Trends Emerging in Compensation Policies for Bank Executives

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Governance policies related to executive compensation are on the rise as a result of increased influence of bank regulators, shareholders and the Securities and Exchange Commission (SEC). These policies are intended to reduce compensation-related risk, encourage a long-term perspective and align executives with shareholder interests.

Meridian’s 2015 proxy research of banks with $10 billion to $400 billion in assets illustrates the prevalence of “standard” and “emerging” practices. Standard practices tend to be common regardless of asset size. Emerging practices are more prevalent at larger banks, but are likely to cascade to community banks over time.

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Standard: Clawback Policies
Clawback policies allow the recovery of incentive compensation that has already been paid or vested when there has been a financial restatement and/or significant misconduct. Most banks currently have clawback policies; however, these may need to be revisited once the SEC issues final clawback rules. While many existing policies allow compensation committee discretion to seek recovery, the proposed rules (July 2015) would require a mandatory clawback of “excess” incentive pay in the event of an accounting restatement.

Emerging: Forfeiture Provisions
While clawback policies seek to recover awards already paid, forfeiture provisions provide for the reduction of incentive payouts and/or unvested awards based on negative risk outcomes such as  a lack of compliance with risk policies. While these provisions are standard at large banks that have faced significant regulatory scrutiny, they are only beginning to be used at smaller banks.

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Standard: Anti-Hedging Policies
Anti-hedging policies prevent executives and directors from participating in transactions that protect against or offset any decrease in the market value of company stock. Such transactions could create misalignment between shareholders and executives since executives would not suffer the same losses as shareholders if the share price drops.

The SEC’s proposed rule (issued February 2015) requires companies to disclose the types of hedging transactions (if any) allowed and the types prohibited for both employees and directors. As seen in our study, most banks already disclose formal anti-hedging policies.

Emerging: Pledging Policies
Pledging policies prevent or limit executives’ and directors’ ability to pledge company shares as collateral for loans. Pledged company stock creates a risk that executives may be forced to sell shares at a depressed stock price in order to raise cash to cover the loan margin, which could further the decline in stock price.

However, some companies allow limited pledging with pre-approval. Pledging enables executives to monetize share holdings without selling company stock. Since 2006, public companies have been required to disclose the amount of company stock pledged by executives and directors. Proxy advisory firms and shareholders typically criticize only significant levels of pledging.

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Standard: Stock Ownership Guidelines
Over 80 percent of banks in our study have stock ownership guidelines that require executives to maintain a minimum level of ownership. Ownership guidelines are typically defined as a multiple of base salary. For CEOs, the most common ownership requirement is five times base salary, while other executives range between one times and three times base salary.

Emerging: Post-Vesting Stock Holding Requirements
Many investors and shareholder advisory firms have started pushing for additional stock holding requirements. Holding requirements restrict executives from selling stock earned from equity awards or option exercises for a period of time after vesting or exercise. Some holding requirements require executives to hold a percentage of shares until ownership guidelines are met. More rigorous policies require executives to hold a percentage of shares for a set period of time (e.g., one year after vesting) or until (or even after) retirement.

Banks have been ahead of many industries in adopting these governance practices as a result of the regulatory scrutiny on compensation programs, and we expect the emerging practices will continue to gain in prevalence across banks of all sizes.

Fighting Off the Activists

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3-2-15-CommerceSt.pngShareholder activism is on the rise and has become an increasingly relevant topic in boardrooms throughout the country. The regional and community banking sectors have also seen an increase in activist investors submitting shareholder proposals. The adage is true: The best defense is a good offense. With activist investors, the best defense is maintaining an extremely efficient, profitable bank with performance metrics and key operating ratios in the top quartile of a realistic peer group.  If this does not describe your situation, then your bank may prove an ideal target for an activist. An honest, objective assessment of a bank’s susceptibility to an activist, as well as strategic preparation about the bank board’s initial response will largely dictate the outcome of an activist’s approach. 

Regulatory structures, such as passivity agreements and certain requirements of the Bank Holding Company Act of 1956 (i.e. acting in concert), offer management advantages that are not available to non-banks. However, regulatory impediments generally do not provide much of a deterrent to activists who support their cases with empirical evidence designed to gather the support of other shareholders. More importantly, the playbook for an activist defense too often results in some form of capitulation to an activist. It is not uncommon for an activist to be awarded a board seat or for the target to be forced into announcing a review of its strategic alternatives. While arguably a compromise, too often those concessions are akin to letting the fox in the henhouse and simply put, things are never the same.

