Thursday, July 2, 2015

The Sacrifice of Virtue

Credit: Darren Walsh

On May 20, 2015, five multinational banks agreed to collectively pay roughly $5.6 billion in fines and penalties to regulators and law enforcement agencies in the United States and the United Kingdom.  Four of those banks (Citicorp, JPMorgan Chase & Co., Barclays PLC, and The Royal Bank of Scotland PLC) agreed to plead guilty to felony criminal charges of foreign exchange price manipulation between December 2007 and January 2013 (varies according to bank).  One bank, UBS AG pleaded guilty to wire fraud in relation to another matter, but was granted conditional immunity from the foreign exchange price manipulation charges because it was first to report it.  The banks also agreed to three years of corporate probation.

In keeping with the post-Enron C-suite tradition of using one's employees as human shields (by invoking memories of the 2002 demise of the public accounting firm Arthur Andersen) and by frightening regulators with hypothetical systemic apocalypse scenarios; these guilty pleas weren't even signed until the U.S. Securities and Exchange Commission (SEC) provided assurances that certain capital markets waivers would be granted to the banks involved.  Now, the U.S. Department of Labor is being heavily pressured to issue its own waiver as to whether these banks should be allowed to manage retirement accounts.

For the purposes of discussion, let's set aside the accountability that comes from government law enforcement and the inevitable follow-on civil litigation (as being one thing) and focus on our own collective behavior as consumers of financial services (as being another thing).

One would tend to think that in living rooms and in corporate boardrooms across the world, people would be reassessing their business relationships with financial services providers that fail to live up to our accepted standards of business ethics... one basic ethical standard being: not violating our criminal laws.

The American Bankers Association (ABA) stayed mum regarding this legal settlement.  Not a word of this in their Press Room and lists of public correspondence.  A policy of silence and disengagement was apparently chosen as the best way to handle family shame.

The energetic and feisty Independent Community Bankers of America (ICBA), on the other hand, sent this letter to U.S. financial regulators expressing sanctimonious outrage and declaring (once again) a regulatory double-standard in this legal settlement.

But surely, the virtuous members of both banking trade associations also scrambled to reassess any correspondent banking and vendor business relationships with the felon banks?

After all, would an employer hire a job applicant with a recent criminal record?  Would investors trust their personal wealth to a broker or financial advisor with a past criminal record?

Add to all that, the ample pool of alternative purchasing choices.  There are many law-abiding banks in the global marketplace that offer similar or identical financial services.

Sadly, you know the answer as well as I.

Scholars have done marketing research on topics like: Is information about whether a firm acts ethically an important consumer concern?  And, if so, will information about a firm's behavior influence their purchase decision?  You would think, in the abstract, that the answer would be an unequivocal "yes".

A research paper in the Journal of Consumer Marketing indicates that, except in the most egregious cases, "consumers do not wish to be inconvenienced, and ethical purchasing will only take place if there are no costs to the consumer in terms of added price, loss of quality, or having to 'shop around' " ...  "The depressing reality is that many ethical abuses can still continue to be carried out by companies without any negative impact on consumer buyer behavior."

I'm a little disappointed by our sacrifice of virtue, but we all get the point. However, there must be, after all, a ceiling (or is it a floor?) on corporate and individual consumers of financial services being numb and lethargic about business ethics?  Does our passivity also make us enablers?

An attorney once told me about a concept called "Does it pass the puke test?"... behavior so contemptible that it makes you want to throw up.  Apparently, at this juncture, we consumers of financial services have opted for living with a free-floating feeling of nausea about the behavior of bad players in the banking industry.  As the colloquial saying goes... we could taste it in our throats, but managed to keep it down.

In today's upside-down world of finance, federal law forbids a person with a criminal record, involving dishonesty or a breach of trust, to work for a bank (without a rare waiver from the FDIC); but, it's OK for a bank with a criminal record to work for us.

Thursday, June 4, 2015

FinCEN's Financial Drone Strike

Image result for "banco madrid"

While in Madrid, Spain a couple of weeks ago on other business, morbid curiosity drove me to pop on over to the city's highly affluent and chic Salamanca District to view (figuratively speaking) the smoldering remains of a U.S. financial drone strike.  As I got off the bus, I saw over there by the Hard Rock Cafe, tucked away in a corner off the Plaza de Colón, the head office of Banco de Madrid, SA.

A sad sight indeed.  As I walked over to the small plaza in front of the bank, there was evidence of the removal of the bank's large signage from the building's roof-line.  Gilded lettering, identifying the bank, had been pried off of blocks of granite in the pedestrian plaza, leaving just a faint outline of the bank's name where the harsh sun of the Castillan meseta was unable to bleach the stone.  Like a tombstone without an epitaph, the bank's name remained on the transom above the building's main entrance door.

In front of that main entrance stood a solitary security guard, shooing off inquiring passers-by while allowing other building tenants through the door.  Very few people came or went during the time I spent pondering and reflecting on this situation.

You see, Banco de Madrid (BdM) is a bank in liquidation.  Without advance warning, on March 10, 2015, the Financial Crimes Enforcement Network (FinCEN), an arm of the U.S. Treasury Department, fingered its parent company, Banca Privada d'Andorra (BPA), as a "foreign financial institution of primary money laundering concern" for abetting transnational organized crime in Russia and China, as well as corrupt officials in Venezuela.

