Here’s How to Address CECL’s Biggest Question


CECL-4-26-19.pngA debate is raging right now as to whether the new loan loss accounting standard, soon to go into effect, will aggravate or alleviate the notoriously abrupt cycles of the banking industry.

Regulators and modelers say the Current Expected Credit Loss model, or CECL, will alleviate cyclicality, while at least two regional banks and an industry group argue otherwise. Who’s right? The answer, it seems, will come down to the choices bankers make when implementing CECL and their view of the future.

CECL requires banks to record losses on assets at origination, rather than waiting until losses become probable. The hope is that, by doing so, banks will be able to prepare more proactively for a downturn.

This debate comes as banks are busy implementing CECL, which goes into effect for some institutions as early as 2020.

Last year, internal analyses conducted by BB&T Corp. and Zions Bancorp. indicated that CECL will make cycles worse compared to the existing framework, which requires banks to record losses only once they become probable.

Both banks found that CECL will force a bank with an adequate allowance to unnecessarily increase it during a downturn. Their concern is that this could make lending at the bottom of a cycle less attractive.

The increase in provisions would “directly and adversely impact retained earnings,” wrote Zions Chief Financial Officer Paul Burdiss in an August 2018 letter, without changing the institution’s ability to absorb losses. BB&T said that adjusting its existing reserves early in a recession, as called for under CECL, would deplete capital “more severely” than the current practice.

BB&T declined to comment, while Zions did not return requests for comment.

The Bank Policy Institute, an industry group representing the nation’s leading banks, said in a July 2018 study that the standard “will make the next recession worse.” CECL’s lifetime approach forces a bank to add reserves every time it makes a loan, which will increase existing reserves during a recession, the group argued.

“The impact on loan allowances due to a change in the macroeconomic forecasts is much higher under CECL,” the study says.

And in Congressional testimony on April 10, JPMorgan Chase & Co. Chairman and CEO Jamie Dimon said CECL could impact community banks’ ability to lend in a recession.

“I do think it’s going to put smaller banks in a position where, when a crisis hits, they’ll virtually have to stop lending because putting up those reserves would be too much at precisely the wrong time,” he said.

Those results are at odds with research conducted by the Federal Reserve and firms like Moody’s Analytics and Prescient Models. Some of the differences can be chalked up to modeling approach and choices; other disagreements center on the very definition of ‘procyclicality.’

Moody’s Analytics believes that CECL will result in “easier underwriting and more lending in recessions, and tighter underwriting and less lending in boom times,” according to a December 2018 paper. The Federal Reserve similarly found that CECL should generally reduce procyclical lending and reserving compared to the current method, according to a March 2018 study.

Yet, both the Fed and Moody’s Analytics concluded that CECL’s ability to temper the credit cycle will vary based on the forecasts and assumptions employed by banks under the framework.

“The most important conclusion is that CECL’s cyclicality is going to depend heavily on how it’s implemented,” says Moody’s Analytics’ deputy chief economist Cristian deRitis. “You can … make choices in your implementation that either make it more or less procyclical.”

DeRitis says the “most important” variable in a model’s cyclicality is the collection of future economic forecasts, and that running multiple scenarios could provide banks a baseline loss scenario as well as an upside and downside loss range if the environment changes.

The model and methodology that banks select during CECL implementation could also play a major role in how proactively a bank will be able to build reserves, says Prescient Models’ CEO Joseph Breeden, who looked at how different loan loss methods impact an economic cycle in an August 2018 paper.

A well-designed model, he says, should allow bankers to reserve for losses years in advance of a downturn.

“With a good model, you should pay attention to the trends. If you do CECL right, you will be able to see increasing demands for loss reserves,” he says. “Don’t worry about predicting the peak, just pay attention to the trends—up or down—because that’s how you’re going to manage your business.”

In the final analysis, then, the answer to the question of whether CECL will alleviate or aggravate the cyclical nature of banking will seemingly come down to the sum total of bankers’ choices during implementation and execution.

Community Banks and Derivatives: Debunking the Four Biggest Myths


derivatives-4-8-19.pngThose of us who were in banking when Ronald Reagan entered the White House remember the interest rate rollercoaster ride brought about by the Federal Reserve when it aggressively tightened the money supply to tame inflation. It was during this era of unprecedented volatility that interest rate swaps, caps and floors were introduced to help financial institutions keep their books in balance. But over the years, opaque pricing, unnecessary complexity and misuse by speculators led Richard Syron, former chairman of the American Stock Exchange, to observe, “Derivative. That’s the 11-letter four-letter word.”