Accordingly, even with regulatory protections or other structural impediments that a company may have to slow down an activist, if a board has concerns about its vulnerability to an activist, it would be wise to seek the advice of experienced investment bankers.  Even if the board does not have concerns, it is wise to consult with an investment bank that has not been involved in the business activities of the bank or its holding companies, and is experienced in activism. The investment bankers can provide an independent assessment of the bank along with the available strategies and appropriate tactics to respond to the activist. The investment banker should be prepared to provide underperforming banks with strategic advice on the steps to be taken to increase the profitability of the bank and simultaneously prepare a strategic plan to fend off the unwanted advances of an activist. The plans need to be anticipatory in nature. If the board begins to plan only after an attack, its actions are reactive and the activist is in control of the situation.

When an activist calls, it is often the temptation for management to recommend that the board reject or stonewall the initial foray against the target or as described above, quickly compromise. The circle-the- wagons approach provides the activist just the type of unreasonable response that may garner support for the activist cause.  Failure by management to communicate with the activist shareholder is usually the response that motivates other shareholders to immediately align with the activist. 

Activists do not initiate contact without specific reasoning to put forward valid shareholder proposals. The typical activist is looking for ways to maximize the value of its investment rather than run the bank or remove mangers.The failure to recognize this point causes most targets to act unreasonably and cause the activist to pursue that very strategy of removal. Rather than an out-of-hand rejection, the board should give the activists’ recommendations serious consideration. In some situations, compromise or embracing the viable ideas of an activist may actually have some merit and show that the board is reasonable and confident that it has a plan to address shareholders’ concerns. Whatever the initial reaction by the target, it should not be based on a hasty decision-making process. 

Although it may be wise to give studied consideration to shareholder proposals, this is a far cry from acceptance. In the initial phases of a discussion, the board should consider the ultimate objective of the activist. Is this activist a long-term investor interested in a strategic acquisition? Is he a short-term investor interested in receiving a higher price in the near term? Or, regardless of the investment holding period, is he interested in putting the bank in play in order to precipitate a takeover and obtain a higher price for all shareholders? The ultimate objective of an activist, which can evolve as circumstances change, will often dictate the appropriate corporate response. The board needs to demonstrate it is acting in the best interests of all shareholders and exercising is its fiduciary duties in good faith.

This Is Not Your Granddad’s M&A

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1-26-15-Naomi.pngDoing a bank M&A deal is nothing like it was just a few short years ago. The regulatory environment has changed substantially. The process takes longer and due diligence is much more involved than ever before, said speakers at Bank Director’s Acquire or Be Acquired Conference on Monday, an annual three-day conference in Scottsdale, Arizona, that attracted more than 800 attendees this year. 

While deal pricing has improved, as well as the sheer number of buyers and sellers in the market looking to do a deal, actually getting from transaction to completion is somewhat of a challenge, speakers said. For one, regulators are scrutinizing both buyers and sellers for any regulatory compliance issues. A few years ago, it wasn’t a big deal if a seller had some compliance problems.  It was assumed that the buyer would take care of them. That’s not always the case anymore, and sellers should try to clean up their problems, both from a regulatory standpoint and also to make themselves more valuable to potential buyers.

John Dugan, a partner at the law firm Covington & Burling LLP, and former comptroller of the currency from 2005 to 2010, said banks need to anticipate regulatory questions and potential delays as well as address with regulators how the bank will handle the increased compliance demands of becoming a larger institution, he said. Banks that reach the thresholds of $10 billion or $50 billion in assets following an acquisition will have adhere to  new sets of regulations. For example, at $10 billion in assets, banks must undergo stress testing and their debit fee income will be cut substantially due to a provision in the Dodd-Frank Act.

Dugan said his firm has seen an increase in Community Reinvestment Act protests following the announcement of a deal. Buyers and sellers should have at least a satisfactory rating on CRA exams.

 “It used to be larger institutions that were targeted, and now [advocacy] groups are going [after] smaller institutions,’’ Dugan said. Such challenges can delay the closing of an acquisition. Some compliance problems are especially serious.  “If there is a BSA (Bank Secrecy Act) issue at hand, it is almost certainly a deal killer,” Dugan said. 

Speakers at the conference emphasized the importance of talking to the bank’s regulators regularly to inform them of the bank’s plans to make acquisitions, and to inform them well in advance of a deal announcement to get a sense of whether the deal will be approved. Regulators will rarely say anything definitive, but could provide a good indication of potential problems.

“The days are gone of calling your regulator the night before a deal,’’ said Eric Luse, a partner at the law firm Luse Gorman PC, in Washington, D.C.

Regulators are less likely to share information with a buyer about a potential acquisition target than in years past, Dugan said. There was a time when  it was common for a buyer to send someone to attend board meetings of the seller after a deal had been signed, but regulators are increasingly asserting that practice is taking control over the organization before the deal is final, said John Freechack, a partner at Barack Ferrazzano Kirschbaum & Nagelberg LLP in Chicago. Regulators also are pushing back against deal language that protects a buyer by allowing a buyer to refuse the seller’s approval  of certain sized loans in advance of the closing of the deal.

