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Monday, June 19, 2017

U.S. Bank Supervisors: Stray Watchdogs? 


Image result for camels
CAMELS (credit dailymail.co.uk)


You would definitely think so if you read the opinion piece recently published by the President and the General  Counsel of The Clearing House Association, titled How Bank Supervision Lost Its Way.  

On one hand, BRAVO! to the authors for underscoring the fact that the application of regulatory rules and standards is as important as the rules and guidelines themselves.  So many federal agency bureau heads think that when they burp out a rule, or a set of guidelines, that the world magically changes, in a uniform way, when they slip those rules and guidelines into an envelope and send them to both examiners and bank CEOs.  

On the other hand, the article relies on a series of anecdotes and assertions to assemble a narrative that, in general, doesn't really square with my 37 years as a national bank examiner and almost four years as a bank director.  However,  I'm very sympathetic to a philosophical undercurrent in the article - that many bankers feel that, on occasion, there's some kind of regulatory Three Card Monte going on when it comes to assigning CAMELS ratings.


Background Information

For those readers not steeped in the details of bank supervision, the Uniform Financial Institutions Rating System (UFIRS or CAMELS rating system) is an internal rating system used by the federal and state regulators for assessing the soundness of financial institutions on a uniform basis and for identifying those insured institutions requiring special supervisory attention.

The CAMELS rating system rates a bank using six components plus an overall composite rating.  They are rated on a scale of 1 (strong) to 5 (critically deficient) in the areas of (C)apital Adequacy, (A)sset Quality, (M)anagement, (E)arnings, (L)iquidity, and (S)ensitivity to Market Risk - hence the term CAMELS.  There are other specialty examination ratings, but CAMELS is the Big Kahuna.  CAMELS also helps drive individual bank deposit insurance premiums.

Long-time readers of the National Bank Examiner may remember my February 18, 2014 blog post titled:  Officially Distorted.   That post raised the issue of the economic distortion created by the unnaturally high profile of the bank regulatory agencies and their examiners.  The issue was reiterated in the July 2016 blog post titled:  The Nuns With Guns.

 The Three Developments

To sum up The Clearing House article, the authors assert that:

 "..three developments have converged to halt the ability of many banks to open branches, invest, or merge to better meet the needs of their customers.  First, even as banks have dramatically improved their financial condition by increasing their capital, liquidity, and asset quality positions, supervisors have transformed the supervisory scorecard (the CAMELS rating system) from a measurement of financial condition to a measurement of compliance.  Second, supervisors have adopted a series of unwritten rules that produce lower CAMELS ratings.  Third, supervisors have adopted another series of unwritten, or in some cases written, rules (albeit none with any basis in statute) that translate those low ratings or other supervisory issues into a bar on expansion." 

Combing through the article trying to find out where this argument might have gone astray, the following statement jumped off the page:

"With the sole exception of a few small changes in 1996 (most notably, the addition of the "S" component), the CAMELS standards have not been materially updated in the almost 40 years since their adoption..."

Well, that explains most of why I feel a disconnect.  The authors have not taken into consideration the tectonic shift that occurred in the inter-agency CAMELS rating system in December 1996.  In particular, the explicit (and transformational) insertion of risk management, as an additional formal evaluation factor, into the updated CAMELS rating system.

"The major changes to UFIRS include an increased emphasis on the quality of risk management practices [emphasis mine] and the addition of a sixth component called "Sensitivity to Market Risk." The updated rating system also re-formats and clarifies component rating descriptions and component rating definitions, revises composite rating definitions to parallel the other changes in the rating system, and highlights risks that may be considered in assigning component ratings. (Joint Interagency Common Questions and Answers)

The previous CAMEL rating system was largely considered (by both bankers and examiners) as a snapshot of current financial condition.  Those who were unaware of the importance of the 1996 changes, may still believe that it does.

