It’s been one quarter after another of surprises from the
Federal Reserve Board.
After shocking many forecasters in 2019 by making three
quarter-point cuts to its benchmark interest rate target, the data-dependent Fed
was widely thought to be on hold entering 2020. But the quick onset of the
coronavirus pandemic hitting the United States in March 2020 quickly rendered
banks’ forecasts for stable rates useless. The Fed has acted aggressively to
provide liquidity, sending its benchmark back to the zero-bound range, where
rates last languished from 2008 to 2015.
During those seven years of zero percent interest rates,
banks learned two important lessons:
The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.
The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about funding/liquidity and realize meaningful savings in the process.
To illustrate: A bank looking to access the wholesale
funding market might typically start with fixed-rate advances from their Federal
Home Loan Bank. These instruments are essentially a bundled product consisting
of liquidity and interest rate protection benefits; the cost of each component
is rolled into the quoted advance rate. By choosing to access short-term
funding instead, a bank can then execute an interest rate swap or cap to hedge
the re-pricing risk that occurs each time the funding rolls over. Separating
funding from rate protection enables the bank to save the liquidity premium
built into the fixed-rate advance.
Some potential benefits of utilizing derivatives in the
funding process include:
Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.
Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs.
While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.
With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.
Reserve Board has announced its much-anticipated final rule that addresses the
often-confusing question of when a company controls a bank and when a bank
controls another company.
revises existing regulations that address the concept of “controlling
influence” for purposes of the Bank Holding Company Act or the Home Owner’s
Loan Act. It goes into effect on April 1.
The control rule is important: any entity in control of, or controlled by, a bank is subject to the same regulatory supervision and limitations as the bank. These limitations have created hurdles for bank investments by private equity firms and other entities, and have made partnerships between banks and fintech firms difficult to negotiate and structure.
current Bank Holding Company Act, an investor is deemed to control another
company if (1) the investor directly or indirectly owns, controls, or has power
to vote 25% or more of any class of a target’s voting securities, (2) the
investor controls in any manner the election of a majority of a target’s
directors or trustees, or (3) the Federal Reserve determines, after notice and
opportunity for a hearing, that the investor directly or indirectly exercises a
“controlling influence” over the management or policies of the target.
Bank Holding Company Act, there is a presumption that directly or indirectly
owning, controlling, or having the power to vote less than 5% of any class of a
target’s voting securities is not considered control. Where a transaction
created ownership that exceeded the 5% threshold, it was necessary to address
the question of whether there was a controlling influence. Since that term
wasn’t defined, parties relied on the Fed’s interpretations in similar
situations or sought informal guidance of Fed staff on a case-by-case basis,
which led to uncertainty.
“Previously, control reviews have been situation-specific and often followed precedents that were not available to firms or to the public,” the Fed notes in its press release announcing the new rule.
business planning difficult, if not impossible. Seeking feedback in the
proposal stage often resulted in excessive delays and left the parties with
uncertainty as to acceptable structure and permissible relationships going
The new rule
seeks to provide more bright-line guidance with a tiered approach to determining
control based on the ownership of voting
shares. The indicia of control used for ownership are similar to those applied
by the Federal Reserve under the old rule when providing guidance on individual
transactions, and vary based on the following levels:
to 14.9%; and
There are more relationship restrictions as the ownership percentage increases. Those restrictions relate to director representation; officer and employee overlaps; business relationships (including size and terms of relationships); and contractual powers or limitations on operation of the organization. The Federal Reserve outlined the interplay between percentage ownership and restrictions in a chart that was included in the press release.
investors will have more power to influence a bank’s business, which may spur
the influx of capital from new sources. Banks, however, may encounter that
influence and the increased rights of investors through proxy solicitations
challenging the board.
perspective of banks investing in other companies, the industry had hoped for
more relief from the limitations on business and contractual relationships.
