Regulatory Guidance on Stress Testing: What Every Board Must Know and Should Do

frayed-rope.jpgThe banking agencies (the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency) recently issued the Supervisory Guidance on Stress Testing (the “guidance”).  This guidance becomes effective July 23, 2012 and applies to banking organizations with more than $10 billion in total consolidated assets. 

However, all banks regardless of size should pay close attention and follow the principles outlined in the guidance in order to implement an optimal risk management program at the bank. 

This article highlights what every bank board must know about the guidance and should do, regardless of the bank’s size. 

What the Guidance Says

The guidance says that a banking organization with more than $10 billion in total consolidated assets should implement stress testing as a key component of its risk management program. The main purpose is to enable the organization to fully understand its risk exposures and impact from stressful events and circumstances and better equip the organization to handle a wide range of adverse outcomes in the future.  

The guidance says banking organizations should incorporate five principles into a stress testing framework so that:

  • It is tailored and captures the organization’s enterprise risks
  • It employs multiple stress testing approaches
  • It is forward looking and flexible
  • It produces stress test results that are clear, actionable and support informed decision making
  • It includes strong governance and effective internal controls

The stress testing framework should cover all risks such as credit, market, operational, interest-rate, liquidity, country and strategic risk.

A banking organization’s senior management needs to design and implement the stress testing, while the board should approve the framework and policies.  The board should then monitor compliance.  The board also needs to use the results from stress testing to assess the impact to the risk profile, risk appetite and strategic plan. There should also be an independent review and validation of the framework used in the stress tests.

What the Board Must Know

Failing to follow the guidance and implement a stress testing framework commensurate with the banking organization’s size and risk profile will be deemed an unsafe and unsound banking practice. Bank examiners will closely evaluate the board’s role and ultimately hold it accountable.

Ultimately, the board is responsible for ensuring the banking organization has an effective enterprise risk management program that includes an appropriate stress testing framework.  The board should make sure senior management covers all risks and utilizes stress testing techniques such as scenario and sensitivity analysis and reverse stress testing.  Stress testing should provide the board with critical intelligence that ultimately can result in optimal risk management performance.  The board should also ensure that the stress testing framework’s adequacy and effectiveness is evaluated and validated independently.  

What Community Banks Should Do

While banking organizations with $10 billion or less in consolidated assets are exempt from the guidance, it would be prudent for the boards at these organizations to closely review the guidance and consider implementing a stress testing framework commensurate for their size and complexity, as a best practice. 

For example, a community bank could incorporate reverse stress testing as described in the guidance as a tool.  Reverse stress testing means the banking organization identifies “break the bank” type adverse outcomes, such as suffering material credit losses that result in severe undercapitalization, an employee committing a large fraud that results in a material loss, the bank being used for money laundering that results in criminal penalties or the bank being accused of lending discrimination and prosecuted by the Department of Justice (DOJ). The bank should then deduce the types of events that could lead to such an outcome.  This can reveal potential blind spots or previously unknown sources of risk that can then be mitigated through enhanced risk management.  Community banks in particular, due to their size, limited resources and less diversification in geographic location and product mix, may be more vulnerable to “break the bank” type of adverse events and may not be able to withstand such surprises unless they have planned for such an outcome. 

Ultimately, stress testing provides critical forward looking risk management intelligence that the board should use to guide the banking organization to attain optimal risk management performance and maximize shareholder value, regardless of the size of the organization.

Pooling Resources to Buy Middle Market C&I Loans

Community banks have been pushed, squeezed and shoved out of the lending market during the past two decades for many types of commercial and industrial loans, where the pricing has become so competitive that it’s not worth the effort. But with the pitfalls of high concentrations in commercial real estate so obvious now, many banks are trying to diversify revenue streams in order to survive. John Delaney and Lewis “Lee” Sachs founded asset manager Alliance Partners in June 2011 to help community and regional banks diversify income and gain access to C&I loans too big to otherwise put on their books. The related entity, BancAlliance, is a cooperative of member banks that identifies, evaluates and refers loans to members. Bank Director magazine talked to John Delaney and Lee Sachs about the market for C&I loans and how their company works.

Why did you think there was a need for this?

Lee Sachs: From the bank’s perspective, for the last 20 years, they’ve been pushed out of so many different markets. As a consequence, community banks have gone from having around 60 percent of their loan assets in real estate to some having almost 80 percent of their assets in real estate. That is not a sustainable business model over time.