The Brahmins at the federal bank regulatory agencies would surely assert that risk management "was always in there"; but the reality of the matter is that prior to the 1996 changes, CAMEL ratings were only loosely influenced by risk management considerations - mainly as a background factor flavored by the examiner's experience and judgement, but without articulated evaluation standards.


The First Development

The quote directly above speaks to the authors' first argument - "supervisors have transformed the supervisory scorecard (the CAMELS rating system) from a measurement of financial condition to a measurement of compliance."

Nope, the CAMELS rating became an assessment of financial condition and risk management practices, which include, among other risk management practices, an assessment of compliance risk management.

There was no "repeal and replace" of financial condition for compliance in the CAMELS rating system.


The Second Development

The second argument - "supervisors have adopted a series of unwritten rules that produce lower CAMELS ratings."  Speaking solely from my own experience at the Office of the Comptroller of the Currency (OCC), there is written guidance.

For example, at the OCC, risk management is evaluated across a spectrum of eight risk categories which take into account the quantity of risk and the quality of risk management in each risk category.  The entire process is called the Risk Assessment System (RAS).

This is verbatim from page 8 of the Community Bank Supervision portion of the Comptroller's Handbook:

"Relationship Between the RAS and the CAMELS Rating System
The RAS and the CAMELS rating system are used together during the supervisory process to evaluate a bank’s financial condition and resilience. The RAS provides both a current (aggregate risk) and a prospective (direction of risk) view of the bank’s risk profile that examiners incorporate when assigning regulatory ratings. The CAMELS rating system, which includes forward-looking elements, references the primary risk categories that examiners consider within each component rating, as well as the quality of risk management practices. (Updated 12/03/2015)

Under the RAS, for example, examiners may assess credit risk in a bank with insufficient risk management practices and increasing adverse trends as “moderate and increasing” or “high and increasing.” If the component rating for asset quality does not reflect the level of supervisory concern posed by credit risk as identified by the RAS, the component rating may be changed. Additionally, examiners consider their assessments of risk management practices for each of the risk categories when assigning management component ratings. Using the RAS and the CAMELS rating system in this manner provides an important verification of planned activities and supervisory findings. (Updated 12/03/2015)"


The Third Development

Lastly, there is the the third argument - "supervisors have adopted another series of unwritten, or in some cases written, rules (albeit none with any basis in statute) that translate those low ratings or other supervisory issues into a bar on expansion."

Let's first deal with Community Reinvestment Act (CRA) ratings and Bank Secrecy Act/Anti-Money Laundering (BSA/AML) compliance.  CRA performance ratings and the BSA/AML compliance record must be taken into account when a regulator is asked to approve any corporate expansion.

By statute, the CRA rating must be taken into account when making such a decision.  After the 9/11 terrorist attacks on the Twin Towers and the Pentagon, terrorist financing concerns, which found form in the USA PATRIOT Act, required BSA/AML compliance to be taken into consideration also.

Where an "unwritten" factor may exist could be the nature of the collective psyche of bank regulators.  They have a conservative tendency in the administration of the legally-assigned banking industry oversight duties.  Although there have been a handful of notable exceptions in the history of bank supervision (subprime lending, Option ARMS, etc), bank supervisors tend to restrain entrepreneurial expansion until the risk management infrastructure is built and is operating consistent with the bank's risk appetite.  Putting the horse in front of the cart, and not vice-versa.


But the Authors are Making a Point

Are there rips in the fabric and firmament of  the bank supervision CAMELS rating cosmology.  Yes.  Do they need to be addressed as soon a practicable?  Yes.

There are occasional situations where the assessment of financial condition and risk management practices are in a state of tension.  Lacking clear, enunciated decision criteria for field examiners (and their accompanying internal layers of review), subjectivity will likely drive the decision.

Let's look at a couple of examples:


CAMELS Capital Adequacy Component Rating

Let's take XYZ Community National Bank.   XYZ Community National Bank happens to sport the highest risk-based capital and leverage ratios in the nation.  Credit risk, interest rate risk, operational risk, etc. are all well-controlled.  A unique and proud distinction reflecting the severe risk-averse nature of the family that owns the bank.  The CEO remembers that she received the OCC's Guidance for Evaluating Capital Planning and Adequacy , but filed it away after scanning it briefly, since it seemed irrelevant considering the bank's quite pleasant circumstances capital-wise.

