What to Do When Caught Between Investors and Regulators

hands-tied.jpgIt’s tough to please both regulators and shareholders these days, especially when they want contradictory things. Take the case of executive compensation.

Shareholder groups have been pushing for a greater tie between performance and executive pay. One of the most powerful of these, Institutional Shareholder Services, screens executive pay packages to see how they stack up against peers relative to performance and how the change in CEO pay mirrors change in total shareholder value over five years. ISS recommendations to shareholders on such matters can strongly influence a company’s say-on-pay shareholder advisory vote. Umpqua Holdings Corp. and other banks found this out, as described in a recent story in Bank Director magazine.

But looking at the stock price and shareholder value is exactly what regulators don’t like.

Jim Nelson, a senior vice president of supervision and regulator for the Federal Reserve Bank of Chicago overseeing large banks and savings institutions, is concerned with the use of stock price or return on equity as a measure of performance in making pay determinations. Return on equity doesn’t factor in the risk that executives might be taking to achieve such returns, he said at Bank Director’s Bank Executive & Board Compensation conference recently in Chicago.  There are many factors that can influence the stock price which are outside the realm of management’s control, he said.

“We think most of the people in the firm don’t have a direct impact on the value of the stock price,’’ he said. “We’re looking for a measurement tied to something that that person does control.”

Regulators also explained how they feel about shareholders in their 2010 Guidance on Sound Incentive Compensation Policies, which applies to all banks and thrifts.

The joint regulatory guidance says “shareholders of a banking organization in some cases may be willing to tolerate a degree of risk that is inconsistent with the organization’s safety and soundness.”

So there’s the rub. Do you please shareholders or do you please regulators? But there are ways to combine the concerns of both.

“It’s not the amount [of bonus or incentive pay],’’ Nelson said. “What we’re looking at is the arrangements. You should reward individuals who are producing an attractive risk-adjusted return for you. If they are making more money with low risk, they should be paid more than someone who is making money with high risk. I think that is aligned with what shareholders want and the board wants. There is a lot more free enterprise in this approach than people think.”

He said some big banks are adjusting their profits based on risk metrics before handing out bonuses.

Meanwhile, big banks also are taking into account the needs of shareholders and the recommendations of shareholder advisory groups. Tying short and long-term bonuses, at least in part, to shareholder return is one way to do that.

For example, Buffalo, New York-based First Niagara Financial Corp., one of the nation’s 25 largest bank holding companies with $35 billion in assets, paid out long term incentives to top executives in three ways: stock options, time-vested restricted stock and performance-based restricted stock that vests in three years based on total shareholder return relative to the SNL Mid-Cap Bank Index.

Barbara Jeremiah, a First Niagara director who chairs it compensation committee, said when the bank ran into troubles trying to raise capital for its acquisition last May of HSBC branches in New York and had to cut its dividend in half, the board recognized the hit shareholders took and wasn’t locked into paying short-term bonuses based on earnings per share. The board had made sure it had some level of discretion in determining the bonus, she said.

The board adjusted incentive compensation for CEO John Koelmel to reflect the decline in stock price and reduction of the dividend. Jeremiah encouraged compensation committee members and human resources directors at the Bank Director conference to read and stay abreast of how others viewed executive pay, making note of an article by Gretchen Morgenson of The New York Times entitled  “C.E.O.’s and the Pay-‘Em-or-Lose-‘Em Myth.”

 “We need to keep that outside view,’’ Jeremiah said. “How do our customers and others view us?”

How to Win the Regulators’ Approval

As banks are expected to follow more strenuous regulations and requirements, one thing that can help ease the load on the board is having a good relationship with the regulators. There are simple ways directors can improve in this area, and as with most relationships, it comes down to two main principles: communication and engagement. 

What steps should bank boards be taking to ensure that they maintain a good working relationship with the regulators?

Ralph-Sharpe.jpgTransparency, honesty and timeliness are essential; never hide or sugarcoat bad news. Provide realistic projections—better to understate and over-perform. Be engaged; welcome opportunities to meet with examiners—with or without management, and in and out of board meetings. Ask questions, and listen to the answers. If you disagree, do so respectfully.

