What Will Rates Do in 2024?

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The following piece appeared in the fourth quarter 2023 issue of Bank Director magazine.

What will the interest rate environment look like in 2024? If the summary of economic projections is any indicator, not even the group setting the rate knows.

The Federal Reserve’s Board of Governors and the Reserve Bank presidents submit their economic projections every quarter, in conjunction with the Federal Open Market Committee’s March, June, September and December meetings. These include their estimates about the direction of inflation, growth in gross domestic product, the unemployment rate and, of course, the target federal funds rate. The Fed releases an aggregated, anonymized version of these projections after those meetings conclude.

Those economic projections are the closest the public gets to being able to read the FOMC’s mind, especially when it comes to the future. A look at the projected target midpoint ranges for the federal funds rate in 2024 underlines that the FOMC’s mind isn’t made up at all. The June projections indicated the 2024 target midpoint range spans almost 250 basis points, from 3.63% at the lowest end to 6.12% at the highest end. A 2024 midpoint of 4.38% to 4.62% received the most consensus.

Looking even further back, the FOMC’s interest rate predictions in 2022 for 2023 demonstrate the extent the committee underestimated its own changes and revised its projections over the course of a year. In September 2022, a little more than a year ago, the median 2023 fed funds rate that FOMC members projected was 4.6%; their summary of projections ranged from 3.9% to 4.9%. What actually happened in July 2023 was another increase in the fed funds rate, to a target range of 5.25% to 5.5% — about a percentage point higher than they had projected. Throughout 2022, participants’ projections for 2023 stayed within range of each other, but the rates they targeted grew.

Now, as 2023 draws to a close, the target range for 2024 rates is widening. Disagreement among voting members is increasing, according to August research from the Federal Reserve Bank of San Francisco. Researchers created an index that charts divergence in rate projections using the quarterly changes in the FOMC’s “dot plot” and found that disagreement among members has increased from “nearly nonexistent” levels at the start of the coronavirus pandemic. “Since the dots typically do not align, the degree of disparity between them gives an indication of the level of disagreement at any point in time,” they wrote.

When it comes to interest rates, the Fed’s outlook is less certain the further it goes into the future — and that includes the next year.

“[T]here tends to be relatively less disagreement about policy in the year the forecast is made, but more disagreement about the next year, and even more about the following year,” the researchers write.

Bankers may feel the need to pin down a prediction of interest rates for 2024, and the direction and pace of change. The Fed feels no such pressure.

Proposal Blurs Line Between Boards and Management, Critics Say

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Congress began grilling the head of the Federal Deposit Insurance Corp. last week about alleged workplace culture issues and harassment at the federal agency, putting the agency in an awkward spot just as it tries to ramp up scrutiny of bank corporate governance.

Bank observers are worried that new corporate governance guidelines from the FDIC could create unintended consequences for boards of directors, blurring the line between board oversight and management. 

The proposed guidelines would apply to about 60 institutions above $10 billion in assets that are state chartered but not members of the Federal Reserve, state-licensed insured branches of foreign banks, and state savings associations, according to an estimate from lawyers at Mayer Brown. It would establish standards “that encourage an active and involved” board to “protect” the bank and “oversee and confirm” that it operates in a safe and sound manner. The proposal states that a “board should establish” an effective risk management program and communicate its risk appetite and policies, identify breaches of policies and procedures and establish consequences for these breaches. As an enforceable guideline, the FDIC could take formal action against institutions that fail to submit or implement acceptable plans. 

“The proposed guidelines would clarify the FDIC’s expectation that corporate governance and risk management frameworks need to evolve along with growth, complexity and changing business models and risk profiles of larger [insured depository institutions],” said FDIC Chairman Martin Gruenberg in a statement announcing his support for the proposal. “[T]he experience of the three large [bank] failures this spring should focus our attention on the need for meaningful action to improve the corporate governance and risk management processes of large IDIs under the Federal Deposit Insurance Act.”

But the proposal doesn’t have universal support among the FDIC’s board. Director Jonathan McKernan dissented at the Oct. 3 meeting where the policy was revealed and told Bank Director he hopes institutions both above and below $10 billion in assets submit comment letters sharing their perspectives and concerns with the FDIC.

“This guidance would increase the expectations, and impose new expectations, on boards,” he says in an interview. “It would go so far as to conflate the roles of board and management, and those are important distinctions to maintain. We can’t have the board and directors trying to act as managers.”

Meg Tahyar, a partner and head of the financial institutions practice at the law firm Davis Polk, says the proposal “sounds like a good idea” in theory, but has issues in its execution. 