Alas, at her own risk, she failed to read this dark and ominous threat embedded in the text of the capital planning guidance:

"A bank’s failure to have an effective capital planning process may be an unsafe and unsound banking practice. If a bank does not have an effective capital planning process that is commensurate with its overall risks, the OCC may require immediate corrective action.  An ineffective or weak capital planning process may invalidate the bank’s internal capital assessment and necessitate that examiners determine an appropriate capital level.  The OCC may impose higher capital requirements if a bank’s level of capital is insufficient in relation to its risks; determining the appropriate capital level is necessarily based in part on judgment grounded in agency expertise.  Potential OCC actions to ensure adequate capital may include, as deemed necessary, an individual minimum capital ratio, memorandum of understanding, formal written agreement, consent order, cease-and-desist order, or a prompt corrective action directive."

Sensing that she was having a James Comey moment, the bank CEO got the impression from the behavior of the examiner-in-charge, when he subsequently pointed out the written text of the OCC bulletin, that this set of best practice guidance (disseminated without notice and comment) was, in fact, a direction and not a suggestion or a recommendation.

Sprinkled throughout the guidance is the sweeping broad-brush phrase "commensurate with its overall risks", but the OCC guidance still requires that there be an identifiable capital planning process, and further, attaches certain specific corporate governance requirements to that capital planning process.

XYZ Community National Bank has the highest capital ratios in the nation, but no capital planning process.  How is the examiner going to rate the Capital component of the CAMELS rating for XYZ Community National Bank?  Now, to add an additional degree of difficulty to the judgement - what if the extreme ends of this example were not so clear cut?


CAMELS Management Component Rating

Or let's take this recent example: "Regulators ding Wells Fargo's community-lending record, citing accounts scandal".  Wells Fargo is a systemically-important megabank that managed through the worst financial crisis since the Great Depression with a solid financial footing.  By all public accounts, the management of the bank seems to manage the bank's panoply of other risks adequately, but obviously not compliance management risk, nor operational risk, nor reputation risk, nor (possibly) strategic risk.

How do you think the bank supervisors rated the overall Management component of the Wells Fargo CAMELS rating?

Here, let me help you with the official rating criteria for the Management CAMELS component:

1  - A rating of 1 indicates strong performance by management and the board of directors and strong risk management practices relative to the institution's size, complexity, and risk profile. All significant risks are consistently and effectively identified, measured, monitored, and controlled. Management and the board have demonstrated the ability to promptly and successfully address existing and potential problems and risks.
2  - A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the institution's size, complexity, and risk profile. Minor weaknesses may exist, but are not material to the safety and soundness of the institution and are being addressed. In general, significant risks and problems are effectively identified, measured, monitored, and controlled.
3  - A rating of 3 indicates management and board performance that need improvement or risk management practices that are less than satisfactory given the nature of the institution's activities. The capabilities of management or the board of directors may be insufficient for the type, size, or condition of the institution. Problems and significant risks may be inadequately identified, measured, monitored, or controlled.
4 -  A rating of 4 indicates deficient management and board performance or risk management practices that are inadequate considering the nature of an institution's activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and require immediate action by the board and management to preserve the soundness of the institution. Replacing or strengthening management or the board may be necessary.
5  - A rating of 5 indicates critically deficient management and board performance or risk management practices. Management and the board of directors have not demonstrated the ability to correct problems and implement appropriate risk management practices. Problems and significant risks are inadequately identified, measured, monitored, or controlled and now threaten the continued viability of the institution. Replacing or strengthening management or the board of directors is necessary.

The rating?  Beats the hell out of me.  Could be a 3.  Could be a 4.  Those ratings are confidential so we, the general public, will never know.


