What Facebook’s Data Debacle Could Mean for Banking


regulation-5-2-18.pngThere was a particular moment on the second day of his most recent testimony Facebook CEO Mark Zuckerberg struck a rare smile.

Zuckerberg, on Capitol Hill to answer pointed questions about the scraping of company’s data on 87 million of its users by U.K.-based Cambridge Analytica—was asked if Facebook was a financial institution.

The odd inquiry came during a string of questions from Rep. Greg Walden, the Oregon Republican who chairs the House Energy and Commerce Committee that grilled Zuckerberg about the massive company’s complex web of operations, which includes a mechanism for users to make payments to each other using popular apps familiar to bankers like PayPal and Venmo, as well as debit cards.

Facebook is not a financial institution in the traditional sense, of course, but it does have a clear position in the financial services space, even if just by its role in providing a platform for various payment options. It has not disclosed how much has been transferred between its 2 billion users, and it certainly has raised questions about how tech companies—especially those with a much narrower focus on financial technology, or fintech—collect, aggregate, use and share data of its platform’s users.

This relationship could soon change as Washington lawmakers discuss possible legislation that would place a regulatory framework around how data is collected. Virtually any industry today is dependent on customer data to market itself and personalize the customer experience, which is predominantly on mobile devices, with fewer personal interactions.

“I think it’s likely something is going to happen here, because we’ve kind of been behind the curve as it relates to [regulation], especially Western Europe,” says David Wallace, global financial services marketing manager at SAS, a global consulting and analytics firm.

While banks are somewhat like doctors and hospitals in the level of trust that consumers historically have had with them, that confidence is finite, Wallace says.

Survey data from SAS released in March shows consumers want their banks to use data to protect them from fraud and identity theft, but they aren’t crazy about getting sales pitches.

At the same time, payments services like Paypal’s Venmo and Zelle, a competing service that was developed by a consortium of banks, also collect data, but have a lower “score” with consumers in trust, according to Wallace.

Where’s the Rub?
The question from Walden barely registered on the national news radar, but it also highlights new areas of concern as banks begin to adopt emerging technologies like artificial intelligence, and market new products that are often driven by the same kind of data that Facebook collects.

The recent SAS survey also asked respondents about their interactions with banks, and how AI might influence those. Most of the survey respondents say they are generally comfortable with their bank collecting their personal data, but primarily in the context of fraud and identity theft protections. Sixty-nine percent of the respondents say they don’t want banks looking into their credit history to pitch products like credit cards and home mortgages.

As the Cambridge Analytica situation demonstrates, there is a fine balance that must be observed giving all companies the opportunity and space to succeed in an increasingly digital environment while protecting consumers from the misuse of their personal data.

Congress tends to be a hammer that treats every problem like a nail—so don’t be surprised if the use of customer data is eventually regulated. Thus far, the only regulatory framework in existence that’s been suggested as a model of what might be established in the U.S. is the GDPR, or General Data Protection Regulation, currently rolling out in Europe. It essentially requires users to opt-in to allowing their data to be shared with individual apps or companies, and is being phased in across the EU.

How that approach might be applied to U.S. banks, and what the impact might be, is still unclear. It could boil down to a “creepy or cool” factor, says Lisa Loftis, a customer intelligence consultant with SAS.

“If you provide your (health) info to a provider or pharmacy, and they use that information to determine positive outcomes for you, like treatments or new meds you might want to try, that might factor into the cool stage,” Loftis explains.

If you walk by a bank branch, whether you go in it or not, [and] you get a message popping up on your phone suggesting that you consider a certain product or come in to talk to someone about your investments without signing up for it, that’s creepy,” she adds.

Any regulation would likely affect banks in some way, but it could be again viewed as a hammer, especially for those fintech firms who currently have a generally regulation-free workspace as compared to their bank counterparts.

