Regulators Revive Efforts to Pass Dormant Compensation Rules

When it comes to incentive compensation, everything old is new again.

Financial regulators are expected to revive rulemaking on a number of compensation provisions that never went into effect but were mandated by the Dodd-Frank Act of 2010.

Some of the issues that bank and securities regulators could consider in the coming quarters include measures that will gauge executive pay against their performance, as well as mandate clawback provisions and enhanced reporting around incentive compensation structures, said Todd Leone, a partner and global head of compensation at consulting firm McLagan. He was speaking during Bank Director’s 2021 Bank Compensation & Talent Conference, held Nov. 8 to Nov. 10 in Dallas.

All banks with more than $1 billion in assets would need to comply with the final version of the enhanced incentive compensation requirements. Public companies, including banks, would need to comply with any final rules around clawbacks and pay versus performance. If the topics sound familiar, Leone reminded the crowd, it was because they were debated when the banking reform bill initially passed in 2010. Regulators considered rulemaking several years later. But the move to finally pass those rules could catch banks off-guard, especially when considering that rulemaking was essentially paused under the administration of President Donald Trump. Below is Leone’s overview of the proposed rules.

Clawbacks
Clawback provisions, or a company’s ability to take back previously awarded pay or bonuses after a triggering event such as a restatement of earnings, were a hotly debated topic of the post-crisis financial reform bill more than a decade ago. They also came into focus in the bank space after news broke about the Wells Fargo & Co. fake account scandal in late 2016. In 2017, the bank’s board announced it would seek $75 million in previously awarded compensation from two of the senior executives that it held accountable for the scandal. In response, a number of banks created clawback policies of their own.

In October 2021, the U.S. Securities and Exchange Commission, under Chair Gary Gensler, reopened the comment period for the clawback provision, or Section 954 of the act. Leone pointed out that the proposed rule defines a triggering event as an accounting restatement for a material error. A company has up to three years to claw back incentive pay linked to the financial information that is restated; potentially impacted employees include current or former executive officers. Leone expected a final rule by the second half of 2022 but recommended that audience members stand pat until something is published.

“Don’t touch existing policies, since it’s in flux,” he recommended for banks that created their own policies.

Pay For Performance
Pay for performance, or Section 953(a), is a proposed disclosure requirement for public companies, including banks, that would most likely appear as a table in the proxy statement. The disclosure compares total shareholder return for a company against a company-selected peer group, along with compensation figures of a company’s top executives. The company would need to state the principal executive’s reported total compensation for the current year and past four years, along with the average reported total compensation for other named executive officers over the current year and past four years.

Like the clawback proposal, this provision was first debated by the SEC in 2015; it is in “final rule stage,” according to the agency, and Leone believed it could go into effect in the second half of 2022. The rule could create a “fair bit more work” for companies to comply with, he said. But he believed it will have a similar impact on the industry as the CEO pay ratio disclosure, which compares the pay of the CEO to that of the company’s median employee and has yet to lead to significant changes in pay for either group.

Incentive Compensation Rules
Similar to the other two proposals, the enhanced incentive compensation rule, or Section 956, has come up again. The SEC included it as a proposed rule in its agency rules list for spring 2021. Leone joked that he had used the same presentation slide on the enhanced incentive compensation rule a decade ago. The rule has been proposed by regulators twice since the passage of Dodd-Frank: It was 70 pages when it was first proposed in 2011 but had grown to 700 pages when it was re-proposed in 2016, he said.

Leone believed this rule will come up again in the spring of 2022, and that rulemaking will take some time because a number of regulators will need to collaborate on it. It would apply to all banks with more than $1 billion in assets, along with other financial institutions such as credit unions and broker dealers. The requirements would vary based on asset size, with the biggest firms facing the most stringent rules around their incentive compensation agreements. Under previous iterations of the rule, financial institutions would need to include provisions to adjust incentive compensation downward under certain circumstances, outline when deferred incentive compensation could be forfeited and build in a clawback period of seven years.

In the end, Leone recommends banks be proactive when it comes to changing compensation rules.

Expect more, not less regulation,” he said.

Banks Face a New Regulatory Environment: From Overdrafts to Fair Lending

Regulatory risk for banks is evolving as they emerge from the darkest days of the pandemic and the economy normalizes.

Banks must stay on top of regulatory updates and potential risks, even as they contend with a challenging operating environment of low loan growth and high liquidity. President Joseph Biden continues to make progress in filling in regulatory and agency heads, and financial regulators have begun unveiling their priorities and thoughts in releases and speeches.

Presenters during the first day of Bank Director’s Audit & Risk Committees Conference, held on Oct. 25 to 27 in Chicago, provided insights on crucial regulatory priorities that bank directors and executives must keep in mind. Below are three of the most pressing and controversial issues they discussed at the event.

IRS Reporting Requirement
While politicos in Washington are watching the negotiations around Biden’s proposed budget, bank trade groups have been sounding the alarm around one way to pay for some of it.