Stay informed and keep up with regulatory developments. Read the Office of the Comptroller of the Currency’s Director’s Book (available online) and attend regulator outreach sessions when offered. Assign a regulatory liaison to ensure timely and complete responses are provided to examiners for things such as Matters Requiring Attention (MRAs), but don’t bury examiners in paperwork.

Finally, learn the business of your bank. Know the difference between being a director instead of an investor.

—Ralph Sharpe, Venable

geiringer.jpgAs a former regulator, I find that I sometimes need to remind directors that examiners are people too, and that how they are treated during examinations can directly impact your bank’s ratings. Directors need to set the “tone at the top” that everyone at the bank should treat examiners with courtesy and respect, take seriously any reasonable suggestions that they make, and handle any disagreements with as much civility as possible under the circumstances.

Directors themselves can build better relations with regulators by sending representatives to key meetings with examiners and occasionally requesting executive sessions with them to discuss issues outside the presence of management. Of course the best way for a bank board to maintain a good working relationship with regulators is to oversee a safe and sound bank.

—John Geiringer, Barack Ferrazzano

Cliff-Stanford.jpgMeetings with regulators, such as exit meetings, are crucial opportunities to listen and to seek clarification of points raised by the regulators. This does not mean that directors should be passive or should not register concerns or objections to factual inaccuracies. However, arguing and cementing a position on a “judgment call” issue during a meeting with examiners can often lead the examiners to cement their own in return, hurting the chances that directors can influence the perception of the bank’s performance.

Remember the placard from the British Government during World War II– “keep calm and carry on.” Examiners will have findings, sometimes in the form of Matters Requiring Attention by the Board, but often there are simple (not necessarily easy) steps to be taken. Directors will show much good faith and earn credibility with examiners by concerted engagement to drive management to address key regulatory concerns promptly.

Finally, remember that regulators have bosses and careers, and operate in a fast-moving regulatory environment just as banks do. Directors that show an appreciation for the challenges faced by regulators will create a store of goodwill that can only help their bank.

—Cliff Stanford, Alston & Bird

Angelee-Harris.jpgBuild your own communication lines with regulators. Rather than relying solely on management to maintain primary contact with regulators, authorize your chairman, audit committee head and perhaps your compensation committee chairman to meet face-to-face with primary regulatory contacts. After that, be sure to maintain consistent communication on behalf of the board.

Be honest with regulators and seek their guidance. When regulatory issues occur, alert regulators early and disclose all known facts—no matter how negative. There is oftentimes a tendency to downplay negative details or dribble out full details over time. These actions erode a regulator’s trust. Instead, talk early and often to regulators. Admit when you need to get back to them with more facts. Do not assert facts you cannot support. Regulators are a key resource, so be open to ask them for advice and guidance.

Try to see issues from a regulatory viewpoint. Like banks, regulators work in an environment of heightened scrutiny and could be called to task for failure to conduct full diligence or take proper action. Anticipating and offering to provide the proper access and information a regulator needs to fulfill her duties will go a long way to maintaining good regulatory working relationships.

—Angelee Harris, Manatt Phelps & Phillips

Coming To Grips With Risk And Regulation

audit12-ballroom.jpgNow that the worst of the financial crisis is behind them, bank boards might think they can finally breathe a sigh of relief. Except that they can’t. More than 350 people attending the Bank Director Audit Committee Conference June 7-8 in Chicago learned about the new challenges facing audit committees this year—from new regulations regarding risk and compensation, to the struggle that many banks face trying to build capital and grow revenue and earnings in a difficult economic environment. Participants also received instruction on how to identify and root out large-scale internal fraud, one of the worst threats to the bank’s survival, as well as an update on trends in liability and insurance for bank directors.

“The conversation has shifted,” said Robert Fleetwood, a bank attorney with Barack Ferrazzano Kirschbaum & Nagelberg LLP in Chicago, who spoke at the conference. “Now, it’s more of a ‘thank God we survived.’ Once you can label yourself a survivor, you can think about the next three to five years.”