John Delaney: Banks do better when they have balance and choice, and the problem with community banks is they don’t have balance and they don’t have a lot of choice. A lot of community banks have just become local real estate lenders. Much of the growth occurring in our country is in the middle markets. The U.S. is more of a service economy and service-based businesses tend to be more regional and national, and you need a certain amount of scale to successfully compete for loans in that market. Right now, a disproportional benefit of that growth goes to large banks. If you look at where jobs are being created, it’s at fast growing, mid-sized business that go from 100 employees to 1,000 employees in a couple years. The middle market requires loans of $50 million to $250 million, which are bigger than what a lot of community banks can handle. However, these borrowers would prefer to do business with community banks. Truly, that’s what they would rather do.

Lee Sachs: Sometimes a Main Street bank will lose a client as that client grows, because the bank can’t accommodate the larger loans. One of the things we help our members do is retain that client.

Who are your members and what does it cost to join?

Lee Sachs: We have 38 members and they’re all over the country, from $200-million asset banks to $10 billion. They don’t pay anything to join. We receive asset management fees based on the volume for the loans they fund through BancAlliance. The banks set the parameters for the loans, policies and procedures, and they tell us what kind of loans they want. Each individual loan may or may not fit with every bank’s needs. We introduce a loan to the membership and each member decides if that loan works for them. We service the loans on behalf of the group. We consider ourselves an extension of their loan department.

John Delaney: We’ve looked at 450 opportunities, and a little less than 10 percent made it through our filter, so 40 loans have been approved on behalf of the network.

C&I lending is a fairly competitive business, especially in terms of pricing, so how do you think you can offer a strategy that will be attractive to community banks?

John Delaney: For small banks, there are too few opportunities in C&I lending and too many banks going after that. In terms of national credits and mid-sized businesses, we find that to be a market that has average competition. We don’t think it is nearly as competitive as the C&I loans in the local footprints. The return profile is better and the risk profile is better.

How do the regulators view your model?

Lee Sachs: We’ve gotten good feedback. We are doing this very carefully; we designed this in a way that fits with regulatory guidelines. The former Comptroller of the Currency, John Dugan, has been outside counsel for BancAlliance and has been instrumental in helping us think this through.


Fairness to Consumers Is the New Emphasis in Banking Regulation

Get ready. Even small banks and thrifts are going to be affected by a post-crisis shift in regulation toward what’s fair and transparent to consumers, says Tim Burniston, until recently a senior associate director with the Federal Reserve Board’s Division of Consumer and Community Affairs. In that position he was detailed to the Consumer Financial Protection Bureau (CFPB) to develop its large depository institution supervision program. He now heads the consulting practice at Wolters Kluwer Financial Services.

What will be the impact of the new CFPB?

This is an agency that has unprecedented reach, authority and concentration of power. It has not only supervision responsibility for depository institutions with assets above $10 billion and their affiliates, and nonbank institutions, but rulemaking responsibilities transferred to it for 18 federal statutes, including the Truth in Lending Act and the Equal Credit Opportunity Act. It has enforcement powers for addressing wrongdoing by those who violate regulations and it acts on consumer complaints. Among other things, the CFPB has the authority to write rules that prohibit abusive practices, which are forbidden by the Dodd-Frank Act.

How is this creating a new tone for supervision?

Fairness is really the lens through which the CFPB will likely look at practices and processes across an institution’s product and services life cycle. The agency is focusing on the concept of risk to consumers. That represents a big departure from what banks have been used to, where the emphasis was traditionally placed on risk to the bank itself.

How will this change the exam process?

The CFPB has a responsibility to ensure that institutions follow the laws, so there is a technical compliance element to their work, but they are also looking at supervision from a consumer risk perspective. The CFPB has stated that the goal of its large bank supervision program is to “prevent harm to consumers from unlawful financial practices and ensure that markets for consumer financial products and services are fair, transparent and competitive.”

What specifically is the CFPB interested in regulating?

CFPB’s charge is quite broad, and I am not surprised by what it has shown an interest in so far. They did a town hall meeting on payday lending. They did another on checking accounts and just launched an inquiry into overdraft programs with a focus on order processing, marketing, misleading information and customer demographics. They released mortgage servicing and origination examination procedures. They issued a proposal on remittances. We see them starting to take a look at issues that consumer advocates have raised questions about during the last few years. The regulation of non-depository companies, which includes payday lenders and debt collectors, is challenging. These entities largely have not been subject to routine federal supervision in the past. The CFPB’s nonbank supervision program in accordance with Dodd-Frank is risk-based, which means it will concentrate on those entities that pose the greatest risks to consumers. To regularly examine every one of them would require huge numbers of staff.

How will the CFPB impact banks below $10 billion?