“You don’t get good corporate governance by assigning a list of tasks to directors,” she says. “By assigning a list of tasks — and there are so many lists of tasks here, they’re very detailed and then [the FDIC makes] them enforceable — it becomes a compliance exercise,” she says. “You’re turning what should be corporate governance into a low-level compliance job.” 

The proposal also widens the constituents that bank directors would need to take into account, says Nathan Ross, vice president of policy at the Conference of State Bank Supervisors, the national organization of state banking and financial regulators. Corporate governance standards, primarily developed at the state level, have established that directors have a fiduciary duty to shareholders. The proposal states that the board “should consider the interests of all its stakeholders, including shareholders, depositors, creditors, customers, regulators, and the public.” 

Ross says if the proposal were to sail through exactly as written, “we do think that it would distract boards from their oversight role and inappropriately task them with responsibilities that fall to management.” 

These guidelines could be a tall ask for external and independent bank directors, who are often members of the community and lack a banking background. Tahyar and the Conference of State Bank Supervisors are worried that the proposal will ultimately make board service less attractive to potential directors, complicating the board talent search. 

Tahyar points out that the FDIC reserves the right to apply the standards to banks below $10 billion if it believes they pose a heightened safety and soundness risk. She also says directors at banks with $5 billion in assets should begin considering the impact of this proposal, given the likelihood they would be subjected to it in future years. She echoes McKernan’s encouragement that directors at FDIC-examined banks read the proposal and submit a comment letter to the agency ahead of the due date Dec. 11. 

Current Compliance Priorities in Bank Regulatory Exams

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Updated examination practices, published guidance and public statements from federal banking agencies can provide insights for banks into where regulators are likely to focus their efforts in coming months. Of particular focus are safety and soundness concerns and consumer protection compliance priorities.

Safety and Soundness Concerns
Although they are familiar topics to most bank leaders, several safety and soundness matters merit particular attention.

  • Bank Secrecy Act/anti-money laundering (BSA/AML) laws. After the Federal Financial Institutions Examination Council updated its BSA/AML examination manual in 2021, recent subsequent enforcement actions issued by regulators clearly indicate that BSA/AML compliance remains a high supervisory priority. Banks should expect continued pressure to modernize their compliance programs to counteract increasingly sophisticated financial crime and money laundering schemes.
  • In November 2021, banking agencies issued new rules requiring prompt reporting of cyberattacks; compliance was required by May 2022. Regulators also continue to press for multifactor authentication for online account access, increased vigilance against ransomware payments and greater attention to risk management in cloud environments.
  • Third-party risk management. The industry recently completed its first cycle of exams after regulators issued new interagency guidance last fall on how banks should conduct due diligence for fintech relationships. This remains a high supervisory priority, given the widespread use of fintechs as technology providers. Final interagency guidance on third-party risk, expected before the end of 2022, likely will ramp up regulatory activities in this area even further.
  • Commercial real estate loan concentrations. In summer 2022, the Federal Deposit Insurance Corp. observed in its “Supervisory Insights” that CRE asset quality remains high, but it cautioned that shifts in demand and the end of pandemic-related assistance could affect the segment’s performance. Executives should anticipate a continued focus on CRE concentrations in coming exams.

In addition to those perennial concerns, several other current priorities are attracting regulatory scrutiny.

  • Crypto and digital assets. The Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC have each issued requirements that banks notify their primary regulator prior to engaging in any crypto and digital asset-related activities. The agencies have also indicated they plan to issue further coordinated guidance on the rapidly emerging crypto and digital asset sector.
  • Climate-related risk. After the Financial Stability Oversight Council identified climate change as an emerging threat to financial stability in October 2021, banking agencies began developing climate-related risk management standards. The OCC and FDIC have issued draft principles for public comment that would initially apply to banks over $100 billion in assets. All agencies have indicated climate financial risk will remain a supervisory priority.
  • Merger review. In response to congressional pressure and a July 2021 presidential executive order, banking agencies are expected to begin reviewing the regulatory framework governing bank mergers soon.

Consumer Protection Compliance Priorities
Banks can expect the Consumer Financial Protection Bureau (CFPB) to sharpen its focus in several high-profile consumer protection areas.

  • Fair lending and unfair, deceptive, or abusive acts and practices (UDAAP). In March 2022, the CFPB updated its UDAAP exam manual and announced supervisory changes that focus on banks’ decision-making in advertising, pricing, and other activities. Expect further scrutiny — and possible complications if fintech partners resist sharing information that might reveal proprietary underwriting and pricing models.
  • Overdraft fees. Recent public statements suggest the CFPB is intensifying its scrutiny of overdraft and other fees, with an eye toward evaluating whether they might be unlawful. Banks should be prepared for additional CFPB statements, initiatives and monitoring in this area.
  • Community Reinvestment Act (CRA) reform. In May 2022, the Fed, FDIC, and OCC announced a proposed update of CRA regulations, with the goal of expanding access to banking services in underserved communities while updating the 1970s-era rules to reflect today’s mobile and online banking models. For its part, the CFPB has proposed new Section 1071 data collection rules for lenders, with the intention of tracking and improving small businesses’ access to credit.
  • Regulation E issues. A recurring issue in recent examinations involves noncompliance with notification and provisional credit requirements when customers dispute credit or debit card transactions. The Electronic Fund Transfer Act and Regulation E rules are detailed and explicit, so banks would be wise to review their disputed transaction practices carefully to avoid inadvertently falling short.

