Compensation Regulation and Dodd-Frank: Where Are We Four Years Later?

9-12-14-McLagan.jpgWhere were you on July 21, 2010? If you were working for a bank, or in compliance for a publicly traded company, you know the world got much more complex on that date. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law, all 2,315 pages of it. Four years later, it makes sense to ask the status of the various regulations coming out of the Act, especially in one of the most complex areas, compensation.

There were six items in the Dodd-Frank Act that specifically focused on compensation. Of these six, five applied to all public companies; only one was focused specifically on financial institutions—incentive compensation. Four years later, only two of these six have been implemented. While this speaks to the general level of gridlock in Washington, D.C., at our regulatory bodies, it is important to understand what has been implemented, what is coming and how it impacts your bank.

If you are a publicly traded bank, say-on-pay has been with you for four years and has had a very direct impact on executive compensation. This fall, we may get final regulations on the pay ratio disclosure, which requires public companies to report the ratio of CEO pay to the median pay of all other employees. This could go into effect in 2015, which could impact proxy statements in 2016. Also, we may see proposed regulations on clawbacks this fall.

Most bankers are awaiting final regulations on incentive compensation arrangements; a regulatory item that has been in a proposed state for more than three years. However, there is related final guidance on a similar subject—Sound Incentive Compensation Policies. Although this joint regulatory guidance did not come out of the Dodd-Frank Act, it is in effect today and applies to all banks and thrifts, regardless of whether they are public or private and regardless of size.

Section Provision Shorthand Applicability Status
951(a) Shareholder Vote on Executive Compensation Say-on-Pay All public companies Effective, January 2011
951(b) Shareholder Vote on Golden Parachute Compensation Say-on-Golden-Parachutes All public companies Effective, January 2011
953(a) Pay Versus Performance Disclosure All public companies Not proposed
953(b) Pay Ratio Disclosure CEO Pay Ratio All public companies Proposed, September 2013
954 Recovery of Erroneous Awarded Compensation Clawbacks All public companies Not proposed
956 Enhanced Compensation Reporting Structure Incentive Compensation Arrangements All banks and thrifts >$1 billion in assets  Proposed,
May 2011

Say on Pay
In the 2014 proxy season, there were five banks who failed to receive majority shareholder support for their executive pay plans, or say-on-pay. Collectively in the 2012 and 2013 proxy seasons, there were a combined five banks that failed. The frequency of failed say-on-pay votes has increased.

What four years of say-on-pay has taught us is that you don’t want to fail your say-on-pay vote, and compensation that is extraordinarily high will get highly scrutinized. Plus, institutional investors have created their own governance groups and fighting a failed say-on-pay vote is expensive.

If your firm has a less than 70 percent positive vote for say-on-pay you have some homework to do for the next year. Also, having a healthy dialogue with your institutional investors has never been as important as now.

There have been no proposed regulations on clawbacks to date. This section would require that a company recover compensation that should not have been paid because of a restatement of earnings. This applies to current and former executive officers for the preceding three years after the restatement of earnings.

This absence of a proposal is striking given this is already a rule for the chief executive officer and chief financial officer as a result of the Sarbanes-Oxley Act.

Incentive Compensation Arrangements
Section 956 is the one area which specifically focuses on financial institutions. This provision applies to all banks greater than $1 billion in assets—public or private as well as credit unions over a certain size, all farm credit agencies and broker dealers.

The essence of the provision requires reporting to a firm’s primary federal regulator within 90 days of the end of the fiscal year. What has to be reported relates to a firm’s incentive compensation arrangements, primarily a description of all incentive compensation plans (including equity and post-retirement benefits), governance structures in place to ensure excessive compensation is not paid, and changes in incentive compensation from the previous year.

In addition for firms with assets greater than $50 billion, 50 percent of all incentive compensation has to be paid over a three year period.

Interestingly, Section 956 was proposed in April, 2011 it still has not been finalized more than three years later.

Still, banks should get prepared. All banks covered under the rule should have a formal review process of incentive compensation: Identify covered employees, review the plan designs and how compensation is paid over time; and make sure you have proper internal risk controls in place. The compensation committee of the board should oversee this review.

In the end, much of Dodd-Frank has not been finalized, but you can help prepare now by educating yourself about what is coming down the pike.

Silver Lining for Community Banks: Using New Regulations to Your Advantage

4-18-14-Crowe.pngIn recent days and months, there has been much discussion about the challenges small banks face to comply with increased regulatory requirements, particularly those stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act. Though the costs of compliance have increased and can prove burdensome, especially to small banks, industry observers and participants who approach the requirements with a glass-half-empty attitude are missing an important opportunity: If community banks take a strategic approach to compliance, they can differentiate themselves from the competition.