Capitalizing on Good Times



With a strong economy, a corporate tax cut and more sympathetic regulators in Washington, banks have a lot to look forward to in 2018. But don’t confuse brains with a bull market—or a tax cut, says Tom Brown of Second Curve Capital. Happy days may be here again, but banks can’t afford to be complacent. In this interview with Steve Williams, a principal at Cornerstone Advisors, Brown offers four tips for CEOs looking to invest their bank’s expected tax windfall back into the business.

  • The Need To Transform
  • How CEOs Should Focus Their Attention

Motivating Buyers & Sellers in 2018



Several factors will drive M&A in 2018, but shareholder lawsuits will remain a fact of life for the banking industry. In this video, Josh McNulty of Bracewell LLP explains how market stability and more de novo activity could drive more deals. He also addresses how boards can minimize the risk of shareholder lawsuits.

  • Three Factors Driving Buyers
  • Barriers for Sellers
  • Outlook for Shareholder Lawsuits

Four Tips for Choosing a Fintech Partner


fintech-partner-2.png

Over the last three years we’ve implemented five strategic partnerships with fintech companies in industries such as mobile payments, investments and marketplace lending. In doing so, we’ve developed a reputation of being a nimble company for fintechs to partner with, yet we remain very selective in who we decide to work with.

We are very often asked–in places like the board room, at conferences and at networking events, how we choose what fintech companies to work with. It is a great question and one that needs to be looked at from a few angles. If you’re a financial institution looking to potentially begin partnering with fintech companies, below are some criteria to consider when vetting an opportunity.

A Strategic Fit: How does this relationship fit into your strategic plan? Finding a fintech that helps advance your goals may sound obvious, but it can be easy to get caught up in the fintech excitement, so don’t allow the latest fad to influence your choice of a partner. Don’t lose sight of your vision and make sure your potential partners buy into it. It’s better to have a few, meaningful partnerships than a host of relationships that may inadvertently distract you from your goals and spread your resources too thin.

Cultural Alignment: Make sure to do some research on the fintech’s management team, board of directors and advisory board. How do they–and their company’s mission-fit with your organization’s mission? Do you trust their team? Our CEO, Mike Butler, likes to say that we have a culture of trying to do things, not trying to NOT doing things. That’s important to us, and we want to work with teams that think similarly. Spending time together in the early stages of the relationship will help set the stage for a solid partnership in the future.

A Strong Business Plan: Is the company financially sound? Is their vision viable? Back to earlier commentary on not getting too caught up in the latest technology trend, consider testing the business idea on someone who isn’t a banker, like a friend or family member. While you might think it’s a great idea, does it appeal to a consumer that is not in our industry? If the business plan passes muster, another issue to consider is the fintech’s long-term plan and possible exit strategy, and the impact it would have on your business if the relationship went away. It’s important to understand both the fintech’s short- and long-term business plans and how those will impact your bank’s balance sheet and income statement today and in the future.

Compliance Buy-In: Does the fintech team appreciate the importance of security? Do they appreciate the role of regulation in banking and finance? Do they understand they may need to modify their solution in light of certain regulations? We know fintechs can sometimes look at banks with impatience, feeling that we’re slow to move. And while some might move at a slower pace than other, we banks know that there are good reasons to proceed cautiously and that compliance isn’t a “nice to have” when it comes to dealing with other people’s money. We are never willing to compromise security and are sure to emphasize that early in the conversation. It’s critical to find a partner with a similar commitment.

We’re in an exciting time; the conversations on both the bank and fintech sides are increasing about collaboration rather than competition. Considering criteria like the above will help banks take advantage of new possibilities in a meaningful way.

Using Reg A+ to Raise Capital and Grow Your Bank


OTC-Markets-11-23-15.pngA recent Securities and Exchange Commission amendment to Regulation A of the Securities Act allows small private companies and non-reporting public companies to raise up to $50 million in capital from regular investors without registering with the SEC. The new rule, mandated under Title IV of the JOBS Act of 2012, has the potential to dramatically expand access to capital for small companies, including banks.