Several directors spoke at the conference about their challenges and solutions at a wide range of banks, from the Bank of Tennessee in Kingsport with just $650 million in assets to $20-billion asset SVB Financial Group in Santa Clara, California, which has offices in China, India and the United Kingdom. 

Regulation and capital will be huge areas of concerns during the next few years, as most of the rules coming out of the Dodd-Frank Act haven’t been finalized yet. Plus, many banks still lack sufficient capital to acquire other institutions. Risk management will be an area of heightened focus for regulators and banks, the vast majority of which don’t have a separate risk committee. As part of that, even though stress testing is only required for banks above $10 billion in assets, the Federal Deposit Insurance Corp. this month published a guide to stress testing for community banks.

However, Pamela Martin, a senior supervisory financial analyst in the supervision division of the Federal Reserve, tried to calm worries at the conference about increased regulation and pressure to comply with rules designed only for the bigger banks.

“Dodd-Frank is really geared at the largest institutions and it’s not designed for community banks,’’ she said. “We have no intention of applying this to community banks, including stress tests.”

Speakers at the conference also talked about how to handle risk on the audit committee and ferret out fraud.

“If I served on a bank board, I would want to know someone served as [the chief risk officer],” said James Shreiner, a senior executive vice president at Fulton Financial Corp, a $16.5-billion bank holding company based in Lancaster, Pennsylvania. “They might have 10 other jobs that they do but [banks] need to have someone who is responsible for risk and not have that be someone responsible for the revenue side.”

Knowing what the bank’s risks are, including the potential for fraud inside and outside the bank, is a particular focus for audit committee members.

“People are more willing to take a risk. Profits are down. Loans are down,’’ said Wynne Baker, the head of the banking practice at KraftCPAs in Nashville. “You want to be in business five years from now and so you want to make sure you have the right tone at the top.”

Regulators to bankers: We Hear You

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Regulatory Game Changers and How to Deal with Them

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

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

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

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

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

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

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

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

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

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

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

Directors and the Exam Process: Get Involved Early

life-perserver.jpgMy colleagues and I frequently meet with bank boards that have received very sobering reports from their bank’s examiners.  While the directors’ responses to bad examination reports vary greatly, there is one emotion that is nearly universal: a feeling of helplessness.  As a result, directors almost always express a desire to get involved in the exam process after they receive negative feedback from the examiners, whether through requesting meetings with higher-level regulators, appealing the exam findings, or fighting a proposed enforcement action.  Unfortunately, those actions, particularly if taken after a final examination report is issued, seem to have little positive impact on the examination process and may even prove to be harmful to the bank.

The good news, however, is that there is a way for directors to get involved in the regulatory examination process that can have a meaningful positive impact.  Discussed below is our top recommendation for directors to be involved in the examination process.  We believe early, proactive involvement can positively impact the outcome of a regulatory examination and also enhance the board’s understanding of regulatory criticism.

While most directors’ first contact with examiners is at the examiners’ exit meeting with the board, we suggest director involvement earlier in the examination process.  There should be one or more outside directors present at the examiners’ preliminary exit meeting with management.  During this meeting, the examiners will present their preliminary findings from the examination.  In addition to highlighting the engagement and availability of the bank’s directors, attending this meeting allows the directors to understand the key issues in the examination.  By hearing the examiners deliver their findings first hand, the directors will have a better sense of the seriousness of the issues being identified.  Finally, directors will be able to ask questions of the examiners that might not be easily asked by members of management; e.g., asking for an interpretation of a regulation.

By attending this preliminary exit meeting, directors are also able to ensure that the bank’s board has a timely understanding of the issues presented by the examiners.  Members of the bank’s executive management team have a natural tendency to relay examination criticisms to the board through their own point of view.  Management may fear adverse action by the board as a result of regulatory criticisms or may feel so strongly about their point of view that they tend to “water down” the comments of the examiners.  By having outside directors attend the meeting, those directors can deliver an independent report of the regulatory criticisms to the board.