Large banks have shown interest in investing in fintech startups and limiting their
competitor’s ability to participate.
other areas the new rule does not address. It does not impact existing
investments that have been approved because the parties have agreed with the
Fed not to take certain actions (referred to as passivity commitments). The regulator
stated it will no longer require or seek those commitments but will consider
relieving firms from any existing commitments.
The new rule also does not impact the concept of control for purposes of other regulations, including the Change in Bank Control Act, Regulation O and Regulation W. So a person or entity will still be required to obtain approval to acquire control of a bank or a bank holding company with the presumption that the acquisition of 10% or more of voting securities being considered a change in control.
There are other aspects of the rule that will need to be considered, including calculating equity ownership, accounting rules and the impact of convertible securities. While the new rule does not provide the level of relief that some in the industry had hoped for, it does provide much-needed guidance that will allow parties to create business relationships with more certainty and efficiency.
Federal banking regulators are trying to make life easier for regional and community banks by making changes to Basel III capital rules, particularly in areas that have been subject to banker complaints. Whether the changes provide real relief may be up to the bank.
Last week, the Federal Reserve Board, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued a proposal to “reduce regulatory burden” by simplifying regulatory capital rules that dictate how much capital banks must maintain. The rules mostly apply to banks subject to what’s known as “standardized approaches,” so it will generally impact banks and thrifts with less than $250 billion in total consolidated assets or less than $10 billion in total foreign exposure. Comments on the proposal are due within 60 days of publication in the Federal Register, which hadn’t occurred as of Thursday morning.
“This is an effort to make lives for community banks a little bit easier,’’ says Luigi De Ghenghi, a partner in Davis Polk’s Financial Institutions Group. The big picture on all of this is that as the industry approached the 10-year mark for the start of the financial crisis, regulators are looking at ways to update rules as the health of the industry has improved. Still, regulators are sensitive to accusations that they may be exposing the industry to another financial crisis by rolling back rules too enthusiastically, industry observers say.
“The U.S banking agencies are walking a bit of a tight rope because on the one hand they want to be seen as simplifying the capital rules and giving an appropriate level of capital relief,’’ De Ghenghi says. “On the other hand, they don’t want to be seen as substantively weakening capital standards,” especially since lack of capital and risky loans were a factor in the failure of hundreds of community banks during and after the crisis.
It would be wrong to assume that this is coming out of the new Trump administration’s drive to provide financial regulatory relief, as detailed in the Treasury Department report in June. Although politics is always a factor, the latest proposal comes out of an Economic Growth and Regulatory Paperwork Reduction Act, which requires banking agencies to review regulations every 10 years and to get rid of “unduly burdensome regulations” while ensuring the safety and soundness of the financial system. The review kicked off in 2014 and concluded earlier this year.
One of the most important of the proposed changes deals with the definition and risk weighting of high volatility commercial real estate (HVCRE) loans, which are considered among the higher risk loans that banks make to developers and builders, such as non-recourse loans. But community bankers had complained that the HVCRE loan definition and exemptions were too complex to apply and that the risk weightings were too high for the risks these loans posed.
“The banks were pushing the trade associations to push members of Congress to say, ‘We need a fix here,’’’ says Dennis Hild, managing director at Crowe Horwath and former bank examiner and supervisory analyst with the Federal Reserve. “’We think we know what falls under the purview of a high volatility real estate loan and the regulators come in [for an exam] and there is a disagreement on certain sets of loans.’”
To respond to the need for clarification, the proposal creates a new high volatility loan category for loans going forward that focuses less on underwriting criteria and more on the use of the proceeds, according to De Ghenghi. It potentially includes a wider array of commercial real estate loans, but lowers the risk weight from 150 percent to 130 percent, meaning banks have to hold slightly less capital against these loans. Also, banks will be able to include higher amounts of mortgage servicing assets and certain deferred tax assets as common equity Tier 1 capital, a new tier of regulatory capital that was created after the financial crisis as part of the global agreement known as Basel III.