Conclusion

So while there is much for me to disagree with in The Clearing House article, I do agree that, in certain circumstances, CAMELS ratings decisions may have an aura of mysticism.  Thus, frustrating the ability of others to fully understand the CAMELS rating decision.

The OCC Ombudsman posts appeals summaries to the OCC website, but the last CAMELS rating appeal summary was published two years ago, in the second quarter of 2015.  The last appeals summary of any sort was dated the first quarter of 2016.  And, frankly, there are very few bank appeals in any given year anyway.  CAMELS-related appeals summaries could be very helpful in understanding the rating process, but they are very scarce.

Maybe the independent appeals process and examination quality control provisions of what has been titled the Financial CHOICE Act will help in this respect and also help address some of the other concerns mentioned by the authors of  The Clearing House article.



Monday, March 20, 2017



National Bank Charters for Fintech:
  Back to the Future?


Image result for fintech companies
credit: Business Insider


After a long and deliberate process of soliciting public input through multiple discussion documents and a forum on responsible innovation, Tom Curry, the Comptroller of the Currency, has just released his agency's draft Licensing Manual Supplement called Evaluating Charter Applications from Financial Technology Companies and a companion document titled OCC Summary of Comments and Explanatory Statement: Special Purpose National Bank Charters for Financial Technology Companies.

These documents are the result of a call for comments on an earlier document issued by the OCC on December 2, 2016 titled Exploring Special Purpose National Bank Charters for Fintech Companies.

In a nutshell, it contemplates the creation of a Special Purpose National Bank (SPNB) charter for the purpose of supporting responsible innovation in the financial technology (fintech) sector.  The charter would be an alternative to state-by-state licensing and, by providing a Federal licensing option, it is consistent with the tradition of the dual-banking system here in the United States.  The proposal, to me, is an honorable and admirable effort to expand the arc of what we call "banking" in order to keep up with the times.

The OCC received over 100 comment letters.  Most were supportive, but several were critical.  Some legal objections were raised, but we can leave that to the lawyers to sort out along the way.  I was more concerned with the regulatory policy decisions; and three, in particular, trouble me:


Accountability

First, I think the OCC is dodging public accountability through the lack of transparency in a vital piece of the charter approval process - the operating agreements.  For those not familiar with OCC's operating agreements, they are the "guardrails" which newly-chartered banks must steer between during the initial years of their operations.

The operating agreements are a critical part of the synthetic regulatory architecture that the OCC has to custom-build for those SPNBs who otherwise would not be subject to certain important legal requirements affecting "normal" national banks due to the SPNB's lack of deposit insurance and/or bank holding company status.

The OCC plans to announce the existence of an operating agreement, but will not disclose its contents.  That smacks of hiding the ball and provides no way for the public to assess the strength, effectiveness, and durability of the OCC's feat of custom-tailored regulatory architecture.

This layer of "regtech" overlaying the fintech in these SPNBs looks too much like our collective infatuation with the financial engineering craze of the early 2000's that later brought us boomerang products like Collateralized Debt Obligations (CDOs) and other financial derivatives that unexpectedly turned toxic.

The operating agreements for SPNBs need to see the light of day.


The Role of the Fed

Second, is the troubling wink-and-a-nod telegraphing, via footnote 17 in Exploring Special Purpose National Bank Charters for Fintech Companies, of the ability to avoid Federal Reserve Bank membership, and therefore Federal Reserve jurisdiction, by legally domiciling the national bank in U.S. territories and insular possessions.

Trivia note: The U.S. has 16 territories, five of which are permanently inhabited - Puerto Rico, Guam, Northern Mariana Islands, the U.S. Virgin Islands, and American Samoa.

Now, Tom, is that any way to treat a regulatory fraternity brother?  The Fed and the OCC need to be co-sponsors here; there are too many cross-jurisdictional issues, payments system impacts, and regulatory arbitrage risks involved with SPNBs for the OCC to go this alone.