In addition, by identifying key regulatory issues, and particularly disagreements, bank directors have the greatest likelihood for influencing the examination process.  It is at this time, after preliminary findings are made but before a final examination report is delivered to the bank, that a bank and its directors should present additional information and viewpoints that might alter the findings in the final examination report.  We have found that examiners are willing to review additional information at this juncture and, where appropriate, the examiners will alter their conclusions in response to such information.  Ideally, such information is presented prior to the examiners’ exit meeting with the full board.  Our experience tells us that this approach is much more effective and timely than a formal appeal of final examination findings. 

By inserting themselves into the regulatory examination process, we believe directors can have a positive influence on the regulatory examination process.  While we would not recommend having the full board involved in functions that are typically left to management, having an independent point of view involved early in the examination process can be very helpful.  Not only can directors display their involvement in the oversight of the bank’s operations, they can also help with strategy for dealing with regulatory issues at a time when conclusions have not yet been formed.  Finally, directors can better understand regulatory feedback and can track management’s progress toward addressing regulatory concerns.

Is the Grass Greener? Five Considerations before Converting your Charter

greener-grass.jpgBecause many banks continue to take a bruising from banking examiners, it should come as no surprise that some have considered a change of charter in hopes of finding a less overbearing overseer.

In particular, recent headlines have shown that a significant number of national banks have left a national charter for a state charter.  Since 2000, almost 300 national banks have made the switch. 

Provisions from a spate of recent Office of the Comptroller of the Currency consent orders may illustrate why, with some provisions requiring significantly higher capital ratios than other regulators have demanded from similarly situated state-chartered institutions as well as  other provisions essentially forcing national banks to either sell to new owners or face receivership.

If you are contemplating a charter conversion for your bank, there are a number of key issues to consider before you make the change.  These include:

Access to Government Officials:  Because state regulators are geographically closer and more familiar with the situation on the ground, channels of communication may be more open and less adversarial.  Likewise, small financial institutions may exert greater political influence either directly or through their state bankers’ association. 

However, in practice, most state regulators exercise great deference to the FDIC or Federal Reserve in both examinations and regulatory approvals, and for institutions seeking growth, dual application processes required by the state and federal regulator may raise more issues in connection with required regulatory approvals.

Reliance on Federal Preemption:  Many multi-state institutions rely on the federal preemption of state laws afforded national banks.  Although the Dodd-Frank Act has rolled back federal preemption in some respects, preemption remains effective in many areas crucial to national bank operations.  Consequently, conversion to a state charter could raise supervisory issues for certain product lines.   

While a 1997 Cooperative Agreement brokered by the Conference of State Bank Supervisors is intended to coordinate regulation and supervision among the states, certain state laws in jurisdictions outside of the bank’s home state continue to apply and may necessitate changes to various products to comply with consumer protection statutes and fair lending laws.  However, this concern is mitigated by parity or “wildcard” statutes enacted in many states, which allow state-chartered banks to engage in activities that would be permissible for a nationally chartered institution. 

The upshot, however, is that converting institutions in some cases may need to undertake burdensome surveys of state laws to ensure compliance with disparate local requirements.

Additional Powers and Restrictions:  State bank charters frequently feature notable differences in terms of the powers granted and restrictions imposed on bank activities.  These often include different legal lending limits, restrictions on sales of insurance, and ownership of banking premises.  For states that permit LLC banks, even the legal structure of an institution can be different.  A thorough understanding of these differences is important to ensure that the bank’s business plan following conversion will not be impeded.

New Requirements under Dodd-Frank: To eliminate perceived problems related to regulatory arbitrage, the Dodd-Frank Act generally precludes charter conversion whenever the converting institution is subject to a consent order or memorandum of understanding issued by its current regulator.  Although there is an exception to this rule if the converting bank seeks prior approval from its regulator and submits a written corrective-action plan, relief under this exception is rare and unlikely to be granted in most circumstances.