Andorra, a tiny sovereign principality high in the Pyrenees mountains, has five banks.  BPA is one of them.  From 2009 to 2014, BPA was alleged to have provided assistance to third-party money launderers, "including professional gatekeepers such as attorneys and accountants", by laundering hundreds of millions of dollars through correspondent bank accounts at four U.S. banks.  In return, BPA's high-level managers accepted payments and other benefits from their criminal clients.

The same day of FinCEN's announcement, the National Andorran Finance Institute (INAF) decided to intervene BPA "to guarantee the continuity of its operations."  Andorran authorities also later arrested BPA's Chief Executive Officer on suspicion of money laundering.

Concurrently, the Bank of Spain also seized BPA's 100%-owned banking subsidiary in Spain - BdM.  Shortly thereafter, a crushing wave of funds withdrawals by customers left BdM unable to meet its obligations in a timely manner.  When Spanish authorities refused to bail out the bank, the bank filed for bankruptcy protection on March 16, 2015.

From a human perspective, there is no denying a degree of unfortunate collateral damage from FinCEN's financial drone strike as it impacted BdM's unsuspecting Spanish bank customers and bank employees who were not involved in aiding and abetting money laundering.  FinCEN noted that "BPA's activity of primary money laundering concern occurred largely through it's Andorra headquarters." FinCEN never mentioned BdM in its news release.

Fortunately, most of BdM's bank customer deposits were insured.  But for the estimated 500 clients with uninsured deposits, they get receivership IOUs.  Those bank employees who are unable to secure new jobs at other banks, will join the swollen ranks of Spain's unemployed.  Costs to the deposit guarantee fund in Spain is estimated to be in the neighborhood of 500 million euros.

The take-away?  FinCEN can exert brute force with a blunt instrument against any bank in the world.  It gives new meaning to the concept of "U.S. global force projection"... a term usually associated with our warriors at the Pentagon.

Unlike the genteel megabank check writing-for-wrongdoing exercises engaged in by other U.S. banking regulators, the long arm of U.S. law enforcement, as practiced by FinCEN in its PATRIOT Act Section 311 proceedings, ends in a tightly clenched fist, and sometimes a financial mushroom cloud.

So over there in the center of Madrid's Plaza de Colón, standing on a high marble pedestal, is a larger-than-life statue of Christopher Columbus gazing west towards the Americas.  Maybe he should also be scanning the horizon for FinCEN drones.

Wednesday, March 18, 2015

G-SIB Failures: Either Way, You Pay

Credit: Thierry Cheverney

I have been reading the public responses to the November 2014 Financial Stability Board (FSB) consultative document on "Adequacy of Loss-Absorbing Capacity of Global Systemically Important Banks in Resolution"   This consultative document frames the broad outlines of what will eventually constitute the international framework for the bank "bail-in" process.  A process meant to (hopefully) minimize the impact of a bank failure on financial stability, (hopefully) eliminate future bank bailouts by governments, and (hopefully) do away with the "too big to fail" concept.

In its most general sense, the idea of a "bail-in" is to have Global Systemically Important Banks (G-SIBs) maintain a layer of  Total Loss-Absorbing Capacity (TLAC)-eligible liabilities in an amount sufficient to convert (some or all) of the bank's obligations to unsecured and uninsured creditors into a confidence-inducing chunk of bank equity capital.  The debt-to-equity conversion would be triggered should the bank's existing shareholder's equity cushion be depleted by losses.  

Think of the G-SIBs as the supertankers of global banking and their skippers, our Captains of Finance.  Many years ago, changes were made to the structural integrity of our global fleet of petroleum supertankers.  Most of the fleet transitioned from single-hulled vessels to double-hulled vessels in the interest of greater public safety.

TLAC works in much the same way - the first hull (and line of defense) is shareholder capital, the second hull (and line of defense) are the monies owed to unsecured and uninsured creditors that can be converted to equity capital.

It's the intent of the FSB to identify a TLAC of sufficient thickness to help avoid a financial Exxon Valdez disaster - a supertanker that lacked a double-hull at the time of its grounding in Alaska in 1989.

The consultative document proposes a minimum TLAC requirement of approximately 16-20% of risk weighted assets and 6-8% of total assets or at least twice the Basel III leverage capital requirement, excluding any Tier 1 common equity used to meet any applicable capital buffer requirements.

The public responses, which come from banks, trade associations, academia, rating agencies, and others, are supportive of the "bail-in" idea in general, but differ on interpretations of the proper size of the TLAC cushion, eligible TLAC debt instruments, and the issue of pre-positioning TLAC  - both from a home country/host country perspective and from the perspectives of single point of entry (SPE) resolution and multiple point of entry (MPE) resolution.

There are two things that make me uneasy about the proposed bail-in regime.  One is the compartmentalized approach regarding bank insolvency and the other is this annoying hallelujah chorus that is proclaiming the end of costs to taxpayers by eliminating government bank bailouts of G-SIBs.