Going Beyond the Minimum
The benefits of thoughtfully implementing new regulatory requirements have been demonstrated in the past. Consider the know-your-customer requirements that mandated that banks obtain more information about their customers’ behavior to better verify customer identities, which in turn helps identify suspected money laundering activities. When the requirements went into effect, some banks simply did the minimal amount that was required.

Other banks took a more strategic approach. Some saw the new information-gathering requirements as the chance to truly get to know their customers better and enhance the level of service they provide. For example, some institutions developed dynamic discussions with account applicants, with bank staff varying their follow-up questions based on the information new customers provided. These fluid conversations were designed to create better account-opening experiences and to yield insightful data to better serve customers and support new product and service development.

Setting a Community Bank Apart
Community banks can take steps to successfully combine compliance efforts with a focus on enhancing customer service.

  • Fully integrate new regulations for a consistent customer experience. Given the multitude of regulations being implemented during the next several years and their potential impact on bank customers, compliance efforts must be embedded into existing processes. An approach that bolts new systems or processes onto existing ones typically is inefficient and leads to inconsistency that could have a negative effect on customers’ experience with the bank and the bank’s ability to effectively comply with new regulations.
  • Spread compliance-minded professionals bank-wide. It is no longer cost effective or time efficient for a community bank to rely exclusively on its compliance department as the sole line of defense in the bank’s efforts to comply with new regulations. Regular communication with and training of existing personnel is critical to instituting a culture of compliance. When hiring new employees, community banks should seek out professionals who are operationally focused and capable of integrating new regulations and compliance activities into operations.
  • Create open lines of communication. When all those at a community bank expand their focus to include new regulatory requirements, continuous communication is necessary to prevent duplicating efforts. Consider the example of a proactive underwriting manager who invested in a fair-lending tool to boost his department’s compliance activities. Unfortunately, the manager did not inform the bank’s compliance officer, who had already implemented a different fair-lending tool. Regular meetings between lines of business and members of the compliance team will foster more effective and efficient systems of compliance.
  • Seek input from business leaders who understand customer needs. The leaders who manage a bank’s lines of business are accountable for day-to-day activities and are in the best position to recognize how regulatory changes could affect customers. Bringing business leaders into the decision-making process early and often can make the difference between a problematic compliance framework and a solid program that operates as designed and fosters growth of the business.
  • Focus on what the bank does well. Some community banks are jettisoning lines of business that are no longer profitable, especially as they analyze overall rising expenses as well as costs specifically associated with compliance. This is an opportunity to focus exclusively on areas where the community bank excels in serving clients.

    Conversely, competitors eliminating lines of business also can provide community banks with an opportunity to fill a market void and strengthen their competitive position. These types of decisions should be made in the context of market analysis that identifies opportunities and risks.

Small but Mighty
Every bank, regardless of size, will encounter challenges in meeting new regulatory requirements. Finding the silver lining in increased compliance efforts and costs can position community banks as stronger, more competitive, and more focused on their customers’ needs than ever before.

The Changing Landscape for Incentive Pay

10-25-13-Blanchard.pngHistorically, bank employees have enjoyed a culture where employees had a feeling of entitlement to generous annual salary increases and profit-sharing bonuses merely for continuing to work for the bank. That is changing. Performance based cultures that reward shareholders and employees and allow transparent communication of expectations and results are becoming more prevalent.

Creating compensation plans that provide a transparent link between actual organizational performance and executive pay is now the rule rather than the exception. Several aspects of the Dodd-Frank Act encourage pay for performance, including mandatory clawbacks of unearned compensation, transparency of incentive compensation agreements and shareholder say-on-pay advisory votes. The increasing influence of shareholder advisory groups (primarily Institutional Shareholder Services and Glass-Lewis) have driven public banks to change executive compensation practices to reflect pay for performance.

Private banks also are shifting executive compensation practices as their regulators look for best practices in executive compensation. Blanchard Consulting Group’s 2012 Executive Benefits Survey showed that 59 percent of banks said regulators reviewed executive compensation plans and practices during the exam. Blanchard Consulting Group’s 2013 Compensation Trends survey found that 63 percent of banks have modified executive compensation incentive plans in at least one of the last three years based on the changing bank regulations.

Compensation transparency at the executive level as well as emphasis on cost containment (salary and benefits costs are generally the largest budget expenditure for a bank) are supporting a larger overall bank cultural shift away from “pay for loyalty.”

