Bank Board Risk Committee: What Every Board Should Do

5-14-14-FIS.pngOnly a fraction of the nation’s banks are required to have a board-level risk committee. Under the Federal Reserve’s enhanced prudential standards coming out of the Dodd-Frank Act, publicly traded bank holding companies with assets of $10 billion or greater and all other bank holding companies with assets of $50 billion or greater must have a risk committee.

But banks of all sizes are going ahead and adding risk committees anyway. The Bank Director 2014 Risk Practices Survey, sponsored by FIS, identified that 76 percent of banks with assets between $5 billion to $10 billion and 54 percent of banks with less than $5 billion in assets had proactively implemented a board-level risk committee even though they did not have to by law.

A key finding from the survey was that banks that implemented a separate board-level risk committee performed better financially and reported a higher median return on assets (ROA) of 1.00 and median return on equity (ROE) of 9.50, compared to banks that govern risk with a combined audit/risk committee or within the audit committee. Having a board-level committee focused on how risks can be mitigated to enable attainment of financial and strategic plan objectives will result in a higher level of performance.

The other key benefit that a separate board-level risk committee can provide is proactive oversight of risk management. Effective risk management is identifying and mitigating risks before they become a material problem. It is forward-looking, not reviewing after the fact. So trying to oversee risks with a combined audit/risk committee or within an audit committee is extremely challenging and conflicting, since the focus of the audit committee is looking in the rear view mirror and after the fact. A risk committee can stay focused on overseeing risk limits and tolerances, and look for systemic risks and emerging risk trends. This way, material problems and surprises can be avoided before they arise and negatively impact earnings, capital or reputation.

So how can one go about implementing a highly effective board-level risk committee? The key to success is to get it right from the beginning. Start with the committee charter. The charter sets the tone and is the foundation for a highly effective risk committee.

The following PDF is a risk committee self-assessment checklist based on the Federal Reserve requirements for bank holding companies and industry best practices. A Yes answer will confirm either compliance with a regulatory requirement or a best practice. A No answer will identify a weakness. So if you have a risk committee, use the checklist to identify gaps and areas for improvement. If you do not yet have one, use the checklist below to jump start devising the risk committee charter.

Download the checklist in PDF format.

Interest Rate Risk: Are Your Assumptions Accurate?

4-16-14-Moss-Adams.pngModel assumptions have gained a great deal of importance in the banking industry. Financial institutions are using them more and more to generate output that summarizes the risks embedded in their balance sheet. But are these models always accurate? The answer, at least from banking regulators, is increasingly no.

For example, many interest rate risk (IRR) models continue to show that earnings will improve as a result of an increase in interest rates. However, a December 2012 presentation by the San Francisco Federal Reserve indicates that deposit assumptions, such as decay rates, beta-adjusted gaps (the relative repricing rate assumed for deposits versus a benchmark rate), account balances and deposit mix have a significant impact on IRR measurements. As a result, the Fed contends that the current IRR environment may cause model results to provide misleading data. In particular, the Fed cited an increase in non-maturity deposits as a percentage of total deposits.

The Fed noted that one of the main reasons for the increase in non-maturity deposits since midway through the recession is the drop in the federal funds rate. It believes that customers have parked funds over the past several years in non-maturity deposits since there’s been little difference in earnings between non-maturity and time deposits. This shift has caused non-maturity deposits to increase to 83 percent of total deposits as of December 31, 2012, from an average of 62 percent from 1985 to 2008—an increase of 33 percent.

So, for example, if your institution’s IRR model deposit mix assumption is based on current or recent historical deposit characteristics, there could be a surprise waiting for you, since it isn’t likely that interest margins on your deposit base will remain the same as interest rates rise. More likely, most institutions’ deposit mix will return to average pre-recession levels.

Changes to basic deposit assumptions can have a significant impact on earnings. For example, if interest rates rise by 200 basis points (bps), reallocation of the deposits mix to pre-recession levels may negatively impact earnings at risk (EAR) by up to 400 bps. EAR is a measure of the change in earnings based on changes in interest rates. Let’s say you’re currently reporting a positive exposure to EAR of 5.8 percent using today’s deposit mix. By adjusting the deposit mix to pre-recession levels, using the same 200 bps increase in interest rates, you’d see your EAR drop to a positive exposure of 1.8 percent.

Similarly, changing account balance assumptions to assume a decline in non–interest bearing deposits or changing deposit decay and beta-adjusted gap assumptions could easily take a positive EAR result and make it negative.