This will help “the institutions that have substantial amounts of mortgage servicing assets or deferred tax assets,” says Hild.
The agencies have summed up the proposal’s impact on community banks here. The 10-year review details several other changes already made or in the works to reduce the regulatory burden. Among them, the agencies made changes to provide institutions with up to $1 billion in assets, instead of the $500 million limit, with the opportunity for an 18-month exam cycle instead of a 12-month exam cycle, if they score highly on their exams. The agencies also proposed this summer to increase the threshold for requiring an appraisal on a commercial real estate loan from $250,000 to $400,000.
Chief risk officers, risk committees and enterprise risk management—which go together like toast, eggs and ham—are still relatively new concepts in banking even though they have been mandated by the Federal Reserve Board since 2014 for institutions of a certain size. Banks with $10 billion in assets or greater are required to have an enterprise-wide risk committee, and banks above $50 billion must also have a chief risk officer. Union Bankshares Corp., a $7.8 billion asset institution headquartered in Richmond, Virginia, has all three. Under the leadership of Executive Vice President and Chief Risk Officer David G. Bilko, the holding company for Union Bank & Trust implemented its ERM program two years ago. Bilko is an enthusiastic supporter of an ERM approach, which he believes provides a clearer, more unified view of the bank’s risk profile than its previous approach, which tended to be fragmented. In an interview with Bank Director Editor in Chief Jack Milligan, Bilko talks about the challenges of implementing an ERM program, among other topics.
Define your role at Union. What are you responsible for? Bilko: In a nutshell, my responsibility can be boiled down to this: I own the design, implementation and governance of the enterprise risk management program.
We utilize the traditional three-lines-of-defense model. From a risk management perspective, the first line?which is the front line of the business units and support functions, really own and are responsible for managing risk. The second line, which is the ERM function that I manage, provides the program, tools standards and consistent practices that we use to help the first line in their risk management responsibilities. The third line of defense, which is the internal audit function, does the test work to ensure that those things are working properly.
How long has Union had an enterprise risk management program in place? What were some of the big challenges you had to deal with in terms of implementation? Bilko: We’ve had our ERM program fully in place for about two years now. It took us eight months or so to get the foundation laid and put the elements of the program in motion. We started with more of a top-down approach to make sure we had the right governance structure?the reporting structures to the board and executive management?set up. Concurrently, we implemented what I would call the bottom up part of it, which is the grass-roots risk and control assessment process.
It takes time to get that into motion and by the latter half of 2014, we were finished, or at least established in a consistent fashion. We’ve just continued to build on it from there. It’s really a maturation process. It’s never over. You always have to continue to mature and get better at it.
In terms of challenges, one is awareness. In an organization such as ours, where risk management was more distributed across the organization, we were doing it but it was ad-hoc in nature and not tied together in a central program, or a consistent discipline across the organization.
You have to make people aware of what enterprise risk management is, and what it isn’t, and who’s doing what, and how it’s supposed to work, and what the governing principles are. The awareness piece of it is an educational process that takes time, and is a challenge, in terms of how you go about that.
Which also leads into another challenge, which is role clarity. I mentioned the three lines of defense; people need to know what is expected of them under the program.
ERM gives you a holistic view of risks throughout the enterprise. That sounds like something that’s good to have, but does it really, in a very tangible way, enable management and the board to control risk more effectively than when risk management was siloed—or as you put it, distributed—throughout the organization? Bilko: In my opinion, it does because it allows you to break down your risks into portfolios that receive very focused attention on a regular basis. There’s constant assessment and identification of risk that leads to control or mitigation, and it all rolls up into a risk profile at the portfolio category level, which would include such risks as credit, market, operational, strategic and reputation, that then can be consolidated into an aggregate portfolio for the institution. We provide quarterly updates on those risk portfolios as well as the aggregate risk profile, so that anything that needs to be addressed is addressed more quickly.