Bail-ins for G-SIB leviathans will likely shift the costs to taxpayers from one government expense bucket (targeted bank bailouts) to a different government expense bucket (economic stimulus programs).  Because of the immense size of the G-SIBs relative to any measures of GDP (country, regional, global), the losses sustained by a G-SIB failure will likely be destabilizing to real economies. When it comes to a G-SIB resolution, government pays, either way.

A compartmentalized approach

It is important to remember that banks can fail in two ways.  First, there is the classic equity insolvency.  Losses erode the shareholder capital of the bank until the point where government authorities trigger their on-the-shelf resolution plans and wind down the affairs of the bank.

The other bank failure vector is a liquidity insolvency.  A bank is unable to meet funding demands and the central bank (as lender-of-last resort) cannot continue to support the bank's liquidity due to lack of eligible collateral or it unilaterally decides to terminate lifeline funding to the bank.

TLAC deals with the classic equity insolvency.  It doesn't appear to me to deal with the potential of liquidity insolvency.  And most important, it doesn't discuss the calculus of the critical dynamic inter-relationships between capital and liquidity in times of financial stress.  Mandatory liquidity coverage ratios will buy time, but are not themselves a solution.

A key question: Will market participants lend funds (without asset pledges) to a "bailed-in" bank absent government guarantees, when there might be marketplace uncertainty about how deep the bank's capital hole really is?

In the fog of a financial crisis, transparency and truth are always the first casualties.  Information is incomplete, rumors abound, and it always takes some time for the second shoe to drop.  And like all rational players (who tend to prefer pleasure to pain), institutional funds providers, honoring their own fiduciary responsibilities, might just stand on the sidelines.

The paper obliquely hints at these difficulties, when the authors say:
"Resolution is not resurrection.  But nor is it insolvency: the institution or successor institution (e.g., bridge institution) has to meet at least the minimum conditions for authorization in order that supervisors may allow it to continue performing authorized activities, in particular critical functions.  Moreover, the reorganization or solvent wind-down that will be necessary following resolution may require a level of capitalization above that required by supervisors so that counterparties continue to trade with the resolved firm and provide funding to it."

Size Matters

Second, the hallelujah chorus ignores the implications of the total cost of a G-SIB failure.  It's not that living wills, the bankruptcy process, and orderly liquidation authority cannot wind-down one or more of any failing G-SIBs by bailing-in shareholders, unsecured creditors, and uninsured depositors.

But at the bail-in point, how large are the cumulative financial losses sustained by legacy shareholders and those now bailed-in?  And second, how will those cumulative financial losses be subsequently transmitted through the national and global real economies?

Remember the sub-prime Collateralized Debt Obligations (CDOs)?  Risk managers were patting each other on the back because they had sliced and diced these financial instruments and thought they had diversified away the risk by distributing the risk to thousands of investors all over the world.  So instead of a few big losers, the smaller distributed losses dragged down economies all over the globe. Sub-prime lending triggered, not only a recession, but this era's mother of all recessions - the Great Recession.

As a point of reference, a May 2012 working paper produced by the research department of the Federal Reserve Bank of Philadelphia pegs the damage (total write-downs) from sub-prime CDOs at $420 billion.

At year-end 2014, for example, the two most complex G-SIBs, JPMorgan Chase and HSBC Holdings, had total Tier 1 capital of $187 billion and $153 billion respectively.  Just pause and reflect for a moment on the size of these numbers.  These sizable Tier 1 capital numbers, when translated into potential bail-in-able dead-weight losses (not even considering the contagion/propagation effects of investor debt leverage) could, individually or collectively, induce recessions in the real economy.

To paraphrase Ross Perot, what you would likely hear "is the giant sucking sound" of aggregate economic demand dropping due to understandably defensive financial behaviors on the part of the injured legacy shareholders, the new bailed-in shareholders, and some portion of the now understandably frightened creditors in the G-SIB.

So either way, government pays for G-SIB failures.  In a bail-in, TLAC regime, government expenditures will likely be in the form of economic stimulus or rehabilitation programs instead of targeted bank bailouts.  Remember, the world has experimented with the bail-in concept during the banking crisis in Cyprus in 2013.  The deep scars from that country's economic upheaval have yet to heal.

It is the size of the cumulative loss to the bailed-in shareholders, creditors, and uninsured depositors that needs to be reduced in order to limit the impacts to the real economy of G-SIB failure.  That argues for less market share concentration in the market for banking services globally.  If we want to contain the economic damage from the failure of a G-SIB, and limit the costs to government, the smaller the all-in costs of G-SIB failure, the better.  Until G-SIBs get smaller, either way, government will pay.

Saturday, January 24, 2015

"All for One, One for All"
(An Encore)

Sadly, passing with scant notice by the banking industry media this month was an important 2015 news release by the Office of the Comptroller of the Currency (OCC).   The news release heralded the distribution of an OCC white paper titled: "An Opportunity for Community Banks: Working Together Collaboratively".  The paper presents the OCC's views on collaborative efforts by community banks and also describes how community banks can pool resources to obtain cost efficiencies and leverage specialized expertise.
"As diverse as community banks are, they share the same commitment to supporting the communities they serve.  With this in mind, the OCC sees an opportunity for community banks to share resources and expertise to the mutual benefit of all involved.