Living Wills

Third, is the optionality regarding resolution plans or living wills. They should be required, updated regularly, and reviewed during the ongoing supervision process.  The OCC learned the hard way, with the first batch of internet banks in the late 90's, that entrepeneurial, start-up cultures that are venturing into uncertain business terrain will run into novel and unexpected situations that can complicate the receivership process.

Moreover, as these entities scale up and become more interconnected with the rest of the financial system, the OCC might be stuck with the regulatory equivalent of unscrambling an egg.  Instructive in this respect was the failure of the Penn Square Bank, N.A. in Oklahoma City on July 5, 1982.  Some of America's largest banks were brought to their knees by this small bank located in a shopping mall.

Unlike the situation with the internet banks, where the FDIC ended up holding the bag at the end of the day, SPNBs will be liquidated by the OCC.  Living wills also help reduce the agency's reputation risk.


Back to the Future

Why am I urging these changes?  President Harry Truman once said that "the only thing new in the world is the history you don't know."

Let me take you back in time, to the mid-1990's, when the OCC wanted to support another financial technology innovation - the internet bank.   Internet banks were the latest "new thing" in banking and the OCC was positioning itself to be the premier regulator of this new genre of banks.  I remember our Comptroller at the time, Gene Ludwig, saying frequently that the structure of the banking industry would soon look a lot like the bar scene in Star Wars.

The internet bank charters didn't do so well.   Here's a list, how many can you still recognize?

CompuBank, N.A., chartered by the OCC on August 20, 1997 was the OCC's first internet bank charter.  By January 2001, it was under a formal enforcement action (Compubank OCC Formal Agreement).  By April of 2001, NetBank, Inc. of Alpharetta, Georgia (an internet bank supervised by the Office of Thrift Supervision) acquired all of the deposits of CompuBank, N.A. (which then ceased operations).   The transfer of accounts from CompuBank was a fiasco for customers.  Between 4,000 to 8,000 customers had trouble accessing their deposit accounts.   NetBank, in turn, was closed by the FDIC on September 28, 2007.

The second internet bank chartered by the OCC was NextBank, N.A. on May 8, 1999.  It was subsequently closed by the FDIC on February 7, 2002 in a rare Thursday night closing.  Things were so gummed-up at NextBank, N.A. that not a soul bid for the bank and the FDIC was unable to even guesstimate an initial loss amount to the FDIC deposit insurance fund.  The subsequent assessment of the quality of OCC's supervision of NextBank, N.A. in the Material Loss Review conducted by the Office of the Treasury Inspector General was not one of our finer moments as a bank supervisor.  It remains in the OCC's Pantheon of woodshed experiences.

In the end, the Special Purpose National Bank charter proposal is also an early test of the OCC's newly-minted enterprise risk management function.  Without the changes I'm suggesting, I hope they have the risk pegged as High, and Increasing.





Friday, September 30, 2016


Misbehavioral Finance


Credit: McMillan


Question:  Why would a captain purposefully capsize her ship?

Answer:  Because the ship she is commanding was floating right-side-up in an upside-down world.


I've been keeping an eye on what is happening to the German Sparkassen to see how they are reacting to the Eurozone's (and particularly Germany's) negative nominal interest rate environment.  I would like to know what we, in the United States, can learn about the street-level structural business impact of the negative nominal interest rate environment on the community banking model.

The German Sparkassen can be viewed as a rough analog to community banks in the United States.  They are a network of 409 local savings banks that offer a full menu of banking services to individual persons and small-to-medium size businesses.  The major difference is the ownership structure, as Sparkassen are public-sector municipal banks and are not privately-owned.  They, however, compete with the retail operations of the large private banks in Germany.

Negative Interest Rate Policy (NIRP)

In the U.S., at the present time, we are fortunate to be only observers of the negative nominal interest rate banking phenomenon.  We have ring-side seats to the most dangerous monetary policy experiment in the history of modern finance.

NIRP is misbehavioral finance in action, plain and simple.  It can be likened to the Rosemary's Baby of monetary policy.  This experiment involves the corrupting, by mainly the European and Japanese central banks, of a core economic concept of what constitutes "money" in our society - money as a fundamental store of value.