As community banks bought into Syron’s “D-word” conclusion and resolved to avoid their use altogether, several providers fed these fears and designed programs that promise a derivative-free balance sheet. But many banks are beginning to question the effectiveness of these solutions.

Today, as commercial borrowers seek long-term, fixed-rate funding for 10 years and longer, risk-averse community banks want to know how to solve this term mismatch problem in a responsible and sustainable manner. The fact that Syron voiced his opinion on derivatives in 1995 suggests that now might be a good time to examine the roots of “derivative-phobia,” by considering what has changed in the past quarter-century and challenging four frequently heard biases against community banks using swaps.

1. None of my community bank peers use interest rate derivatives.
If you are not hedging with swaps, and your total assets are between $500 million and $1 billion, then you are in good company: More than nine out of ten of your peers have also avoided their use.

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But if your bank is larger, or your growth plans anticipate crossing the $1 billion asset level, more than one in four of your new peers use swaps.

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Once your bank crosses the $2 billion mark, more than half of your peers manage interest rate risk with derivatives, and institutions not using swaps become a shrinking minority.

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Community banks should consider their growth path and the best practices of their expected peer group before dismissing out-of-hand the use of derivatives.

2. The derivatives market is a big casino, and swaps are always a bet.
While some firms (AIG in 2008, for example) have used complex derivatives to speculate, a vanilla swap designed to neutralize a bank’s natural risks operates as a hedge. Post-crisis, the Dodd-Frank Act brought more transparency to swap pricing, as swap dealers are now required to disclose the wholesale cost of the swap to their customers. In addition, most dealers are now willing to operate on a bilateral secured basis, removing most of the counterparty risk that the trading partners of Lehman Brothers experienced firsthand when that company collapsed. These changes in market practices have made it much more practical for community banks to execute simple hedging transactions at fair prices with manageable credit risk.

3. Derivatives accounting always results in unwanted surprises and volatility.
Derivatives missteps led to FAS 133—regarding the measurement of derivative instruments and hedging activities—being issued in 1998, bringing the fair value of derivatives out of the footnotes and onto the balance sheet for the first time. But the standard (now ASC 815) proved difficult to apply, leading to some notable financial restatements in the early 2000s. Fast forward nearly twenty years, and the Financial Accounting Standards Board has issued an overhaul to hedge accounting (ASU 2017-12) that is a game-changer for community banks. With mandatory adoption in 2019, there are more viable ways to solve the age-old mismatch facing banks. And the addition of fallback provisions, combined with improvements to “the shortcut method,” greatly reduces the risk of unexpected earnings volatility.

4. ISDA documents should always be avoided.
While admittedly lengthy, the Master Agreement published by the International Swaps and Derivatives Association was designed to protect both parties to a derivative contract and is the industry standard for properly documenting an interest rate swap. Many community banks seeking an ISDA-free solution for their customers are actually placing the borrower into a lightly-documented derivative with an unknown third-party. If a borrower is not sophisticated enough to read and sign the ISDA Master Agreement, they have no business executing a swap in the first place. A simpler solution is to make a fixed-rate loan and execute a swap behind the scenes to neutralize the interest rate risk. This keeps the swap and the agreement between two banks, and removes the borrower from the derivative altogether.

For community banks that have been trying to solve their mismatch problem in a manner that is derivative-free, it is worth re-examining the factors that have led to pursuing a derivatives-avoidance strategy, and counting the costs and hidden exposures involved in doing so.

2019 Risk Survey: Cybersecurity Oversight


risk-3-25-19.pngBank leaders are more worried than ever about cybersecurity: Eighty-three percent of the chief risk officers, chief executives, independent directors and other senior executives of U.S. banks responding to Bank Director’s 2019 Risk Survey say their concerns about cybersecurity have increased over the past year. Executives and directors have listed cybersecurity as their top risk concern in five prior versions of this survey, so finding that they’re more—rather than less—worried could be indicative of the industry’s struggles to wrap their hands around the issue.

The survey, sponsored by Moss Adams, was conducted in January 2019. It reveals the views of 180 bank leaders, representing banks ranging from $250 million to $50 billion in assets, about today’s risk landscape, including risk governance, the impact of regulatory relief on risk practices, the potential effect of rising interest rates and the use of technology to enhance compliance.

The survey also examines how banks oversee cybersecurity risk.