Some community banks may have excess capacity or may have developed platforms or expertise that enable them to provide shared services to other community banks that may not have sufficient resources or demand.  Other community banks may look to collaborate with fellow community banks that share the same core values as a cost-effective way to meet growing demands while retaining their individual identities."
In today's world of continually narrowing net interest margins and the shrinking availability of "sugar high" one-time gains opportunities (like releases from loan loss reserves, profits from investment portfolio securities sales, and 'ringing the register' on deferred tax assets), the inexorable additional step (absent sale of the bank) has to be an increased focus on the control of non-interest expenses.

A ever-increasing part of those overhead costs, in these these post-PATRIOT Act/post-Dodd-Frank Act days, is the cost of regulatory compliance and the almost unavoidable expenditures (for community banks, at least) for the army (yes, it's an army these days) of regulatory compliance cling-ons --- bank consultants (guilty as charged) .

Oh, and let's not forget that army's camp followers - the inevitable information technology (IT) expenditures that often dwarf the consulting fees.

In this OCC paper, we have a major federal bank regulator acknowledging the burden and encouraging banks to seek cost-saving opportunities by leveraging the power of further collaboration... and then outlining the ground rules for doing so prudently.

Waiting for the Federal Reserve to "normalize" interest rates in order to kick start industry net interest margin expansion (and bank profits), in the population of banks that are asset-sensitive, could be like waiting for rain during a drought.  The path to that interest rate normalization in the United States, seemingly visible on the horizon a few weeks ago, could now be extended given the tit-for-tat central bank beggar-thy-neighbor actions taking place in Europe and Japan.  

Two years ago, the Federal Deposit Insurance Corporation (FDIC) also noted these cost burdens in a series of community banker interviews.  Back then, I commented that the full realization of the benefits of legal cooperation among community banks had yet to be achieved.  Now the OCC has surfaced the issue once again.

So here is the earlier blog post:

*  *  *  *  *  *  *  *
March 14, 2013

I wanted to comment on the recent FDIC Community Banking Study.  It's a very nice piece of work, highly recommended.  Its data-driven triangulation of the profile of the community bank population should help immensely as opportunities, costs, and regulatory burdens for community banks are debated and deliberated upon in policy circles.

The community banker interviews, discussed in Appendix B of the study, haven't received much banking media attention, but deserve to be highlighted.  The study's authors conducted interviews with nine community bankers to understand what drives the cost of regulatory compliance.  While that may be a small sample size, the collective opinions of these nine community bankers merit attention.

Here are some clips:

Most of the interview participants stated that no one regulation or (supervisory) practice had a significant effect on their institution.  Instead, most stated that the strain on their organization came from the cumulative effects of all the regulatory requirements that have built up over time.”

Most of the interview participants indicated that they consider regulatory compliance as part of the normal cost of conducting business.  Consistent with the notion that these costs were a normal part of business, the interview participants noted that their overall business model and strategic direction had not changed or been affected by the regulatory compliance cost issues.”

While the primary goal of the interviews was to identify what drives regulatory compliance costs at community banks, two related themes emerged.  A majority of the interview participants discussed their increasing reliance on consultants and their dependence on service providers....

...Many of the interview participants stated that their increasing reliance on consultants is driven by their inability to understand and implement regulatory changes within required timeframes and their concern that their method of compliance may not pass regulatory scrutiny...

...With regard to dependence on service providers, each of the interview participants noted that they had contracted with at least one firm to provide products and automated processes that provide a cost-effective means of complying with certain regulations.  While these service providers are considered beneficial to their bank's operations, interview participants noted that these firms have few incentives to make timely changes to their software to meet new regulatory requirements.  These time delays could affect their bank's ability to comply with new or changed rules.”

One option community banks might consider to deal with the increasing reliance on consultants and the concern about service provider responsiveness is confederation. Confederation describes a type of organization which consolidates authority from other independent and autonomous bodies.

In the community bank context, it might be a central organization that uses the collective leverage of its members to drive down consultant costs, be a clearinghouse for compliance solutions, or possibly promote standardized compliance solutions among its members.  A confederation has the potential to use its muscle to improve servicer responsiveness or, in some cases, potentially replace vendors entirely and provide those services to members on a not-for-profit basis.

One example of a confederation in another industry is the Independent Grocers Alliance (IGA).  The Independent Grocers Alliance was started in May 1926 when a group of 100 independent retailers organized themselves into a single marketing system.  Contrasting with the big chain grocery store business model, IGA operates through stores that are owned separately from the brand.  But like the big chain stores, IGA provided their local members with common branding, technical support, a distribution network, and the leverage of the consolidated buying power of its members.

Today, IGA has expanded into the world's largest voluntary supermarket chain with more than 5,000 member stores worldwide.

To varying degrees, and in several respects, banking trade associations have taken many of the steps toward stronger confederation among community banks.  Some have subsidiaries that provide compliance management consulting services and certain vendor platforms.  But as the comments made by these nine community bankers seem to indicate, there are opportunities for further advancement.

Tuesday, December 30, 2014

A Gift for the New Year:

New Year 2

"Let us not look back in anger, nor forward in fear, but around in awareness."        - James Thurber*

One December holiday season gift I always look forward to is the public release of the OCC Semiannual Risk Perspective by the Office of the Comptroller of the Currency.