Reg A is a longstanding exemption from SEC registration that allowed companies to raise up to $5 million in any 12-month period from an unlimited number of accredited and unaccredited investors. Under old Reg A, companies were required to submit an offering statement to the SEC for review and to comply with individual state Blue Sky laws, which are intended to protect the public from fraud, before the offering could be recommended or sold to investors in each state.

While Reg A was initially popular with companies–including banks–it’s popularity has since waned due in part to the high cost and complexity of federal and individual state filing requirements and the low offering limit.

Then Congress passed the JOBS Act which among several provisions proposed expanding Reg A to make it work better for small companies. Colloquially referred to as Reg A+, the amended version has done just that by giving companies a choice of two tiers of offerings:

  • Tier 1, which allows for offerings of up to $20 million in any 12-month period, with not more than $6 million in offers by selling securities holders that are affiliates of the issuer.
  • Tier 2, which allows for offerings of up to $50 million in any 12-month period, with not more than $15 million in offers by selling securities holders that are affiliates of the issuer.

Both tiers are subject to basic requirements as to issuer eligibility, disclosure and other matters, while companies conducting Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements. Companies are also allowed to make confidential filings with the SEC as well as “test the waters” with investors prior to an offering.

Most importantly, companies conducting a Tier 2 offering are exempt from state Blue Sky laws, lifting a significant barrier under old Reg A.

In addition, Reg A+ securities purchased by non-affiliated investors are unrestricted and are freely transferable on day one, a notable difference from exempt offerings more commonly done under Regulation D. This allows companies to obtain a stock symbol and create a public market for its securities almost immediately, providing shareholders access to liquidity.

In anticipation that many Reg A+ companies will go public on the OTC Market Group’s OTCQX Best or OTCQB Venture Markets, we have introduced specific in-boarding requirements for companies wishing to take that route.

Current Status and What It Means for Banks
Since Reg A+ became effective, approximately 35 companies have publicly filed a Form 1-A offering statement with the SEC. That includes at least one bank–First Light Bancorp, the holding company for Commerce Bank in Evansville, Indiana–which has filed to raise up to $10 million in a Tier 1 offering. Additionally, a dozen or more companies are believed to have filed confidentially with the SEC.

Reg A+ expands the opportunities available to small banks looking to raise capital and go public without the burden of SEC registration and Sarbanes-Oxley Act compliance. As a capital raising mechanism, Reg A+ is also uniquely suited to small community and regional banks for several reasons:

  • Securities sold under Reg A+ can be offered to unaccredited investors, allowing community banks to leverage their existing relationships with their depositors and community members.
  • Banks receive Blue Sky preemption in the states within which they operate, making the Blue Sky requirement in Tier 1 offerings less burdensome.
  • Banks are already required to have annual audited financial statements and file quarterly reports with their banking regulator, making it relatively easy for them to comply with the disclosure and audit requirements of a Tier 2 offering.
  • Raising capital and going public under Reg A+ does not require companies to immediately register with and report to the SEC, a key concern for small banks that are unwilling to shoulder the costly–and often duplicative–requirements of being an SEC reporting company.

The Regulatory Tiers: Should You Grow Past $1 Billion, $5 Billion or Even $10 Billion in Assets?


5-15-15-Debevoise_article.pngFor the largest U.S. banks, the incentives and objectives of the current regulatory landscape are clear—you must shrink to reduce your regulatory burden and concurrently become less systemically important. However, for the vast majority of U.S. banks, those with less than $50 billion of assets (including the large majority of much smaller banks), the framework resulting from the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and other regulatory initiatives provides a much more muddled context for growth decisions.