The proposal would require financial institutions to report how much money was deposited and withdrawn from a customer’s bank account over the course of the year to the IRS in order to help the agency identify individuals evading taxes or underreporting their income. Initially, the budget proposal would require reporting on total inflows and outflows greater than $600; in subsequent iterations, it was later pushed to $10,000 and would exclude wage income and payments to federal program beneficiaries. It has the support of the U.S. Department of the Treasury but has yet to make its way into any bills.

Like all aspects of the spending bill, the budget proposal is in flux and up for negotiation, said Charles Yi, a partner at the law firm Arnold & Porter, who spoke via video. Already, trade groups have mounted a defense against the proposal, urging Biden to drop it from considerations. And a critical senator needed for passage of a bill, Sen. Joe Manchin (D-W.V.), came out against the proposal; his lack of support may mean Congressional Democrats would be more apt to drop it.

But if adopted, the informational reporting requirement would impact all banks. Banks would have to report a much greater volume of data and contend with potential data security concerns.

“Essentially, you’re turning on a data feed from your bank to the government for these funds and flows,” said Arnold & Porter Partner Michael Mancusi, who also spoke via video.

Overdrafts Under Pressure
Consumer advocates have long criticized overdraft fees, and regulators have brought enforcement actions against banks connected to the marketing or charging of these fees. Most recently, the Consumer Financial Protection Bureau settled with TD Bank, the domestic unit of Canada-based Toronto-Dominion Bank, for $122 million over illegal overdrafts in 2020. And in May, Bank of America’s bank unit settled a class lawsuit brought by customers that had accused it of charging multiple insufficient fund fees on a single transaction for $75 million.

Pressure to lower or eliminate these fees and other account fees is coming not just from regulators but from big banks, as well as fintech and neobank competitors, said David Konrad, managing director and an equity analyst at the investment bank Keefe, Bruyette & Woods. Banks have rolled out features like early direct deposit that can help consumers avoid overdrafts or have started overdraft-free accounts. These institutions have been able to move away from overdraft fees because of technology investments in the retail channel and mobile apps that give consumers greater control.

But insufficient funds fees may be a significant contributor of noninterest income at community banks without diverse business lines, and they may be reticent to give it up. Those banks may still want to consider ways they can make it easier for consumers to avoid the fee — or choose when to incur it — through modifications of their app.

Fair Lending Scrutiny Continues
Many regulatory priorities reflect the administration in the White House and their agency picks. But Rob Azarow, head of the financial services transactions practice at Arnold & Porter, said that regulators have heightened interest in fair lending laws — and some have committed to using powerful tools to impact banks.

Regulators and government agencies, including the Consumer Financial Protection Bureau and the U.S. Department of Housing and Urban Development, have stated that they will restore disparate impact analysis in their considerations when bringing potential enforcement actions. Disparate impact analysis is a legal approach by which institutions engaged in lending can be held liable for practices that have an adverse impact on members of a particular racial, religious or other statutorily protected class, regardless of intent.

Azarow says this approach to ascertain whether a company’s actions are discriminatory wasn’t established in regulation, but instead crafted and adopted by regulators. The result for banks is “regulation by enforcement action,” he said.

Directors should be responsive to this shift in enforcement and encourage their banks to conduct their own analysis before an examiner does. Azarow recommends directors ask their management teams to analyze their deposit and lending footprints, especially in zip codes where ethnic or racial minorities make up a majority of residents. These questions include:

  • What assessments of our banking activities are we doing?
  • How do we evaluate ourselves?
  • How are we reaching out and serving minority and low-to-moderate income communities?
  • What are our peers doing?
  • What is the impact of our branch strategy on these communities?

Cryptocurrency: The Risk Banks Already Have

The cryptocurrency market continues to evolve: New companies launching coins, wallets, exchanges and applications seemingly emerge every day, and crypto founders were named to Time Magazine’s Most Influential List.

The total market capitalization of cryptocurrency eclipsed $2 trillion on April 5, 2021, and sat at $2.44 trillion as of Sept. 15, 2021. El Salvador became the first country in the world to make Bitcoin legal tender, with President Nayib Bukele saying, “Bitcoin would be an effective way to transfer the billions of dollars in remittances that Salvadorans living outside the country send back to their homeland each year.”

More importantly, financial regulators have taken notice. Make no mistake, regulation oversight is coming. Kenneth Blanco, director of the Financial Crimes Enforcement Network, said, “Banks must be thinking about their crypto exposure. If banks are not thinking about these issues, it will be apparent when examiners visit. In January, the Office of the Comptroller of the Currency published a letter clarifying the authority to participate in independent node verification networks (INVN) and use stablecoins to conduct payment activities and other permitted banking activities for national banks and federal savings associations, along with the instructions that in participating in this capacity, “a bank must comply with applicable law and safe, sound, and fair banking practices.”

Gary Gensler, the U.S. Securities and Exchange Commission chairman, is intimately knowledgeable of cryptocurrency, having taught a course called Blockchain and Money at the Massachusetts Institute of Technology. Sen. Elizabeth Warren (D-Mass.) has pressed Treasury Secretary Janet Yellen to use her position as the chair of the Financial Stability Oversight Council to “ensure the safety and stability of consumers and our financial system.”