When you have to pay someone to accept your money (that exists in the form of bookkeeping entries), then your money (that exists in the form of bookkeeping entries) does not have a stable value, it instead becomes a eroding asset which loses purchasing ability every day.

Money in the form of physical banknotes might seem to escape the corrosive centripetal force of NIRP, but the cost of storing, protecting, and insuring physical banknotes is itself a form of negative interest rate.  So people and companies in NIRP economies need to compare one cost to the other when making decisions about their money.

But all sorts of twisted, counter-intuitive behaviors occur in this NIRP environment.  For example, it has long been a basic tenet of finance that you try to defer paying your taxes for as long as it is allowable.  In the upside-down world of NIRP, it is better to prepay as many expenses as possible, including your taxes.

Governments, have traditionally had to pay interest for the privilege of borrowing when they spend more money than they take in from taxes and fees.  In the doppelgänger world of negative nominal interest rates, the marketplace pays governments to borrow more!  In fact in the first quarter of 2016, the German government made over a billion euro issuing negative rate debt.

Buying bank cashier's checks or bank drafts have been mentioned in the internet chatter as a way to avoid negative rates while avoiding the costs (and dangers) of bulk cash storage.  Is this the kind of unhealthy game-playing behavior we want to encourage?

What other kinds of weird behavioral finance distortions, yet to be appreciated, is NIRP giving birth to?

How NIRP is Affecting the Sparkassen

Nevertheless, my histrionics and prejudices aside, observing and learning how NIRP is affecting the Sparkassen could be instructive should the Federal Reserve ever be dragged toward negative nominal interest rates by the arsonous behavior of the central banks practicing NIRP or, even by the next recession in the United States.

In the United States, the banking system has occasional bouts with dealing with negative real interest rates.  That is, the nominal rate of interest less the rate of inflation.  Negative real interest rates are invisible, however, to retail bank customers because their nominal rates of interest (the interest rates they see printed on their bank statements) have, so far, always been positive interest rates.

Generally, banking is all about the spread, the margin; the difference between what a bank pays and what the bank receives.  In a normal, positive interest rate world, the bank pays for deposits and charges for making loans.  In the upside-down world of pure negative interest rates, the bank pays for loans and charges for deposits.  In the bizarre twilight zone that exists between those two states of being, banks would have negative deposit interest rates and positive loan rates - effectively taking in income from both sides of their balance sheet to make their margin.

The book-trained economists running the central banks that have signed up to NIRP blithely assume that their banks are as flexible as an Indian Yogi and can contort themselves into any form of pretzel to maintain their interest margins.

The Sparkassen are showing us a collision between the economist's academic theory and the customer's reality.  In the impure, real world we live in, the victim in the middle, becomes the bank and that raises further questions about whether NIRP also undermines systemic financial stability.

If a community bank levies an interest charge on its depositors (or attempts to cloak its intentions in the form of  "administrative" charges) that bank risks losing its key funding source and lifeblood.

On the other hand, attempt to raise the rates on loans and the bank risks being noncompetitive in the market.  So interest margins collapse and the viability of the traditional community banking business model comes into question.

In August, after finding its interest margin squeeze no longer tolerable, a tipping point may have been reached.  One community bank in Germany began charging retail customers for depositing money in the bank.  It would not, probably could not, shelter its customers from the European Central Bank's dysmorphic monetary policy and still stay in business.

Wolfgang Münchau, in the Financial Times (subscription required), summed up the conundrum:

"Of the German banks, the Sparkassen and the mutual savings banks are most affected. They are classic savings and loans outlets in that they lend locally and fund themselves through savings. Credit demand is more or less fixed. So when savings exceed loans, as they now do in Germany, the banks deposit their surplus with the ECB at negative rates — known as “penalty rates” in Germany. They cannot offset the losses by cutting interest rates on savings accounts because of the zero lower bound. Savers would switch from accounts to cash in safe deposit boxes."