Although there is a growing recognition and empathy for the regulatory burdens faced by smaller institutions, there is also the reality that the CFPB will have influence in the supervisory and regulatory community. It is a part of the Federal Financial Institutions Examination Council, which is a body that tries to promote uniformity in the exam process, and the CFPB director sits on the Federal Deposit Insurance Corp. (FDIC) board as well. The CFPB’s voice will be heard in those agencies.

How can bank directors monitor management’s progress in addressing these changes?

No one is expecting directors to be technical compliance experts, but it’s important for directors to be aware of, and to understand, what the hot button issues are so they can ask good questions of management and ask what steps the institution is putting in place to address those issues. One place for the board to start is with questions about how the supervisory emphasis on fairness and transparency could affect their institution.

But if you’re less than a $10-billion asset institution, should you still be preparing for an exam where fairness to consumers is emphasized?

Yes. I think that fairness in how consumers are treated will continue to be prominent in the post-crisis supervisory environment. In addition to the CFPB, over a year ago, the FDIC re-established a dedicated consumer protection division. They had merged their former compliance division within the safety and soundness group in 2002 and have now broken it back out again. That’s a good example of how this is not just about the CFPB and not just about big banks.

10 Ways Banks Can Grow in 2012

water-grass.jpgIt’s old news that banks are operating with fewer avenues for growth than in years past,  and it’s no surprise that bankers are scrambling for new ways to make up for this lost growth. In doing so, however, bankers need a smart and focused strategy to make the most out of the opportunities available. In a recent report,  “Top 10 Ways Banks Can Grow in 2012,” Grant Thornton LLP comes up with a priority list for growth in the current financial environment.

1. Focus Strategic Plan on Growth

Strategic plans should not be viewed as simply a regulatory requirement, but as a valuable instrument in the assessment, and often continual reassessment, of goals. Grant Thornton writes, “Now that many companies are shifting from survival mode to seizing opportunities in an improving economy, banks should develop and modify their 2012 strategic plans with a renewed focus on growth objectives.” This includes examining whether you are properly incentivizing your growth goals with employees, taking a new look at where you should and shouldn’t be cutting expenditures in your marketing, and rethinking previous decisions about which products are most relevant to today’s market.

2. Examine an Acquisition

While there are many current roadblocks to a successful M&A transaction, ranging from new regulations to uncertainty about future pricing, M&A is still considered a popular avenue for growth. Before incorporating an acquisition into the growth plan, however, banks need to consider post-acquisition issues.

 Aside from preparing for the complex accounting and financial aspects of an acquisition, directors need to be prepared for potential cultural conflicts. “Communication and leadership are probably the most important prerequisites for a successful integration. It’s critical that there be transparent communication between the acquirer and the acquired entity, so that important cultural issues, such the composition of the combined institution’s senior leadership team, are handled in a timely manner,” says Grant Thornton.

3. Implement Smart Tax Strategies and Structures

Banks need to ensure their tax strategies are taking advantage of all new federal benefits, as well as being up-to-date with state and local rules that cover their operating area. “Incentive credits that apply to banks should be implemented in all applicable jurisdictions. Federal benefits from credits (e.g. new market tax credits, energy credits, low-income housing tax credits) and bonus depreciation should be analyzed,” says Grant Thornton.

4. Develop New Service Offerings

Banks should consider adding new services to their existing line-up, as well as maximizing the potential of the services they already have. In terms of maximizing current potential, bankers should increase cross-selling to their established clients and determine which services need a renewed focus after being pushed aside during the downturn. 

For new areas of growth, bankers should consider teaming up with other entities that can help them expand services such as brokerage and financial planning. At the same time, they should consider participating in quality loans that are recently becoming available through other institutions trying to increase capital ratios.

5. Make Technology Work for You and Your Customers

Putting money into new technology expenditures may be hard to stomach for banks during a downturn, but it also may be necessary if their competitors are making those same investments. Grant Thornton suggests supplying tablets or iPads to your field staff which can be used to personalize customer marketing materials and complete loan applications remotely.  Grant Thornton also recommends considering a switch to cloud computing services—after first evaluating the inherent risks—if you haven’t already. “Cloud computing offers a number of distinct advantages over its predecessors, including a more efficient and cost effective use of internal resources, greater speed to deployment, lower operating and capital costs, and higher performance,” says the report. 

6. Send the Right Message with Social Media

Larger financial institutions, and even many smaller ones, are interacting with their customers in new and creative ways across a wide spectrum of social media platforms. Whether it is to bolster public image or to spread information about new products and services, social media offers an inexpensive way to communicate directly with clients.