More banks are hiring chief information security officers: The percentage indicating their bank employs a CISO ticked up by seven points from last year’s survey and by 17 points from 2017. This year, Bank Director delved deeper to uncover whether the CISO holds additional responsibilities at the bank (49 percent) or focuses exclusively on cybersecurity (30 percent)—a practice more common at banks above $10 billion in assets.

How bank boards adapt their governance structures to effectively oversee cybersecurity remains a mixed bag. Cybersecurity may be addressed within the risk committee (27 percent), the technology committee (25 percent) or the audit committee (19 percent). Eight percent of respondents report their board has a board-level cybersecurity committee. Twenty percent address cybersecurity as a full board rather than delegating it to a committee.

A little more than one-third indicate one director is a cybersecurity expert, suggesting a skill gap some boards may seek to address.

Additional Findings

  • Three-quarters of respondents reveal enhanced concerns around interest rate risk.
  • Fifty-eight percent expect to lose deposits if the Federal Reserve raises interest rates by more than one hundred basis points (1 percentage point) over the next 18 months. Thirty-one percent lost deposit share in 2018 as a result of rate competition.
  • The regulatory relief package, passed in 2018, freed banks between $10 billion and $50 billion in assets from stress test requirements. Yet, 60 percent of respondents in this asset class reveal they are keeping the Dodd-Frank Act (DFAST) stress test practices in place.
  • For smaller banks, more than three-quarters of those surveyed say they conduct an annual stress test.
  • When asked how their bank’s capital position would be affected in a severe economic downturn, more than half foresee a moderate impact on capital, with the bank’s capital ratio dropping to a range of 7 to 9.9 percent. Thirty-four percent believe their capital position would remain strong.
  • Following a statement issued by federal regulators late last year, 71 percent indicate they have implemented or plan to implement more innovative technology in 2019 to better comply with Bank Secrecy Act/anti-money laundering (BSA/AML) rules. Another 10 percent will work toward implementation in 2020.
  • Despite buzz around artificial intelligence, 63 percent indicate their bank hasn’t explored using AI technology to better comply with the myriad rules and regulations banks face.

To view the full results of the survey, click here.

Grow Core Deposits Using Custom Rewards, Not Toasters


deposit-12-20-19.pngOver the past three years, the Federal Reserve has raised interest rates nine times and created an environment where banks can earn more on their lending portfolios, but also a heated battle to win deposits.

Compounding the issue is technology, which has made it easier than ever for customers to shop around for competitive rates and switch banks.

To grow and retain deposits, financial institutions need to be proactive in providing the rates and benefits customers want. But it can be a challenge to offer those benefits in a way that increases the quality and quantity of all-important core deposits.

Many banks have structured rewards programs so they reward a new product purchase or behavior, but they don’t incentivize long-term changes in customer interactions with the bank.

Institutions have long offered incentives such as hundreds of dollars of cash back for new account openings, or extravagant gifts for scheduling a recurring transfer of funds. However, these arrangements can often backfire. Once the customer receives their cash back, the newly opened account can languish unused and transaction-less indefinitely.

The expensive gadget the bank gave away doesn’t make financial sense against the $10 monthly transfer the customer automated from their checking account to their savings account.

Institutions like Leader Bank, a $1.4 billion asset bank based in Arlington, Massachusetts, and Opportunity Bank of Montana, a $700 million asset bank based in Helena, have solved this issue by incentivizing behaviors that build the habits of an ideal core customer. As for the rewards, they provide benefits that can be easily administered because they tie into the bank’s existing business model.

The types of behaviors that create habits for bank customers—and profitability for the bank—should be focused on the continuous utilization of bank products.

Here are some examples:

  • Use the bank’s debit card for 10 or more transactions a month. This moves the bank’s debit card to top-of-wallet and increases interchange fee income. 
  • Sign up for a sizeable monthly direct deposit. Banks can require a direct deposit of $800 or $1,500—whatever amount makes sense in their local market. This behavior ensures that the account earning rewards becomes the customer’s primary account. 
  • Sign up for e-statements. Even a simple behavior like opting into e-statements will save the bank money.

When all of the activities above are bundled together, these requirements for qualifying for rewards could transform a customer into a valuable core depositor.

In return for the customer meeting the bank’s qualifications, banks should go far to provide return value. One-time gifts and prizes are often not enough to drive consistent, ongoing customer behavior; the rewards must be ongoing as well.

Practical, local, ongoing benefits will help a community bank stand out and compete against mega-banks.