A number of large, leading banks are evolving their crypto programs, testing their crypto infrastructure and readying their organizations for participation in the crypto marketplace, whether as a custodian, exchange, coin issuer, broker, payment processor or participant. Other banks are in the queue to be fast followers and/or limited participants. They want to see how the market develops and how regulators react to the initial wave of participation. Yet, other institutions look at cryptocurrency participation as either a long-term initiative, or an activity that does not fit their risk profile.

The fact of the matter is, likely every bank has exposure to cryptocurrency in some capacity. Approximately 13% of Americans bought or traded cryptocurrency in the past 12 months, and approximately 46 million Americans (17% of the adult population) own at least a share of Bitcoin. That means that about one in eight Americans actively participates in the crypto marketplace. Unless your bank has less than eight customers, the law of averages dictates that your institution has exposure and one or more of your customers has sent or received money to or from entities within the cryptocurrency marketplace.

The good news is there are tools to help banks identify current exposure, track payments and facilitate compliance monitoring and reporting needs. As with any tool, the effectiveness of those tools comes down to features and performance. Some tools use name matching to identify that participation. However, the ownership structure of many of these emerging companies use innocuous-sounding corporate holding company names for payment processing to their crypto companies, which can make these tools less effective — complicating the current struggle of evaluating false positives by name checking alone. There are also tools and services which can do advanced due diligence on virtual asset service providers and help identify crypto money service businesses and previously unidentified crypto payments. Once an institution can assess current state exposure, it can develop an action plan.

Acknowledging that willingly or otherwise, most financial institutions have been brought into the crypto ecosystem and should be developing a plan of action now. The first step is to identify and assess an institution’s current state of exposure to cryptocurrency. Next, it should develop a strategy defining the institution’s planned participation in this space. Key considerations include: how transactions outside the organization’s risk tolerance will be handled and how the governance, risk and compliance (GRC) programs of the organization need to be updated to reflect the current and future state of doing business.

As the crypto ecosystem and regulations continue to evolve, savvy institutions will ensure they understand their current exposure in the market and work toward a target future-state GRC program that addresses the risks to which the organization is exposed.

Smart Ways to Find Loan Growth

In a long career focused on credit risk, I’ve never found myself saying that the industry’s biggest lending challenge is finding loans to make.

But no one can ignore the lackluster and even declining demand for new loans pervading most of the industry, a phenomenon recently confirmed by the QwickAnalytics® National Performance Report, a quarterly report of performance metrics and trends based on the QwickAnalytics Community Bank Index.

For its second quarter 2021 report, QwickAnalytics computed call report data from commercial banks $10 billion in assets and below. The analysis put the banks’ average 12-month loan growth at negative -0.43 basis points nationally, with many states showing declines of more than 100 basis points. If not reversed soon, this situation will bring more troubling implications to already thin net interest margins and stressed growth strategies.

The question is: How will banks put their pandemic-induced liquidity to work in the typical, most optimal way — which, of course, is making loans?

Before we look for solutions, let’s take an inventory of some unique and numerous challenges to what we typically regard as opportunities for loan growth.

  • Due to the massive government largess and 2020’s regulatory relief, the coronavirus pandemic has given the industry a complacent sense of comfort regarding credit quality. Most bankers agree with regulators that there is pervasive uncertainty surrounding the pandemic’s ultimate effects on credit. Covid-19’s impact on the economy is not over yet.
  • We may be experiencing the greatest economic churn since the advent of the internet itself. The pandemic heavily exacerbated issues including the e-commerce effect, the office space paradigm, struggles of nonprofits (already punished by the tax code’s charitable-giving disincentives), plus the setbacks of every company in the in-person services and the hospitality sectors. As Riverside, California-based The Bank of Hemet CEO Kevin Farrenkopf asks his lenders, “Is it Amazonable?” If so, that’s a market hurdle bankers now must consider.
  • The commercial banking industry is approaching the tipping point where most of the U.S. economy’s credit needs are being met by nonbank lenders or other, much-less regulated entites, offering attractive alternative financing.

So how do banks grow their portfolios in this environment without taking on inordinate risk?

  • Let go of any reluctance to embrace government-guaranteed lending programs from agencies including the Small Business Administration or Farmers Home Administration. While lenders must adhere to their respective protocols, these programs ensure loan growth and fee generation. But perhaps most appealing? When properly documented and serviced, the guaranties offer credit mitigants to loan prospects who, because of Covid-19, are at approval levels below banks’ traditional standards.
  • Given ever-present perils of concentrations, choose a lending niche where your bank has both a firm grasp of the market and the talent and reserves required to manage the risks. Some banks develop these capabilities in disparate industries, ranging from hospitality venues to veterinarian practices. One of the growing challenges for community banks is the impulse to be all things to all prospective borrowers. Know your own bank’s strengths — and weaknesses.
  • Actively pursue purchased loan participations through resources such as correspondent bank networks for bankers, state trade groups and trusted peers.
  • Look for prospects that previously have been less traditional, such as creditworthy providers of services or products that cannot be obtained online.
  • Remember that as society and technology change, new products and services will emerge. Banks must embrace new lending opportunities that accompany these developments, even if they may have been perceived as rooted in alternative lifestyles.
  • In robust growth markets, shed the reluctance to provide — selectively and sanely — some construction lending to help right the out-of-balance supply and demand currently affecting 1 to 4 family housing. No one suggests repeating the excesses of a decade ago. However, limited supply and avoidance of any speculative lending in this segment have created a huge value inflation that is excluding bankers from legitimate lending opportunities at a time when these would be welcomed.

