What to Know: The Yield Curve is Squeezing Banks, and Other Topics

governance-9-28-17.pngOne of the biggest challenges of serving as a bank director is understanding all of the changes that are occurring in a very complex and highly regulated industry. Most independent directors do not have a career background in banking, and while they usually bring an experienced and thoughtful perspective to their board service, they still have to learn about the industry and stay abreast of the many changes that are occurring.

This week Bank Director held the 2017 Bank Board Training Forum in at The Ritz-Carlton Buckhead in Atlanta, where 225 attendees comprised of independent directors, chairmen, lead directors and chief executive officers met for a day and a half to hear presentations on the latest industry developments, discuss their common problems in peer collaboration sessions and network at refreshment breaks throughout the day and at the Monday evening reception. This is the fourth year that we have held this event and the attendance has more than doubled over that period of time, which I think is a strong indication that directors view professional education as an important process. The agenda included presentations and panel discussions on audit, compensation, risk and technology, as well as the industry’s recent performance.

This year we also invited chairmen, lead directors and CEOs to meet separately on the first day in small group peer exchanges where they were able to share their experiences, discuss a variety of issues they have in common and learn from each other.

Some of the topics under discussion included the disappointing trajectory of interest rates, and proposed Federal Reserve supervisory guidance that will clarify the role of the bank board.

In the opening presentation, John Freechak, a principal at the investment banking firm Piper Jaffray Companies, reported on how a flattening yield curve in recent months is a sign that the industry’s margin pressure from low interest rates might not be easing any time soon. Freechak explained that interest rate spreads had widened following the victory by Donald Trump in the 2016 presidential election. Early market optimism that the Trump Administration would be able to achieve meaningful regulatory reform and tax cuts helped maintain those spreads into early spring, but the well documented legislative struggles by the administration and Republican-controlled Congress has led to an erosion of confidence. The Federal Reserve has said it intends to gradually raise rates, but long-term rates have yet to move appreciably. “The dwindling spread has hurt the profitability of banks as they reach for yield in a low interest rate environment,” said Freechak.

And proposed guidance on supervisory expectations for bank boards of directors, released by the Federal Reserve Board in August and intended to pertain only to banks with assets of $50 billion or more, could end up having a wider application, according to Jim McAlpin, a partner at the law firm Bryan Cave, in a presentation on board culture. “While initially applicable only to the largest banks, application of these expectations would likely spread to all banks,” McAlpin said. One of the core board responsibilities defined in the proposed guidance is to oversee the development of the bank’s strategy. “Much of what passes for strategic planning in banks is actually operational planning and budgeting,” McAlpin said. “High performance boards have a strong sense of ‘we,’ coupled with an expectation of success. This leads them to become more proactive and assertive in the strategic planning process.” Bank Director digital magazine’s November issue will discuss this issue in greater depth.

The 2018 Bank Board Training Forum will be held September 10-11 at the Four Seasons Hotel in Chicago.

Facing Strategic Anxiety Head On

Banks need to be more agile to face the challenges in today’s marketplace, and boards and management teams need to focus on strategy more frequently. Brian Stephens of KPMG outlines the strategic issues impacting banks and how they should be addressed by bank leaders.

  • How Shareholder Expectations Have Changed
  • Questions to Ask About the Customer Experience
  • A New Approach to Strategic Planning

Coming Out of the Shadows: Why Big Banks Are Partnering With Fintech Firms

fintech-8-4-17.pngEver since the introduction of the ATM machine in the 1960s, which several inventors have claimed credit for, banking’s technology has often come from outside the industry. Community and some regional banks across the country almost exclusively rely on vendors for everything from check processing to their core banking systems, and they have done so for decades.

Some banks don’t even count their own money. Counting machines developed by vendors do that, as well.

But banks in general have preferred to keep vendors hidden in the background so customers didn’t know they were there, and big banks have sought to develop much of their own technology in-house. Last year, when I interviewed Fifth Third Bancorp CEO Greg Carmichael for the third quarter 2016 issue of Bank Director magazine, the bank was proud to have developed and spun-off payment processor Vantiv and was planning to hire 120 technology staffers so it would have roughly 1,000 people working in information technology at the end of that year. Bigger banks have even larger crews.