Conversion Expenses and Licenses:  State examination fees are generally less than those charged by the OCC, in part because state regulators share examination responsibility with either the FDIC or Federal Reserve, neither of which charge fees for their exams.  However, state regulators typically charge an application fee for a conversion plus additional fees based on things like the number of branches and the bank’s authorized capital stock.  In some states, bank directors and officers also may be required to obtain licenses, and in any jurisdiction, the bank likely will incur legal fees to prepare compliant board and shareholder resolutions, articles of incorporation, bylaws, publication notices, and other legal documents related to the conversion process.  As such, while banks should enjoy long-term savings, bankers should be cognizant of the up-front cost of conversion.

Charter choice remains a key consideration for bank operations.  Although historical benefits of the national bank charter continue, it appears that many are finding in the current regulatory environment that those benefits do not outweigh other considerations affecting bank performance. 

Bank Secrecy Act: Do Regulators Care?

Accounting fraud, terrorist attacks and economic meltdowns are the catalysts for many of today’s financial regulations. With so much focus recently on the Dodd-Frank Act, many financial institutions may be overlooking the compliance requirements for the Bank Secrecy Act (BSA), or anti-money laundering law. In this video, John ReVeal, attorney for Bryan Cave LLP, shares his insights into how BSA violations are perceived by the regulators.

Is Bank of America Too Big to Manage?

too-big.jpgLast week’s news that Warren Buffett was putting $5 billion into troubled Bank of America Corp. (BAC) might have brought a sigh of relief from those folks who were concerned that the country’s largest bank was in danger of failing, although I doubt the actual risk of failure was very high. I think we can safely assume that the regulators in Washington have been overseeing BAC with the same level of care that the Nuclear Regulatory Commission might give to an ailing nuclear reactor–and I don’t think the dooms-day metaphor is inappropriate here.

If you read the financial headlines or watch the business news shows, you know that BAC is struggling to extricate itself from a host of mortgage-related problems, including continuing credit losses from its 2008 acquisition of Countrywide Financial Corp., which has turned out to be a hellish disaster for the bank. Institutional investors had become increasingly concerned that BAC was undercapitalized and drove the stock price down to around $6 a share. The low share price might not have been an accurate reflection of BAC’s true financial condition, but this is one of those situations where perception can quickly become reality. If enough consumer and business customers had become spooked by the falling share price and began to pull their deposits out of the institution, or if other banks had stopped funding it in the interbank lending market, the result could have been a dangerous liquidity crunch.

And that would force President Obama, Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Tim Geithner to make a really tough call: With the weak U.S. economy in danger of falling into the second trough of a double-dip recession, would they prop up the nation’s biggest bank—or allow it to go under? Supposedly the Dodd-Frank Act brought an end to the unofficial regulatory policy of “Too Big to Fail” by providing the Federal Deposit Insurance Corp. with new liquidation authority that will allow it resolve the failure of a large and complex institution in an orderly manner. But would the White House and the Fed be willing to take the risk that such an event wouldn’t push the economy into another ditch? Would they flinch?

Hopefully, we’ll never find out.

The real significance of Buffett’s $5 billion capital infusion is that it offers BAC a much needed vote of confidence from one of the world’s most successful investors, and that seems to have stabilized the bank’s share price for now. Interestingly, Buffett’s money does little to strengthen BAC’s capital position from a regulatory perspective. What Buffett actually purchased was preferred stock, which won’t count towards its Tier 1 capital ratio. Buffett also received warrants to purchase 700 million shares of BAC common stock at $7.14 a share, so he will most likely be handsomely rewarded for his public service.

The interesting question to me is whether BAC, with $2.26 trillion in assets as of year-end 2010, is simply too big to manage. The bank scored 127th out of the 150 largest publicly owned U.S. banks and thrifts on Bank Director’s 2011 Bank Performance Scorecard, which is a measurement of profitability, capitalization and asset quality. The company scored poorly in all three categories. (To see the 2011 ranking, view our digital issue). CEO Brian Moynihan, who was not responsible for the Countywide acquisition, is trying to revive the bank’s profitability through a program of asset sales and layoffs, although the continued decline in housing prices nationally makes BAC’s home mortgage exposure look like a cosmic black hole.