The M&A process in general takes longer to complete. Al Laufenberg, a managing director at investment bank Keefe, Bruyette & Woods, said deals that took five to six months from announcement to closing a few years ago are now taking eight or nine months. Part of that is the longer timeframe to get regulatory approval. But buyers and sellers are spending more time on due diligence as well. Buyers are spending extra time scrutinizing other issues alongside credit quality, including cyber security policies and regulatory compliance, he said. Buyers may spend only two days on loan quality and 25 days reviewing cyber security and compliance with regulations, he said. 

Building in extra time to do a deal and ensure good regulatory relations could make a huge difference in successful deal-making. 

Four Ways Board Members Can Avoid Personal Liability

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9-24-14-Dinsmore.pngOn top of everything else bank board members must think about these days, they must also consider and avoid their own exposure to personal liability for actions taken (or not taken) in connection with their board duties. What can you do to avoid personal liability?

  1. Good corporate governance is the first line of defense for a board of directors. With today’s demanding regulatory climate, bank boards are being held more accountable than ever. Directors need to go back to the basics. Understanding the duties of care and loyalty are the foundation of corporate governance and properly documenting actions taken at the board meetings provides evidence that directors exercised their fiduciary duties.

    Beyond this, regulators are asking, “Was the board informed?” and “Did the board approve this?” The key to avoiding personal liability is to stay informed of important decisions by management. There are legal protections in most states for boards that make judgments in the course of business. The board can show it exercised business judgment by documenting the decision-making process with full disclosure, including any discussions fully disclosed in the minutes. Each individual director is obligated to speak up and challenge management.

  2. Engaged independent, outside directors can strengthen a board’s exercise of its fiduciary duties. Though most Federal Deposit Insurance Corp. lawsuits against bank directors have come out of bank failures, with the creation of the Consumer Financial Protection Bureau and the increasing role of shareholder activists, we may see heightened scrutiny on boards with an eye towards damages should the bank sell, falter, or fail. Engaged, independent directors have an important role to play in protecting the board. They should hold regular executive sessions without management, and these sessions also should be documented. In keeping with this concept, it is effective for the board to name a lead independent director who will guide executive sessions and secure the minutes. The lead outside director should also communicate with management.
  3. A knowledgeable director is a good director. Having an appropriately educated board is good for the bank, good for the individual director, and looked on favorably by the regulators. Directors would be wise to undertake risk management education, with content appropriate for the size and scope of the bank. The test applied by the regulators is whether the board is knowledgeable enough to understand the risks attendant to the bank’s operations and product lines (existing and planned), and to challenge management’s analysis of such risks and the proposed action plans to mitigate or take advantage of them. This is not to suggest that directors need to be experts in, for example, designing a capital or liquidity stress test model, but directors are expected to understand management’s analysis of the output in order to effectively guide the bank’s decision-making process.

    A best practice is to develop and adopt a director education policy/program that includes, at a minimum, the following:

    • general description of subject matter expected to be covered and updated annually;
    • number of hours/days of education expected for the year;
      acceptable forms of education—external, internal, self-study, trade association seminars, etc.
    • who pays the cost (including travel);
    • whether attendance/completion will be included in annual director evaluations; and
    • assignment of responsibility for documenting, monitoring and reporting on compliance with the policy.
  4. Paying attention to and engaging with your regulators will reduce your risk of serving on a bank board. A bank director’s primary responsibilities vis-a-vis the bank’s regulators are:

    • to review and understand regulatory reports and other correspondence from the regulator;
    • to formulate corrective action to address issues/deficiencies identified in regulatory reports;
    • to assign responsibility to appropriate bank management or staff for implementation of corrective action;
    • to monitor and manage the progress of corrective action to its timely and effective completion; and
    • to maintain an open line of communication with the bank’s examiner in charge and others within the regulatory agency, as appropriate.

These responsibilities apply whether your bank is well managed, highly profitable, and well capitalized or subject to a formal enforcement action. If your bank finds itself in the latter category, the risk of personal liability is significantly higher. The federal regulatory agencies have little patience for boards that do not take seriously their responsibility to “fix the problems” and are quick to threaten and impose civil money penalties where timely, effective and complete corrective action is not taken. Timely and open communication with the regulators is also important, especially where corrective action deadlines will not be met. Regulators are human too, and like most of us, they hate bad news surprises.

Bank board members need to keep personal liability top of mind. These four practices may not be complete safe harbors, but they will go a long way to helping protect personal assets.

What to Do When Caught Between Investors and Regulators

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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

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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

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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

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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

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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

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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.