Some of the biggest banks continue to invest in innovation laboratories and pump out new technologies with little to no help from outside vendors, and do an excellent job with it. But there is evidence that even some of the largest banks are warming to the idea that great technology really is coming from startup fintech firms, and that partnerships will speed up the process of innovation and give banks access to sizeable talent outside the banking sector.

The market is changing way too fast for banks to do all the things in-house they’ve done in the past,’’ says Michael Diamond, general manager of payments for mobile banking and identification vendor Mitek, which sells its products to several of the biggest banks. “They know that.”

Aite Group researcher Christine Barry describes it this way. Historically, most large banks have promoted the technologies they have built themselves and kept the names of any technology partners undisclosed. “They did not view such partnerships as a strength and rarely allowed technology partners to reveal their names,’’ she and David Albertazzi wrote in a recent research report, “Large Banks and Technology Buying: An Evolving Mindset.” “That mindset has begun to change, given the increased attention many fintech companies are now enjoying in the marketplace.”

Nowadays, fintech partnerships are viewed as a leg up for a financial institution, and even the biggest banking players are proudly announcing their affiliations with a multitude of small firms.

USAA, long an innovator in its own right, partnered in 2015 with Nuance to offer virtual assistants to customers, and later, a savings app. TD Bank last year partnered with Moven to offer a money management app for consumers. This year, Capital One Financial Corp. joined other big banks in offering Bill.com to small- and medium-sized businesses, a platform for managing invoices and bill payment on a mobile device.

About 92 percent of banks plan to collaborate with fintech companies, according to a 2017 survey by information technology consulting firm Capgemini Global Financial Services.

In the past, technology might have helped improve back-office efficiency or reduced wait times in the branch. Nowadays, it’s at the forefront of strategic planning and the way banks plan to offer a competitive edge, Barry says.

It’s not just attitude that’s changed. The technology itself is developing rapidly. New ways of interacting with customers using artificial intelligence or virtual reality will be harder to banks to develop themselves, and easier to obtain through partnerships. Amazon’s Alexa, the voice service that powers the Echo, already is transforming consumers’ expectations for shopping, because they can now talk with a robot and order what they want online through voice commands. (For more on what banks are doing about AI, see Bank Director digital magazine’s Fintech issue.)

APIs, or application programming interfaces, will make it easier for banks to offer their customers a variety of technology solutions, by opening up their systems to technology vendors, as described in a recent issue of Bank Director digital magazine.

One of their biggest obstacles for banks is to monitor every vendor for compliance with regulations and security concerns. Smaller banks just prefer to do business with established vendors they trust. But already, they have begun to tap into the benefits of a wave of new fintech technologies, too, by asking core processors such as FIS and Fiserv to connect them with best of breed products, Diamond says. “They need the outsourcers to outsource themselves,’’ he says.

Risk Versus Return in M&A Transactions

transactions-2-20-17.pngMergers and acquisition (M&A) transactions need to be looked at from a risk versus return perspective. Participants in deals, both the buyer and seller, should understand the value proposition of the transaction and determine whether it is better to continue to grow and thrive organically or execute on a deal. Understanding value drivers and how to optimize value is the key to prospering in the future.

1. Know your value and what drives it.
There are both value creators and value detractors that exist for every company. It might be weak internal controls, a consent order or a multimillion-dollar, unfunded pension that weakens your deal prospects. On the other hand, you may have strong core deposits, strong profitability metrics or an experienced and actively engaged management team with deep client relationships that drive growth and value.

Value detractors specific to each company can be corrected over time. As the risk profile of the company improves, it is shown that valuation multiples will also improve. A company that has many value detractors can improve its risk profile over time. By improving its risk profile, the company increases the market’s perception of the value of the company, leading to higher valuation multiples. As your institution’s comparative value to the market changes over time, you must conduct periodic valuations to understand what the company’s current value is and what is driving it.

2. Understand your bank’s strategic paths, value and the execution risks of each path.
Once a company has a better understanding of its current value, it must understand the different decision tree paths available. Each of these paths will have a resultant present value of the company based upon executing on each path into the future. The risks and return associated with each path needs to be assessed. Below is an example of a strategic decision tree with five different paths. Each of these future strategic paths is modeled to determine the resultant present value resulting from each scenario path.


Not only is a present value calculated for each path, but the key risks and value drivers for each path need to be determined as well. For instance, if the company remains independent (path A), a key risk is that it may not be able to attract and retain key talent necessary for the company to thrive in the future.