“Social media provides the opportunity for banks to demonstrate their commitment to corporate social responsibility and help regain confidence from their customers and the public after being largely maligned during the recession,” says Grant Thornton. 

Banks should be cautious, however, as such open communication is a two-way street, and it can be difficult to control negative feedback. In addition, social media provides an avenue for both fraud and privacy breaches, and this risk should be examined as part of any social media plan. 

7. Ready Your Bank for Risk

All banks prepare for risk, but banks should take the extra step of incorporating an enterprise risk management (ERM) approach that fits each organization’s individual needs and objectives. “(ERM) is an approach to assessing and addressing the full risk profile of the bank, including strategic risks such as operational, financial, regulatory, credit and market risks. The assessment process allows all parties to fully understand the impact of major new initiatives across the bank, and enables clear, strategic decision-making,” says Grant Thornton.

8. Understand Regulations

Keeping up and complying with new regulations can be a difficult task given the recent influx of rules stemming from the Dodd-Frank Act and the formation of the Consumer Financial Protection Bureau, but no bank wants to find themselves in noncompliance. Fortunately, as long as the bank’s overall risk management approach is sound and the most potentially costly regulations are given special attention (i.e. the Fair Lending Act, the Unfair or Deceptive Acts or Practices program, and the Bank Secrecy Act) then banks can still see growth while staying compliant. 

9. Plan for the Worst-Case Scenario: Stress Testing

While recently made mandatory for some of the nation’s top banks, stress testing can be a valuable tool to any bank wanting to fully understand potential risks and prepare its growth plans accordingly. “Continual stress testing should be relevant to the bank’s specific portfolios, balance sheet and customer base. Stress testing should cover: asset concentration and credit quality; contagion risk, such as exposure to European debt; and capital structure and availability,” says Grant Thornton. By understanding possible future risks and building contingency plans, banks can more confidently and strategically take advantage of growth opportunities.  

10. Build a Stronger Foundation for Mortgage Lending

Despite potential roadblocks stemming from recent mortgage reform, banks should still consider growing mortgage banking efforts in areas where there is still a large or expanding market. 

“The recent improvement in housing starts and sales of existing homes indicate that there is still a large market for home mortgages.  If properly managed, a new or expanded mortgage banking effort could be very profitable,” says the report.  

Aside from home mortgages, banks should also take a look at new growth sectors in commercial real estate such as apartments, which look promising due to a high number of rental customers and a relatively low number of new apartments being built in the past few years. 

The full article can be accessed on Grant Thornton’s web site.

Experts: Risk will be key issue in 2012

In preparation for the upcoming audit committee conference in Chicago in June, Bank Director asked bank attorneys and accounting experts speaking at the conference to name the top issue facing bank audit committees in 2012-2013.  Most thought audit committees will have to wrestle with risk issues, whether it’s the risk created by certain types of compensation or the risk of running into problems complying with all the new rules resulting from the Dodd-Frank Act.

Pat-Cole.jpgIf not number one, compensation risk will certainly be one of the top issues facing audit committees over the next 18 months. And a key question audit committees need to ask themselves is: Are our pay practices defensible? Whether the compensation review involves peer group composition, external benchmarking, internal equity and incentive plan risk assessments, or true pay-for-performance, investors and regulators alike will want evidence that all of the reward components are fair. Going forward, simple assurances won’t be enough to satisfy them.”

—Patrick J. Cole, human resources senior consultant, Crowe Horwath LLP

Ronald-Janis.jpgThe top issue facing audit committees this year is how to handle forward-looking risk management, including consumer compliance, regulator exam and balance sheet risk.

—Ronald H. Janis, partner, Day Pitney LLP


Bill-Knibloe.jpgThe accounting issues are complex, and the bank regulators are taking a very conservative approach to interpreting them, which may or may not be in accordance with past accounting practice (historical GAAP). Their conclusions on the time frame for the implementation of related adjustments can also be problematic.”

—Bill Knibloe, partner, Crowe Horwath LLP

Michael-Rave.jpgThe top issue for bank audit committee members is how can the audit committee improve its risk management program and focus on key risks?  Do management and the board have a clear, concise response program in case of a crisis?”

—Michael T. Rave, attorney, Day Pitney LLP

Wynne-Baker.jpg“Audit committee members should continue to increase their knowledge and education on banking because the banking model will demand more from directors.”

— Wynne E. Baker, member-in-charge, KraftCPAs PLLC

The Double-Barreled Regulatory Assault on Retail Banking

shotgun.jpgFollowing the financial crisis, one can cite any number of areas where the regulatory pendulum has swung too far.  Retail banking is one of those areas.  The Dodd-Frank Wall Street Reform and Consumer Protection Act ushered in a new—and an oddly schizophrenic—regulatory regime for retail bankers.