Consider these options:

  • Reimburse ATM fees. One of the primary benefits that a mega-bank has over the typical community bank is its national footprint. Banks of any size can offer ATM fee reimbursement as a reward. Not only does this expand the bank’s footprint by giving customers access to their cash from anywhere, it also reinforces the customer’s new habit to use their debit card more frequently. 
  • Offer cash back on debit card transactions. Cash back signals to customers that your bank is grateful to have their business and mirrors offers by major credit card companies. Whether your bank can offer 1 percent or 3 percent, your institution can likely find a sweet spot for this attractive incentive that makes financial sense.
  • Provide discounts with local merchants. Leader Bank partners with more than 20 local merchants who provide discounts to the bank’s rewards customers when they shop at their businesses. This type of reward can help the bank integrate deeper into the local community. 
  • Offer higher yielding rates on companion savings accounts for core customers, but only if and when they meet the criteria.

Given that rising interest rates are a major driver in the battle for deposits, rates on savings accounts may be a key component to driving customer acquisition. But your bank may not have to pay that higher rate out every month.

With a technology solution, banks can manage their rewards in such a way that, unless a customer meets all of the criteria for rewards in a given month, they don’t earn rewards that month either. This feature optimizes savings for the bank and ensures that customers continue to engage with the bank like a core customer.

By playing to their strengths and rewarding the right behaviors, banks can create custom rewards programs that both make sense with their business model and provide the kind of marquee benefits today’s consumers are seeking.

How The Fed Changed The Game for Private Banks


stock-11-20-18.pngIn late August 2018, the Federal Reserve issued an interim final rule increasing the asset threshold from $1 billion to $3 billion under the Fed’s Small Bank Holding Company Policy Statement. The interim policy now covers almost 95 percent of the financial institutions in the U.S., significantly enhances the flexibility in capital structure, acquisitions, stock repurchases and ownership transfers, among other things, for institutions organized under a holding company structure.

No Consolidated Capital Treatment
The most significant benefit of small bank holding company status is that qualifying banks are not subject to consolidated capital rules. Instead, regulatory capital is evaluated only at the subsidiary bank level. As a result, small bank holding companies have the unique ability to issue debt at the holding company level and contribute the proceeds to its subsidiary bank as Tier 1 common equity without adversely impacting the regulatory capital condition of the holding company or the bank. Due to the expanded coverage of the new rule, banking organizations with up to $3 billion in assets can now take advantage of this benefit to support organic and acquisitive growth, stock repurchases and other corporate transactions.
Acquisition Leverage

Perhaps the most significant application of this benefit is in acquisitions by private institutions, whose equity may be less attractive or undesirable acquisition currency. For these institutions, an acquisition of any scale often requires additional capital, and, without access to public capital markets, utilizing leverage may represent the only viable option to fund the transaction.

Under the Small Bank Holding Company Policy Statement, an acquiring bank holding company may fund up to 75 percent of the purchase price of a target with debt, which equates to a maximum debt to equity ratio of 3-to-1, so long as the acquirer can reduce its debt to equity ratio to less than 0.3-to-1 within 12 years and fully repay the debt within 25 years. The enhanced ability to utilize debt in this context is designed to enable private holding companies to be more competitive with other institutions who have access to the public capital markets or who have a public currency to exchange.

Stock Repurchases
Ownership succession also remains a critical issue for many private holding companies, and the new rule extends the ability to use debt to enhance shareholder liquidity to an expanded group of organizations. In many cases, and especially for larger blocks of stock, a holding company represents the only prospective acquirer for privately-held shares. By using debt to fund stock repurchases, a small bank holding company can create liquidity to a selling shareholder, while providing a benefit to the remaining shareholders through the increase in their percentage ownership.

Moreover, stock repurchases often present themselves at times and in amounts that make equity offerings a less suitable alternative for funding. Finally, as discussed below, stock repurchases can be utilized to enhance shareholder value.

Attractiveness to Investors
While the new rule increases the operating flexibility of banking organizations by providing additional tools for corporate transactions, the use of leverage as part of an organization’s capital structure also results in a number of meaningful benefits to shareholders. First, holding company leverage, whether structured as senior or subordinated debt, generally carries a significantly lower cost of capital, as compared to equity instruments. The issuance of debt is non-dilutive to common shareholders, which means existing shareholders can realize the full benefit associated with corporate growth or stock repurchases funded through leverage without having to spread those benefits over a larger group of equity holders. In addition, unlike dividends, interest payments associated with holding company debt are tax deductible, which lowers the effective cost of the debt. Accordingly, funding growth or attractively priced stock repurchases through leverage can be immediately accretive to shareholders.

