasing scrutiny from regulators.

How can traditional lenders reverse this trend and break the SMB lending logjam? Simply put, banks need to harness the power of financial technology, machine learning and big data to bring small business lending online. By streamlining the origination process, banks can reduce operational costs dramatically for these loans while offering the speed and convenience SMB borrowers demand–and get–from alternative lenders. Reducing loan origination costs improves their profitability and introduces a virtuous circle of increased lending that expands lending options for borrowers at more competitive pricing.

The innovations don’t stop there. New machine learning algorithms can supplement the traditional, narrowly defined credit score criteria with enhanced, real-time data like shipping trends, social media reviews and other information relevant to a small business’ financial health. Thus armed, banks can identify an expanded field of highly qualified borrowers without increasing risk. They can pilot risk-based pricing models based on a borrower’s creditworthiness, ending the all-or-nothing style of flat pricing for approved loans. The possibilities are exciting and enormous. But traditional lenders will need the right financial technology to break this lending logjam and unleash the SBM market’s full potential.

A version of this article originally appeared on the Mirador blog.

Election Results Could Mean Less Regulation for Banks


Regulation-11-10-16.pngIt’s an understatement to say Republican presidential nominee Donald Trump’s surprise victory shook up the world Tuesday. Trump got elected promising change in Washington and made statements that portrayed a confusing mix of anti-bank and anti-regulation rhetoric. But with the House and Senate now controlled by Republicans, many industry observers are optimistic that the election will mean the appointment of more bank-friendly regulators, while the Consumer Financial Protection Bureau (CFPB) could also be weakened.

Although many economists feel Trump’s policies would be bad for the national economy, bankers by and large felt Trump would actually be good for the economy, according to a Bank Director poll in September.

“We think the main result of Donald Trump’s election will be that Trump will be able to appoint regulators who are more industry friendly than regulators appointed by President Obama,’’ wrote Brian Gardner, an analyst with investment banking company Keefe, Bruyette & Woods, in a note to investors Wednesday. “The regulatory implications are more important than what might come out of Congress but are broadly positive for financials in our view.”

CFPB
As far as banking regulations, the biggest thing in jeopardy may be the CFPB. President Trump will be able to appoint someone to head the agency, and a Republican-led Congress may make a move to gut or end it. That’s not to say such a move would be easy to do, but if Congressional elections in 2018 remove even more Democrats from office, it’s a possibility. The existence and approach of the CFPB has been a thorn in the side of many.

The Dodd-Frank Act
It’s unlikely the Dodd-Frank Act will be gutted entirely even with a Republican-controlled Congress. Democrats still will have at least 47 seats in the Senate and be able to block legislation that they don’t support, as 60 votes are needed to pass legislation in the Senate, Gardner wrote.

Even some industry lobbyists will be advocating against that, as it would create even more uncertainty. “Our industry has spent billions implementing Dodd Frank and complying with the CFPB,’’ said Richard Hunt, the president and CEO of the Consumer Bankers Association, in an interview Wednesday. “The last thing the banking industry needs is a whipsaw effect of uncertainty.”

Instead, some lobbyists are advocating for measures that would ease regulation on community banks, especially. The Independent Community Bankers of America “believes the unified Republican control of the executive and legislative branches presents a unique opportunity for enacting significant community bank regulatory relief and fully intends to leverage this opportunity for the benefit of community banks, their customers, and the communities they serve,” the group wrote in a memo to members and published on its website.

Wall Street Reform
The Republican Party platform this year, which former Trump campaign manager Paul Manafort said was in fact Trump’s platform, supported the return of the Glass-Steagall Act, which forbid banks from having both commercial and investment banking businesses. It was a surprising move, as the other person supporting the return of Glass-Steagall was Massachusetts Democratic Senator Elizabeth Warren. But few expect Trump to actually push hard for this, let alone be successful.

Aite Group senior analyst Javier Paz, who covers assets managers, wrote in a note that there was talk of President Trump leaning hard on Wall Street, but “we believe this was a tactical shift to keep Hillary Clinton from outflanking him on the topic of Wall Street reform. Time will tell, but we highly doubt new pieces of legislation building on what Dodd-Frank started will be forthcoming under President Trump.”

Hunt says he counted about 35 seconds of anti-bank rhetoric during four presidential and vice presidential debates. “There is campaigning and then there’s governing,’’ he says. “This is where Speaker Ryan, McConnell and the president will get together and come up with a shared vision for what they want the first 100 days and first year to look like to show the American people that Washington can work.”

Federal Reserve
There is a lot of uncertainty about what impact a Trump presidency will have on the Federal Reserve. Trump has been critical of Fed Chairwoman Janet Yellen and the central bank’s policies. He has said the Fed has been artificially keeping rates too low but his views on the Fed have not been consistent. He will be able to appoint two members to the Federal Reserve after he takes office, and Yellen’s term ends in January 2018, according to Gardner. Although the Fed was widely expected to raise rates in December, some predict that won’t happen now, as uncertainty about the markets could lead the Fed to delay a rate hike.