As regulator priorities continue to evolve, boards and executive teams should monitor developments closely in order to stay informed and respond effectively as new issues arise.

Regulatory Crackdown on Deposit Insurance Misrepresentation

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Federal banking regulators have recently given clear warnings to banks and fintechs about customer disclosures and the significant risk of customer confusion when it comes to customers’ deposit insurance status.

On July 28, 2022, the Federal Deposit Insurance Corporation and the Federal Reserve issued a joint letter to the crypto brokerage firm Voyager Digital, demanding that it cease and desist from making false and misleading statements about Voyager’s deposit insurance status, in violation of the Federal Deposit Insurance Act, and demanded immediate corrective action.

The letter stated that Voyager made false and misleading statements online, including its website, mobile app and social media accounts. These statements said or suggested that: Voyager is FDIC-insured, customers who invested with the Voyager cryptocurrency platform would receive FDIC insurance coverage for all funds provided to, and held by, Voyager, and the FDIC would insure customers against the failure of Voyager itself.

Contemporaneously with the letter, the FDIC issued an advisory to insured depository institutions regarding deposit insurance and dealings with crypto companies. The advisory addressed the following concerns:

  1. Risk of consumer confusion or harm arising from crypto assets offered by, through or in connection with insured banks. This risk is elevated when a nonbank entity offers crypto assets to the nonbank’s customers, while offering an insured bank’s deposit products.
  2. Inaccurate representations about deposit insurance by nonbanks, including crypto companies, may confuse the nonbank’s customers and cause them to mistakenly believe they are protected against any type of loss.
  3. Customers can be confused about when FDIC insurance applies and what products are covered by FDIC insurance.
  4. Legal risk of insured banks if a crypto company or other third-party partner of the bank makes misrepresentations about the nature and scope of deposit insurance.
  5. Potential liquidity risks to insured banks if customers move funds due to misrepresentations and customer confusion.

The advisory also includes the following risk management and governance considerations for insured banks:

  1. Assess, manage and control risks arising from all third-party relationships, including those with crypto companies.
  2. Measure and control the risks to the insured bank, it should confirm and monitor that these crypto companies do not misrepresent the availability of deposit insurance and should take appropriate action to address any such misrepresentations.
  3. Communications on deposit insurance must be clear and conspicuous.
  4. Insured banks can reduce customer confusion and harm by reviewing and regularly monitoring the nonbank’s marketing material and related disclosures for accuracy and clarity.
  5. Insured banks should have appropriate risk management policies and procedures to ensure that any services provided by, or deposits received from, any third-party, including a crypto company, effectively manage risks and comply with all laws and regulations.
  6. The FDIC’s rules and regulations can apply to nonbanks, such as crypto companies.

At a time when crypto companies are increasingly criticized for courting perceived excessive risk and insufficient transparency in their business practices, the FDIC and other banking agencies are moving to ensure that these companies’ practices do not threaten the banking industry or its customers. On Aug. 19, the FDIC issued letters demanding that five crypto companies cease and desist from making false and misleading statements about their FDIC deposit insurance status and take immediate corrective action.

In addition to the FDIC’s suggestions in its advisory, we suggest both banks and fintech vendors consider the following measures to protect against regulatory criticism or enforcement:

  1. Banks should build the right to review and approve all communications to bank customers into their vendor contracts and joint venture agreements with fintechs and should revisit existing contracts to determine if any adjustments are needed.
  2. Banks should consult with legal counsel as to current and expected regulatory requirements and examination attitudes with respect to banking as a service arrangements.
  3. Fintechs should engage with experienced bank regulatory counsel about the risks inherent in their business and contractual arrangements with insured banks by which the services of the fintech is offered to bank customers.
  4. Banks should conduct appropriate diligence as to their fintech partners’ compliance framework and record.

Additionally, should a bank’s fintech partner go bankrupt, the bank should obtain clarity — to the extent that it’s unclear — as to whether funds on deposit at the bank are property of the bankruptcy estate or property of a non-debtor person or entity; in this case, the fintech’s customers. If funds on deposit are property of non-debtor parties, the bank should be prepared to address such party’s claims, including by obtaining bankruptcy court approval regarding the disposition of such funds on deposit. Additionally, the bank may have claims against the bankrupt fintech entity, including claims for indemnity, and should understand the priority and any setoff rights related to such claims.