I think it’s fair to say that risk diversification is viewed by most experts as a good thing. The great majority of banks that have failed in recent years were small institutions that had a high concentration of commercial real estate loans on their books. A little more diversification would have been a good thing for them. But diversification is a double edge sword than can cut both ways. BAC is so big and so diversified that it’s hard to find a meaningful banking business in the consumer, corporate or capital markets sectors that it isn’t in, or a financial product that it doesn’t offer. So when the U.S. economy goes into a deep recession as it did a few years ago, a large and highly diversified financial institution often ends up with an impressive assortment of afflictions that are Job-like in nature.

Perhaps BAC is simply too large for any management team and any board of directors to run effectively. I don’t believe that Congress or the regulators should break up the company into smaller pieces. In a free market economy, BAC should be allowed to seek its own destiny. 

But the company’s performance might be twice as good if it were half as large.

A Conversation with a Regulator: What Bank Directors Need to Know

bert-otto.jpgBert Otto has been deputy controller for the central district of the Office of the Comptroller of the Currency since 1997. He is responsible for oversight of 545 community banks and federal savings associations and manages a staff of 480 employees in Chicago. He has worked for the OCC since 1973 and has supervised examiners in Peoria, Illinois; Boston; Washington, D.C.; and Syracuse, New York.

What do directors need to know about the regulatory exam and when should they get involved?

The first thing they need to understand is the areas that will be reviewed. It’s kind of the game plan for the examination process for the year. The directors will get a clear understanding of the safety and soundness areas, if it’s CRA (Community Reinvestment Act), if it’s fair lending, they learn what areas will be reviewed.

A lot of times, we will ask the directors how they want to be involved in the exam process. A lot of times, we will meet with these directors at their businesses, to make it a little bit informal for them. They can talk about management and we can talk about our assessment of management, too. A lot of directors have taken us up on that.

A lot of times the directors will really share a lot about the community, the bank itself, what their feelings are about management, about the bank’s business model. It’s a good opportunity for them to pick our brains, too, as to what the current issues are. They can do that at a board meeting, too, but a lot of times we will offer to have our examiners come out and talk to them informally.

Another way to get involved is to sit in on a loan discussion. The loan discussion is such a key area of an exam, especially in community banks, that they will get a good understanding of what that’s all about, plus they can get a sense of how much the loan officers know, how they can respond to questions from the examiners and the knowledge they have about their borrowers.

What should bank directors do during the exam?

My suggestion is for a lot of the outside directors to stay plugged into the exam process. They typically run for a couple of weeks. The audit chairman clearly needs to know what is happening with the exam process. There is nothing wrong with a couple of audit committee members meeting with examiners, not every day, but at the end of the week, to stay plugged into what the issues are.

What common mistakes do you see bank directors making?

A lot of times they will jump too quickly to change the institution’s’ business model or strategic plan. A lot of time we tell these directors: “Don’t just do what your competitors are doing.” We saw a lot of that during the last downturn, where commercial real estate in 2004, ’05 and ’06 was really growing, so everybody jumped in it, and jumped in it in big ways.

You need to have a well-conceived business model.  You can tweak it some, but some of these institutions have been around for 100 or 150 years, and they’ve done some things right.

A lot of time we see directors not ask enough detail and probing questions of management. At the board meetings, they need to ask questions of management and hold management accountable. They need to have enough time prior to board meetings to review board packages. We see that a lot where directors get two- or three-inch thick packages and they don’t have enough time to review. They need concise summaries that show trends.

In our more problem banks, we have seen directors who are overly trusting of management. They put management in and they have a good working relationship. But not making sure they hold management accountable gets them into trouble.

How much time does the board need to review board packages?

The average board needs two or three days to review a board package, for your average community bank. You just can’t get it to them a day ahead of the board meeting or the day of the meeting and expect them to have a good understanding and ask good questions.