Final Thoughts
Funding growth, stock repurchases and other corporate transactions can be a challenge for banking organizations that do not have access to public capital markets or have a public currency. However, the revised Small Bank Holding Company Policy Statement provides management teams and boards of directors with additional tools to fund corporate activities and growth, manage regulatory capital, and enhance shareholder liquidity and value.

Three Important Things Jerome Powell Said To Congress


strategy-8-9-18.pngJerome Powell’s semi-annual appearance before Congress was perhaps a bit more newsworthy than it has been for past chairmen of the Federal Reserve, and his core message signals a few key moves that will certainly impact how banks manage themselves over the next several months.

Powell’s appearance was overshadowed with questions about trade policy and what was happening further down Pennsylvania Avenue, but the core message from Powell, who has been on the job for less than a year, was that the central bank is continuing on a path toward normalization of interest rates, a place the U.S. economy hasn’t seen in a decade or longer.

Despite the tangents that media-savvy politicians tried to take Powell down, his core messages as it applies to bankers is important and provides signals as to how the Fed will manage the economy over the next several months.

Here’s some takeaways:

Bank profitability likely to remain high. Powell’s comments about the overall tax climate and overall business environment point to good things on the horizon for banks, which have reported strong earnings since the end of last year when tax reforms were passed.

Said Powell: “Our financial system is much stronger than before the crisis and is in a good position to meet the credit needs of households and businesses … Federal tax and spending policies likely will continue to support the expansion.”
Second-quarter results have illustrated that, with some banks reporting quarterly earnings per share around 40 percent above last year.

Fed getting back to “normal.” For several years since the crisis, the Fed bought large quantities of U.S. Treasury bonds—known as quantitative easing—to pump cash into the market and boost the economy. With plenty of indicators that the economy is now humming, Powell said the Fed has begun allowing those securities to mature, bringing that practice to an end.

“Our policies reflect the strong performance of the economy and are intended to help make sure that this trend continues,” Powell said.

“The payment of interest on balances held by banks in their accounts at the Federal Reserve has played a key role in carrying out these policies … Payment of interest on these balances is our principal tool for keeping the federal funds rate in the FOMC’s target range. This tool has made it possible for us to gradually return interest rates to a more normal level without disrupting financial markets and the economy.”

Cybersecurity tops list of risks. In his appearance before the House Financial Services Committee, Powell said cybersecurity, and the unexpected threats therein, is what keeps him up at night, aside from what he called “elevated” asset prices that would fall under more traditional concerns, like commercial real estate.

Preparing for the worst-case cybersecurity scenario is top-of-mind, he said, even more than traditional risks. Preventing and preparing should be the focus, he said.

“(Do) as much as possible, and then double it,” he said, a signal of how serious the Fed views the issue.
He then tamped that statement down, and said the Fed “does a great deal” with its supervision of banks, and advised them to continually maintain “basic cyber hygiene” by keeping up to date on emerging trends and threats.

“We do everything we can to prevent failure, but then we have to ask what would we do if there were a successful cyberattack,” he said. “We have to have a plan for that too.”

A Timely Reminder About the Importance of Capital Allocation


capital-7-6-18.pngCapital allocation may not be something bank executives and directors spend a lot of time thinking about—but they should. To fully maximize performance, a bank must both earn big profits and allocate those profits wisely.

This is why the annual stress tests administered each year by the Federal Reserve are important, even for the 5,570 banks and savings institutions that don’t qualify as systemically important financial institutions, or SIFIs, and are spared the ritual. The widely publicized release of the results is an opportunity for all banks to reassess whether their capital allocation strategies are creating value.

There are two phases to the stress tests. In the first phase, the results of which were released on June 21, the Fed projects the impact of an acute economic downturn on the participating banks’ balance sheets. This is known as the Dodd-Frank Act stress test, or DFAST. So long as a bank’s capital ratios remain above the regulatory minimum through the nine-quarter scenario, then it passes this phase, as was the case with all 35 banks that completed DFAST this year.

The second phase is the Comprehensive Capital Analysis and Review, or CCAR. In this phase, banks request permission from the Fed to increase the amount of capital they return to shareholders by way of dividends and share buybacks. So long as a bank’s proposed capital actions don’t cause its capital ratios from the first phase to dip below the regulatory minimum, and assuming no other deficiencies in the capital-planning process are uncovered by the Fed during CCAR, then the bank’s request will, presumably, be approved.