Dodd-Frank imposes greater regulatory burdens on all banks, including the smallest U.S. institutions. Prudent organic or acquisitive growth is a typical way to increase economies of scale, and thus reduce the relative costs of such burdens. However, at the $1 billion, $10 billion and $50 billion asset thresholds, Dodd-Frank and the rest of the U.S. framework impose increasing regulatory burdens, offsetting the benefits of growth to at least a degree. The banking agencies have indicated little desire or ability to materially reduce these burdens.

This article is intended to assist community and regional bank leadership in the above asset level ranges to make informed judgments as to whether the benefits of a particular growth opportunity outweigh its regulatory burdens.

$1 Billion of Assets

In a 2014 survey published by the Mercatus Center at George Mason University, covering banks with a median asset size of $220 million, almost 60 percent of these banks stated that they were altering mortgage offerings in response to Dodd-Frank regulatory requirements, with a specific focus on the regulations of the Consumer Financial Protection Bureau (CFPB). The stated reason for these retrenchments is the increased compliance costs (including doubling of compliance staffing) after Dodd-Frank.

In the interest of completeness, it also should be noted that at $500 million of assets, a non-Dodd-Frank requirement applies—the Federal Deposit Insurance Corp.’s annual independence and reporting requirements for audit committees. However, the FDIC began implementing those rules in the 1990s, and the 2014 survey did not cite them as a disincentive to growth.

Thus, to reduce the Dodd-Frank burdens, there appears to be a significant scale advantage in a small community bank prudently growing to close to $1 billion of assets. Moreover, as discussed in the next section, if a less than $1 billion bank or thrift does not have a holding company, the Federal Reserve Board recently provided a substantial funding benefit to such a bank establishing one.

$1 Billion to $10 Billion of Assets

Until recently, there was no regulatory disincentive to a bank holding company or savings and loan holding company crossing $1 billion of assets. However, on May 15, 2015, the Federal Reserve Board’s revised Small Bank Holding Company Policy Statement (the Policy Statement) becomes effective. The revised Policy Statement increases the asset threshold of institutions to which its benefits apply from $500 million to $1 billion.

Subject to certain limitations, the revised policy statement excludes holding companies (but not their underlying banks/thrifts) with less than $1 billion of consolidated assets from the risk-weighted and leverage capital requirements (further heightened by Dodd-Frank) that apply to larger holding companies. This capital requirement elimination makes it much cheaper for these holding companies to raise funds for acquisitions and other activities (including replacing more costly capital instruments), principally by enabling them to issue more senior debt. In this regard, an analysis by a prominent investment bank states that the Policy Statement will allow up to 3:1 senior debt to equity funding, which could lower an eligible holding company’s weighted average cost of capital to 6.15 percent compared to 12 percent for exclusively common equity funding.

Given this funding advantage, a holding company with assets approaching $1 billion must carefully evaluate any growth strategy. On the one hand, growth above $1 billion should provide important economies of scale to reduce the impact of Dodd-Frank’s enhanced compliance burdens. On the other hand, growth above $1 billion of assets will remove an important funding advantage (i.e., greater use of senior debt) that less-than-$1 billion asset institutions have over larger competitors.

There also is a new Dodd-Frank Act-required compensation rule to consider if a bank goes above $1 billion in assets. All banks and thrifts at that level will have to disclose more about their compensation practices, including their incentive pay practices, in a rule proposed in 2011 by joint banking regulatory bodies, but not yet implemented.

$10 Billion to $50 Billion of Assets

Crossing $10 billion
Dodd-Frank’s asset size-triggered burdens first truly apply to a banking institution crossing $10 billion of assets. Rather than simply being subject to CFPB regulations as administered by their primary bank regulator (as occurs with less than $10 billion asset banks), the CFPB itself examines institutions above $10 billion. Many of our clients have commented that the CFPB moves much more rapidly to burdensome and costly enforcement actions than their primary bank regulators, and even have taken the added precaution of asking us to perform pre-exam reviews to reduce the likelihood of such actions.