What kind of relationship should banks and their regulators have?

We need to have a good relationship so the bank and management understand why we’re there, and our knowledge for what’s going on in the industry, so we can provide them with some guidance. They might need clarification on guidance from Washington. We want management to pick up the phone and call if there is something that is not clear. I would rather not wait until the exam has already started because some action may have been taken that needs to be unwound. Each party needs to understand each other.

Communication is important because information needs to be shared. During the exam, we are going to be touching management quarterly with questions such as: How are your earnings?  How is your capital position? Have you had any changes in management or other changes we need to know about? That helps us put together a supervisory strategy for when we come in. We want a good relationship with management because we will call them at least quarterly and we will be coming in yearly. If there is guidance coming out from Washington that they are not clear on, they need to call their portfolio manager, an individual from the OCC, who should be able to explain what that guidance is or what our expectations are.

How long do exams take and how often are they done?

It depends on the size and condition of the institution. If a smaller institution is (CAMELS) rated 1 or 2 (a good score on regulatory scale), it could happen every 18 months. Larger institutions could be every 12 months. Problem banks, with CAMELS ratings of 3 to 5, you could see us every six months.

How should you handle a disagreement with your regulator?

If it’s a (CAMELS) rating or a classified loan disagreement, the first point of contact should be the assistant deputy comptroller of the local field office. The next step would be coming to me, the OCC deputy controller, or the ombudsman. The ombudsman reports directly to the comptroller. We hope all our disagreements are worked out on a local level, but if they can’t, that’s the process. All of our conclusions should be supported by facts.  If we say we have an unsafe and unsound business practice, because the bank is extending loans without satisfactory credit information, those are hard to disagree with. We need to base all our conclusions on facts.

How often would a conclusion from a regulator be reversed after a disagreement?

Ninety-nine percent of the disagreements get worked out at the local level; very seldom do we get some at my level or the ombudsman. They get some, but they are more often related to CRA issues or fair lending issues. We haven’t had a lot related to CAMELS ratings. Most of this is a give and take. If there is an unsafe and unsound banking practice, or if there is a violation of law, those tend to not be overturned. There might be a case where there are some new facts that come in on a loan classification, where during an exam the examiner may have looked at a loan as substandard. We may get new information later on where that decision gets overturned, but I don’t have numbers on how many decisions get overturned.

How do you think Dodd-Frank will impact community banks, even though they were exempted from many of the provisions?

There will be some impact. Clearly the challenges facing community banks, just the volume of compliance activities they need to be focused on, it does concern us. Where is the tipping point, causing community banks to exit the business?  It depends on how the regulations are going to be written, the Consumer Financial Protection Bureau obviously has the pen, but clearly it’s going to affect all banks.

In terms of unfair, deceptive or abusive practices and in general all regulations, the larger institutions have a lot more resources to understand these rules than smaller banks do.

For example?

Community banks are going to be impacted by Dodd-Frank’s directive that federal agencies modify regulations to remove references to credit ratings for determining creditworthiness. You wouldn’t think that impacts community banks, but it does.

The institutions use credit rating agencies for ratings for permissible investment securities. Dodd-Frank has done away with that, so institutions of all sizes are going to have to do independent analysis, a lot more than what they’ve done in the past, in investment securities.

Are regulators or Congress trying to cut down on the number of community banks in this country?

We don’t want to cut down on community banks; they provide a lot of services to their communities. There are challenges. Interest margins have been cut quite a bit. They are struggling with high concentrations of commercial real estate. Community banks are struggling. I think what’s going to happen, is some banks do very well, and some aren’t going to do very well. That’s why it’s so important to have a strong business model and to stick to what you do well. Some banks become niche players, and there are some risks associated with that, but you get good at something. Quite honestly, with the stresses of the compliance costs from Dodd-Frank, there may be banks that exit the business. We’re not pushing that and Congress isn’t pushing that, but there is some inevitability here: Where is that tipping point for a community bank?