Fed Account Guidance Yields More Confusion

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In seeking answers from the Federal Reserve Board and one of the regional banks, a crypto fintech’s lawsuit may have forced the regulator to issue guidance on how other companies can gain access to the nation’s vaunted payment rails. 

At issue are which companies are eligible to request master accounts at the 12 Federal Reserve Banks, and in turn, how the Reserve Banks should consider those requests. Central to this debate — and the timing of this guidance — is the Custodia lawsuit.

The day after the Board released the guidance, it asked a judge to dismiss a lawsuit from Custodia, a company that holds a special purpose depository institutions charter from the Wyoming Department of Banking. Custodia, which focuses on digital asset banking, custody and payment solutions, applied for a master account from the Federal Reserve Bank of Kansas City in October 2020, and sued both the Kansas City Fed and the Board this year to force a decision; the Board cited the final guidelines in its justifications for a dismissal. 

“Honestly, it makes the guidelines seem like they were written, in part, to get courts to give [the Board] more deference when it winds up in litigation,” says Julie Hill, a law professor at the University of Alabama who has written about Fed account access. 

Outside of the lawsuit, the guidance speaks to the interest that fintechs and companies with novel bank charters have shown in opening Fed accounts. A Fed account comes with access to the payment rails; the entire banking as a service (BaaS) business line is premised on banks serving as intermediaries and account holders for fintechs to send and store customer money. 

If the path to applying for a master account becomes clearer, institutions with novel banking charters could bypass bank partnerships, and request and operate these accounts directly. But experts tell Bank Director that the Aug. 15 guidance codifies existing practices while offering little insight into how nonbanks can get these accounts — leaving most fintechs and bank partners where they started. 

Companies that want Fed accounts request access from one of the 12 Reserve Banks, depending on which district the company is located in. The final guidance that the Federal Reserve Board issued is directed to those Reserve Banks; its involvement in these regional banks’ decision-making indicates that the Board is trying make these decisions consistent across regions and may be involved in individual requests as well, experts say.

The Fed’s guidance includes six principles that the regional Reserve Banks should use when evaluating these requests, along with a three-tiered review framework for the amount of due diligence and scrutiny that the Reserve Banks should apply to requests submitted by different types of institutions. 

But observers still see shortcomings in the guidance. Several experts pointed out that the guidance doesn’t address which companies are eligible to apply, which is the first hurdle nonbanks must address before requesting an account. It was one of the most frequently asked questions that companies submitted to the regulator, says Matthew Bisanz, a partner in Mayer Brown’s financial services regulatory and enforcement practice. 

The guidance retains the “substantial discretion” that Reserve Banks have in deciding approvals, meaning that institutions still do not have a clear path to account access, according to a Mayer Brown client note. The process is so unclear that these accounts are granted via requests rather than applications that regulators would normally employ, Hill points out.

Observers are waiting to see how the guidance figures into the Custodia case. Hill says that Custodia is an interesting test case; the company is in a strong position to request an account and addresses many of the regulator’s stated risk concerns. It has an ABA routing number and applied to become a member of the Kansas City Fed, which could advance it from tier three to tier two in the review framework. The company also accepts U.S. dollar deposits but does not have FDIC deposit insurance, which is one factor in the tier one considerations.

What’s Next
Hill says the next step for the Reserve Banks is potentially getting together to develop a sort of operating procedure, which could make the request and decision-making process more consistent across regions. And fintechs that might be interested in a novel bank charter may want to reach out to sympathetic lawmakers in Congress and explain their cause. Custodia and other crypto companies have found a champion in Sen. Cynthia Lummis, R-Wyo., and an ally in Sen. Pat Toomey, R-Pa., both of whom have raised concerns with the Fed and could author legislation that is more accommodative to novel banking charters that the Fed would need to follow. 

In the meantime, companies that want a Fed account and aren’t interested in becoming bank holding companies or partnering with a BaaS bank may find themselves in limbo for a while. Bisanz points out that in litigation, the Fed cited a case that said delays of three to five years are not unreasonable; Custodia brought its lawsuit to expedite a decision. For novel banks, waiting years for a decision may as well mean the death of a business model. 

“There is no guarantee of an application under these guidelines, and there is no guarantee of a decision,” Bisanz says. “Nothing in these guidelines says that the Reserve Banks will act expeditiously. People should read the guidelines, consider applying — but also be ready to sit tight.”