There’s reason to believe the participating banks in this year’s stress tests will seek permission to release an increasingly large wave of capital. Banks have more capital than they know what to do with right now, which causes consternation because it suppresses return on equity—a ratio of earnings over equity. And last year’s corporate income tax cut will only further fuel the buildup going forward, as profits throughout the industry are expected to climb by as much as 20 percent.

We probably won’t know exactly how much capital the SIFIs as a group plan to return over the next 12 months until, at the soonest, second-quarter earnings are reported in July. But early indications suggest a windfall from most banks. Immediately after CCAR results were released on June 28, for example, Bank of America Corp. said it will increase its dividend by 25 percent and repurchase $20.6 billion worth of stock over the next four quarters, nearly double its repurchase request over last year.

The importance of capital allocation can’t be overstated. It’s one of the most effective ways for a bank to differentiate its performance. Running a prudent and efficient operation is necessary to maximize profits, but if a bank wants to maximize total shareholder return as well, it must also allocate those profits in a way that creates shareholder value.

One way to do so is to repurchase stock at no more than a modest premium to book value. This is easier said than done, however. The only time banks tend to trade for sufficiently low multiples to book value is when the industry is experiencing a crisis, which also happens to be when banks prefer to hoard capital instead of return it to shareholders.

As a result, the best way to add value through capital allocation is generally to use excess capital to make acquisitions. And not just any ole’ acquisition will do. For an acquisition to create value, it must be accretive to a bank’s earnings per share, book value per share or both, either immediately or over a relatively brief period of time.

If you look at the two best-performing publicly traded banks since 1980, measured by total shareholder return, this is the strategy they have followed. M&T Bank, a $119 billion asset bank based in Buffalo, New York, has made 23 acquisitions since then, typically doing so at a discount to prevailing valuations. And Glacier Bancorp, a $12 billion asset bank based in Kalispell, Montana, has bolstered its returns with two dozen bank acquisitions throughout the Rocky Mountain region.

The point is that capital allocation shouldn’t be an afterthought. If you want to earn superior returns, the process of allocating capital must be approached with the same seriousness as the two other pillars of extraordinary performance—prudence and efficiency.

The Deregulation Promise Beginning to Bear Fruit


regulation-5-14-18.pngEd Mills, a Washington policy analyst at Raymond James, answers some of the most frequent questions swirling around the deregulation discussion working its way through Congress, the changing face of the Fed and other hot-button issues within the banking industry.

Q: You see the policy stars aligning for financials – what do you mean?
The bank deregulatory process anticipated following the 2016 election is underway. The key personnel atop the federal banking regulators are being replaced, the Board of Governors at the Federal Reserve is undergoing a near total transformation, and Congress is set to make the most significant changes to the Dodd-Frank Wall Street Reform Act since its passage. This deregulatory push, combined with the recently enacted tax changes, will likely result in increased profitability, capital return, and M&A activity for many financial services companies.

Perhaps no regulator has been more impactful on the implementation of the post-crisis regulatory infrastructure than the Federal Reserve. As six of seven seats on the board of governors change hands, this represents a sea change for bank regulation.

We are also anticipating action on a bipartisan Senate legislation to increase the threshold that determines if an institution is systemically important – or a SIFI institution – on bank holding companies from $50 billion to $250 billion, among other reforms.

Q: Can you expand on why Congress is changing these rules?
Under existing law, banks are subject to escalating levels of regulation based upon their asset size. Key thresholds include banks at $1 billion, $10 billion, $50 billion and $250 billion in assets. These asset sizes may seem like really large numbers, but are only a fraction of the $1 trillion-plus held by top banks. There have been concerns in recent years that these thresholds are too low and have held back community and regional banks from lending to small businesses, and have slowed economic growth.

Responding to these concerns, a bipartisan group in the Senate is advocating a bill that would raise the threshold for when a bank is considered systemically important and subjected to increased regulations. The hope among the bill’s advocates is that community and regional banks would see a reduction in regulatory cost, greater flexibility on business activity, increased lending, and a boost to economic growth.

The bill recently cleared the Senate on a 67-31 vote, and is now waiting for the House to pass the bill and the two chambers to then strike a deal that sends it to the president’s desk.

Q: What changes do you expect on the regulatory side with leadership transitions?
In the coming year, we expect continued changes to the stress testing process for the largest banks (Comprehensive Capital Analysis and Review, known as CCAR), greater ability for banks to increase dividends, and changes to capital, leverage and liquidity rules.