Bankers must remember the lesson from the last banking crisis: Chasing growth using loans made during a competitive environment of lower credit standards always leads to eventual problems when economic stress increases. This is the “lesson on vintages” truism. A July 2019 study from the Federal Deposit Insurance Corp. on failed banks during the Great Recession revealed that loans made under these circumstances were critical contributors to insolvency. Whatever strategies the industry uses to reverse declining loan demand must be matched by vigilant risk management techniques, utilizing the best technology to highlight early warnings within the new subsets of the loan portfolio, a more effective syncing of portfolio analytics, stress testing and even loan review.

CRA Modernization Goes Back to the Drawing Board

Bankers value certainty and consistency when it comes to regulation, but the Community Reinvestment Act currently offers neither.

In May 2020, the Office of the Comptroller of the Currency issued a controversial revision of the decades-old law. The rewrite stirred up a hornet’s nest of controversy not just because of the changes themselves — some of which were long overdue and well received — but because the agency acted on its own after it was unable to reach an agreement with the Federal Reserve and the Federal Deposit Insurance Corp. The OCC’s decision was also significant because national banks account for approximately 70% of all CRA activity, according to the agency.

“I think not having all the regulators on the same page creates a lot of confusion in the industry,” says Michael Marshall, director of regulatory and legal affairs at the Independent Community Bankers of America.

The CRA, which was enacted in 1977 and applies to all federally insured banks and thrifts, was intended to require financial institutions to help meet the credit needs of the communities where they also raised their deposits. However, under the banking industry’s trifurcated federal regulatory system, compliance is monitored by three different agencies – the OCC for national banks, the Fed for state-chartered banks that are members of the Federal Reserve System, and the FDIC for state-chartered, nonmember banks.

Normally, the feds want one rule that applies to all banks regardless of their regulator. The FDIC initially joined the OCC in the CRA overhaul, but FDIC Chair Jelena McWilliams announced in May 2020 that the agency was not ready to finalize the revisions, intimating that she felt banks were too busy dealing with the impact of the pandemic on their borrowers to implement the new rule. The Fed, for its part, had already bowed out of a joint rulemaking process over a disagreement with the approach taken by the other two agencies. In September 2020, the Fed announced its own Advance Notice of Proposed Rulemaking (ANPR) to modernize the CRA and invited public comment on how to accomplish that.

The OCC’s decision to go it alone means there are now two CRA laws in effect — the agency’s revision rule for banks with a national charter and the previous rule for everyone else. Unfortunately, the confusion surrounding the CRA doesn’t end there.

The OCC’s revision was promulgated under former Comptroller of the Currency Joseph Otting, who was appointed by former President Donald Trump. Otting unexpectedly resigned as comptroller shortly after the agency’s CRA rule changes went into effect in May of last year, even though he was only halfway through his five-year term. The agency is now being run by Acting Comptroller Michael Hsu, a former Fed official who was appointed by the Biden Administration.

In July, the OCC announced that it would rescind the CRA revision developed under Otting — even though some parts of the new framework are already in effect, and national banks had already begun to comply with them. In the OCC’s announcement, Hsu said the “disproportionate impacts of the pandemic on low and moderate income communities,” along with comments that had already been provided to the Federal Reserve under its ANPR process and the OCC’s own experience implementing the 2020 revision, convinced him of the need to start over.

While the OCC deserves credit for taking action to modernize the CRA through adoption of the 2020 rule, upon review I believe it was a false start,” Hsu said in a statement. “This is why we will propose rescinding it and facilitating an orderly transition to a new rule.” Hsu also indicated the OCC would work closely with the Fed and FDIC in a joint rulemaking process, which would in effect piggyback off the Fed’s separate rulemaking process that began last September.

One of the biggest complaints about the CRA is that it was written in an era when deposit-gathering activities were almost exclusively branch-based. The industry’s digital transformation in recent years enables institutions — including large banks with national or multi-regional footprints as well as newer, digital-only banks — to raise deposits from anywhere in the country.

“When we thought of banks [in 1977], we thought of big buildings and pillars,” says John Geiringer, a partner and the regulatory section leader in the financial institutions group at Barack Ferrazzano Kirschbaum & Nagelberg. “Now, between our phones and smart watches, each of us is effectively a walking bank branch.”

Geiringer says the regulators are well aware that digital transformation puts traditional, branch-based banks at a disadvantage when it comes to CRA compliance. “I think there is the recognition in the regulatory community that to the extent that fintechs are encroaching upon the business of banking, they should be held to comparable standards,” he says. “There should be one level playing field.”

There was also a degree of ambiguity in the original law about what kinds of activities qualified for CRA consideration, and there could be variations between different examiners and agencies. One welcomed aspect of the OCC’s revised rule is a non-exhaustive, illustrative list of example activities that would qualify for credit. “Before, you had to call somebody,” says Geiringer, who referred to this as “the secret law of CRA.” With its revision, the OCC under Otting tried to provide more clarity around the issue of qualifying activities.