Creating a Performance Based Culture

What can your bank do to start to support a sales and performance based culture? Creating a bank-wide annual incentive plan (AIP) with individual employee goals that “roll-up” to the executive AIP goals is one alternative. For example, in the lending department, all the loan officers’ portfolio loan growth goals at target performance levels should add up to the overall bank target loan growth goal. Your bank can also affect change with strategic use of the annual salary increase budget. For example, your bank may target a 3 percent salary increase for all employees. Instead of just giving all employees a 3 percent increase, many banks are now using position on a salary range and performance reviews to give more of a salary increase to high performing employees or those that are meeting performance expectations and are low on the salary range. There is an opportunity for strategic salary budget use, especially with the recent economic hardship that certainly broke down employee entitlement thinking around salary increases. Many banks froze salary increases or bonuses or both during 2008 to 2010. This practice as well as bank failures, mergers and acquisition activity, reduction in force, and hiring freezes gave employees a clearer sense of how their pay and job security is affected by overall bank performance.

Impact on Executive Officer, Producer and Staff Level Incentive Plans

Both executive and non-executive incentive plans are being structured to meet several different planning objectives including the following:

  • Earning opportunities under executive officer incentive plans should be reasonable and capped, as cash incentive plans with unreasonably high payout opportunities may motivate executives to take excessive risks or manipulate earnings.
  • Incentive plans that relied historically on profitability or income goals are adding strategic and/or asset quality goals that focus on long-term viability.
  • Many banks with producer plans that pay out frequently are moving to annual payouts and considering holding back/deferring a portion of the incentive payout until it can be determined that a loan will not become problematic.
  • Mortgage lender compensation restrictions by the Federal Reserve and Dodd-Frank prohibit banks from paying mortgage lenders incentives that are based on fees.
  • Many banks are now including a long-term incentive component in executive pay-for-performance programs to help mitigate regulatory concerns that executives focus exclusively on short-term goals.
  • Today, the most common form of long-term incentive for publicly traded banks is restricted stock, which is viewed more favorably by the new regulations and guidelines. Restricted stock typically provides a stronger retention device than stock options and typically provides lower stock dilution rates.
  • Many private banks will use phantom stock and/or performance-based deferred compensation programs when real stock is not available.
  • Stock ownership guidelines and holding requirements (especially in public banks) are viewed favorably by regulators and shareholders.

Incentive compensation programs have experienced increased scrutiny in recent years. However, performance based compensation seems to be more useful than ever. Banks need to be more strategic and many are trying to drive a performance turnaround. To that end, identifying, quantifying, and driving the right performance plan can play a critical role and can differentiate your bank and your high performing employees from the competition.

What is the Worst Aspect of Dodd-Frank?

The Dodd-Frank Act is the most substantial piece of financial legislation since the Great Depression, and also one of the least popular among bankers. But not everyone agrees what part of Dodd-Frank should be thrown out the window or changed. Is it the Volcker Rule? The Durbin amendment? How about the Consumer Financial Protection Bureau? Bank Director asked a group of attorneys to answer that question.

If you could change one thing in the Dodd-Frank Act, what would it be?

Smith_Phillip.pngI would not have established the Consumer Financial Protection Bureau (CFPB). It was not community financial institutions that initiated unfair, deceptive or abusive consumer practices, yet the trickle-down effect on smaller banks from enforcement endeavors against larger organizations will have a negative impact. Instead of punishing banks that did not cause the crisis with a brand new investigative arm of the government, what about focusing on the true troublemakers?

— Philip K. Smith, Gerrish McCreary Smith, PC

Lynyak-Joe.pngTitle XIV of the Dodd-Frank Act has required the CFPB to substantially rewrite the substantive and procedural rules governing the U.S. residential mortgage system, including application, underwriting and servicing of home mortgage loans. As part of that statutory mandate, severe limitations were placed on the origination of mortgages, including the creation of so-called qualified mortgages and rules on loan originator compensation. To enforce those limitations, penalties were expanded for originators, servicers and assignees of mortgages—without a statute of limitations. The optimum change would be to modify these mortgage rules in a manner that would facilitate the availability of credit by lenders by providing greater flexibility in the types of loans permitted, as well as limiting the liability for originators and assignees for violations. Failure to do so may inhibit the availability of credit to the home mortgage segment.

— Joe Lynyak, Pillsbury Winthrop Shaw Pittman LLP

fisher_keith.pngThe Dodd-Frank Act pretends to eliminate so-called too big to fail while actually enshrining it (using different words) in federal statutory law. Worse, the Act expands the scope of potential bailouts to include nonbank financial companies. Title I of Dodd-Frank, which creates the Financial Stability Oversight Council, greatly multiplies the degree of moral hazard and creates structural incentives for institutions not currently large enough to be considered Systemically Important Financial Institutions (SIFIs) to expand so as to aspire to join that exclusive club. From a public policy viewpoint, this is simply awful. Adding yet another unwieldy federal bureaucracy—the Financial Stability Oversight Council—to the mix is also fundamentally misguided. Outright repeal of Title I would be a vast improvement. Secondly, while the creation of a federal agency devoted to consumer financial protection may have been inevitable, having a large bureaucracy with a broad and diffuse legislative mandate and virtually unlimited funding seems misguided. At a minimum, the CFPB should be made subject to congressional oversight and the appropriations process.