Moreover, these institutions for the first time become subject to mandatory regulatory stress testing. These stress tests impose systems and operational burdens, and also can impair the institution’s reputation because it must publish the results. If the institution is publicly traded, and most banks above this level are, it is required to establish a stand-alone risk committee with a “risk” expert as defined in the statute. Finally, the Dodd-Frank Durbin Amendment applies to these banks. By capping the interchange fees that banks issuing debit cards can charge on merchant transactions at about half of their previous level, the Durbin Amendment costs the banking industry about $8 billion per year. Crossing the $10 billion asset threshold thus can be particularly costly for banks that are significant debit card sponsors.

Approaching $50 billion
Although efforts to raise this threshold are under way, Dodd-Frank currently imposes its most substantial asset-based enhanced burdens at the $50 billion asset level. However, banks with assets even $10 billion or more below that level, and experiencing or contemplating material growth, may consider preparing for, and even implementing, elements of this enhanced framework. These banks thereby can seek both to protect themselves from adverse regulatory action by demonstrating a commitment to “best practices,” and to position themselves for prompt regulatory approval of growth opportunities if they cross $50 billion, by showing an ability to satisfy the enhanced requirements.

Because the enhanced burdens at $50 billion are material, publicly traded banks further face difficult disclosure decisions. Publicly traded banks approaching $50 billion, and even those banks well below $50 billion, need to consider and review their disclosure as a whole—from regulation and supervision disclosure to Risk Factors and Management’s Discussion and Analysis (MD&A) disclosure in offering documents and ongoing reports —to reflect the full scope of the impact of approaching and eventually crossing $50 billion. The Securities and Exchange Commission (SEC) regularly issues comments to banks requesting additional discussion of the impact of heightened prudential standards and increased compliance expense that result upon crossing $50 billion. Disclosure procedures for these banks also need to be reviewed to integrate Basel III’s Pillar 3 reporting standards into existing disclosure review procedures. For example, while final Basel III Pillar 3 rules provide banks flexibility on how to make Pillar 3 disclosure, this flexibility raises questions about whether to include Basel III Pillar 3 disclosures in SEC reports, whether to furnish or file these Pillar 3 disclosures with the SEC, and whether and how to incorporate these Pillar 3 disclosures into securities offering documentation.

As the above indicates, while Dodd-Frank largely focuses on the biggest U.S. banks, the current regulatory framework also requires complex analyses by community and regional banks as to whether particular opportunities are worth the enhanced compliance burdens they may raise.

RELATED VIDEO:

Gregory Lyons of Debevoise discusses the nuances of different asset thresholds and what banks must consider. Video length: 6 minutes


Getting Friendly With Your Regulator


4-27-15-Jack.png“The regulatory environment today is the most tension-filled, confrontational and skeptical of any time in my professional career.” – H. Rodgin Cohen, senior chairman, Sullivan & Cromwell LLP

Six years after the worst financial crisis since the Great depression, bankers and their advisors are still complaining about regulation and the regulators. Cohen, who some people consider to be the dean of U.S. bank attorneys, made that statement back in March at a legal conference. Is the regulatory environment today really that bad? There are really two banking industries in this country—the relative handful of megabanks that Cohen has spent the better part of his career representing, and smaller regional and community banks that make up 99.99 percent of the depository institutions in this country.

There is no question that the megabanks have remained under intense regulatory scrutiny well after the financial crisis ended and the banking industry regained its footing. Overall, the industry is profitable, well capitalized and probably safer than before the crisis. But the regulators, led by the Federal Reserve, have never relaxed their supervision of the country’s largest banks, including the likes of JPMorgan Chase & Co., Bank of America Corp. and Citigroup. If the senior management teams and boards at those institutions are feeling more than a little paranoid, it’s probably for good reason. Joseph Heller, the author of Catch-22, wrote in his novel, “Just because you’re paranoid, doesn’t mean they aren’t after you.” The regulators might not be “out to get” the megabanks, but they clearly see them as a systemic threat to the U.S economy, and for that reason, have kept them on a short leash.