The OCC rule also imposed new data collection requirements that the ICBA’s Marshall says are of concern to smaller banks. But overall, the OCC’s CRA rewrite seemed to be an honest attempt to modernize a law that badly needed it.

So, what happens now?

I think the interagency process is going to continue moving forward, but in a slightly different direction in light of the fact that we now have the Biden Administration in power,” Geiringer says. “We have seen issuances from both the Biden Administration and others calling for more of an inclination toward the unbanked and the underbanked, and similarly … low- and moderate-income areas.”

A permanent comptroller, once one has been installed at the OCC, could pursue a progressive agenda that goes beyond just modernization. Another scenario that could potential impact any CRA reform initiative is the fate of Fed Chair Jerome Powell, whose term ends in February 2022. Powell is a middle-of-the-road Republican who might be expected to have a moderating influence on CRA reform. Should Powell be replaced by a Democrat who leans more to the left on economic policy matters, that could steer CRA reform in a more progressive direction.

Equally unclear is how long a joint rulemaking process — if indeed the three federal agencies commit to that — will take. A unified revision probably won’t be issued until 2022 at the earliest. In the meantime, the industry is left with no clear sense of what that new rule might look like.

Why Regulation Should be Part of Cryptocurrencies’ Future

Despite a recent embrace by the capital markets and financial corporations, digital assets and cryptocurrencies are still not at the point of widespread, global adoption. To get there, lawmakers and financial agencies should implement rules and regulations to protect consumers and enable the space to develop further as an alternative financial system.

The evolution of digital assets like cryptocurrencies has a phenomenal potential to change the financial industry. However, it also creates challenges. Digital assets are decentralized and do not rely on either governmental authorities or financial institutions to create, transmit or determine the value of a cryptocurrency. Supply is determined by a computer code; prices can be extremely volatile. Over the past decade we have witnessed digital asset exchanges being closed down due to fraud, failure or security breaches.

Within the United States, there is no uniformity in the regulatory framework with respect to how businesses that deal in digital assets should conduct themselves. New York is one of the few states that has a functional regulatory regime through the New York State Department of Financial Services. Meeting compliance in New York has become a badge of legitimacy. However, there are also a significant number of companies that have chosen not to operate in New York due to these regulations. On the other hand, Wyoming has adopted a lighter regulatory framework and is widely considered the most crypto-friendly jurisdiction in the United States.

Congressional Developments
In April, the U.S. House of Representatives passed “The Eliminate Barriers to Innovation Act,” a bill that directs the Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission to establish a digital asset working group and open new regulatory frameworks for both digital assets and cryptocurrencies.

The bipartisan bill would initiate the commission of a specialized working group that would evaluate regulation of digital assets in the U.S. The joint working group would include the SEC and CFTC, in collaboration with financial technology firms, financial firms, academic institutions, small and medium businesses that leverage financial technology and investor protection groups, as well as business or non-profit entities that are working to support historically underserved businesses. The working group would draft recommendations to improve the current regulatory landscape in the U.S., which will then be extended internationally where possible. The working group will be given a year to evaluate and provide technical documentation on how these recommendations should be implemented through compliance frameworks.

Regulation Ensures Market Stability
While some people believe that cryptocurrencies should operate completely independently from any form of regulation, publicly accountable businesses are vigorously regulated in order to protect consumers and economic stability. Independent audits are similarly required to protect the interests of all stakeholders, ensure that the applicable laws and regulations are adhered to and that the financial statements are free from material misstatement, as well as fraud (to a certain extent).

Regulators around the world regularly warn crypto asset investors to be extremely cautious and vigilant, partially due to a lack of regulation, which creates an opportunity for fraudsters to prey on uninformed investors. Fraud and error can usually be mitigated by prevention, detection, and recourse. Introducing regulations to govern the cryptocurrency industry will mean preventative measures are in place to ensure fraud doesn’t occur and that there is appropriate legal recourse for victims. There is also a significant role for auditors in detecting possible instances of fraud or error, as well as assisting with the recourse process.

Digital Asset Outlook
Mazars will be keeping a close watch on the progress of the innovation bill. We believe positive regulatory changes are ahead. Gary Gensler, the recently confirmed head of the SEC, has a keen knowledge of, and appreciation for, the applicability of digital assets in the global financial services ecosystem. Gensler is the former head of the CFTC, as well as a professor at the MIT Sloan School of Management where he researched and taught blockchain technology, digital currencies and financial technology.

In a recent interview with CNBC, Chair Gensler said there needed to be authority for a regulator to oversee the crypto exchanges, similar to the equity and futures markets. He said many crypto coins were trading like assets and should fall under the purview of the SEC.

We welcome this level of engagement and improved regulation, which will be good for the industry, investors, consumers and society at large. Without regulation, cryptocurrencies are unlikely to become a standard part of investment portfolios due to the current high level of risk.

The information provided here is for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

Navigating Four Common Post-Signing Requests for Additional Information

Consolidation in the banking industry is heating up. Regulatory compliance costs, declining economies of scale, tiny net interest margins, shareholder liquidity demands, concerns about possible changes in tax laws and succession planning continue driving acquisitions for strategic growth.