— Keith Fisher, Ballard Spahr LLP

Mark-Nuccio.jpgThat’s an easy one—the Volcker Rule! Hugely reactionary and draconian, the post-Depression idea that banks should be kept almost entirely out of proprietary trading and private fund investment is epic silliness. Since Gramm-Leach Bliley, plenty of organizations handled their freedoms in these areas well. Instead, why not ban mortgage lending? There has to be a better way to address the perceived risks of the banned Volcker Rule activities. The risk to the economy created by the law (as well as the risk of further boggling the implementation of it) outweighs any possible benefit. Adopted more than three years ago and still waiting for final regulations (or better yet re-proposed regulations)—there’s a reason for that kind of delay—it’s a bad law!

— Mark Nuccio, Ropes & Gray LLP

Gregory-Lyons.jpgI would add a provision that expressly permits the agencies to tailor the law, either by regulation or on an individual institution basis, to ensure the rules to which an institution will be subject are appropriate for that institution. Dodd-Frank is a very broad, sweeping law, and that necessarily will result in it having unintended consequences for some institutions. For example, should insurance companies and other nonbank-centric financial services firms that either are designated as non-bank SIFIs or that retain a reasonably small bank presence be subject to the same capital rules as bank-centric institutions?

— Gregory Lyons, Debevoise and Plimpton LLP

Shareholders Give Banks a Thumbs-Up on Pay

6-26-13_Semler.pngBank directors can take heart from the results of say-on-pay votes during the past three years. Since the 2010 Dodd Frank Act gave shareholders of public companies the right to an advisory vote on executive compensation practices, banks have, on average, slightly outperformed all other companies in affirmative votes.

Although say-on-pay voting is ostensibly about pay only, it is one of the few mechanisms shareholders can use to directly send a message about their overall satisfaction with the company. Since the 2008 recession, banks have been subjected to intense scrutiny and an avalanche of negative publicity for their perceived role in precipitating the financial crisis. Nevertheless, if bank shareholders are unhappy, it hasn’t shown up in their say-on-pay votes.

From Semler Brossy’s say-on-pay database, we looked at the 2013 voting results through May 27th for all banks in the Russell 3000 index and compared them to the results for all other companies in the Russell 3000. We found that banks averaged a positive say-on-pay approval vote of 92.9 percent. The average for all other Russell 3000 companies is 91.1 percent. Banks not only outperformed other companies on the average approval rate but also in terms of variance: 83 percent of banks passed with more than 90 percent approval for executive pay compared to 77 percent for companies overall. Interestingly, no banks have as yet failed say-on-pay this year, while 2.2 percent of other companies recorded less than 50 percent shareholder approval, basically a failure.

These results have held remarkably steady since say-on-pay was instituted in 2011. In 2011, banks averaged 92.6 percent approval versus other companies at 90.7 percent. In 2012, banks averaged 91.7 percent approval versus other companies at 89.7 percent. Also, banks have failed say-on-pay at a slightly lower rate than companies in general, with failure rates of 0.5 percent in 2011 and 1.6 percent in 2012, versus general industry numbers of 1.5 percent in 2011 and 2.7 percent in 2012.

What about the results for big banks versus small banks? After all, it was the big banks that bore the brunt of negative publicity about executive pay and government bailouts after 2008, while small and regional banks were largely unscathed. But when we looked at the 2013 results for the 30 largest banks by assets compared to all other banks, we found little difference. The large banks averaged 93.1 percent approval and the other banks averaged 92.5 percent, with similar results holding for 2012 and 2011.

These positive results may stem from a combination of factors. Shareholders are likely evaluating the compensation practices of their banks separately and distinctly from broad public or other concerns. Also, bank boards are likely taking the time to carefully design compensation programs and also clearly explaining this linkage of pay and performance in the proxy materials. In any case, no negative messages here. Move along.

Trends in Incentive Compensation: How the Federal Reserve is Influencing Pay

5-14-13_Pearl_Meyer.pngIn the absence of final guidance from regulators on incentive compensation risk (Section 956 of the Dodd-Frank Act), the Federal Reserve is actively driving for changes in compensation practices and incentive use among the largest banks as part of its goal to mitigate risk-taking. Following adoption of joint regulatory guidance on incentive compensation approved by all banking agencies in June 2010, the Federal Reserve undertook a “horizontal” review of the 25 largest and most complex banking organizations. While the process has been ongoing, over the last year, the Fed has expanded its focus on the next tier of larger regional banks. We have learned much through this process that may change practices across the banking industry.