In addition to the execution risks associated with each path, the financial value of the company under each scenario is also based upon a set of assumptions. Those assumptions must be reviewed carefully and the management team and the board of directors must critically review and sign off on those assumptions. More specific to M&A transactions, here are some of the major factors that impact an M&A deal:

  • Price: A stronger buyer currency shortens the work-back period of tangible book value dilution in a stock transaction.
  • Form of Consideration: Cash may decrease the work-back period of dilution in a transaction relative to utilizing stock consideration, due to higher earnings per share accretion, but utilizing cash will reduce the amount of capital at the combined entity.
  • Cost Savings: Acquisition of smaller banks and in-market deals will generally have higher savings (30-50 percent), while market or business line expansions generally have somewhat lower savings (25-35 percent).
  • Synergies: Deals can provide many synergies such as higher legal lending limit, greater franchise, new combined customer base, new sources of fee income, complementary loan and deposit products, or additional management bench depth for the combined entity.
  • Transaction Expenses: These are nonrecurring expense items and therefore should not be included in the pro forma combined income statement going forward but will impact tangible book value per share (TBVS) dilution and work-back period. Transaction expenses should generally be 7-12 percent for community bank deals and levels outside the range should be reviewed.
  • Mark-to-Market Assumptions: The target gets marked-to-market in a deal and these marks will initially impact TBVS upward or downward. The marks will be amortized/accreted through earnings over time. The marks generally have a bigger initial impact on TBVS and the earnings impact will be taken over a longer time period.

3. Recognize that a good deal on paper does not translate to a successful resultant entity.
Even with an extensive review of the assumptions, modeling and financial aspects of a transaction, a good deal on paper does not necessarily translate into a successful entity. Merger integration will make or break an institution’s ability to realize value in a transaction. Practical issues including vendor selection, branding and employee retention impact restructuring expenses. Social issues, such as corporate culture and leadership structure, define the bank moving forward.

Remember that there is an inherent risk versus return tradeoff in every M&A transaction. Understanding your institution’s risk profile, corporate culture, and all possible strategic paths will mitigate risk and maximize return.

Why a Compliance Mindset Is Hurting Community Banks

risk-management-1-20-17.pngCommunity banks are wasting money on compliance. They are spending more than ever, hiring additional risk officers, internal auditors, compliance officers, vendors and consultants. They are checking every box and fulfilling every mandate. And they are doing it all wrong.

A recent study by the supervision division at the Federal Reserve Bank of St. Louis found that spending more on compliance isn’t leading to higher regulatory ratings for the smallest community banks. It isn’t elevating the bank’s regulatory management scores, or positioning banks for success.

That’s because having a compliance mindset is a recipe for mediocrity, no matter the size of the bank. The banks that will earn the most leeway with regulators—and maximize value for shareholders—will naturally implement and utilize the tools and processes that are a prerequisite for compliance as a critical function of their strategic and capital planning processes.

When that happens, compliance becomes a mere afterthought; something that is more icing on a cake that doesn’t need icing to begin with. This type of approach is actually easy to execute. You don’t need expensive, overrated and highly misleading black-box models and software. You don’t need an entire department dedicated toward enterprise risk management.

What you do need is a cultural mindset, which starts with the CEO and the board of directors. They must change the outlook in the bank so that risk management tools are used to play offense, not defense. These proactive and forward-looking tools enable the team to see problems before they materialize. The CEO can then position the bank to gain a competitive edge, while its competitors (from both an operational and capital markets perspective) get blindsided.

I participated in a recent regulatory panel with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. The topic was how best to manage commercial real estate concentrations. Part of the discussion revolved around the role of stress testing, which can be critical to showing examiners that a bank has enough capital to handle a risky portfolio.

Stress testing is a great tool for the job, but it’s a tool, not the job. Banks that simply submit stress tests to regulators as evidence that they can manage a loan portfolio aren’t going to get what they want.

Instead of viewing stress tests as an end game, bank CEOs need to think of them as tools to provide insights. Reports must be discussed at the board level and understood by the highest levels of management. And then the bank must adjust its strategy if the tests show a potential problem. This lesson applies to much more than concentrations. The results of adequate stress testing offer a strategic guide to capital planning, M&A and more.