The premise of the new legislation is that, had the prior retail banking regulatory regime been different, material aspects of the financial crisis would have been averted.  In particular, proponents of the legislation asserted that federal bank regulators focused on safety and soundness considerations significantly to the exclusion of consumer protection.

Whether these problems were real or imagined, they were given a legislative “solution.”  Dodd-Frank created a new federal super-regulator for consumer financial services regulation, the Bureau of Consumer Financial Protection (CFPB).  With generous funding and a singular focus on consumer protection without regard for prudential considerations, the CFPB has a host of unprecedented powers, including:

  • rulewriting authority for 18 federal consumer credit laws;
  • authority to issue rules implementing the new consumer protections added by Dodd-Frank, most notably the statute’s open-ended proscription on unfair, deceptive or abusive practices;
  • direct compliance-related supervisory authority for banks with total assets of more than $10 billion.

In other parts of the Dodd-Frank legislation, however, Congress seems to have forgotten that the CFPB was the “solution” to the perceived problem of lax federal oversight.  Notwithstanding the CFPB’s creation, Dodd-Frank ushers in a wholly separate alternative “solution.”  Specifically, Dodd-Frank increased state enforcement authority.  State attorneys general, in particular, in effect have been deputized to enforce aspects of federal consumer financial protection law.  Dodd-Frank also erected an array of barriers to federal preemption, the principle by which banks that operate on a multi-state basis often are permitted to follow a single uniform federal standard rather than a hodgepodge of different and potentially inconsistent state laws.

Although federally chartered banks and thrifts will bear the worst of the new anti-preemption changes, state chartered banks also stand to lose some of the preemption efficiencies they have enjoyed.  Many preemption rules apply without regard to charter type and, even where preemption is specific to federally chartered banks, most states have some variety of “wildcard” statute offering state banks parity with their federal counterparts.

It was shortsighted to have concluded that preemption is always contrary to consumer interests and that rolling back preemption and hamstringing it in the future ensures better public policy.  Let us recall some examples from a prior financial crisis— the extraordinarily high interest rate environment of the late 1970s and early 1980s when the prime rate of interest, at its peak, skyrocketed to 21 percent.

  • Many state usury limits were set at well below market rates of interest.  Credit, particularly housing credit, was unavailable to consumers as banks were forbidden from charging rates at prevailing market levels.  The solution was federal preemption of mortgage loan interest rates.
  • In that extreme rate environment, banks and consumers alike often preferred adjustable rate mortgages.  ARMs would have reduced the bank’s risk of rate volatility, and consumers with immediate housing credit needs could have avoided locking in historically high rates for the long term.  Unfortunately, this was not possible in a number of states that mandated that loans have level payments that could not vary over the life of the loan.  The solution was federal preemption of these state rules.
  • Also during this era, consumers did not always get the rates and other mortgage loan terms they deserved based on their credit history.  Various states prohibited “due-on-sale clauses,” the contractual provisions permitting a bank to deem the entire note due and payable upon sale of the property.  Under these laws, mortgage loans became “assumable” by any purchaser of the property, including one less creditworthy than the initial borrower.  Hence, the initial borrower was forced to pay a risk premium even if he or she had no intentions of selling.  The solution, again, was federal preemption of state prohibitions on due-on-sale clauses. 

These examples demonstrate that states are not always the best source of enlightened retail banking public policy (or always nimble in making adjustments in a crisis).  These examples also show that preemption can be pro-consumer and an important tool in meeting an economic crisis.

Unfortunately, these policy lessons of the past seem to have been lost.  Retail bankers now face a double-barreled assault focused on consumer protection from the CFPB and the states.  Either one of these “solutions” to perceived regulatory failures of the past would have prompted bankers substantially to tighten their internal consumer compliance controls.  Facing both “solutions” simultaneously means that compliance must be a high priority at every level of the bank, starting at the board of directors.

Regulators to bankers: We Hear You

Federal regulators are feeling the heat from community bankers fed up with the burden of increased regulations, and two of them made efforts to appease a crowd in Nashville last week attending the Independent Community Bankers of America National Convention and Techworld. More than 3,000 people attended the convention.

gruenberg-icba.jpgThe Federal Deposit Insurance Corp.’s Acting Chairman Martin Gruenberg said he has begun a series of roundtables with small banks in each of the six FDIC districts across the country, and will review the exam and supervision process to make it better and more efficient.