What are the themes coming from the Federal Reserve’s review of the largest banks and how might they influence bank compensation programs?

  1. Adjust Incentives for Risk: Whether payouts are discretionary or formulaic, regulators want to see incentive awards adjusted or deferred to better account for risk. Appropriate techniques include adjustments to the incentive “pool” or to specific awards. Deferral of awards is another appropriate approach when annual incentives comprise a significant portion of the pay package and/or are based on results that may change after the performance period. Deferral payouts are typically subject to additional performance criteria. 
  2. Reduce/Eliminate Stock Options:  Stock options have been attacked in recent years by many constituencies for various reasons, among them the view of regulators that they have the potential to drive risky behavior. But eliminating options altogether is a topic of debate among many compensation committees. Some believe options help align executives with shareholder value. The reality is that providing a very significant majority of pay in the form of stock options can motivate risk, but that used in smaller proportion, options are an appropriate vehicle within an overall portfolio of risk-balanced incentives.
  3. Limit Upside Leverage: Major shareholders and advisory firms like Institutional Shareholder Services have focused in recent years on driving stronger pay-performance alignment. However, regulators have expressed a preference for lower upside rewards for achieving performance above target, which can reduce the incentive for strong performance. Many of the largest banks have responded by reducing the caps on incentive pay to 150 percent of the target incentive, down from as much as 200 percent of target. It remains unclear what other program changes will be made over time to accommodate the regulators’ changes to program design. 
  4. Reduce/Eliminate Relative Performance: Regulators have also indicated their distaste for incentive awards that are based on relative performance—a narrow and prescriptive view that appears to be receiving more resistance from banks, for good reason. While short term plans typically focus on absolute goals that reflect annual budgets, long-term incentives often employ a three-year performance period. The problem is that the current economic and banking environment has made setting long-range goals a near impossibility. If banks are prohibited from considering relative performance, the unintended consequence is likely to be less challenging performance goals. In addition, because long-term plans often pay out in stock, to better align with shareholder value, consideration of a bank’s performance relative to industry peers is a valid perspective. That said, relative performance alone and without proper protections (e.g. performance gates) can result in inappropriate payouts. For example, at the start of the financial crisis, some banks rewarded for three-year total shareholder return (TSR) relative to a peer/industry index, such that higher rankings resulted in greater awards. Because those plans failed to account for the trend toward negative shareholder return, however, they also resulted in some high payouts for declining value—for being the best of the worst. Rather than eliminating relative performance altogether from long-term plans, banks should focus on better designed plans with features and discretionary adjustments designed to avoid such outcomes. 
  5. Define Discretion: Discretion remains a legitimate and appropriate means for adjusting pay and making award decisions in response to special circumstances, including the need to maintain sound risk management. However, the Securities and Exchange Commission and shareholder advisory firms are pushing companies to more clearly document and communicate the factors that were considered when discretion was employed in award payouts.

In the end, resorting to prescriptive or one-size-fits-all compensation designs will not meet the ultimate objectives regulators are seeking. Compensation programs must seek balance between:

  • Fixed and variable /performance pay
  • Cash and equity
  • Short and long-term perspective
  • Absolute and relative performance

Risk-taking generally results when performance-based plans are overly focused on a particular component of pay, or on a specific measure, rather than a broad view of performance.  A compensation program that balances the elements outlined above and provides a sound portfolio approach to incentives will be far less likely to drive inappropriate or excessive risk-taking, ultimately promoting good pay-performance alignment.

Waiting for Volcker

5-2-13_Vockler.pngIt has been nearly a year since the Volcker Rule was supposed to go into effect and there is still no agency rule to implement the Volcker Rule, which was passed as part of the Dodd-Frank Act. Regulators have shown few signals that a final implementing rule should be expected in 2013. 

The statutory provisions referred to as the Volcker Rule contain two main elements: a prohibition on proprietary trading by banking entities, and a prohibition on certain bank investments in private equity and hedge funds. The proprietary trading ban includes a number of exemptions, including for market making and hedging.

The statute itself leaves the interpretation of these terms to five regulatory agencies: the Board of Governors of the Federal Reserve System (Fed), The Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

In October 2011, the Fed, FDIC, OCC, and SEC jointly proposed implementing regulations.  In February 2012, the CFTC issued a substantially similar proposal. 

Under the Dodd-Frank Act, the five agencies are not required to issue rules jointly. Instead, the statute allows the Fed, FDIC, and OCC to issue joint rules with respect to insured depository institutions (IDIs); the Fed to issue rules for bank holding companies, nonbank systemically important financial institutions, and their subsidiaries; and the SEC and CFTC to issue rules for entities for which they are the primary regulators. 