I like it because bank examiners are in the unique position of seeing the operational insides of every bank they visit, and collectively, they scrutinize the entrails of every bank in the nation.  It's a privilege denied to those of us on the outside, who peer from the public galleries or only know the inner workings of the bank in which one works.  This privilege allows bank examiners to accurately gauge the range and variations of banking practices in the industry and to compare notes on risk-taking behaviors horizontally, both within and across banking markets.

It's not that I don't trust the instincts of the business and trade press.  In fact, I would argue that there were many times when the investigative reporters from the Wall Street Journal,  New York Times, Washington Post, Bloomberg News, or the American Banker bested the examiner corps at their own game by unearthing significant banking issues that the then-chagrined regulators were later obliged to address.

No, what gives me pause and what makes it difficult to digest the relentless media "chatter" at face value, is the composition of the analysis stream within the business and trade press.  The pieces written by consultants, politicians, and spokespeople for special interests who have a tendency to raise conjecture, philosophical tilt, or even nonsense to the level of conventional industry wisdom.

Such as the "yelling fire in the theater" pieces that implicitly (or even shamelessly) (and, of course, conveniently) call for the specialized services of the author or his/her professional services firm.  Or the predictable flurry of subject-specific think pieces that precede any major subject-specific banking conference that, I guess, are written to help channel interest towards the author's booth in the grand exhibition hall or to gin up an attentive audience for a panel discussion at said banking conference.

So, occasionally, it's nice to take a break from the "spin" machines.  As the great actor Walter Brennan used to say when referring to his Old West gun-slinging prowess:  "No brag, just fact."  That's (refreshingly) what you get with the OCC's Semiannual Risk Perspective.

[Most of you are probably not old enough to remember Walter Brennan (sigh), so here's the bit captured on YouTube.]

I encourage you to read the entire document.  It's a well-organized, well-developed, and well-presented 41 pages.  In these times of Dodd-Frank Act massive missives, it's a comparatively quick read.

Too busy or can't handle reading it on the screen of your mobile device?  Here's the "Reader's Digest" version:

The OCC Semiannual Risk Perspective explores three key risk themes and provides the following guidance to bank management and boards of directors:

1)  Strategic risk remains high for many banks as management teams search for sustainable ways to generate target rates of return or struggle to implement their strategic plans effectively.

"Banks’ boards of directors and senior managers should ensure that strategic planning and product approval processes appropriately consider expertise, management information systems, and risk controls for the banks’ business lines and activities.  Banks also should incorporate management succession and retention of key personnel into their strategic planning process.
Compliance programs should keep pace with the volume and complexity of regulatory changes, as well as the changing nature of bank customers and transactions."

2)  Operational risk is high as banks adapt business models, transform technology and business processes, and respond to increasing cyber threats. 

"Bankers should maintain heightened awareness and appropriate resources to identify and mitigate cyber threats and vulnerabilities, and should incorporate cyber-resilience planning and controls into their business continuity planning and testing.
Bankers should also ensure that risk management of third-party relationships is commensurate with the breadth, complexity, and criticality of these arrangements as outlined in OCC Bulletin 2013-29.   As banks experience increased system and process interconnectedness, as well as increased concentration risk when vendors consolidate, they need to identify and monitor risks of third-party relationships and ensure resilience against business disruption.
 Banks also should identify and assess cross-channel payment, operational, and compliance risks, and ensure their ability to measure, monitor, and control risks associated with new activities."

3)  Competitive pressures, the need for revenue growth, and the ongoing low interest rate environment continue to complicate bank risk management.

"Banks’ boards of directors and senior managers need to monitor elevated [loan and investment] policy exceptions to established underwriting standards and be alert to the product terms that layer on additional risks.  ALLL [Allowance for Loan and Lease Losses] processes should be reviewed to determine whether additional qualitative adjustments are needed to reflect the increased risk in loan portfolios.
Banks with significant concentrations in longer term assets should assess their vulnerability to a sudden rise in interest rates.  Banks also need to assess how nonmaturity deposits (NMD) react to rising rates and consider the uncertainty of depositor behavior in their model assumptions and resulting risk exposure.
Banks should ensure investment decisions meet their fiduciary customers’ investment objectives, needs, and risk tolerances.  It is also important to ensure that the oversight of the retail nondeposit investment sales program includes an assessment of the product platform’s appropriateness for the bank’s client base. "

*Thanks to the Financial Services Roundtable SmartBrief for the introductory quotation.

Have a safe, sound, and prosperous New Year everyone! 

Tuesday, November 18, 2014

Milestone and Millstone
 (Part 2)

The previous National Bank Examiner blog post Milestone and Millstone (Part 1) recapped the milestone judicial decision regarding the legal liability of bank directors under the North Carolina business judgement rule in a case involving the failure of the Cooperative Bank of Wilmington, North Carolina.  This blog post deals with the millstones borne by bank examiners in the form of blemished or uneven bank supervisory policy guidance.  Policy guidance that really needs to be addressed across all bank regulatory agencies if this judicial decision survives the appellate process.

If what bank examiners do (or do not do) in the performance of their examining duties, their CAMELS ratings, and their subsequent followup activities, are going to be legally mapped to the question of whether a bank director does (or does not) have legal liability in a failed bank receivership scenario, then (at least) two things ought to change.