How Banks Can Make a Lasting Impact With the Financially Underserved

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For the financially underserved in the United States — primarily socioeconomically disadvantaged people of color, as well as minority-owned small and medium-sized businesses that lack sufficient access to the banking ecosystem — the widening wealth gap and financial hardships resulting from the pandemic is their lived reality.

Herein lies an opportunity for banks. There are millions of U.S. households that are unbanked or underbanked, according to the Federal Deposit Insurance Corp., and nearly 1 million minority-owned small businesses, according to the U.S. Census Bureau. Without access to the banking system, these groups often turn to higher-cost alternatives for their banking needs, and may be unable to build wealth for financial goals such as retirement or a home purchase. This lack of access also means they may be unable to borrow to attend college or start a business.

These groups need the support and security that the banking system offers. Now, with more banks reassessing the fee structures of their deposit accounts and financial products, financially underserved individuals and businesses are likely to represent new customers and additional sources of growth in the face of increasing competition from nonbank financial technology companies.

What’s more, bringing financially underserved individuals into a banking system that fosters an environment of trust and promotes their financial well-being can directly benefit U.S. economic growth. Narrowing the wealth gap for Black Americans could add roughly $1 trillion to the U.S. economy by the end of this decade, according to a recent study by McKinsey & Co.

Household wealth in the United States continues to grow, but a large number of people still lack financial assets such as stock market investments or nonfinancial assets such as real estate.

Census data underscores the disparity in homeownership rates among various racial groups in the United States. Homeownership rates for all races, except white Americans, has declined as the pandemic continues, the data show. Further, the gap between white and Black homeowners is yet again nearing its widest point since the U.S. Census Bureau began tracking the data.

The economic disparities don’t end with financially underserved U.S. households. The pandemic has deeply affected small businesses owned by people of color, according to data published by the Federal Reserve. Here are some of the findings from the Fed’s 2021 Small Business Credit Survey:

  • Ninety-two percent of Black-owned firms reported experiencing financial challenges in 2020 (up from 85% in 2019), followed by Asian-owned firms (89%, up from 70%) and Hispanic-owned firms (85%, up from 78%). White-owned firms were the least likely to report financial challenges (79%, up from 65% in 2019).
  • Black business owners were the most likely to tap into their personal funds in response to their firms’ financial challenges (74%) compared to Hispanic-owned firms (65%), Asian-owned firms (65%), and white-owned firms (61%).

The Fed also points out the concerns faced by small businesses owned by people of color in how they obtain financing needed to operate their businesses. From the report:

  • Across owner groups, Black-owned firms that applied for traditional forms of financing were least likely to receive all of the financing they sought (13%). Hispanic and Asian-owned firms (20% and 31%, respectively) were also less likely than white-owned firms (40%) to receive all of the financing for which they applied.
  • Firms owned by people of color were twice as likely as white-owned firms to report that they did not use a financial services provider. Twelve percent of Black- and Hispanic-owned firms did not use financial service providers, followed by 11% of Asian-owned firms and 6% of white-owned firms.

The financing challenges that underserved individuals and minority-owned businesses faced before the pandemic, coupled with the shock of the pandemic itself, has created a perfect storm. This current economic environment highlights the need to help these groups — and that banks can play a significant part in this effort. Here are some ways banks can deploy support:

  • Invest in community development financial institutions (CDFIs) or become CDFI-certified.
  • Create programs to support community development activities.
  • Increase educational outreach to the under- or unbanked.
  • Support minority communities through charitable giving.

Banks don’t necessarily need to be creative with ways to support the financially underserved, but they do need to be intentional. During the current economic recovery, the public has viewed banks much more favorably than they did coming out of the Great Recession. But in the near term, working to close the increasing wealth gap and support the financially underserved will likely be key areas where banks can make the biggest difference, cultivating increasingly favorable views from customers and the broader public. In doing so, banks can unlock a means to new growth while simultaneously supporting continued economic expansion.

This article was originally published by RSM US LLP in its winter 2022 industry outlook for financial services.

The Evolving, Post-Pandemic Role of Management and Directors

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Many community bankers and their boards are entering the post-pandemic world blindfolded. The pandemic had an uneven impact on industries within their geographic footprints, and there is no historical precedent for how recovery will take shape. Government intervention propped up many small businesses, disguising their paths forward.

Federal Reserve monetary policies have hindered the pro forma clarity that bank management and boards require to create and evaluate strategic plans. Yet these plans are more vital than ever, especially as M&A activity increases.

“The pandemic and challenging economic conditions could contribute to renewed consolidation and merger activity in the near term, particularly for banks already facing significant earnings pressure from low interest rates and a potential increase in credit losses,” the Federal Deposit Insurance Corp. warned in its 2021 risk review.