Unlike many industries, where the signing and closing of an acquisition agreement may be nearly simultaneous, the execution of a definitive acquisition agreement in the bank space is really just the beginning of the acquisition process. Once the definitive agreement is executed, the parties begin compiling the information necessary to complete the regulatory applications that must be submitted to the appropriate state and federal bank regulatory agencies. Upon receipt and a quick review of a filed application, the agencies send an acknowledgement letter and likely a request for additional information. The comprehensive review begins under the relevant statutory factors and criteria found in the Bank Merger Act, Bank Holding Company Act or other relevant statutes or regulations. Formal review generally takes 30 to 60 days after an application is “complete.”

The process specifically considers, among other things: (1) competitive factors; (2) the financial and managerial resources and future prospects of the company or companies and the banks concerned; (3) the supervisory records of the financial institutions involved; (4) the convenience and needs of the communities to be served and the banks’ Community Reinvestment Act (CRA) records; (5) the effectiveness of the banks in combating money laundering activities; and (6) the extent to which a proposal would result in greater or more concentrated risks to the stability of the United States banking or financial system.

During this process, the applicant and regulator will exchange questions, answers, and clarifications back and forth in order to satisfy the applicable statutory factors or decision criteria towards final approval of the transaction. Each of the requests for additional information and clarifications are focused on making sure that the application record is complete. Just because information or documents are shared during the course of the supervisory process does not mean that the same information or documents will not be requested during the application process. The discussions and review of materials during the supervisory process is separate from the “application record,” so it helps bank management teams to be prepared to reproduce information already shared with the supervisory teams. A best practice for banks is to document what happens during the supervisory process so they have it handy in case something specific is re-requested as part of an application.

Recently, we consistently received a number of requests for additional information that include questions not otherwise included in the standard application forms. Below, we review four of the more common requests.

1. Impact of the Covid-19 Pandemic. Regulators are requesting additional information focused on the impact of the coronavirus pandemic. Both state and federal regulators are requesting a statement on the impact of the Covid-19 pandemic that discusses the impact on capital, asset quality, earnings, liquidity and the local economy. State and federal agencies are including a request to discuss trends in delinquency loan modifications and problem loans when reviewing the impact on asset quality, and an estimate for the volume of temporary surge deposits when reviewing the impact on liquidity.

2. Additional, Specific Financial Information. Beyond the traditional pro forma balance sheets and income statements that banks are accustomed to providing as part of the application process, we are receiving rather extensive requests for additional financial information and clarifications. Two specific requests are particular noteworthy. First, a request for financial information around potential stress scenarios, which we are receiving for acquirors and transactions of all sizes.

Second, and almost as a bolt-on to the stress scenario discussion, are the requests related to capital planning. These questions focus on the acquiror’s plan where financial targets are not met or the need to raise capital arises due to a stressed environment. While not actually asking for a capital plan, the agencies have not been disappointed to receive one in response to this line of inquiry.

3. List of Shareholders. Regardless of whether the banks indicate potential changes in the ownership structure of an acquiror or whether the consideration is entirely cash from the acquiror, agencies (most commonly the Federal Reserve), are requesting a pro forma shareholder listing for the acquiror. Specifically, this shareholder listing should break out those shareholders acting in concert that will own, control, or hold with power to vote 5% or more of an acquiring BHC. Consider this an opportunity for both the acquiror and the Federal Reserve to make sure control filings related to the acquiror are up to date.

4. Integration. Finally, requests for additional information from acquirors have consistently included a request for a discussion on integration of the target, beyond the traditional due diligence line of inquiry included in the application form. The questions focus on how the acquiror will effectively oversee the integration of the target, given the increase in assets size. Acquirors are expected to include a discussion of plan’s to bolster key risk management functions, internal controls, and policies and procedures. Again, we are receiving this request regardless of the size of the acquiror, target or transaction, even in cases where the target is less than 10% of the size of the acquiror.

These are four of the more common requests for additional information that we have encountered as deal activity heats up. As consolidation advances and more banks file applications, staff at the state and federal agencies may take longer to review and respond to applications matters. We see these common requests above as an opportunity to provide more material in the initial phase of the application process, in order to shorten the review timeframe and back and forth as much as possible. In any event, acquirors should be prepared to respond to these requests as part of navigating the regulatory process post-signing.

ESG Principles at Work in Diversifying Governance

Before environmental, social, and governance (ESG) matters became commercially and culturally significant, the lack of diversity and inclusion within governance structures was noted by stakeholders but not scrutinized.

The shifting tides now means that organizations lacking diversity in their corporate leadership could be potentially subjected to shareholder lawsuits, increased regulation and directives by state laws, investment bank requirements, and potential industry edicts.

Board and management diversity is undoubtedly a high-priority issue in the banking and financial services sectors. Numerous reports establish minority groups have historically been denied access to capital, which is mirrored by the lack of minority representation on the boards of financial institutions.