Specifically, there is a need to address a fundamental structural flaw in the Uniform Financial Institutions Rating System (UFIRS), in terms of appropriately weighing today's immediate problems against today's risks (tomorrow's problems) in its numerical CAMELS composite and component ratings.

And second, there is a need to install policy guardrails, consistent across all bank regulatory agencies, that appropriately balance standardized calibrated escalation of adverse examination findings with the boundaries of examiner/field office discretion and latitude in using moral suasion as a bank supervisory tool.

 UFIRS: A job half-completed is an incomplete job.

The Uniform Financial Institutions Rating System (UFIRS) was originally created in 1979 as an internal rating system, used by federal bank regulators, for uniformly evaluating the soundness of financial institutions and to identify those institutions requiring special supervisory attention.   Supervisory agencies derived composite ratings for each financial institution from a subsidiary set of component ratings for Capital adequacy, Asset quality, Management, Earnings, and Liquidity (the old CAMEL ratings system)

Composite ratings ranged on a scale from "1" (sound in every respect), to "2" (fundamentally sound), to "3" (exhibits some degree of supervisory concern), to "4" (exhibits serious financial or managerial deficiencies that result in unsatisfactory performance), to "5" (exhibits critically deficient performance).

The original UFIRS considered both banking practices and performance, but the rating standard, or rubric, driving the determination of a financial institution's composite rating was the bank's record of performance and the "snapshot" evaluation of bank soundness derived from the bank's latest examination results.   While risk was considered implicitly in the old CAMEL rating system, the progressive adoption of risk-focused supervision by banking supervisors over the years since 1979 argued for making risk assessment in the UFIRS clear and explicit.

So on December 19, 1996, the Federal banking agencies issued the 1996 Revision of the UFIRS.  The major changes included an increased emphasis on the quality of risk management practices and the addition of a sixth component rating called "Sensitivity to Market Risk".  The CAMEL rating system became the CAMELS rating system and the evaluation standards for component ratings now included explicit consideration of processes to identify, measure, monitor, and control risks.

The drafting work done by the Interagency CAMEL Working Group of the Federal Financial Institutions Examination Council (FFIEC) was admirable, and the revised, risk mangement-sensitive component rating definitions remain quite good and continue to be germane and very useful.  But when the proposed UFIRS revisions were considered by the FFIEC Task Force on Supervison (the senior staff supervisors within each federal banking agency), the Task Force on Supervision chose to retain the performance-based context of the existing composite rating definitions. 
"4. Composite Rating Definitions.  The composite rating definitions parallel proposed changes for component descriptions and ratings. The revised composite rating definitions contain an explicit reference to the quality of overall risk management practices.  The basic context of the existing rating definitions is being retained.  The composite ratings would continue to be based on a careful evaluation of an institutions managerial, operational, financial, and compliance performance." (my emphasis) 
The FFIEC Task Force on Supervision, and later the agency heads themselves, took a nicely remodeled home and placed it on the old, creaky performance-based UFIRS composite rating foundation.

Performance is fundamentally retrospective... it looks back from the present to the past.  It's a lagging indicator.  Quality of risk management is prospective, looks forward in time, and can be a leading indicator.  The focus on performance, as the composite rating bottom-line, relegates, in a de facto manner, the evaluation of the quality of risk management practices to an important, but still secondary consideration.  So at the end of the day, the UFIRS composite and component ratings present a time-distorted view of intrinsic bank soundness.

Why is this a millstone for bank examiners?  One only needs to look at the seeds of the recent financial crisis.  The erosion of credit underwriting standards, particularly in the real estate sector, and the pursuit of hot money funding drove unprecedented banking performance in terms of profitability and growth.  Until late July 2007, when the credit markets first started to lock-up and the banking system began its inexorable march toward financial crisis and taxpayer bailout.

When confronted with a situation where a bank exhibits superior performance metrics but questionable risk management practices, which aspect drives the component and composite ratings under the UFIRS?  The basic context of the UFIRS emphasizes performance.

This was underscored by the Office of the Comptroller of the Currency (OCC) at the time in OCC Bulletin 97-14 , a follow-up on common questions and answers about the 1996 revised UFIRS :

"How do the revised rating system and the OCC's supervision by risk program interrelate?
They exist in tandem... The CAMELS rating system remains a measurement of the bank's current overall financial, managerial, operational, and compliance performance.  (all emphasis mine)  Supervision by risk prospectively assesses not only the quality of risk management and the quantity of risks, but also the direction of risk."
Even in the current Bank Supervision Process section of the Comptroller's Handbook, the OCC reinforces this concept:
"The major distinction between the RAS [Risk Assessment System] and rating systems is the prospective nature of the RAS. The rating systems primarily provide a point-in-time assessment of an institution’s current performance. (my emphasis) The RAS reflects both a current (aggregate risk) and a prospective (direction of risk) view of the institution’s risk profile."
How to fix this structural weakness in the UFIRS?  Although CAMELS composite ratings are enshrined in the granite bedrock of certain federal statutes, the means by which they are arrived at are not.  I would suggest creating explicit sub-ratings, for analytical purposes, within each CAMELS component rating.  One for performance and one for risk management.  Then, to be conservatively prudent, use the worst of the two sub-ratings to drive the individual CAMELS component ratings and, ultimately, roll those up into the composite rating of the bank.  I think this would be a small step forward by providing a more accurate measure of a bank's intrinsic soundness.