Bank management and boards must be able to understand shareholder value in the expected bearish economy, along with the financial markets that will accompany increased M&A activity. They need to understand how much their bank is worth at any time, and what market trends and economic scenarios will affect that valuation.

As the Office of the Comptroller of the Currency noted in its November 2020 Director’s Book, “information requirements should evolve as the bank grows in size and complexity and as the bank’s environment or strategic goals change.”

Clearly, the economic environment has changed. Legacy financial statements that rely on loan categories instead of industries will not serve bank management or boards of directors well in assessing risks and opportunities. Forecasting loan growth and credit quality will depend on industry behavior.

This is an extraordinary opportunity for bank management to exploit the knowledge of their directors and get them truly involved in the strategic direction of their banks. Most community bank directors are not bankers, but local industry leaders. Their expertise can be vital to directly and accurately link historical and pro forma information to industry segments.

Innovation is essential when it comes to providing boards with the critical information they need to fulfill their fiduciary duties. Bank CEOs must reinvent their strategic planning processes, finding ways to give their boards an ever-changing snapshot of the bank, its earnings potential, its risks and its opportunities. If bank management teams do not change how they view strategic planning, and what kind of data to provide the board, directors will remain in the dark and miss unique opportunities for growth that the bank’s competitors will seize.

The OCC recommends that boards consider these types of questions as part of their oversight of strategic planning:

  • Where are we now? Where do we want to be, and how do we get there? And how do we measure our progress along the way?
  • Is our plan consistent with the bank’s risk appetite, capital plan and liquidity requirements? The OCC advises banks to use stress testing to “adjust strategies, and appropriately plan for and maintain adequate capital levels.” Done right, stress testing can show banks the real-word risk as certain industries contract due to pandemic shifts and Fed actions.
  • Has management performed a “retrospective review” of M&A deals to see if they actually performed as predicted? A recent McKinsey & Co. review found that 70% of recentbank acquisitions failed to create value for the buyer.

Linking loan-level data to industry performance within a bank’s footprint allows banks to increase their forecasting capability, especially if they incorporate national and regional growth scenarios. This can provide a blueprint of how, when and where to grow — answering the key questions that regulators expect in a strategic plan. Such information is also vital to ensure that any merger or acquisition is successful.

New Rule Settles a Vexing Problem for Bank Exams

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One of the most contentious aspects of post-financial crisis bank examinations under the administration of President Barack Obama just got resolved.

A new set of rules implemented this year confirm a rather simple and straightforward idea: Supervisory guidance and bank regulations are different. It attempts to address concerns from banking trade groups that the regulators sometimes used supervisory guidance in place of a formal rule in examination feedback — in short, that supervisory guidance effectively substituted as a rule — and has implications for how supervisory guidance should be used going forward.

“I think there was a growing concern that [regulators] were using the soft guidance as a means of enforcing hard requirements,” says Charles Horn, a regulatory and transaction attorney at Morgan Lewis. He cites the supervisory guidance around leveraged lending as one example of guidance that created concern and confusion for the banking industry.

The Rule
The rules, which build on a 2018 interagency statement, were passed by the individual bank regulatory agencies — the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Consumer Financial Protection Bureau and the Federal Reserve — at different times but feature similar language. They specify that supervisory guidance does not establish rules that have the force and effect of law, in contrast to rules that undergo the rulemaking process that includes notice and comment periods, according to notice from the law firm Covington. A regulator’s examination staff cannot use supervisory guidance as the basis for issuing the dreaded report known as a “Matter Requiring Attention” or for any other enforcement action or report of noncompliance.

Both the Fed’s and OCC’s rules state that its examiners will not base supervisory criticisms or enforcement actions on a “violation” of or “non-compliance with” supervisory guidance, and will limit the use of thresholds or other “bright-lines” included in supervisory guidance expectations.

“Unlike a law or regulation, supervisory guidance does not have the force and effect of law,” stated the OCC in January 2021 and the Federal Reserve in March of the same year. “Rather, guidance outlines expectations and priorities, or articulates views regarding appropriate practices for a specific subject.”

There are several reasons why regulators issue supervisory guidance. Guidance can educate and inform the agency’s examiners, and could be shared with banks so that both groups are on the same page. Regulators may also issue guidance on issues that are too timely or trivial to merit rulemaking. Sometimes, banks ask regulators to provide guidance or insights on an issue. It can come in many shapes and forms: bank bulletins, frequently asked questions and circulars, among others. Most pieces of supervisory guidance are not issued with a notice and comment period.

“It’s remarkable how much guidance the agencies have issued over the years,” says Greg Baer, president and CEO of the Bank Policy Institute, a research organization whose membership includes some of the biggest banks in the country. The BPI was one of the groups that formally petitioned the agencies to turn the 2018 interagency statement into a rule.