Following on that thought, a related Financial Times article gives an example:

"In Dillingen an der Donau, a small town in rural Bavaria, the local Sparkasse savings bank is providing an unusual service. For customers who live a long way from a branch, it is giving out free bus tickets. And for those who cannot get to the bank at all — the old or sick, for example — it offers to send a member of staff directly to their homes to deliver small sums of cash.
The Sparkasse came up with the idea to compensate for the fact that it was closing several branches as revenues dwindled due to interest rates being at a record low and customers visiting less frequently. “If your revenues are shrinking, then you have to do something about your costs,” says an official at the bank. “You have to economise.”
The pressure on Germany’s army of savings banks is just one example of the increasing strains on the country’s financial system caused by the ultra-loose monetary policy of the Frankfurt-based European Central Bank.
In a bid to jolt the eurozone’s lacklustre economy back to life, the central bank has, over the past five years, slashed interest rates to record lows and even pushed its deposit rate into negative territory. On top of this, it has launched a €1.7tn asset purchase programme, which has driven down bond yields across the continent."

In it's 2015 Annual Report, BaFin, the German Financial Services Regulator said this about the Sparkassen:

"Most banks currently have sufficient capital to survive this period of low interest rates.  But earnings will deteriorate significantly if ­interest rates remain at these low levels – despite the positive economic conditions.  Even a rise in interest rates would not solve the problems immediately.  Banks that have focused heavily on maturity transformation, i.e. accepting short-term cash deposits and turning them into long-term loans, would only feel the effects after a considerable time lag.  A sudden sharp rise in interest rates would even exacerbate their situation.
BaFin looks across the board at what the institutions under its direct supervision are doing to counteract these problems.  Are they cutting costs?  Are they interrogating their business models and thinking of ways to expand their non-interest-bearing business?  Are banks offering their services on adequate terms and conditions?  It is also important to find out whether they strengthen their capital in a timely manner.  There are no one-size-fits-all solutions.
One thing is certain, however: it would be irresponsible to wait and do nothing, because there can be no reliable predictions as to how long the low interest rates will persist."

Accelerated Financial Darwinism

Add the post-financial crisis layering-on of increasing regulatory compliance costs, and the community bank model in Germany is under immediate existential threat.  For the Sparkassen, evolution must become revolution.

NIRP, new compliance requirements, as well as growing customer preferences for distance-banking services for routine transactions, are forcing the Sparkassen (like the captain at the beginning of this blog post) to have to flip their existing community banking model upside-down.

Instead of overlaying distance-banking technology services over an existing brick-and-mortar network (as is also the present community banking structure paradigm in the U.S.), the German community banks need to immediately consider a lower-overhead and smaller brick and mortar network that is sits on top of more cost-efficient technology-driven distribution channels.

These necessary strategic structural changes in the model of community banking in Germany should be a wake-up call for community banks in the U.S.  We, in the United States, have had the luxury of moving in an evolutionary fashion, with most community banks surfing the slow changes in their customer demographics at the pace of a leisurely stroll.

In the end, the pressures of a "Big Flip" in Germany means either extinction of a treasured form of banking, making the Sparkassen a quaint footnote in the history of banking in Germany or, alternatively, we will see its rebirth and revival.

I'm hoping for the latter.   As we are finding out in the financial press this week, relying on the German banking giants, Deutsche Bank and Commerzbank, is not a wonderful alternative.

Saturday, July 9, 2016


The Nuns With Guns


Credit: Zerohero



Recently the Wall Street Journal ran a series of articles on the present state and potential future of banking.  One of the most intriguing articles in the series was one entitled: Nuns With Guns: The Strange Day-to-Day Struggles Between Bankers and Regulators

"The sobering reality of banking in 2016 is that lenders are awash in new regulations; and growing armies of rule-interpreters and enforcers -- for good or ill -- are bringing striking changes to banks' internal cultures."