So what can you do to help your institution address these risks and regulators’ concerns?

  1. Reexamine key IRR assumptions. Don’t focus only on deposit assumptions, but regularly evaluate all assumptions feeding your IRR. This exercise most likely will result in an adjustment of your model assumptions and drive a deeper understanding of the true risks embedded in your balance sheet.
  2. Perform stress testing or scenario testing of your assumptions periodically. Determine which have the greatest potential impact on your institution, and spend more time ensuring those assumptions are valid.
  3. Perform detailed, comprehensive back testing. The best way to determine whether the assumptions used in your IRR model are reasonable is to test actual results based on prior assumptions. Analysis will help you identify the impact of shifts in transactional patterns and the resulting impact on the balance sheet. Although you may not be able to predict these types of shifts, by completing this testing you’ll be able to modify assumptions and update your model, resulting in more accurate, meaningful reporting.
  4. Revisit scenario testing. What changes are occurring in the market that could affect your institution negatively? What’s the likelihood they’ll occur and the degree of impact on your institution? Is your institution willing to assume that level of risk?
  5. Document your evaluation. Your regulator conducts analysis in these areas to evaluate your management of IRR. Thoroughly documenting the basis of your assumptions will aid them in understanding how you mitigate risk as an organization.

Stress Testing: Should A Bank Build or Buy?

4-14-14-Trepp.pngThe banking industry received a rude awakening in March when the Federal Reserve rejected five banks’ capital plans and stress testing reports, indicating that the stakes are rising for stress testing. More banks are beginning to develop stress testing programs and directors are faced with the decision to rely on internal systems and models or to look beyond their institution to third-party data and solutions. More commonly known as “build versus buy,” this choice is a difficult one to make, as there is no one-size-fits-all approach. To provide decision-makers with some helpful guidelines, we focus on the following key factors that will determine which route a bank should take.

The completeness of a bank’s data set will be a strong determinant in making the decision to build or buy. Small and large banks alike have been criticized by regulators for their stress testing models resting on what is deemed an inadequate base. In August 2013, the Fed published a report citing strengths and weaknesses identified in large bank holding companies’ stress testing approaches. A key criticism was, “weaker practices [that] failed to compensate for data limitations or adequately demonstrate that external data reasonably reflect” the bank’s exposures. A bank’s data should contain the following:

  • Metrics on loan performance, such as payment and delinquency history
  • Metrics that influence payment behavior, such as loan-to-value ratios, debt service coverage ratios, credit rating and cash flows
  • Measures of loss severity
  • Descriptors of the relevant market backdrop for the loan, borrower and property

In addition, the data should span at least a full credit cycle and be able to accurately represent the market. If a bank’s data sets are lacking in any of these areas, management should strongly consider the “buy” side, whether that involves augmenting data with that of a third-party or using a third-party model.

If a bank does not have sufficient internal resources to complete the required work to build a stress testing model, some level of outsourcing should be considered.

Staffing: To conduct stress testing completely independently, a bank will need to allocate personnel for management and oversight, data analysis, model creation, documentation, testing and validation. To provide a point of reference, large banks employ teams of 50 or more people for their stress testing work. A hybrid approach, in which a bank builds some components of the model and outsources other work, is also an option. If a bank chooses to use third-party models, regulators expect its management team to understand the ins and outs of the tools they are using, particularly in their stress test reporting.

Development and Maintenance: In developing a stress testing system, a bank must commit substantial resources to both systems and people for data warehousing, creating forecasting models, output collection, reporting, and of course, maintenance of the systems. Requirements and expectations will evolve over time, which means there will constantly be areas in need of improvement. While the largest commitment is upfront when a bank decides to build, it is also a sustained commitment.

Cost considerations are undoubtedly a significant factor in a bank’s decision to build or buy. Choosing to build incurs the highest cost—for both initial development and ongoing maintenance. Beyond the maintenance expected as a result of evolving regulatory requirements, technological advances will also involve a substantial investment. Spending will vary by the size and complexity of the bank and its system. Last year, three banks in the $50-billion asset range—Comerica, Huntington Bancshares, and Zions Bancorp.—announced that they were each spending in the neighborhood of $10 million on their regulatory compliance efforts, a large portion of which was understood to be for stress testing expansion. Smaller institutions will not be expected to spend as much, but building a system will easily cost hundreds of thousands of dollars upfront, and similar amounts to maintain.