“We are going to work very hard to understand community banks better,’’ he said. He added that he didn’t want to raise expectations unrealistically, but he thinks the agency can do better.

Bankers have been bristling under the weight of increased regulation following the financial crisis, including the passage of the Dodd-Frank Act in 2010 that has new rules for everything from compensation practices to the creation of a new Consumer Financial Protection Bureau that will define and forbid “abusive practices” among financial institutions.

Although many of the new regulations are supposed to apply only to large institutions, with the CFPB applying to banks and thrifts with more than $10 billion in assets, Eric Gaver, a director at $500-million asset Sturdy Savings Bank in New Jersey, said he’s skeptical.

“The general trend is [regulations meant for big banks] become a best practice for small institutions on future exams,’’ he said.

Regulatory exams have been a crucial point of frustration, as more than 800 banks and thrifts are on the FDIC’s list of “problem” institutions requiring special supervision. In response, U.S. Rep. Shelley Moore Capito (R-West Virginia), and Carolyn Maloney (D-New York) introduced last year the Financial Institutions Examination Fairness and Reform Act (H.R. 3461), which would allow bankers to appeal exam decisions to a separate ombudsman.

The ICBA is supporting the idea of a separate appeals process and ombudsman.

walsh-icba.jpgHowever, Acting Comptroller of the Currency John Walsh stood up before the ICBA crowd Tuesday and defended the existing review process in the face of the proposed legislation.

“We have long supported the notion that bankers deserve a fair and independent review,’’ he said, adding that the Office of the Comptroller of the Currency (OCC) Ombudsman Larry Hattix is independent of the supervisory process and reports directly to Walsh.

Appeals can be viewed on the OCC’s web site, which lists only five appeals since the start of 2011. Of those, the ombudsman sided with examiners in four of the five.

Walsh said that “as regulators, we don’t expect to be loved,” but that he can promise there shouldn’t be any surprises about how the OCC approaches the exam.

Walsh disputed rumors that regulators want to reduce the number of community banks and thrifts in the country.

“I can assure you the OCC is deeply committed to community banks and thrifts and the goal of our institution is to make sure your institutions remain safe and sound and able to serve your communities,’’ he said.

OCC’s Walsh: “I feel your pain”

The Dodd-Frank Act is unlikely to be repealed, although it may be tweaked, according to John Walsh, the acting comptroller of the currency, who spoke before a crowd of about 400 bankers and bank directors at the 2012 Acquire or Be Acquired conference Monday in Phoenix.

The banking industry has been pushing for a repeal of Dodd-Frank, or at least major changes.

The Office of the Comptroller of the Currency (OCC) supervises about 2,000 banks and federal savings associations, most of them community institutions with less than $2 billion in assets. 

Walsh said he didn’t see how Dodd-Frank could be repealed because some of the work of implementing it has already been done, including the merger of the Office of Thrift Supervision and the OCC.

“We just spent a year and a half joining the OTS and the OCC,’’ he said. “I’m not sure how you just send everybody back to their two buildings.”

Walsh said there may be pieces that could be changed, although that would be up to Congress.

Even though many of Dodd-Frank’s new rules apply only to banks and thrifts above $10 billion in assets, some will impact community banks as well. For example, the new Consumer financial Protection Bureau (CFPB) will have minimum standards for mortgages, new disclosure requirements, a new regime of standards and oversight for appraisers and an expansion of the Home Mortgage Disclosure Act requirements for lenders.  The bureau also must define and ban “unfair or abusive” practices.

“Each change will have a proportionately larger impact on community banks due to their small revenue base,’’ Walsh said.

He said checking accounts will be impacted as debit card fee income falls as a result of the Dodd-Frank Act. Also as a result of the law, banks of all sizes will have to evaluate the quality of securities investments they make, without relying on the rating agencies to evaluate the appropriateness of such investments. Small, community banks don’t have the resources of larger banks to do such assessments in-house.

Walsh said economic weakness and regulatory burdens are putting more pressure on bank management and told the crowd: “Believe me when I tell you that I feel your pain.”

He also acknowledged that more decisions are being made in Washington, D.C., decisions that formerly would have been made in local OCC district offices when economic times were better.

“In difficult times or in particular when difficult decisions are being made…. we do subject more of those decisions to review,” he said.

Joe Kesler, the president and chief executive officer of First Montana Bank in Missoula, Montana, who attended the conference, said he would most like to have the Consumer Financial Protection Bureau disbanded.

Even though the CFPB’s rules are supposed to apply to banks of $10 billion in assets or more, and Kesler’s bank has about $300 million, he thinks the bureau’s decisions will trickle down to banks of his size. First Montana Bank has a mortgage business, and the CFPB has begun putting together new rules for residential mortgages.