The trick to compliance is to not treat it as a compliance exercise. It must be an integral part of strategic planning. A CEO cannot give a stress test to the chief risk officer and say, “Make the problem go away.” CEOs must look at the results, understand them and use them to adjust their strategic thinking. If organic growth is not working, the proper analytics can guide the executive team’s strategic course toward a merger or acquisition.

A funny thing happened when I began talking about this compliance mindset on the recent regulatory panel. The regulators nodded their heads in agreement.

How Many Banks Look 10 Years Ahead?

FutureOfBankingArticle.jpgWhat is the biggest challenge facing bank directors today?

The list of possible answers is pretty long. Is it the continuation of a low interest rates squeezing net interest margins for years? The cost of all the new regulations since the financial crisis? The cybersecurity cat-and-mouse game, where the hackers always seem to be one step ahead of you? Or is it keeping pace with the rapid changes in digital technology, particularly in the mobile space?

All of those are very plausible answers, but I’d like to suggest another one—preparing for the future. I think that most bank boards spend their time on what’s happening today in their institutions and relatively little time thinking about the future, and by that I mean looking deep into the future—10 years out, where emerging trends can have a transformative impact on the entire industry. There are reasons for this, of course. Today’s operating environment for banks is challenging, so it’s not surprising that bank boards tend to place most of their focus on performance issues, particularly at public companies. Boards do engage in strategic planning on an annual basis, and the resultant business plans often have a five-year time horizon, but they are usually based on what the bank will do in the current environment. It’s harder to understand how larger, more systemic issues will impact the bank. 

Bank Director will hold its third annual Bank Board Training Forum on September 29-30 in Chicago. This event was designed to be a little different than our other events, which focus on specific activities like risk management, compensation and mergers and acquisitions, and often appeal to senior executives or directors who are focused on that one issue. The Training Forum, by contrast, looks at a wide range of issues that impact the entire board, and tries to synthesize those into a holistic view for all of the directors.

In the spirit of that approach, I will be giving a presentation on the future of banking 10 years out. Of course, 10 years is a big chunk of time, so any predictions one makes today could very well turn out to be wrong. For example, who would have predicted the following in 2006?

  • The worst financial crisis since the Great Depression.
  • The total collapse of the U.S. housing market.
  • The Dodd-Frank Act and Basel III. However, if you had predicted the crisis, then you could have predicted with reasonable certainty that regulatory consequences would follow, since history shows this to be the case.
  • The over-the-top popularity of smartphones and their impact on banking and just about everything else. In fact, Apple didn’t introduce the iPhone until 2007.
  • An emerging financial technology sector which is beginning to revolutionize banking.

It’s not that some of these transformative trends or events weren’t already in evidence 10 years ago. A minority of economists were concerned in 2006 that the Federal Reserve’s accommodative monetary policy of low interest rates was creating a bubble in housing prices, but even they did not predict the cataclysm that later occurred. And smartphones had already been on the market for a couple of years in 2006, but their numbers were small and their capabilities limited compared to their market dominance today.

If predictions about the future are hard to make, I don’t think the predictions themselves are as important as the process of constantly looking forward. A board that has its eye on the future as well as the present is going to be better prepared to react to changing circumstances.

As for what I think the next 10 years has in store for banking, those will come in a later post.

The Little Bank That Could

strategy-9-23-16.pngSoon after Josh Rowland’s family bought Lead Bank in Garden City, Kansas, in 2005, the small financial institution felt the full impact of the financial crisis. The loan portfolio was in bad shape. Several employees lost their jobs. The entire experience lead to a lot of soul searching.

“It was really existential,’’ Vice Chairman Rowland says. “What do we survive for? What’s the point of a community bank? The situation was that dire. We had to really decide whether we should give it up.”

After much discussion, the family decided to hire Bill Bryant as the chief executive officer to help clean up the bank, now with $164 million in assets, and really focus on its niche: small business owners. A lot of community banks say they are serving small business owners, but Lead Bank decided to go a step further. In 2011, it launched a business advisory division for the purpose of coaching small business owners on cash flows, provide part-time or interim chief financial officers, and advice on strategic planning and even mergers and acquisitions. Rowland says a lot of small businesses could use advisory services, especially if they can’t afford to hire a full-time CFO. Lead Business Advisors has senior managing director Patrick Chesterman, a former energy executive for a large propane company and Jacquie Ward, a trainee analyst. The bank overall made a profit of $500,000 in the first six months of the year and saw assets grow 30 percent in the last year and a half, according to Federal Deposit Insurance Corp. data.