We expect the Fed will shift away from regulation to normalization of the fed funds rate. This could represent a multi-pronged win for the banking industry: normalized interest rates, expanded regulatory relief, increased business activity and lower regulatory expenses.

Another key regulator we’re watching is the CFPB (Consumer Financial Protection Bureau), which under Director Richard Cordray pursued an aggressive regulatory agenda for banks. With White House Office of Management and Budget Director Mick Mulvaney assuming interim leadership, the bureau is re-evaluating its enforcement mechanisms. Additionally, Dodd-Frank requires review of all major rules within five years of their effective dates, providing an opportunity for the Trump-appointed director to make major revisions.

Q: We often hear concerns that the rollback of financial regulations put in place to prevent a repeat of one financial crisis will lead to the next. Are we sowing the seeds of the next collapse?
There is little doubt the lack of proper regulation and enforcement played a strong role in the financial crisis. The regulatory infrastructure put in place post-crisis has undoubtedly made the banking industry sounder. Fed Chairman Jerome Powell recently testified before Congress that the deregulatory bill being considered will not impact that soundness.

Q: In your view, what kind of political developments will have effects on markets?
We are keeping our eyes on the results of the increase in trade-related actions and the November midterms. The recent announcement on tariffs raises concerns of a trade war and presents a potentially significant headwind for the economy. The market may grow nervous over a potential changeover in the House and or Senate majorities, but it could also sow optimism on the ability to see a breakthrough on other legislative priorities.

Fed Raises Red Flag in Wells Action


governance-4-17-18.pngIn February of this year, in response to widespread consumer abuses and breakdowns in compliance, the Board of Governors of the Federal Reserve System issued an unprecedented enforcement order against Wells Fargo & Co. that, among other things, requires Wells to submit to the Federal Reserve a written plan to enhance the effectiveness of its board of directors in carrying out its oversight and governance responsibilities, and further restricts Wells’ growth—an action that is typically only imposed on troubled institutions.

In the consent order, Wells agreed to fully cooperate with the Fed in further investigations as to whether separate enforcement actions should be taken against individuals involved in the conduct cited in the order. In connection with entering into the consent order, Wells agreed to replace four directors, three by April and the other by the end of 2018. In addition, on the same date, the Fed publicly released letters of reprimand that it issued to the board of directors of Wells as well as to the company’s past lead director and chairman. These types of supervisory letters usually remain confidential.

While the Federal Reserve’s action was clearly intended to address an egregious situation that involved a breakdown of Wells’ risk management system and resulted in widespread consumer abuses, bank board members and executive management should take note of its statements in the letters of reprimand as they relate to the responsibilities of a board and its leadership, particularly when they become aware of serious matters at the bank, whether related to misconduct, compliance, operations or other areas.

Here are the key governance and oversight considerations noted by the Federal Reserve.

Responsibility of the Board
In its letter of reprimand to the Wells board, the Fed noted that it was incumbent upon the board to “carefully evaluate” the company’s risk management capacity and “to oversee” the implementation by management of an adequate risk management framework for the entire company. The Federal Reserve found that the Wells board failed to take sufficient steps to ensure that the bank’s executive management team had established and was maintaining an effective risk management structure. It also found that reporting by management to the board lacked sufficient detail and failed to include concrete plans to address the serious consumer compliance issues Wells was facing.

The Federal Reserve also emphasized that it was the board’s responsibility to ensure that the company’s performance management and compensation programs were consistent with sound risk management objectives and complied with laws and regulations. The letter stated that the lack of effective oversight and control of compliance and operational risks were material factors in the substantial harm suffered by Wells customers.

Responsibility of the Board Chair
The letter of reprimand to former Chairman and CEO John Stumpf stated that it was the responsibility of the chairman “to ensure that business strategies approved by the board were consistent with the risk management capabilities” of Wells. It further noted that it was incumbent on the chairman to ensure that the full board had sufficient information to fulfill its responsibilities. The Federal Reserve found that Stumpf failed to take appropriate and timely action to address the compliance issues and improper conduct by Wells employees. Also noted were his actions in continuing to support those senior executives most responsible for the failures and in resisting attempts by other directors to hold the executives accountable.