To their credit, the regulators acted jointly at the proposal stage. But, this statutory construct shows the potential for the Volcker Rule to become a regulatory quagmire. It would hardly be efficient if a bank holding company had to separately comply with one rule by the Fed for the holding company, a second joint rule by the banking regulators for any IDI subsidiaries; and a third and fourth rule by the SEC and CFTC for broker-dealer, swap dealer, futures commission merchant, and other subsidiaries regulated by those entities. Aside from substantive requirements, each rule potentially could have different (maybe contradictory, maybe overlapping) compliance and data reporting requirements.

So it may be a victory alone if the regulators adopt a joint final rule. Rumors have circulated in Washington, D.C., that the agencies are prepared to go their separate ways.

Since the rule was proposed, market participants spent significant resources to comment on the rule. Although there have been calls from the political proponents of stricter rules for the agencies to make the final rule tougher than the proposal, many of the comments described ways in which the proposal could lead to significantly reduced market liquidity, increased costs for consumers and other end-users, and could make certain markets economically unviable.

One of the more difficult issues is how the Volcker Rule should distinguish between prohibited proprietary trading and permitted market making and hedging. The proposed rule uses what has been characterized as a trade-by-trade approach to determine whether a position is proprietary, or allowable under an exemption. Commenters noted that market making inherently involves principal risk, dynamic hedging, and that risk is not managed on a trade-by-trade basis. The proposed approach seems suitable for only the most liquid markets, and likely to create barriers to being an effective (and profitable) market maker in less liquid markets, where positions can be held in inventory for long periods, and hedges are not one-to-one. 

Thus, the question is how can the regulators proceed? There are two approaches they should consider. One, the agencies could use a safe-harbor approach, and identify specific activity that would be permitted under the rule. Of course, the danger with this approach is that the regulators draw the safe harbor too narrowly. Two, the regulators could define market making to include hedging that is done as a part of a market-making business, and could provide that the criteria to be a market maker would be fluid depending on the liquidity and other features of the market in which a firm was operating. The danger here could be a lack of legal certainty for any particular market.

In all events, it is almost certain that the final rule will require years of legal interpretation by private practitioners and the regulators before it works in the real world.

Easing the Stress of Stress Testing

4-29-13_Crowe.pngDeadlines are looming for implementation of the stress tests required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Office of the Comptroller of the Currency (OCC) has issued its final details on stress testing for banks, which went into effect on Oct. 9, 2012.

Executives should make sure that their board members have a thorough understanding of the organization’s compliance effort and the bank’s resulting additional responsibilities. Boards should also understand the potential benefits of getting implementation right.

Understanding What Stress Testing Entails
All banks with assets between $10 billion and $100 billion will need to put in place strong methods for producing forecasts for credit risk management and capital planning. However, the level of detail and reporting schedules will vary by asset category. Financial institutions with assets between $10 billion and $50 billion must submit their initial results in March 2014. While banks might feel as though they have plenty of time, implementing a stress-testing framework will take five to six months.

An effective framework should define how various levels of the organization—segments, business lines, and risk types—will work together to accomplish the following objectives:

  • Produce credible outcomes based on high-quality input data and information
  • Identify concentrations of exposures and risks
  • Reflect a bank’s unique vulnerabilities to economic factors that affect exposures and risks
  • Assess and forecast capital and liquidity adequacy at various quarterly horizons
  • Capture “interplay” among different exposures and risks and their combined effects

Managing the Increased Complexity of Stress Tests
The Dodd-Frank stress test is far more complex than the forecasts, loan-loss statements, and other reports that institutions currently must produce. To estimate a bank’s overall health, the stress-test provision mandates the use of prescribed economic scenarios issued by the federal government as well as a bank-defined scenario. These forecasts must cover rolling nine-quarter time horizons, beginning with position information as of Sept. 30 of each year.

The submission package includes the following components:

  • Capital plan, including risk appetite
  • Risk register
  • Risk assessment
  • Portfolio assessment and scoping
  • Stress-testing methodology approach and documentation
  • Fiscal year 2014 submission documentation and data templates

Instructions and templates can be found on the OCC website.

The OCC will assess the processes and practices banks use to analyze and assess capital adequacy, along with processes for risk identification and measurement and management practices supporting its analysis of a bank’s overall health.

Preparing the Board for Effective Oversight
The regulations stipulate that the stress test should adequately and effectively estimate how the bank’s portfolio may respond to prescribed shock scenarios. These estimates and measures need to include each exposure, expected losses, and capital demands throughout the multiyear horizon. These stress tests will become a key component of the bank’s ever-increasing capital planning and compliance requirements. The entire production, from data extracts through board review and approval, must have strong controls, documentation, and audit trails. Therefore, board members should be prepared to verify that their institution’s framework meets this baseline for effective procedures and that the stress-testing production provides effective and actionable information. The board should have an active oversight of both the stress-testing implementation project and the ongoing production.