Some progress has been made. For example, for the first time in its 107-year history, white men held fewer than half of the board seats at the Federal Reserve’s 12 regional outposts. This was part of an intentional effort, as Fed leaders believe a more representative body of leaders will better understand economic conditions and make better policy decisions. However, further analysis reflects such diversity predominantly among the two-thirds of directors who are not bankers, while the experienced banking directors are mainly white males.

Board Diversity Lawsuits
The current pending shareholder suits have been primarily filed by the same group of firms and targeted many companies listed by a recent Newsweek article as not having a Black director. None of these suits involve financial institutions, but it is not hard to foresee such cases coming in the future. The lawsuits generally assert that the defendants breached their fiduciary duties and made false or misleading public statements regarding a company’s commitment to diversity. The Courts have summarily dismissed at least two suits, but a legal victory may not even be the goal in some cases.

Recently, Google’s parent settled its #MeToo derivative litigation and agreed to create a $310 million diversity, equity, and inclusion fund to support global diversity and inclusion initiatives within Google over the next ten years. The fund will also support various ESG programs outside Google focused on the digital and technology industries.

Regulatory, Industry, and Shareholder Efforts
Federal and state regulatory efforts preceded these recent lawsuits. The U.S. Securities and Exchange Commission has issued compliance interpretations advising companies on the disclosure of diversity characteristics upon which they rely when nominating board members and is expected to push more disclosure in the future. Additionally, the U.S. House of Representatives considered a bill in November 2019 requiring issuers of securities to disclose the racial, ethnic, and gender composition of their boards of directors and executive officers and any plans to promote such diversity.

These efforts will likely filter into boardrooms and may spur additional board regulation at the state level. In 2019, California became the first state to require headquartered public companies to have a minimum number of female directors or face sanctions, increasing 2021. In June 2020, New York began requiring companies to report how many of their directors are women. As other states follow California’s lead regarding board composition, we can expect more claims to be filed across the country.

At the industry level, the Nasdaq stock exchange filed a proposal with the SEC to adopt regulations that would require most listed companies to elect at least one woman director and one director from an underrepresented minority or who identify as LGBTQ+. If adopted, the tiered requirements would force non-compliant companies to disclose such failures in the company’s annual meeting proxy statement or on its website.

In the private sector, institutional investors, such as BlackRock and Vanguard Group, have encouraged companies to pursue ESG goals and disclose their boards’ racial diversity, using proxy votes to advance such efforts. Separately, Institutional Shareholder Services and some non-profit organizations have either encouraged companies to disclose their diversity efforts or signed challenges and pledges to increase the diversity on their boards. Goldman Sachs Group has made clear it will only assist companies to go public if they have at least one diverse board member.

Concrete Plans Can Decrease Director Risk
Successful institutions know their diversity commitment cannot be rhetorical and is measured by the number of their diverse board and management leaders. As pending lawsuits and legislation leverage diversity statements to form the basis of liability or regulatory culpability, financial institutions should ensure that their actions fully support their diversity proclamations. Among other things, boards should:

  • Take the lead from public and private efforts and review and, if necessary, reform board composition to open or create seats for diverse directors.
  • When recruiting new board members, identify and prioritize salient diversity characteristics; if necessary, utilize a diversity-focused search consultant to ensure a diverse pool of candidates.
  • Develop a quantifiable plan for diversity issues by reviewing and augmenting governance guidelines, board committee efforts, and executive compensation criteria.
  • Create and promote diversity and inclusion goals and incorporate training at the board and management levels.
  • Require quarterly board reporting on diversity and inclusion programs to reveal trends and progress towards stated goals.

As companies express their commitment to the board and C-level diversity and other ESG efforts, they should create and follow concrete plans with defined goals and meticulously measure their progress.

Why a Solid Risk Management Framework Helps Manage Change

Who owns risk management at your bank?

If your bank limits that function to the teams that report to the chief risk officer, it’s fumbling on two fronts: It’s failing to drive accountability across every corner of the enterprise, and it’s conceding its edge in a marketplace that’s never been more competitive.

Recognizing that every employee owns a piece of this responsibility make risk management an equal offensive and defensive pose for your organization. This empowers your employees to move nimbly, strategically and decisively when the bank encounters change, whether it’s an external regulatory pressure or an internal opportunity to launch a new product or service. In either case, your team navigates through change by building on best operational practices, which, in the end, work to your advantage.

Getting the bank into that position doesn’t happen overnight; the vision starts with the actions of your senior leaders. They set the tone and establish expectations, but everyone plays a hands-on role. When management prioritizes an environment where people can work collaboratively and have transparency into related roles, they foster consistency across your change management process that minimizes risk.

The need for a risk-aware culture aligns precisely with the signals coming out of Washington, D.C., that the stakes are getting higher. The Consumer Financial Protection Bureau hinted early at increased regulatory scrutiny, advising that it would tighten the regulatory standards it had relaxed to allow banks to quickly respond to customers’ financial hardship in 2020.