“The big uncertainty cloud is the impact of the CFPB,’’ he says. “It’s troubling we can’t plan for the future.”

Regulatory Game Changers and How to Deal with Them

Banks have been struck with an avalanche of new regulations. Derrick Cephas with the law firm of Weil, Gotshal & Manges LLP talks about how banks can approach the new regulations in a constructive manner, and how the new rules have changed the regulatory landscape.

What are the new regulations for mid-sized and smaller banks that are really the game changers, in your view?

Although most of the major provisions of Dodd-Frank have the greatest impact on the very large banks, I think that as a matter of industry practice over time, a number of the Dodd-Frank initiatives will be made applicable to smaller banks. For example, the law provides that the Consumer Financial Protection Bureau will apply to banks with assets of $10 billion or more. I can’t imagine that if the CFPB decides that a practice is abusive or against the public interest, that banks below $10 billion in assets will be allowed to continue to engage in that practice. However the CFPB ends up reshaping consumer banking practices, the result is likely to have applicability to smaller banks as well.

The abolition of the Office of Thrift Supervision will also have broad implications for the thrifts, many of which are relatively small, because they will now be regulated by the Office of the Comptroller of the Currency and the Federal Reserve Board.

One of the changes that regulators have instituted over the last few years, with no change in statute, is to have raised the required minimum capital requirements substantially. Prior to the recession, regulators would find a leverage ratio of 6 to 6.5 percent to be acceptable. Now, through the supervisory enforcement process, regulators have effectively increased the minimum acceptable leverage ratio up to 8 percent, or 9 percent in some cases. That approach now has equal applicability, no matter the size of the bank. 

How should bank officers and board members try to tackle this labyrinth of new rules?

They need to establish a tracking system to identify the regulations and statutes that apply to them and what the bank needs to do to stay in compliance. Then they should appoint a senior person internally to be in charge of regulatory compliance on a day-to-day basis, such as a chief risk officer, chief compliance officer or general counsel. That person’s department should be adequately staffed and he or she should report to a committee of the board, either the risk management committee, compliance committee or a similar committee. That committee should report to the board, maybe monthly, maybe quarterly, depending on the severity of the problems.

At what point should a bank really push back against a regulator’s suggestions and input and at what point should it be more receptive?

A bank should always maintain a constructive dialogue with its regulators. If the bank believes that the regulator is taking an inappropriate approach, it should engage the regulator substantively on that issue. If the bank’s management team thinks there’s a better approach, it should make that suggestion to the regulators. But remember that at the end of the process, the regulator decides the issue and once the issue has been fully considered, the bank will then have to follow the regulators’ guidance on the issue. The banks that get in trouble with regulators are the ones that aren’t responsive to regulatory guidance. If regulators conduct an exam and produce a list of issues to be resolved and they come back the next year for another exam and find that the same issues have not been resolved, the message the bank sends is that it doesn’t take compliance seriously and can’t be relied upon to resolve outstanding regulatory concerns. Having a poor relationship with your regulators is not a good strategy. Very few banks achieve their objectives by having an adversarial relationship with the regulators.

Do you see regulation changing the focus for banks and thrifts, and if so, is that good?

Depending upon how long it takes for the economy to stabilize and then improve, I think you’re going to see an increased emphasis on regulation for the foreseeable future.  There will be a focus on asset quality, capital adequacy, basic risk management, risk reduction and liquidity requirements. Increased regulation has significant cost implications and also has an impact on bank profitability. If the economy stabilizes and starts to improve, the demand for quality loans starts to increase and the unemployment picture improves significantly, all of that will indicate that the economy has turned the corner and we would then expect to see moderation in the regulatory climate. I don’t expect to see that change in the next two or three years or so. The increased regulation that we now have did not occur in a vacuum. It came in response to a problem.

Why We Need the CFPB

capitol.jpgFew pieces of legislation in recent years have riled up the financial services industry as thoroughly as the Dodd-Frank Act. And the white hot center of that controversial law is probably the new Consumer Financial Protection Bureau (CFPB), which the Act created to police the marketplace for personal financial services. If you’ve been reading the news lately, you know that the CFPB has a new director—former Ohio Attorney General Richard Cordray—who received a sharply-criticized recess appointment recently from President Obama. Senate Republicans had refused to hold confirmation hearings on Cordray until certain changes were made to the agency’s organizational structure, and Obama finally lost his patience and made Cordray’s appointment official while Congress was in recess.