Will Character Bank Supervision Go the Way of Character Lending in Banking?

The Cooperative Bank case highlights the fact that there can be significant variation in the intensity of bank supervisory followup on examination criticisms.  This case appears to be an extreme example, likely complicated by the policy of alternating annual examinations between the FDIC and the North Carolina banking commissioner's office.

But, in general, individual examiners, individual field offices, even individual bank regulatory agencies, differ on the degree of patience shown regarding the pace and effectiveness of bank management's resolution of examination criticisms.

Factors such as the seriousness of the criticism; the urgency associated with the risks involved; the potential for a criticism to balloon into something larger and more dangerous; the confidence the examiner or field office has in the capabilities of the bank's executive management and board of directors; and the physics of the corrective action process (particularly those involving significant data processing changes, multiple vendors, and/or changes in business culture) ---- all of these things, and many more, play into the calculus of the bank supervisory followup on examination criticisms.

But there need to be boundaries.  And those boundaries need to be lined with policy guardrails and a robust quality assurance process.  In this respect, I believe that the Office of the Comptroller of the Currency (OCC) has ably dealt with this issue in its old and new Matters Requiring Attention (MRA) guidance when read together with the OCC's Enforcement Action Policy.

A character loan is a type of unsecured loan whose repayment is premised on the borrower's reputation and the bank's past experience with the borrower.  Is there still a place in banking for character lending?  Yes, but there should be a backstop in the form of demonstrable indications of the ability to repay.

Character bank supervision is premised on the reputation and perceived abilities of a bank's executive management team and the bank regulatory agency's past experience with them.  Is there still a place for character bank supervision in banking by the temperate use of moral suasion prior to resorting to harsher enforcement measures?

Absolutely!  The overwhelming majority of examination criticisms are corrected in this manner.  But there need to be policy guardrails that limit bank management's use of dilatory tactics that may stem from either their unwillingness or inability to correct examination criticisms.  Policy guardrails that also limit a bank regulator's supervisory office from countenancing unresolved examination criticisms over an extended period of time by buying into repeated unfulfilled promises, vague assurances, and incomplete (or ineffective) progress.

Monday, October 27, 2014

Milestone and Millstone
(Part 1)

What a difference you can make in the meaning of a word by changing just one simple letter!  The thought immediately came to mind when reading this final sentence from a story in the New York Times, titled Failed Bank's Broken Vows Mean Littlereporting on the fallout from an adverse federal court ruling against the Federal Deposit Insurance Corporation (FDIC) dismissing one of their failed-bank director liability lawsuits:
"If this ruling is widely followed, it could mean that if a bank can somehow get a 2 rating from the examiner, it can safely ignore anything else the examiner says."
The failed bank in question was the Cooperative Bank of Wilmington, North Carolina.  When the FDIC-supervised, state-chartered bank failed in June 2009, it had $974 million in total assets, 24 branches, a loan production office, and a mortgage company.  Its lending focus was commercial real estate loans and residential land acquisition, development, and construction loans in eastern North Carolina and eastern South Carolina.  Much of the lending was for investment or second homes along the coast.  Loan growth, during the final years, was funded from wholesale sources -- brokered deposits and Federal Home Loan Bank advances.  The initial estimate of loss to the Deposit Insurance Fund was $217 million, but as of  December 2013, it was $293 million -- an increase of  35% over the initial estimate.

A Material Loss Review (MLR) is required, by federal statute, to be conducted by the appropriate Inspector General's office for bank failures where substantial costs are incurred by the Deposit Insurance Fund.  The Cooperative Bank MLR recaps the bank supervisory history of the bank prior to its failure.  The MLR is breathtaking, but not in a good way.

Remember the interagency commercial real estate lending guidance, issued in 2006, that established bank supervisory tripwires of 100% of capital for construction, land development, and other land loans (ADC loans), and 300% of capital for rapidly-rising non-owner occupied commercial real estate lending activity?  Well, at year-end 2007, those figures were 469% and 584% respectively for the Cooperative Bank.  And, due  largely to the capital burn incurred near the end of its life, the concentration of ADC loans at the end of 2008 was 912% of capital.

There is an old axiom in banking supervision - banks tend to decay, not explode. As you can see in the graphic below, however, the bank immediately went from a CAMELS composite rating of  "2" (fundamentally sound) to a "5" (critically deficient) - what bank examiners call a "triple jump".  The bank failed seven-months after the commencement of  its final examination - with the ink barely dry on the bank's final examination report and Cease & Desist (C&D) Order.

A fine "triple jump" might earn you a gold medal in the summer Olympics, but will get you nothing but a big, ugly black eye in the banking supervision business.

And compounding the bank supervisory sin, was the chutzpah/hubris displayed by the then FDIC Director of Supervision and Consumer Protection, Sandra Thompson, in her unapologetic three short paragraph (!) response to the MLR.