Unlike rules, supervisory guidance wasn’t supposed to be binding. But if a bank examiner treated it as binding, it could pressure bank executives to adopt the same approach. Bank trade groups became concerned that examiners could cite situations where the bank was not following supervisory guidance as the reason for issuing an MRA. MRAs fall below the seriousness of enforcement actions like consent orders, but examiners still expect banks to respond to and address them. Failure to address an MRA can generate subsequent MRAs or contribute to more formal administrative actions.

Of course, a rule on the paper could be different than a rule that is applied and enforced during an exam. It may be too soon to know if the rule has made an impact on exams. The impetus for the new rules began under the administration of President Donald Trump, although many of the rules were finalized at the start of President Joe Biden’s administration. The change in administrations and continued regulatory adjustments made in response to the coronavirus pandemic means that the agencies could still be in an adjustment period. It may take some time for the edict to trickle down from the agency heads to the front-line examiners. Bank executives and boards may also need time to learn about the rule and how it might apply to feedback they’ve received from examiners.

Bank examinations are famously secret. And while bankers and directors may have more leeway to ask for clarification on examination feedbacks or even appeal the findings of the report, especially if feedback cites supervisory guidance, they may not feel comfortable doing so to maintain good relationships with their regulators and examiners. Horn, for his part, expects banks to be cautious about challenging examination actions even with this new rule.

“Banks do value good relationships with the regulators, and there are a number of banks that don’t want to take the risk of pushing back against regulatory criticism unless they think it’s important,” he says. “Personally I think [the rule] can be helpful, but we don’t know how helpful it will be until we can see how this plays out over the coming months and, frankly, the coming years.”

Coronavirus Sparks CECL Uncertainty

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Even before COVID-19, the first quarter of 2020 was shaping up to be an uncertain one for large public banks. Now, it could be a disaster.

There is broad concern that the current expected credit loss standard, which has been effective since the start of 2020 for big banks, will aggravate an already bad situation by discouraging lending and loan modification efforts just when the new coronavirus is wreaking havoc on the economy. Congress is poised to offer banks temporary relief from the standard as a part of its broader relief act.

Section 4014 of the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, would give insured depository institutions and bank holding companies the option of temporarily delaying CECL implementation until Dec. 31, 2020, or “the date on which the public emergency declaration related to coronavirus is terminated.”

Congress’ bill comes as the Financial Accounting Standards Board has already rebuffed the efforts of one regulator to delay the standard.

On March 19, Federal Deposit Insurance Corp. Chairman Jelena McWilliams sent a letter to the board seeking, among other requests, a postponement of CECL implementation for banks currently subject to the standard and a moratorium for banks with the 2023 effective date.

McWilliams wrote that a moratorium would “allow these financial institutions to focus on immediate business challenges relating to the impacts of the current pandemic and its effect on the financial system.”

FASB declined to act on both proposals. “We’re continuing to work with financial institutions to understand their specific challenges in implementing the CECL standard,” wrote spokesperson Christine Klimek in an email to me later that day.

It’s not an overstatement to say that the standard’s reporting effective date could not come at a worse time for banks — or that a potential delay necessitating a switch back to the incurred loss model may be a major undertaking for banks scheduled to report results in the next several weeks.

“Banks are being tasked with something pretty complex in a very short timeframe. And of course, this is the first period that they’re including these numbers and a lot of the processes are brand new,” says Reza Van Roosmalen, a principal at KPMG who leads the firm’s efforts for financial instruments accounting change. “They’ve practiced with parallel runs. But you’re immediately going to the finals without having had any other games. This is the hardest situation you could be in.”

CECL has been in effect since the start of the new year for large banks and its impact was finally expected to show up in first-quarter results. But the pandemic and related economic crisis creates major implications for banks’ allowances and could potentially influence their lending behavior.

The standard requires banks to reserve lifetime loan losses at origination. Banks took a one-time adjustment to increase their reserves to reflect the lifetime losses of all existing loans when they switched to the standard, deducting the amount from capital with the option to phase-in the impact over three years. Afterwards, they adjusted their reserves using earning as new loans came onto the books, or as their economic forecasts or borrowers’ financial conditions changed. The rapid spread and deep impact of COVID-19, the bulk of which has been experienced by the U.S. in March, has led to a precipitous economic decline and interest rate freefall. Regulators are now encouraging banks to work with borrowers facing financial hardship.

“For banks, [CECL is] going to be a true test for them. It’s not just going through this accounting standard in the macroeconomic scenario that we’re in,” says Will Neeriemer, a partner in DHG’s financial services group, pointing out that the change comes as many bankers adjust to working from home or in shifts to keep operations running. “That is almost as challenging for them as going through the new standard for the first time in a live environment.”