Executives can help their board members by sharing quarterly updates and making sure board members are familiar with the institution’s credit portfolio, the different scenarios, understanding and interpreting stress-test results, and integrating and “harmonizing” stress-testing views with other existing and future forecasting and asset liability management functions.

Building on Initial Successes
Complying with the stress-testing provision will require a multiyear commitment on the part of institutions and their boards. Banks have the opportunity to both meet their initial regulatory obligations and advance and improve the sophistication of their bank’s risk management operations. In the first year, many banks will struggle to implement a foundational framework and basic processes. Over time, though, executives can develop additional capabilities to enhance the organization’s view of its risk. To support this progression, executives should present board members with a comprehensive strategy for implementation as well as a multiyear road map.

Moving Forward
In the coming months, financial institutions will have to undertake an ambitious effort to put the necessary controls and systems in place to support stress testing. As this endeavor will involve a substantial enterprise-wide investment, executives should confirm that their board members have a full understanding of and commitment to the requirements and potential benefits of effective stress tests. With a unified approach, a bank will be well-positioned to both meet the regulatory compliance objectives and enhance its organization’s risk management capabilities.

Pay Attention: Final Rules on Loan Originator Compensation

4-19-13_Dinsmore.pngJanuary, 2013, was a watershed month for mortgage standards after the Consumer Financial Protection Bureau released the long-awaited final rules on ability to repay, qualified mortgages, mortgage servicing, and appraisal requirements.  Each of these rules promises to keep compliance gurus busy throughout this year and into 2014.

January also heralded another Dodd-Frank final rule of great interest to senior management, boards of directors, and certainly to the frontline, revenue producing, mortgage loan personnel – the mortgage loan originator compensation requirements.

The new compensation rules are potential bottom line changers both for mortgage loan officers/originators and financial institutions themselves—making it imperative that financial institution management and boards of directors move this topic to the top of their to-do lists.

In the aftermath of the mortgage market meltdown, politicians and pundits, and the federal regulators who answer to them, became increasingly focused on the role that loan officers and originators play in the consumer mortgage loan process.  Prior to the meltdown, training and qualification standards for loan originators varied widely within the industry.  Furthermore, compensation programs evolved to incentivize loan officers and originators to lead consumers into more expensive loans.  With Title XIV of the Dodd-Frank Act and the compensation final rules, the consumer protectors set out to end these practices.

What’s Not OK
The rules on compensation prohibit a loan officer/originator from being compensated based on any “term of the transaction” or any proxy for a term of the transaction.  This is not new; this prohibition has been part of Regulation Z since 2011.  The final rule now defines “term of the transaction” but leaves some uncertainty.

A term of the transaction is “any right or obligation of the parties to the credit transaction.”  What does this mean?  The commentary to the final rule answers that question by including descriptions of items the CFPB believes are “terms of the transaction.”  Those items include (see final rule commentary for full list):

  • interest rate
  • prepayment penalty
  • whether a product or service is purchased (e.g., lender’s title policy)
  • fees or charges requiring a good faith estimate and/or HUD-1 disclosure statement (and future Truth-in-Lending Act/Real Estate Settlement Procedures Act combined disclosure)
  • points, discount points
  • document fees; origination fees

What’s OK
CFPB acknowledges the compensation restrictions could create uncertainty for regulated institutions.  To allay this uncertainty, the final rule commentary provides a list of examples of permissible compensation mechanisms, which includes (see final rule commentary for full list):

  • originator’s overall loan volume
  • loan performance over time
  • whether the customer is existing or new
  • quality/condition of loan files
  • percentage of applications resulting in closed loans

Under the final rules, financial institutions are permitted to continue paying mortgage loan officers/originators bonus compensation.  However, bonuses will be subject to some restrictions.  Bonuses may not be based on the terms of the individual loan officer/originator’s transactions, and bonus compensation cannot exceed 10 percent of the individual loan officer/originator’s total compensation for the relevant period.

Looking Forward: Best Practices
The new compensation rules and the other residential mortgage related rules go into effect in January, 2014. Examination teams, armed with new exam procedures, will be descending on banks to test for compliance.  Below are a few best practice steps bank managers and boards of directors may take to be prepared.