The build versus buy decision for stress testing is not always clear-cut, as there are advantages to both. As banks look to increase their focus on qualitative aspects of the process and the entirety of the reporting procedure, building an internal model will make the bank an expert on their stress tests. Using internal data also ensures that reporting accurately reflects the bank’s current operations. On the other hand, third-party tools can easily prevent a bank from falling short due to budgeting or data integrity. Given the maintenance involved, buying is also considered less of a risk. Whichever way your bank goes, including a hybrid approach, it will benefit from more rigorous approaches to capital planning and capital adequacy stress testing.

Meet Rising Compliance Costs with Untapped Internal Resources

5-29-13_Crowe_Post.pngAs almost everyone in the financial institution trenches knows, ever-expanding compliance requirements are taking a toll on banks of all sizes, and some banks are simply resigning themselves to the need to hire additional employees to help shoulder the burden. But many institutions might be able to avoid, or at least reduce, the associated costs by looking within for a solution.

The Federal Reserve Bank of Minneapolis has estimated the relative number of new employees that banks of different sizes might need to hire in response to the same regulatory requirement. It estimated that hiring one additional employee would reduce the return on assets by 23 basis points for the median bank in the group of smallest banks, those with total assets of $50 million or less. Such a decline could cause about 13 percent of the banks that size to go from profitable to unprofitable.

Banks with total assets between $500 million and $1 billion would have to hire three employees and would experience a decline of about 4 basis points in return on assets as a result, according to the Minneapolis Fed. Although very few banks in the larger group would go from being profitable to unprofitable as a result of the heightened regulatory burden, 4 basis points is still a significant reduction in return.

In response to complaints about the dramatic potential effect on “smaller” banks, regulators have indicated that certain new regulations might apply only to big banks or, alternatively, they might adopt a tiered approach. Even if the regulators do demonstrate some flexibility on how new regulations are applied, smaller banks still will need to meet a rising compliance burden for rules and regulations already in place.

In the past five months, for example, relatively small community banks have been hit with severe penalties for fair-lending violations. Three or four years ago, regulators wouldn’t have focused on such institutions, but fair-lending oversight has taken on a new dynamic, and now banks of every size are expected to have robust fair-lending programs. Similarly, oversight of unfair, deceptive or abusive acts or practices (UDAAP) has expanded to cover a much broader scope of activities in the past two years.

While certain sections of the recently implemented servicing amendments to the Real Estate Settlement Procedures Act (RESPA) and the Truth in Lending Act (otherwise known as Reg Z) apply only to banks that handle at least 5,000 mortgage applications a year, nearly every other aspect of these regulations treats all banks the same, regardless of size, and imposes the same fines for violations.

In short, regulators have raised their compliance expectations for every bank these days.

Look Inside First
The bottom line is that your bank, whatever its size, needs someone to be responsible for and well-versed in the regulatory requirements and also to manage the compliance program. Instead of going out and hiring an additional compliance subject-matter expert (SME) to complement your existing compliance manager, though, consider working from within your organization.

You might already have on staff individuals who are qualified to assist with tasks such as monitoring and testing, perhaps an experienced credit analyst, personal banker or loan originator who has shown a strong ability to learn and interest in a long-term career in the banking industry.

For example, you could “borrow” a credit analyst or someone else who is adept at using spreadsheet software and could spare five hours a month to run some spreadsheet sorts of loan application data—both real estate and consumer—for the compliance manager to use for a high-level fair-lending data analysis. Or a personal banker who has shown an understanding of the common deposit regulations could do occasional testing of check holds and error resolution with the appropriate testing spreadsheets.

Don’t limit your consideration to employees with college degrees in finance and accounting. After all, you would be hard-pressed to find compliance SMEs who took a Reg Z course during their college days, even if they majored in finance or accounting. That expertise accrues through real-life experience and continued education. Once you look, you’ll likely find that your front-line people harbor extensive knowledge waiting to be tapped.

Make It a Team Effort
With a strong management structure—including representation and a commitment from all lines of business and senior management—compliance can become a cost-efficient team effort built upon existing resources.

Ongoing monitoring can be conducted within each line of business, with the compliance department merely reviewing it to see that the trends aren’t of concern. Occasional loan data analyses can be conducted by someone outside the compliance department, with the compliance manager providing guidance to confirm the analyst understands the basic concepts of fair lending.