The concern is that CECL will force allowances to jump once more at the beginning of the standard as once-performing loans become troubled all at the same time. That could discourage new lending activity — leading to procyclical behavior that mirrors, rather than counters, economic peaks and troughs.

It remains to be seen if that would happen if Congress doesn’t provide temporary accounting and provisioning relief, or if some banks decline the temporary relief and report their results under CECL. Regardless, the quarter will be challenging for banks.

“It’s temporary relief and it’s only for this year. It keeps the status quo, which I think is important,” says Lawrence Kaplan, chair of the bank regulatory group in Paul Hasting’s global banking and payments systems practice. “You don’t have to have artificial, unintended consequences because we’re switching to a new accounting standard during a period where there are other extraordinary events.”

“The Biggest Threat to the Deposit Insurance Fund I’ve Ever Seen”

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rates-6-28-19.pngA little-known rule called the national rate cap is putting community banks in a bind.

The cap tries to set a high-water mark for rates by calculating a weekly average of advertised interest rates for specific deposit products at branches, plus 75 basis points. This wasn’t a problem when interest rates were dropping or staying steady, but the higher rate environment has now inadvertently handicapped community banks as they compete for deposits.

Bankers say the rate cap, calculated and enforced by the Federal Deposit Insurance Corp., is unrealistically low compared to corresponding market rates. The difference could also make some banks appear riskier if examiners bring up deposit rates in exams.

Peoples Bank in Magnolia, Arkansas, uses wholesale funding to make loans for its low- to middle-income customers who lack deposits, says CEO Mary Fowler. The bank, which is well capitalized and has $200 million in assets, offers attractive rates to bring in and retain many of those funds.

The only problem? More than 90 percent of certificates of deposit (CDs) at Peoples Bank pay a rate that is higher than the rate cap.

“I call [these] traditional deposits, because they’re core as long as you’re paying the best rate in town. But we have to pay market rates for it,” she says.

Other banks are in a similar position, as higher rates have caused the national rate cap to lag the yield on Treasury securities of similar durations. This puts bankers like Fowler in a tough spot. They need to offer rates above the cap to attract or maintain deposits, but doing so invites skepticism from regulators. The FDIC declined to comment.

“Why would a customer get a CD from me when I can only hypothetically pay the national rate cap?” says Joseph Kiley III, president and CEO of Renton, Washington-based First Financial Northwest, a well-capitalized bank with $1.3 billion in assets. He points out that, at times, Treasuries paid more than 100 basis points above the rate cap.

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Bankers say the cap also creates tension with examiners, who see it as a proxy for “potentially volatile” deposits. That’s because the rule, which should only apply to a small subset of thinly capitalized institutions, has become standard across the industry.

Examiners ask executives at healthy banks what they would do with these higher-rate deposits if the bank lost capital and was forced to abide by the cap, says John Popeo, a principal at the consultancy Gallatin Group. Popeo is a former FDIC regulator who helped resolve failed banks after the financial crisis, and represents institutions across the country that are well capitalized and do not have any immediate regulatory issues.

He says examiners are not threatening a regulatory downgrade but want to see how the bank would fund itself in the event it is no longer well capitalized. For some banks, the answer isn’t pretty.

The cap could lead to systemic problems if too many banks dip below well-capitalized levels during an economic downturn, as the FDIC prohibits less-than-well-capitalized banks from offering rates above the cap.

“When they pull your funding, you’re done,” Kiley says. “[Your bank is] just going to bleed to death.”

The FDIC has begun the process of changing the rate cap calculation, but Fowler worries that an economic downturn that threatens bank capital levels could come faster than regulators’ correction. She has been in banking for decades and says the rate cap is “the biggest threat to the deposit insurance fund I’ve ever seen.”

Executives from Peoples Bank wrote five comment letters on the request for proposal. Fowler points out that the FDIC calculated the cap using only Treasury yields prior to 2009, at which point it changed its approach.

In calculating the rate cap now, the FDIC uses an average of prevailing deposit rates at bank branches, but excludes credit unions, negotiated rates and special offers from the calculation. Using branches means that big banks are overrepresented, and online banks paying market-leading rates are underrepresented. Fowler says the FDIC should change this. She thinks it should compare the current approach to the old Treasury approach, and select the rate that’s higher.

Kiley questions whether a rate cap is an antiquated notion but hopes any change will account for how customers interact with banks and rate-shop in the digital age. If the rate cap continues to exist, he would prefer that the FDIC use wholesale funding rates from institutions like the Federal Home Loan Bank.

“We are living in a world where we pretend folks walk into branches and say ‘Hi’ to the teller … and wave to their money in the vault,” he says. “Everyone banks like they buy from Amazon.com. I don’t think there should be a rate cap.”