We’re able to get a more forward looking view rather than always looking behind us, which is more of the old way. This is much more dedicated to seeing the train coming at us rather than looking at it right after it’s run over us.
What advice would you give another bank that starting down the path of ERM design and implementation based your experience? Bilko: First of all, there’s a ton of information and knowledge available today on ERM. You can find whatever you want just by searching the internet, not to mention all the consulting firms that offer advice on it. There’s no shortage of information.
I think the biggest thing you have to do is align the program with your culture. If you do something because it’s traditional, or best practice, but is counter to your culture, it’s going be way more difficult to implement.
One of the things that I focused on here was to make sure I understood our culture, so that we could implement or build a program that was aligned with that, recognizing that culture changes over time.
I also think it’s important to keep it simple so that it’s easier to create and to understand for the people who are involved in it.
What’s your reporting relationship with Union’s CEO, William Beale, and with the board of directors? How do you line up with both of them from a communication and accountability perspective? Bilko: I report directly to our CEO. He actually sits in the office right next to mine, and he keeps me close by. We talk a lot. He’s very inquisitive and very focused on ERM, and he uses me a lot as a sounding board on a lot of different risk and control issues.
The way we’re set up is, I have a direct reporting line into the CEO and a dotted line into the risk committee of the board. I kind of view it as a triangle: The CEO, the board’s risk committee and myself. We try to keep the triangle intact, and be very transparent with everything we’re doing. I think that’s a good way to do it. The risk committee is very involved in the oversight of the enterprise risk management program. Our CEO’s participation and interaction in my process allows us to be better and more affective in terms of governance reporting and actual practice.
Union has both an audit committee and a risk committee. How has the board divided up risk governance between the two, and how often, and in what way, do you communicate with both committees? Bilko: The risk committee of the board is charged with the oversight of enterprise risk management. All the elements of that program are under their umbrella, and we report on them. To draw the distinction between the risk and audit committees, I participate in the audit committee meetings just like our chief audit executive participates in our risk committee meetings. There is a lot of sharing going on there and a lot of interaction. I hear what the conversations are within the audit committee realm from a control perspective and risk mitigation perspective. In the same vein our chief audit executive hears that from the risk committee side. There’s a fairly deep connection there.
Additionally, our audit committee and risk committee have a joint meeting once a year where all the directors on those committees are in the same room and we build an agenda that reflects what the risk management program is doing and reporting on, as well as what the audit group is involved with and some of the significant issues that they’re reporting on.
And finally, we have two directors that are on both the audit committee and the risk committee, so there’s that cross-over that’s happening as well.
I wouldn’t characterize it as dividing up risk between the two committees. I would characterize it as more open and broader communication across the committees so that both are aware of what’s going on, what issues need to be discussed, elevated and acted on. The full board is getting the benefits of those reports from both committees, and they’re both in the know.
Regulation becomes much tougher when a bank crosses over the $10 billion asset threshold. My understanding is that the regulators don’t wait until you get there and then suddenly look at you differently. As you get closer to that magic number, they want to know where you’re going as an organization. They want to know what your growth plans are, they want to know where you think the bank might be in five years, and they want you to start building an infrastructure that is scalable and appropriate for a larger bank, even if you haven’t reached that point legally. Is that how it works, in your experience? Bilko: Yes. The way you described that is pretty spot on. The regulatory agencies, and our primary regulator is the Federal Reserve, want to understand your objectives, your strategies, and if those strategies are growth oriented. We have regular conversations with our counterparts at the Federal Reserve to keep abreast of those types of things and what we can expect. Clearly, it’s a matter of readiness and scalability. If you’re going to grow, you need to be ready to grow. When they talk about it, that boils down to infrastructure and processes that are capable of handling that growth dynamic. It’s something that we’ve certainly experienced over the last few years as we’ve continued to execute our growth strategy.