And monthly meetings can be held to recap compliance activities, be they forthcoming new rules, testing and monitoring results, new training requirements or similar topics, and those meeting minutes can be presented to the audit committee. Ultimately, compliance is a long-term commitment, and you might be able to meet your institution’s rising compliance requirements if you look for ways to leverage the talent and experience of your existing personnel.

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

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

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

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

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

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

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

Waiting for Volcker

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

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

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

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

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

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

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

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

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

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

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

Bank Earnings Trends

The Federal Reserve’s actions in response to the U.S. economy’s sluggish growth and high unemployment rate have virtually ensured depressed bank earnings for the foreseeable future.

The Federal Open Market Committee (FOMC) recently proclaimed that it will “keep the target range for the federal funds rate at zero to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” In addition to keeping interest rates “exceptionally low,” the Fed is embarking on another round of quantitative easing (QE3)—this time with no end date in sight. Indeed, the spigot is now open.


The obvious impact to bank earnings of Fed Chairman Ben Bernanke’s monetary policies is that net interest margins will continue to contract as we have seen virtually every quarter since 2010. Deposit costs are as low as possible, and loan yields will continue to decline as higher rate loans are replaced with lower yielding assets. Interestingly, as the chart [below] depicts, banks with assets less than $1 billion have been able to sustain higher net interest margins than their larger brethren, who have brought down the industry’s margins in lock-step. Banks less than $1 billion maintain a net interest margin of 3.75 percent, while those greater than $1 billion average a net interest margin of 3.42 percent through Q2 2012.  Nevertheless, the majority of banks of all sizes are seeing NIM contraction.


When margins contract, banks are forced to pull other levers in order to maintain consistent net income streams:

  • As asset quality has improved across the industry, banks have been able to release reserves back into income, although at some point this strategy will end as banks are unable to continue depleting their reserves.
  • Declining interest rates have meant increases in the value of securities portfolios for many banks which, in turn, increased income from realized gains on sale; however, securities yields will continue to decline during the low interest rate environment and future gains on sales will decline.
  • Noninterest income is notoriously difficult to generate—especially for community banks—and lawmakers have cracked down on fees such as overdraft, rendering this strategy more or less futile.
  • Banks can streamline operations and become more efficient, although at some point this strategy faces diminishing returns.


All the strategies above can help maintain earnings for the short term, but eventually they will leave bankers grasping at air without any more levers to pull. Absent an increase in net interest margins, returns on assets will continue to decline; this is inevitable. At that point, banks will face a choice: increase credit risk and loan volume to generate yield, increase interest rate risk by stretching for yield, or accept diminished returns. Certainly, one unintended consequence of Chairman Bernanke’s policies is that banks will begin to take on more credit and interest rate risk, threatening the industry’s renewed strength once again.

However, another strategy exists to increase shareholder value: exploring an acquisition or merger is one of the only ways to increase returns in today’s environment. Both buyers and sellers can benefit greatly from this strategy if the right deal is struck. A buyer can increase its net interest income by combining with a partner that has higher yielding assets or a lower cost of funds. Furthermore, cost savings can result in a more efficient operation. Likewise, sellers tired of fighting for returns—particularly those small, community banks—can achieve a liquidity event and cash out or ride the buyer’s stock, resulting in returns that could take years to achieve on a standalone basis.

Banks can expect at least another three years of difficult returns. Thankfully, the industry’s balance sheets are healthier, and it is likely industry consolidation will pick up precipitously as a consequence.

Twist This

america-money.jpgYour country needs you. Your country needs you to go into debt, that is.

Hoping to jumpstart a lackluster lending environment, the Federal Reserve recently announced “Operation Twist” to drive down long-term interest rates such as the 30-year fixed-rate mortgage while increasing short-term interest rates.

The idea, a much bigger replay of a 50-year economic program of the Federal Reserve during the Kennedy administration, is that the move will make long-term borrowing more attractive, which could encourage home buyers to buy homes and businesses to invest in job creation.  But will it?

Scott Brown, the chief economist and senior vice president for Raymond James & Associates, says the Federal Reserve’s $400 billion program of buying and selling U.S. Treasury securities is trying to get banks to lend more, possibly by squeezing the interest margins that banks depend on. This interest margin is the difference between the interest banks charge on loans and the interest they pay out for deposits. As their profits get squeezed, the banks could increase lending to make more money.

But will they?