If I were a FDIC attorney, well-schooled in the legal doctrine of contributory negligence, my supervisor would have to be pointing a gun into my back to get me to walk into a courtroom in this case.  But walk in, the loyal, dedicated FDIC attorneys did - into a judicial buzz saw.  Now we have blood and guts everywhere.

There are (at least) two big issues that stem from Judge Terrence Boyle's dismissal of the FDIC's director liability lawsuit in this case.  The first, is the widely-publicized battlefield victory for community bank directors under the judge's generous interpretation of the North Carolina business judgement rule.  The second, drowned out in the applause by advocates for bank directors, is how this decision, if ultimately upheld, could impact the mechanics and dynamics of the bank examination and regulatory enforcement process going forward.

This National Bank Examiner blog post (Part 1) is devoted to the milestone for community bank directors.

The next National Bank Examiner blog post (Part 2) will be devoted to the millstone created for bank examiners and the bank supervisory process going forward.  Specifically, the need to address the structural flaws in the Uniform Financial Institutions Rating System (UFIRS), in terms of clearly delineating today's immediate problems from today's risks (tomorrow's problems) in its CAMELS Composite and component ratings.   The UFIRS has been held together with duct tape since it was issued thirty-five years ago in 1979... in the olden days before risk-based bank supervision.

And second, balancing standardized calibrated escalation of adverse examination findings with the boundaries of examiner/field office discretion and latitude in using moral suasion as a bank supervisory tool.  An issue that, I believe, the Office of the Comptroller of the Currency (OCC) has ably dealt with in its Matters Requiring Attention (MRA) Reference Guide

But first, the milestone:

A Battlefield Victory for Community Bank Directors

In an article published by the American Association of Bank Directors (AABD) titled Bank Directors in North Carolina and Elsewhere Breathe a Sigh of Relief, the author emphasizes that the court did not find self-dealing, fraud, or any other conduct that might constitute bad faith.  Moreover, the court found that the board of directors employed a rational decision-making process, even though (as in all bank decision-making) there clearly were risks involved.

The court, in its statement, states:
"Under the [North Carolina] business judgment rule, there can be no liability for officers and directors even when "a judge or jury considering the matter after the fact, believes a decision [my emphasis] substantively wrong or degrees of wrong extending though 'stupid,' to 'egregious' or 'irrational,' ... so long as the court determines that the process [my emphasis] employed was either rational or employed in a good faith effort to advance the corporate interests."
"... The record can simply not support a finding that the defendants' business purpose fell so far beyond lucid behavior that it could not even be considered "rational."  Although there were clearly risks involved in Cooperative's approach, the mere existence of risks cannot be said, in hindsight, to constitute irrationality.  Further, corporations are expected to take risks and their directors and officers are entitled to protection from the business judgment rule when those risks turn out poorly."

The AABD article continues:
"In fact, the court cited prior regulatory CAMELS ratings of “2″ for management, asset quality and market risk sensitivity as proof that the board had followed a rational process in its decision-making. That is, inasmuch as the examiners (banking experts) gave the bank satisfactory ratings after examining the details of management’s decisions on loan applications and other business matters, directors (who are not experts equivalent to examiners) should appropriately presume that their overall supervision of management and bank operations was acceptable to the regulators."

Tagging Bank Directors with the Power of Infallible Prophecy

It's worth sharing Judge Boyle's finding regarding the FDIC's claim that "the 'Great Recession' was not only foreseeable, but was actually foreseen by the defendants."  For the purpose of brevity, I've only redacted the bibliographical references.

"The Court discusses this claim only due to the absurdity of the FDIC's position. 
The FDIC relies on several pieces of evidence to support its claim that defendants foresaw the downturn in the economy as early as October 2006.  However, it ignores the unique historical factors happening at the same time including numerous economists and economic forecasters' prognosis of a strong economy going forward at that time.  See e.g. Chris Isidore, Goldman's chief to take on Treasury, "While that pace of growth is widely expected to slow, many economists see the economy remaining strong .... ").  Even as late as April 2007, the United States Treasury Secretary was pushing the idea that the economy was strong and healthy and that the housing market had reached its bottom.  Further, throughout 2007 and into 2008, North Carolina and national economists continued to publish upbeat economic forecasts.
 After the fact, Federal Reserve Chairman Ben Bernanke observed that "a 'perfect storm' had occurred that regulators could not have anticipated," and former Chairman Alan Greenspan confessed that "it was beyond the ability of the regulators to ever foresee such a sharp decline."   Further, the Federal Crisis Inquiry Commission has concluded that "[c]laims that there was a general failure of risk management in financial institutions or excessive leverage or risk-taking are part of what might be called a 'hindsight narrative."
In sum, the FDIC claims that defendants were not only more prescient than the nation's most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans. Such an assertion is wholly implausible. The surrounding facts, and public statements of economists and leaders such as Henry Paulson and Ben Bernanke belie FDIC's position here." 

And Then There's the Bigger Picture - Disparate Treatment
"It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered to be "too big to fail.".  Taking the position that a big bank's directors and officers should be forgiven for failure due to its size and an unpredictable economic catastrophe while aggressively pursuing monetary compensation from a small bank's directors and officers is unfortunate if not outright unjust."

The FDIC filed an appeal on October 2, 2014