But the investment in advisory services is not a quick payback. Rowland says the division is not profitable yet. The challenges include marketing the program to a business community more accustomed to relying on trusted accountants or lawyers for such advice. Banks naturally have a lot of financial information and expertise, but they fail to provide it to their clients. “We ought to be figuring out every possible way to deliver that kind of financial expertise to Main Street business,” he says.

The tactic is an unusual one for community banks, which might have a wealth management division but not a business advisory division per se. And it’s expensive. Baker Boyer, a $571 million bank in Walla Walla, Washington, has been offering business advisory services as part of its wealth management division for years. But it has taken some 15 years to restructure the bank to offer such services, says Mark Kajita, president and chief executive officer. The average personnel expense per employee for the bank is roughly $80,000 annually with six lawyers on staff and the bank’s efficiency ratio is 73 percent, higher than the peer average of 66 percent.

However, the bank made $2.5 million in profits during the first half of 2016, with half of that coming from the wealth and business advisory division. Kajita says what made it possible was the fact that the bank is family owned and can invest in the long term without worrying about reporting quarterly financial results to pubic shareholders.

Community banks of that size have a real need to create a niche,’’ says Jim McAlpin, a partner at Bryan Cave in Atlanta who advises banks. “Historically, community banks have been focused on the small businesses of America, and to offer services to those small businesses is a great strategy.”

Joel Pruis, a senior director at Cornerstone Advisors in Phoenix, says banks have done themselves a disservice by relinquishing advisory services to CPAs and attorneys. “In terms of empowering lenders, in terms of providing more advice, we definitely need more of that,’’ he says. “Bankers need to be seen as a resource and an expert in the financial arena instead of just application takers.”

For Rowland, rethinking the role of the community bank is fundamental to its survival. “I don’t know how we expect to keep doing the same things and expect different results,’’ he says. People don’t feel their bank is adding any value for them, he says. “If that’s our industry’s problem that we haven’t given them an experience, that’s our fault,’’ Rowland says. “We have taught them over years and years that our services are so cheap, they ought to be free.”

Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence

due-diligence-5-16-16.pngIn today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.

So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.

Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.

If the proposed offer consists of primarily cash consideration, the selling institution’s board should focus on the buyer’s ability to fund the transaction at closing. Review of the buyer’s liquidity and capital levels can signal whether regulators may require the buyer to raise additional capital to complete the transaction. Sellers bear considerable risk once a merger agreement is signed and the proposed transaction becomes public. The seller’s customers often think of the announcement as a done deal and the merger also naturally shifts the seller’s attention to integration rather than its business plan, which can benefit the combined company, but affect the seller’s independent results. It is difficult for the seller to mitigate these risks in negotiations, so factoring them into the board’s valuation of a sale offer is the best approach.

When considering a transaction in which a significant portion of the merger consideration is the buyer’s stock, the board has additional diligence responsibilities. First, the board should consider whether the buyer’s stock is publicly traded on a significant exchange or lightly traded on a lesser exchange. As the liquidity of the buyer’s stock decreases, the burden on the seller to understand the buyer’s business and future plans increase, as its shareholders will be “investing” in the combined company, perhaps for a lengthy period of time. The board should also consider if and when there will be opportunities for future shareholder liquidity.

On the other hand, when the seller’s shareholders are receiving an easily-traded stock, both parties will have an interest in mitigating the effects of market fluctuations on the pricing of the transaction. In most cases, a pricing collar, fixing the minimum and maximum amounts of shares to be issued, can allocate market risk between the parties. Such a structure can ensure that a market fluctuation does not cause the seller to lose its premium on sale or make the transaction so costly that it could affect the prospects of the buyer.

In addition to the financial terms of the proposed transaction, the seller’s organizational documents may include language allowing the board to consider a broad range of non-financial matters as part of the evaluation of a proposal. Certain matters, particularly with respect to how the seller’s executives and employees are integrated into the resulting institution and how the buyer’s business plan fits into the seller’s market, can have a significant impact on the success of the transaction. Just as community banking is largely a relationship-based model, the most successful mergers are those that make not only economic sense, but also address the “human element” to maintain key employee and customer relationships. The board can add value by raising these issues with management as part of its discussion of the merger proposal and definitive agreement.