What do you think that the greatest risk challenges are facing banks today, including Union? What do you worry about most? What would keep you up at night? Bilko: I get asked that question a lot, actually. I think what’s top-of-mind always?and it seems to be what we read about the most—is the risk associated with technology, vulnerability to data loss, information security, breaches, those sorts of things. We can play defense, but the bad guys are really good at playing offense, so our defense lags. We don’t consider ourselves necessarily to be a prime target, but the effort to keep our data protected is an ongoing imperative.
Process discipline has also become very important. Operationally, we want to be very sure that we have appropriately determined the risk around our processes, and that they are controlled adequately and are kept up to date. Typically, where you have gaps in your processes is where you have breakdowns.
I would summarize by saying that a lot of risk management is change management?adapting your risk practices to the constant changes that are occurring. We live in a rapidly changing world, both regulatory and otherwise, and we have to be able to adapt quickly.
What’s your professional background, and what path did you follow to become a chief risk officer? Bilko: I have spent my entire career in banking, at both big banks and small banks. I worked for a couple years in retail banking, and then a couple of years in the support group for lending. But up until about the last six years, most of my career has been spent in internal audit. I have been involved with, or at least got to see and learn, just about every aspect of the business, and every area within the institution. It created a broad view for me, of how how things run and what makes these banking organizations tick.
Over the course of time, I was able to really understand all the different functions and businesses within [a banking] organization. Later on, I became more involved in the management and infrastructure of the company as chief audit executive. It was kind of a natural progression from the control world of internal audit to a broader enterprise-risk view.
Internal audit seemed to be a logical training ground for a chief risk officer because there’s probably no one who has a better view of the entire organization than the internal audit team. It’s their job to poke into everything. Are there other disciplines within the bank that could also be good training ground for CROs? Bilko: I would say that beyond internal audit, there’s certainly other skills that will add to the versatility. Technology, data management and data analytics are such a large part of what we do today?and will be going forward?so there’s a clear need for experience and background in utilizing data to better identify, understand and prevent risk incidents or events. The whole big data thing is important to translate well into the risk management world.
And it will never hurt to live for a little while in the credit space, particularly if you’re doing some credit analysis, or you’re supporting a lending activity, where you get to understand the underwriting criteria and loan portfolios.
The Federal Reserve Board waits five years to release the minutes of its official deliberations, and I imagine that ardent Fed watchers and monetary policy wonks have been waiting eagerly for the 2008 vintage transcripts, which cover a period of time when the financial crisis was coming to a full boil and the bank’s policymakers – including former Fed Chairman Ben Bernanke – were scrambling to keep things under control.
Last week the Fed released 1,865 pages of transcripts that included eight formal and six emergency policy meetings in 2008. The bank made a lot of controversial decisions that year. It arranged a marriage between the investment bank Bear Stearns and JPMorgan Chase & Co. when the former was judged to be close to failure, then stood by and did nothing while an even larger investment bank – Lehman Brothers – slid into bankruptcy, leading to a near meltdown in the global financial market.
The central bank also put together a bailout for the troubled insurer American International Group even though it wasn’t entirely clear that it had the legal authority to do so, and worked with the Treasury Department to lay the groundwork for the Troubled Asset Relief Program, which would pump hundreds of billions of dollars into the U.S. banking system.
For all its mystic and mystery, reading through the official transcripts (I did a quick scan of the August 5, 2008 transcript) is like reading an extended report on the state of the U.S. economy because, well… that’s essentially what these Fed meetings are. Fed staffers offer their perspectives on the economy, as do presidents of the district banks and the chairman. It all sounds as exciting as listening to the livestock commodities report on my local NPR station, although the Federal Reserve’s new chair – Janet Yellen, who in 2008 was president of the Federal Reserve Bank of San Francisco – did try to lighten the mood at one meeting when she said that “An accounting joke concerning the balance sheets of many financial institutions is now making the rounds. On the left-hand side, nothing is right; on the right-hand side, nothing is left.”