  1. Ensure consumer compliance teams are trained on the new rules.  Modify consumer compliance audit/review procedures to ensure new rules are appropriately tested.
  2. Ensure mortgage lending management teams and loan officers/originators are trained on the new rules.
  3. Review existing loan officer/originator compensation programs, policies and practices to determine level of compliance; adjust programs and practices accordingly.
  4. Review existing employment, service, and management agreements and other documents relating to residential mortgage lending to determine if problematic provisions exist; amend agreements as necessary.
  5. Assign appropriate personnel to monitor release of guidance from CFPB and other federal regulatory agencies; review new examination procedures when available.
  6. Have management report to board of directors, or appropriate committee, on progress toward compliance.

There is Still More
The compensation final rules address several other important topics, including dual compensation, payment of upfront points/fees, loan originator qualifications, and mandatory arbitration provisions.  These topics are important for all participants in the mortgage lending arena, and you are encouraged to review them.

Boards Must Address New Standards for Consumer Products

4-12-13_wolters_kluwer.pngThe unfair, deceptive or abusive acts or practices standard (UDAAP) is one of the most talked about compliance issues today. The Dodd-Frank Act added the word “abusive” to what was forbidden under the law previously, expanding the scope of what constituted an UDAAP violation. All banking regulators are now charged with enforcing a new standard in consumer protection. This renewed focus on UDAAP has created an especially heightened regulatory concern for banks and other financial institutions governed by the Consumer Financial Protection Bureau (CFPB), particularly due to the lack of certainty behind how the term “abusive” will be interpreted. Given the heavy fines issued by the CFPB in 2012 and high profile settlements, directors will want to take inventory of their UDAAP compliance program and evaluate how each product and service is impacting the consumer. Here are a few recommendations.

Promote a Culture Shift to Focus on Risk to the Consumer
In this new consumer-centric supervisory context, in addition to evaluating the traditional risk to the institution if a compliance violation occurs, banks must also focus on the inherent risk to the consumer for any given process or product. This is a major shift in how institutions are being asked to examine risk and essentially creates a new risk discipline. Board members can lead the charge by making sure that any adverse impact on the consumer is evaluated right alongside traditional risk disciplines.

Set the Tone
Like all things related to regulatory risk and compliance, the best practice for creating a UDAAP-conscious organization is to establish the tone for compliance at the top. Financial institutions are well advised to review what is being communicated downward through various means, particularly in the form of policies, procedures and training materials. The key to establishing an effective UDAAP compliance program within the framework of your compliance management program is having strong controls. The CFPB prescribes the following four interdependent control components:

  • Board and Management Oversight
  • Formal Compliance Program (i.e., policies and procedures; training; and monitoring corrective action)
  • Response to Consumer Complaints
  • Compliance Audit

Ask the Questions
In applying practical thinking to managing UDAAP compliance risk and considering the high-risk areas, ask your senior management, does our compliance management system:

  • Establish compliance responsibility and accountability for UDAAP compliance at all levels of the organization?
  • Communicate to all employees their responsibility for compliance with UDAAP through training and regular compliance updates?
  • Ensure that UDAAP requirements are incorporated into the everyday business processes, as well as the procedures followed by contractors and third-party service providers?
  • Review operations for compliance with UDAAP requirements?
  • Require corrective action when non-compliance or a potential weakness is identified?

Evaluate Fairness and Transparency throughout the Product Lifecycle
Banks should always strive for fairness and transparency when communicating product features, terms and costs to customers, and apply the same standard in the delivery, support and servicing of all products. Consider the full extent of the product lifecycle when assessing your UDAAP compliance risks. High risk areas to focus on are:

  • Advertising and Solicitations
  • Loan and Account Disclosures
  • Servicing and Collections
  • Third-Party Service Provider Oversight

In all aspects of the product lifecycle, stress absolute transparency and hold each business line and product group accountable for continuously reviewing technical accuracy, alignment to actual practices, and clarity and ease of understanding from the consumer’s point-of-view.  

Manage Consumer Complaints
With the CFPB actively soliciting complaints from consumers and using that data to support their supervisory activities, you need to take a close look at your complaint data management and response processes. Particular attention should be paid to:

  • Your definition of a complaint
  • How complaints are categorized and classified internally
  • How they are routed for analysis of root cause, formal response, and ultimate resolution  

An effective complaint management system must be able to receive and process complaints from all sources, ranging from complaints issued directly to the bank to complaints from external sources such regulators, attorneys, the Better Business Bureau, consumer protection groups, web-based sources and social networking media. Complaints, while often troubling, are an opportunity to detect and address UDAAP issues such as false or misleading statements, inaccuracies in disclosures, and excessive and/or previously undisclosed fees.  Keep in mind that third-party service providers performing services on behalf of your organization should have conforming processes in place to receive complaints that mirror your own complaint handling processes. 

If you have not already taken a hard look at where your organization stands with respect to UDAAP, the time for action is now.