What about the rest of the industry—the other 99.99 percent? Has the regulatory environment improved for smaller banks? Based on comments that I hear at our conferences and elsewhere, I would say it has. The cost of regulatory compliance has increased for all banks, including even the smallest of institutions, in part because there are more regulations, but also because regulations are being enforced more strictly than was the case prior to the crisis.  In an interview that I did in the first quarter 2015 issue of Bank Director magazine with Camden Fine, chief executive officer at the Independent Community Bankers of America, Fine pointed to a general improvement in the level and tone of supervision throughout much of the country. Five years ago, bank examinations were “very harsh and inflexible,” to quote Fine. Now, exams generally seem more reasonable—which is understandable since the industry is in much better shape than it was six years ago.

But the regulatory environment might never be as relaxed as it was prior to the financial crisis. Today, the regulators want to be informed of any major decision, such as a potential acquisition or the launching of a new business line, which could impact the safety and soundness of the bank. You might not have thought that you had a “relationship” with your bank’s regulator, in the same way that you have a relationship with your outside legal counsel, investment banker or any number of consulting firms that management or the board might turn to for advice, but you do. That relationship certainly isn’t consultative in the sense that they won’t necessarily help you fix a problem, although it isn’t entirely authoritarian either, because you’re not necessarily asking permission, for example, to acquire another bank. Based on what I’ve been told by lawyers and investment bankers, regulators might express some concerns about the acquisition you have in mind, and they might even outline some areas of specific concern (like pro-forma capitalization). They might say it would be hard to approve the deal if those issues aren’t addressed, but they probably wouldn’t forbid you from going through with it.

I would say that managing the regulatory relationship is one of the key responsibilities for your bank’s CEO. Kelly King, the chairman and CEO at BB&T Corp., told me during an interview last year that he meets regularly with BB&T’s primary federal regulator—the Federal Deposit Insurance Corp.—and keeps it well appraised of the bank’s acquisition plans, which are key to its overall growth strategy. There is also an important role for the board to play—particularly the nonexecutive chairman or lead director—in maintaining a strong regulatory relationship. Those individuals might want to meet periodically with the bank’s regulator as well to drive home the point that the bank’s independent directors are engaged in the affairs of the bank.

I am sure that many older bank CEOs and directors resent the fact that the regulators have intruded so deeply into the business of the bank, but it’s a fact of life in the post-crisis world of banking—and an important relationship that needs to be carefully managed.

What Banks Are Doing Now to Handle Compliance


4-13-15-Naomi.pngA heightened regulatory environment is here to stay, that much seems clear. So how are banks and bank management teams coping?

They are hiring more employees, buying software, scrutinizing vendors for compliance and focusing more and more on the business of complying with regulations, in addition to running the bank. Preston Kennedy, the CEO of $200 million asset Bank of Zachary, in Zachary, Louisiana, says he spends one-third of his time on compliance and regulations. “The regulations are now the table stakes,’’ he says. “If you want to go outside in the winter, you have to wear a coat. If you want to be a banker, you have to abide by a lot of regulations. ”

The following is a list of ways in which banks are coping with increased regulations.

Hiring a Chief Compliance Officer or Chief Risk Officer
Previously the domain of the largest banks, even small banks are hiring chief risk officers or chief compliance officers. In Bank Director’s 2015 Risk Practices Survey, 71 percent of respondents from banks below $1 billion in assets had a chief risk officer. So, too, did 92 percent of respondents from banks with $1 billion to $5 billion in assets. Bank of Zachary, despite its small size, has both a compliance officer and a recently hired chief risk officer, who reports directly to the CEO and the board of directors.