Responsibility of the Lead Director
For financial institutions that have lead directors, the Fed’s letter of reprimand is insightful as to its view of the lead director’s role. The letter stated that former lead director Stephen Sanger “had a responsibility to lead other non-executive directors in forming and providing an independent view of the state of the firm and its management.” The letter noted the failure of the lead director to initiate any serious, robust investigation into the widespread consumer compliance issues that were raised as well as the failure to press management for more information or action after being made aware of the seriousness of the issues. The Fed also noted that Sanger did not perform in a manner consistent with the duties and responsibilities of the lead director that were set forth in Wells’ corporate governance guidelines.

Is Congress Sowing the Seeds of the Next Banking Crisis?


regulation-4-4-18.pngThree weeks ago today, the U.S. Senate passed a bank deregulation bill that either provides modest relief to one of the country’s most heavily regulated and scrutinized industries—or sows the seeds of our next great banking crisis.

Sponsored by Sen. Mike Crapo (R-Idaho), who chairs the Senate Banking Committee, the measure passed by a 67-31 vote that included 15 Democrats and Sen. Angus King, an independent from Maine. The Crapo bill has often been described in the media as a “roll back” of the landmark Dodd-Frank Act of 2010. Passed after the financial crisis—which is approaching its 10-year anniversary, if one considers the Sept. 15, 2008 bankruptcy filing by the investment bank Lehman Brothers to mark the beginning of the crisis—Dodd-Frank imposed a number of new regulatory restrictions and requirements on the entire banking industry, particularly big banks.

The Crapo bill is hardly the full-throated repudiation of Dodd-Frank that some of its harshest critics would suggest. It’s most significant provision raises the designation threshold for Systemically Important Financial Institutions, or SIFIs as they are usually called, from $50 billion to $250 billion. Banks below the $250 billion threshold would no longer be subject to the same level of heightened supervision by the Federal Reserve that would remain in effect for banks above the $250 billion threshold, although the Federal Reserve would have the authority to designate any bank a SIFI if it believes that is warranted.

The bill would also exempt banks with $10 billion in assets or less from Dodd-Frank’s restrictions on proprietary trading (through the so-called Volcker Rule), which was aimed primarily at the practices of the big banks. The complicated capital framework for community banks would be replaced by a simplified leverage ratio that would still leave them well capitalized. And the bill eases a number of residential mortgage loan requirements that have made it difficult for smaller banks to compete in that market.

These changes are hardly an evisceration of Dodd-Frank—particularly when compared to a more ambitious bank deregulation bill that passed in the House of Representatives last year, but has found little bipartisan support in the Senate. Still, progressive Democrats like Sen. Elizabeth Warren (D-Massachusetts) and consumer advocacy groups like Public Citizen would have you believe that the next banking crisis is lurking around the corner if the Crapo bill ever becomes law.

Warren, a strident critic of big banks, says none of her constituents are clamoring for bank deregulation. “[N]ot one single person at any of my town halls, or meetings … or picking up pizza at Armando’s, asked for Congress to work on rolling back the rules on some of the biggest banks in the country so they’ll have a chance to crash the economy again,” she said in an interview with the website Politico. Public Citizen sent Crapo a letter in November of last year that laid out its broad objections to his bill, saying it would “take us in the wrong direction by removing important safeguards that protect the markets and consumers from some of the nation’s largest banks.”

I don’t think there is any question that the banking industry today is stronger than before the crisis. Banks are more highly capitalized, and while the Senate bill would relax oversight for banks that would no longer be designated as SIFIs, it is indisputable that the entire industry is more closely supervised than prior to the crisis. And this is important: The federal banking regulators retain their full authority to crack down on any bank they believe is operating in an unsafe or unsound manner. I think most of the Crapo bill’s changes make sense and won’t lead to a weakening of the industry’s safety and soundness.

Some of the fierce opposition from progressives like Warren is also a sign that even after nearly a decade the financial crisis still has a firm grip on our politics. “We continue to live in a very populist environment—there’s populism on the right and populism on the left,” says Brian Gardner, the director of Washington research at the investment bank Keefe Bruyette & Woods. “I think some of the lawmakers [like Warren] are playing to their base. I think it’s very good politics for them.”

Indeed, many of the Democrats who voted for the Senate bill are running for reelection this fall in states won by President Donald Trump in 2016, so maybe they were playing to their base as well.

Still, I’m not convinced that Warren, who is probably the banking industry’s harshest critic in Congress, is merely being political. Right or wrong, I think she truly believes that big banks pose a deadly threat to the economy and any loosening of their oversight will sow the seeds of another crisis. For Warren, nearly 10 years later, it’s still a matter of principle more than politics.