If you have been paying attention, you also know there’s a difference of opinion between Senate Republicans like Majority Leader Mitch McConnell (R-Kentucky) and the White House over whether Congress was technically still in session, so the legality of Cordray’s appointment might be challenged in court. It’s also entirely possible—perhaps even likely—that the CFPB will be legislated out of existence should the Republican Party recapture the White House and both houses of Congress this fall. No doubt many bankers, their trade associations and the U.S. Chamber of Commerce would like to see that happen.

On the other hand, if the president wins reelection, I am sure he would veto any such bill that might emerge from a Republican controlled Congress, should the Republicans hold the House and retake the Senate this fall, which is possible but by no means assured. And if you give Obama a 50/50 chance of being reelected—which is my guess at this point having watched the Republican presidential race closely—then you can reasonably assume the CFPB has a 50/50 chance of surviving at least until January 2016.

And I think that’s a good thing.

cfpb-richard-cordray.jpgThis probably puts me at odds with most of Bank Director magazine’s readers. There’s no question that Dodd-Frank, combined with a variety of recent initiatives that have come directly from agencies like the Federal Reserve, will drive up compliance costs for banks and thrifts. And the CFPB‘s information demands alone will be a component of those higher costs. However, I have a hunch that what scares some people the most is the specter of a wild-eyed liberal bureaucrat imposing his or her consumer activist agenda on the marketplace. I don’t think Cordray quite fits that description, based on what I’ve read about him, but obviously we won’t know for sure until he’s been in the job for a while, so the naysayers’ apprehension is understandable. At the very least he seems determined to get on with the job, so we should know soon enough what kind of director he will be.

Here’s my side of the argument. Among the primary causes of the global financial crisis of 2008, which was precipitated by the collapse of the residential real estate market in the United States, were some of the truly deplorable practices that occurred during—and contributed to—the creation of a housing bubble. Chief among them were the notorious option-payment adjustable rate mortgages and similar permutations that allowed borrowers to pay less than the amortization rate that would have paid down their mortgages, which essentially allowed them to buy more house and take out a bigger mortgage than they could afford to repay. Some of these buyers were speculators who didn’t care about amortization because they planned on flipping the house in two years. But many of them were just people who wanted a nicer, more expensive house than they could afford and figured optimistically that things would work out. And the expansion of the subprime mortgage market brought millions of new home buyers into the market just when housing prices were becoming over inflated.

I’m not suggesting that the CFPB, had it been in existence during the home mortgage boom, could have single-handedly prevented the housing bubble. The causes of the bubble and the financial panic that eventually ensued were many and varied, including the interest rate policies of the Federal Reserve, the laxness on the bank regulatory agencies when it came to supervising the commercial banks and thrifts, the laxness of the Securities and Exchange Commission when it came to supervising the Wall Street investment banks and the fact that no one regulated the securitization market. But an agency like the CFPB, had it been doing its job, would have cracked down on dangerous practices like the so-called liar loans, or loans that didn’t require borrowers to verify their income. It would have put an end to phony real estate appraisals that overstated a home’s worth, making it easier for borrowers to qualify for a mortgage. And it would have been appropriately suspicious of option-ARMs if a super-low teaser rate and negative amortization were the only way that a borrower could afford to buy a home.

The CFPB is not a prudential bank regulator and will not focus on bank safety and soundness like the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. But in cracking down on some of these dangerous marketplace practices, the CFPB might have reigned in institutions like Wachovia, Washington Mutual, IndyMac and Countrywide that ultimately failed, or were forced to sell out, because it would have discouraged many of the shenanigans that helped feed the housing bubble.

Of course, many of the unsound practices that helped inflate the bubble were widespread outside the banking industry, and one of the CFPB’s principal—and I would say most important—duties will be to regulate the mortgage brokers and nonbank mortgage originators who accounted for a significant percentage of origination volume during the housing boom. Banks and thrifts should benefit greatly from this effort if it leads to the creation of a level playing field where nonbank lenders can no longer exploit the advantages of asymmetrical regulation.

A truism of our financial system is that money and institutional power will always be attracted to those sectors that have the least amount of regulation. For all intents and purposes, both the gigantic secondary market and the large network of mortgage brokers and nonbank mortgage lenders went unregulated during the boom years, and this is where the greatest abuses occurred. (Dodd-Frank also addressed the secondary market, although the jury is out whether its prescribed changes will work. Indeed, at this point it’s unclear whether the secondary market for home mortgages will ever recover.)

In hindsight, having two mortgage origination markets—one highly regulated, the other unregulated—was asking for trouble. And that’s exactly what we got.

Which is why we need the CFPB.