Buying Compliance Software or Getting Outside Advice
Banks also are turning to software vendors, core processors and outside consultants such as Fiserv, FIS, Computer Services, Inc. and DH Corp. to help manage compliance. “We are definitely seeing more indications that banks are relying on software more in all different areas,” says Christine Pratt, a senior analyst at financial services research firm Aite Group. Bank of Zachary just purchased a $35,000 program from Continuity to keep track of new regulations that will impact the bank, and help the bank document its compliance. Proper documentation is key because banks have to prove to regulators that they are in compliance. “In order to run a $200 million bank in suburban Louisiana, we have to rely on a company that is hardwired to the government to keep up with this pipeline of new regulations,’’ Kennedy says. “It’s absolutely ridiculous but it’s the task that we have.”

Incorporating Compliance
Banks are shifting away from handling compliance after the fact and moving toward incorporating compliance into many of their basic business processes, says Jamie van der Hagen, director of consumer lending for Wolters Kluwer Financial & Compliance Services, which sells regulatory consulting services and compliance software to banks. For example, instead of giving out loans and then checking to see if they meet fair lending standards, banks increasingly incorporate fair lending standards into the process of making loans. “Proactive compliance efforts, through automated testing for example, help banks validate their entire portfolio of products and accounts and identify potential compliance issues before they become a problem,’’ says van der Hagen. “Finding and addressing these possible compliance issues can have a positive impact on the bottom line by enabling institutions to identify loans that qualify for CRA credits and other premiums that can help them improve their overall bottom line.”

Starting to Prepare in Advance of Knowing the Final Rules
Banks are finding they have less time than in prior years to adjust after a rule is finalized and goes into effect. That means they have to prepare even as the rules are in the proposal stage. “They don’t have the time anymore to wait for the rule to be formulated,” says Pratt. “Banks have told me they’re writing two different versions of software [to prepare ahead of time]. That’s incredibly expensive.” Alternatively, vendors should help with the process of updating software on time.

Scrutinizing Vendors for Compliance
Regulators are increasingly emphasizing that banks are responsible for the missteps of their vendors on pretty much every law or regulation, including fair lending, debt collection or unfair consumer practices. The New York State Department of Financial Services, the state’s banking regulator, recently surveyed banks to determine their oversight of vendors for cybersecurity, as it is preparing new regulations on how banks should monitor third party vendors. Managing a bank’s vendors for compliance is a complex process, but there are general guidelines to getting it right.

However much of a burden it feels, bank management teams and boards know that they have to comply with regulations to stay in business. Managing the pace of regulatory change and keeping the bank out of the crosshairs of regulatory fines and punitive enforcement actions has become a core responsibility of the bank’s management team. “The pace of regulatory change has really increased in the last 10 years and there is no indication that it is going to go down,’’ says van der Hagen.

New Accounting for Credit Impairment and Equity Securities: What You Need to Know


4-10-15-Crowe.pngSince the financial crisis, the Financial Accounting Standards Board (FASB) has been debating wholesale changes to the U.S. generally accepted accounting principles (GAAP) financial instruments model in two related projects. For the first of the financial instruments projects, the FASB wrapped up in January the bulk of its deliberations on the classification and measurement project and expects to issue a standard in mid-2015. The FASB has come full circle by largely retaining existing GAAP—which means the legal form drives the classification and measurement of financial instruments, namely securities and loans.

However, it will not be business as usual when the new standard goes live for financial institutions. There will be a handful of changes that affect financial institutions, the largest being the requirement for equity securities with readily determinable fair values to be carried at fair value through net income (FV/NI) rather than today’s option to carry them at fair value through other comprehensive income (equity method securities will not be FV/NI).

Of greater interest is the second project: credit impairment. The FASB completed the majority of its deliberations in March and expects to issue a final standard in the third quarter of 2015. This standard, which uses the current expected credit loss (CECL) model, fundamentally will change the way the allowance for credit losses is calculated. The standard will have a pervasive impact on all financial institutions, and questions are circulating about what changes are in store.