In evaluating an offer to sell, the board is responsible for determining whether the bank’s financial advisors and management have considered a range of relevant items in evaluating an offer, including the offer’s financial terms, execution risks associated with the buyer, and social issues relating to the integration of the transaction. Using the bank’s strategic plan to determine which issues require closer scrutiny can focus the board’s attention on truly meaningful issues that will provide additional value to the institution’s shareholders.

Building An M&A Blueprint

Scale is driving buyers and sellers today, with acquirers seeking growth and sellers seeing scale as an obstacle. Christopher Olsen of Olsen Palmer outlines how both buyers and sellers can plan for a successful deal, and explains how even banks focusing on organic growth strategies will be impacted by consolidation.

  • Scale and M&A
  • A Buyer’s Plan
  • A Seller’s Plan
  • Impact on Organic Growth Strategies

Five Steps for Dealing With Subjective Regulation

bank-regulation-2-24-16.pngThere has always been a level of subjectivity in the regulatory process. In the past, it manifested itself as interpretations of written regulations. The post-crisis regulatory environment continues to evolve—as does the subjective aspect of regulation—creating new challenges for bank boards. Bank directors are now faced with subjective terms like “risk culture” and “deceptive acts and practices” included in their exam reports as standards, as well as a regulatory focus on “adequacy” when evaluating strategic planning and capital and liquidity management. Bank directors are now challenged to understand what needs to be done to meet these evolving subjective expectations of the regulators and, in turn, hold senior management accountable.

Trying to define these terms is probably futile, but there are things the board can and should do to ensure these standards are being met.

Educate Yourself
Directors should start by learning as much as they can about these subjective requirements. Understanding how they evolved and what they are intended to correct or prevent will help you understand what has to be done to meet them. The regulators have made it clear they have higher expectations for director oversight of risk taking activities, and the board is expected to challenge, question and, where necessary, oppose management proposals. Education is key to meeting these expectations.

Identify Behaviors
Actions speak louder than words. Too many organizations rely solely on policies or pronouncements to demonstrate compliance with subjective requirements. Take risk culture, for example. The board should ask and understand how everyone in the firm is held accountable for risk. How do compensation plans incorporate risk concepts? How do you deal with policy violations? Are employees rewarded for identifying and addressing risk matters? Directors must then ask whether the answers to these questions demonstrate the type of risk culture the firm is trying to achieve.

Learn From Others
Directors should be acutely aware of industry trends when it comes to subjective regulation. Regulators are relying more and more on horizontal reviews of financial firms to identify best practices. Understanding what has been considered inadequate when it comes to a financial firm’s capital or liquidity planning can provide guidance on evaluating a firm’s own plans. For example, the Federal Reserve publishes the results of its Comprehensive Capital Analysis and Review for the largest banks, which is a good place to start. The public release of capital planning results showed there is both a quantitative and qualitative aspect to planning. While the quantitative aspect of planning is made public through establishing acceptable minimums, the qualitative aspect (how you got there) can best be met by understanding how others succeeded or failed to properly plan.

Create a Program
Understanding what needs to be done is the first part of the challenge. The second step is making sure your firm is doing it properly. Subjective standards have to be incorporated into risk and audit programs. It may seem impossible to audit for something like risk culture, and an audit of risk culture is certainly more art than science, but some questions the audit should include are:

  • Is there an understanding, communication and alignment of values in the firm? 
  • Are risk commitments being met and does the firm and management do what they say they will do?
  • Are there any exploitations of gray areas to benefit individuals?
  • Is there evidence of a balance in the firm between achieving results and managing risk?

Bottom line is the board should insist audits and risk assessments take into consideration how these areas of subjective regulation are reflected in the operation of each area, procedure or process they review.

Tell Your Story
Directors should be ready and able to express their understanding of how they meet today’s subjective standards. For example, understanding the strategic planning process and the manner risk factors are taken into account in both planning and execution of strategy allows directors to ask the right questions throughout the process. The same is true for capital and liquidity planning, where reflecting the right level of question and debate in the minutes will likely be crucial to meeting the regulatory “adequacy” standard.

The examples shared are just some of the subjective terms permeating the regulatory process in today’s environment. Like written regulations, they will continue to evolve and will be heavily influenced by the regulatory climate. Dealing with this regulatory uncertainty will continue to be an important practice for directors.