In response to the competitive and regulatory environment, your bank’s risk management framework should incorporate four key elements:

  • Start with setting the ground rules for how the bank will govern its risk. Define its risk strategy, the role the board and management will play and the committees that compose that governance structure — and don’t forget to detail their decision-making authority, approval and escalation process across those bodies. This upfront work also should introduce robust systems for ongoing monitoring and risk reporting, establish standard parameters on how the bank identifies issues and create a basic roadmap to remediate issues when they come along.
  • Operating Model. Distinguish the roles and responsibilities for every associate, with a key focus on how they manage risk generated by the core activities in that business. By taking the time to ensure all individuals, in every line of defense, understand their expected contributions, your bank will be ahead of the game because your people can act quicker and efficiently when a change needs to happen.
  • Standard Framework, Definitions and Taxonomies. In basic terms, everyone across the enterprise needs to speak the same language and assign risk ratings the same way. Calibrating these elements at the onset builds confidence that your bank gives thoughtful attention to categorize risks into the right buckets. Standardization should include assessment scales and definitions of different risks and risk events, leading to easier risk aggregation and risk reporting that enables a holistic view of risk across the enterprise.
  • Risk Appetite. Nothing is more important than establishing how much risk your organization is willing to take on in its daily business. Missing the mark can impact your customers, bottom line and reputation. Optimally, bank leaders will reestablish this risk appetite annually, but black swan events such as the pandemic should prompt more timely reviews.

Too often, banks reinvent the wheel every time a change or demand comes along. As the industry eyes increasing regulatory pressure in the year ahead, driving and promoting a robust risk management culture is no longer a “nice to have” within your organization; it’s a “need to have.”

When you reset the role and ownership of risk management as a strategic pillar in your bank’s future growth and direction you minimize your bank’s risk and actually propel your company forward.

Banks looking to check out best practices and a strategic framework for creating their enterprise risk framework should check out my latest whitepaper, Turning a Solid Risk Framework Into a Competitive Advantage.

Deal Integration Can Transform Finance, Risk and Regulatory Reporting

A number of banks announced mergers and acquisitions in 2020, capitalizing on growth opportunities against a forbidding backdrop of chronically low interest rates and anemic economic growth during the Covid-19 pandemic.

The deals ranged from more moderately sized with a few headline-grabbing mega-mergers —a trend that expected to continue through 2021.

The appeal of M&A for regional and superregional institutions in the United States is that the right transaction could create big benefits from economies of scale, and enhance the proforma company’s ability to gain business. While the number of deals announced in this environment are modest, the stakes involved in contemplating and executing them certainly are not. Nor is the work that banks will face after a combination. Once the transaction has been completed, the hard work begins.

A Closer Look From Regulators
One potential outcome is added scrutiny from the authorities; a new merged entity, with more assets and a broader range of activities, could have more complex risk calculations and reporting obligations to deal with.

Overall, regulators have sharpened their focus on banks during and after the merger process by performing additional audits, more closely scrutinizing key figures and ensuring that the M&A plan is being adhered to. Even if there are no significant changes to a firm’s profile with regulators, or if any needed changes in risk and reporting obligations are manageable, the formidable task of combining the operations of two organizations remains. A single, seamless whole must be assembled from two sets of activities, two work forces with their own culture and two sets of technological assets.

Merging the Parts, Not Just the Wholes
None of these issues is distinct from the others. Consider the technology: The proforma company will have to contend with two data systems — at least. Each company’s data management architecture has staff that makes it run using its own modus operandi developed
over years.

And that is the best-case scenario. Joining so many moving parts is no small feat, but it provides no small opportunity. Deal integration forces the constituent institutions to reassess legacy systems; when handled correctly, it can assemble a comprehensive, fully integrated whole from existing and new tech to meet the combined entity’s compliance and commercial needs.

Creating the ideal unified finance, risk and reporting system starts with an honest evaluation of the multiple systems of the merging partners. Executives should take particular care to assess whether the equipment and processes of the merged entity are better than the acquirer’s, or have certain features that should be incorporated.

Management also should consider the possibility that both sets of legacy systems are not up to present or future challenges. It could be that the corporate combination provides an opportunity to start over, or nearly so, and build something more suitable from the ground up. Another factor they should consider is whether the asset size of the new unified business warrants an independent verification process to supplement the risk and regulatory reporting program.

Understanding What You Have and What You Need
To get the evaluation process under way for the operational merger, a bank should list and assess its critical systems — not just for their functionality, but with respect to licensing or other contractual obligations with suppliers to determine the costs of breaking agreements.

Managers at the combined entity should look for redundancies in the partners’ systems that can be eliminated. A single organization can have a complicated back-end systems architecture, with intricate workarounds and many manual processes. Bringing together multiple organizations of similar complexity can leave the combined entity with expensive and inflexible infrastructure. A subledger and controlling functions can simplify this for finance, risk and regulatory reporting functions. They can consolidate multiple charts of accounts and general ledgers, relieving pressure on the general ledgers. Organizations in some cases can choose to migrate general ledgers to a cloud environment while retaining detailed data in a fat subledger.

Whatever choices executives make, a finance, risk and reporting system should have the latest technology, preferably based in the cloud to ensure it will be adaptable, flexible and scalable. Systems integration is critical to creating a unified financial institution that operates with optimal productivity in its regulatory compliance, reporting efforts and general business.
Integrating systems helps to assure standardization of processes and the accuracy, consistency,
agility and overall ease of use that result from it.