“With banks in a much better position than they were three years ago, the Fed is betting that a flatter curve, and margin compression, will not cause undo strain, but instead lead them to make up the difference in loan volumes,’’ Brown writes in his weekly commentary. “We’ll see.”

The problem with such an approach is that there are few high-quality borrowers out there wanting to get loans, and the banks have worked hard to improve the credit quality of the assets on their books. The idea that they would stretch their underwriting guidelines to offer more loans is doubtful, and whether their regulators would even allow it is also doubtful.

What could really spur lending is for more high-quality borrowers to somehow come out of the woodwork looking for loans at record low interest rates. But many potential homebuyers can’t sell the homes they do have or take advantage of low rates to refinance as home values continue to decline. Freddie Mac announced this week that the average 30-year fixed-rate mortgage fell to a record low of 4.01 percent as of Sept. 29.

In contrast, the short-term, five-year adjustable -rate mortgage rate ticked up after the Sept. 21 announcement by the Federal Reserve from 2.99 percent to 3.01 percent. It has remained flat since then, according to Freddie Mac.

Whether all this will spur lending is another matter.

“We question whether this program can be successful because we believe the lack of borrowing and lending activity has more to do with other fundamental economic and regulatory conditions than it does with interest rates,’’ writes G. David MacEwen, chief investment officer of fixed income for American Century Investments.

He goes on to describe the Federal Reserve’s toolbox as “nearly empty.”

It may be that the Federal Reserve is in the same boat as the Obama administration: there’s not that much more it can do to incentivize a reluctant and hobbled private sector. The government would like you to borrow, but will you?


Watch out: Federal Reserve Begins Systemic Reviews of Pending Acquisitions

risk-magnify-article.jpgAt first blush, it might seem strange that the Federal Reserve would be scrutinizing Capital One Financial Corp.’s announced $9 billion acquisition of ING Groep NV’s U.S.-based online banking unit to gauge whether it poses a systemic risk to the financial system. Capital One focuses primarily on retail businesses including credit cards and branch banking, and the operation that it’s acquiring from Dutch banking giant ING is an Internet bank. And when most people think of activities that might entail some element of systemic risk, they probably think of large trading or derivative operations—not consumer banking. 

The Dodd-Frank Act now requires the Fed to review bank mergers to determine whether they pose a systemic risk, so to a certain extent, its review of the Capital One/ING deal might turn out to be a pro forma exercise. Brian F. Gardner, a senior vice president and Washington-based government affairs analyst for Keefe Bruyette & Woods Inc., points out that the combined entity would be “pretty plain vanilla. It won’t be derivatives intensive. It won’t be capital markets intensive.”

“I think [the Fed is] serious about systemic risk, but I don’t think this is a good test case for [the systemic review],” Gardner adds. “I think the deal will go through with few objections from the Fed.”

It will probably take some time before acquirers and their financial and legal advisors understand fully what the Fed is looking for when it does a systemic review of a pending acquisition. Bankers certainly understand the concept of systemic risk including size, inter-connectedness and counterparty risk, to name a few its elements. But as Gardner points out, “It’s a term of art, not a term of science. There’s no clear, bright line definition.”

A recent memo from Wachtell, Lipton, Rosen & Katz, a New York-based law firm with a large M&A practice, does shed some light on what the Fed will be looking at when it performs a systemic merger review. 

According to Wachtell, “(T)he Federal Reserve is focusing on the availability of substitute providers of critical financial services and the interconnectedness of the company post-acquisition and seeking information about each party’s involvement in providing numerous wholesale and institutional (and some consumer) financial services, including repo funding, prime brokerage, underwriting of equity or debt or asset-backed securities, clearing and settlement, asset custody, corporate trust, credit cards and mortgage servicing. The Federal Reserve is also seeking information about market shares and specific competitors in these markets, as well as the dollar volume of overlapping activities. In addition, they are requesting information about each party’s three highest positive and three highest negative counterparty exposures, including information about any collateral or hedges.”

These are some of the things the Fed will be looking at during its systemic reviews, but is there a formula or methodology it will use to decide that one acquisition poses no systemic threat while another one does? Gardner says that even if it does have a specific methodology in mind, he doesn’t expect the Fed to articulate it for the benefit of the M&A market. 

“That preserves as much flexibility for them as possible,” he says. And while that ambiguity leaves potential bank acquirers in large, complex transactions in the dark about what to expect, “Ambiguity is the ally of the regulator.”