Still, the transcripts do point to tension between liberal policymakers like Bernanke, who wanted to pump as much money into the economy as possible through a series of drastic interest rate cuts, and monetary hawks like Richmond Fed President Jeffrey Lacker who worried that easy money would light the bonfire of inflation. There was also a clear disagreement between Bernanke and Lacker over the chairman’s support for bailouts. Lacker was intellectually opposed to the federal government’s decades-old practice of rescuing large banks when they got into trouble during an economic downturn – known as Too Big to Fail – and he voiced his opposition during meetings in 2008.
In fact, their disagreement was significant enough that Bernanke felt it necessary to say (for the record, remember) during the August 5 meeting that “President Lacker and I have, I hope respect – I respect him, and I hope he respects me.” Lacker later responded to Bernanke that “For my part, our exchanges have in the past been predicated on nothing but the utmost respect. I expect that to continue. If I have done anything or said anything to contribute to any other impression, I regret it, and I apologize.”
Okay, so neither man was talking smack exactly. They are economists, after all. I wrote a profile of Lacker in 2004 when he became president of the Richmond Fed and found him to be polite, serious and just a little reserved. In public Bernanke comes off as exactly what he was before he became Fed chairman in 2006, a tenured economics professor at Princeton University. If these guys were to fight an old fashioned duel, they would probably swat at each other with rolled up printouts of the latest economic data.
But their disagreement over the 2008 bailouts continues, that much is clear. In January, during remarks at the Brookings Institution shortly before he left the Fed, Bernanke voiced support for the bank’s actions in 2008, as he has previously. He started out by comparing the political pressure the Fed faces today with the pressure it faced in the 1930s. “If you think about the 1930s we had exactly the same kind of reaction,” he said. “In fact it was more intense. And of course [President] Roosevelt, what he argued was that the strong actions he was taking were about saving capitalism essentially.”
“The Fed was created to address financial panics and its independence and its ability to act quickly is a key feature of that the Fed is about. And if we had not done that and if the financial system had imploded and the economy had plunged into even a deeper depression, I think the populist reaction would have been pretty bad as well. So we were kind of stuck one way or the other.
“So we did the right thing, I hope – we tried to do the right thing. And there certainly has been push back,” he concluded.
And one of those skeptics who continue to push back is Lacker, who argued his position on bailouts in a February 11 speech at the Stanford University’s Institute for Economic Policy Research. After laying out all of his reasons for why the federal government shouldn’t be in the business of funding bailouts, and reviewing the steps that have been taken since the financial crisis to end Too Big to Fail – including various provisions in the Dodd-Frank Act, Lacker went one step further. Essentially, he said, the financial markets and bankers themselves will never believe that Too Big to Fail has been unalterably rescinded so long as the Fed retains its discretionary authority to intervene during a crisis.
Lacker’s solution: Repeal the Fed’s emergency lending powers so that it can’t rescue another failing bank ever. The very thing which Bernanke values so highly – The Fed’s independence and its ability to act quickly – is the very thing that Lacker would take away. Bernanke would probably say that the situation in 2008 was so dire that the Fed simply had to intervene. Lacker would probably counter that the Fed’s intervention in 2008 merely convinced the skeptics that when the next crisis occurs, the Fed will once again resort to bailouts. Their differences seem irreconcilable to me.
We know how history turned out in this affair. The Fed gradually defused the crisis and the U.S. economy fell into the Great Recession rather than another depression. Still, it is interesting to ponder this question: If the situation had been reversed and Lacker was Fed chair during the crisis instead of Bernanke, how would have things turned out then? A Fed chair has to be very confident about his or her beliefs when staring into an economic abyss because that’s when academic arguments become very real.
This article originally appeared on The Bank Spot and was reprinted with permission.