What Instruments Are Subject to CECL?
The FASB decided to apply CECL to financial assets measured at amortized cost. For financial institutions, CECL generally will apply not only to loans but also to held-to-maturity debt securities and loan commitments that are not classified at FV/NI.

How Is the Allowance Measured Under CECL?
A current estimate of all contractual cash flows not expected to be collected should be recorded as an allowance. When developing this estimate, institutions also need to consider reasonable and supportable forecasts of the cash flows for the financial asset’s life. Given that CECL effectively is a lifetime estimate, institutions will need to estimate the life of the asset by considering the contractual term adjusted for expected prepayments but not considering renewals or modifications unless the entity expects to execute a troubled debt restructuring (TDR). This new focus on payment speeds outside of an ALM calculation might be a challenge for some financial institutions in terms of both data availability and capability.

The FASB is focusing on making CECL as flexible as possible and is retaining other items that had been incorporated in the incurred loss model. For example, the allowance calculation still includes “relevant quantitative and qualitative factors” based largely on the business environment and similar factors that relate to their borrowers (such as underwriting standards). However, the CECL model is different from today’s incurred loss model because it removes the “probable” threshold and accelerates the recognition of losses.

What Are Some Other Changes?

  • Purchased Credit-Impaired (PCI) Assets. The FASB is changing the definition of PCI and generally is simplifying the PCI model overall to require immediate recognition of changes in expected cash flows.
  • TDRs. At modification, an adjustment will be recorded to the basis rather than as an allowance.
  • Disclosures. The FASB retained the current disclosures with a few additions. For example, the FASB tentatively decided to require credit quality disaggregated by asset class and year of origination (in other words, vintage), subject to staff outreach.

What About Transition?
Once the standard is adopted, there will be a cumulative-effect adjustment to the balance sheet (credit allowance, debit retained earnings). For debt securities with recognized impairment, previous write-downs are not reversed. For PCI assets, an allowance is established with an offset to cost basis.

What Is Next?
At the March 11, 2015, meeting, FASB staff received permission to begin drafting the standard. The FASB will discuss at a future meeting any remaining issues identified during the drafting process, cost-benefit considerations and effective date.

What Does My Financial Institution Need to Do Now?
Top on the list for any financial institution is to begin to think about what data would be necessary to develop better forward-looking estimates of expected cash flows and whether that data currently is being retained.

Congress Makes Capital Requirements Easier for Small Banks


3-9-15-BryanCave.pngFor many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?” Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.

President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.

The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.

In light of this new law, the Federal Reserve has proposed these changes to its policy statement and recently announced parallel changes in reporting requirements for these small bank holding companies. The primary benefit of being deemed a “small bank holding company” is the exemption from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans, to finance growth.

This change should affect strategic and capital planning for all bank holding companies with consolidated assets of between $500 million and $1 billion and for all savings and loan holding companies with assets of less than $1 billion. These companies, which previously were required to comply with the capital requirements applicable to much larger institutions, can now use traditional debt at the holding company level to generate higher returns on equity. With trust preferred securities now a thing of the past, larger institutions cannot use debt or hybrid equity to meet their requirements for Tier 1 capital. Instead, larger institutions are left with traditional equity sources such as common stock and non-cumulative preferred stock, which typically carry a higher cost of capital.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.

While new threshold has not received much press, we believe it could and should have an impact on merger discussions involving smaller institutions. Those companies that will soon be considered “small bank holding companies” should revisit their financial projections to consider whether introducing debt funding at the holding company can increase returns on equity without taking on unwarranted financial risk. Boards may find that this change makes the option of staying independent more viable in the future. Potential acquirers of small banks should also be aware of this change in order to demonstrate that a potential transaction provides a better risk-adjusted return to shareholders than remaining independent. On both sides of the transaction, this relatively quiet change should generate a new way of analyzing the question, “Is bigger really better?”