The article goes on to note the significant hiring of new staff on the part of both banks and bank regulators to deal with the flurry of new regulations.  It also explores some of the psycho-dynamics that occur between front-line bankers and their own bank's internal compliance staff; and further, between both of those groups and the examiners from the multiple government regulators that may have jurisdiction over the bank or some segment of the bank's operations.  

Reportedly, in an exercise conducted during one Barclays PLC employee town hall, front-line bankers and bank compliance executives shared images of how each group thinks of the other.  Front-line bankers were viewed as "cowboys on horses with guns", while compliance executives were viewed as "nuns carrying guns".

The article was a public airing of an often unspoken and usually cloaked aura of tension that suffuses many of the relationships between these three groups today.  The Journal gave us all a quick peek at several internal banking business cultures that are characterized by anxiety, wariness, guarded comments, and over-cautiousness.  Business cultures which, in turn, exhibit a lamentable (and costly) hypersensitivity to both formal and informal communications with government regulators and internal bank compliance staff.

One particular sentence from the article speaks volumes about the situation: "Bank executives largely avoid publicly voicing frustrations with the regulatory regime, and most wouldn't comment on the record for this article."

This backdrop of hypersensitive preoccupation goes well beyond the set of bank operating deficiencies that rise to the level of being cited as Matters Requiring Attention (MRAs) by examiners.  MRAs are "must-do" priorities that obviously must be rectified in a timely manner by the bank.

No, that hypersensitivity even kicks in when there are informal recommendations and off-the cuff observations made by bank examiners.  Chalk it up to free-floating anxiety alluded to in the Journal article.  That anxiety results in resigned acquiescence by front-line bank staff which then prompts "abundance of caution" remedial actions on the part of the bank (with their associated financial expenditures).  These "nice-to-do" remedial actions, in turn, drive up industry-wide compliance costs much further than is really necessary.

And if that, by itself, was not enough; fanning the flames even more are my colleagues in the bank consulting tribe:

"You think compliance costs are high?  Well, they pale in comparison to the civil fines and costs to your reputation of non-compliance!"

This aura of tension and banker hypersensitivity seems, to me at least, to be the inevitable fallout from the fervid bank regulatory agency enforcement postures spawned by the 2008 financial crisis.  


The Evolution of Enforcement Postures

I lived through the financial crisis as a regulator and as part of the team that set up the initial operations of the U.S. Treasury Department's Troubled Asset Relief Program (TARP).  And I fully appreciate that the public's vocal demands for accountability, for both regulators and bankers, forced a re-evaluation of historical banking agency enforcement practices.  Agency enforcement activities moved from a policy of patient, calibrated escalation (beginning with moral suasion), toward a less tolerant, incident-driven policy of  "you've got one bite of the apple".

At the same time, the banking agency enforcement action decision-making process was being moved further from field offices and progressively centralized in geographically-remote district, regional, or headquarters locations in a trend that conflated the industrial concept of uniformity with the more custom-tailored concept of consistency.

Remote decision-makers, who have not had direct connection with the banks (and bankers) involved, tended to avoid the risk of giving bankers the benefit of the doubt on the close calls.  That's just a natural distance bias.  Plus, at the end of the day, regulators rarely get criticized for being too tough or conservative in their decision-making.

Like Agatha Christie's Murder on the Orient Express, where no one person committed the murder in question; no one or two items are expressly responsible for the evolution of the internal bank cultures explored in the Journal article... but the two I mentioned above are strong contributors.

But I will say this, unequivocally.   The enforcement environment has succeeded in frightening community bank boards of directors.   More often than not, community banks choose the costlier path of least resistance: "just do what the examiner suggests."

It is difficult to broad-brush this issue as many talented individuals, in both bank compliance departments and in the bank regulatory agencies, use their exceptional people skills to successfully manage through this issue and promote positive and productive relationships.  These people really mean that a "recommendation" is truly a recommendation, and a voluntary action... not a stealth requirement.


The Dangers of Regulator-focused Banking

I've explored the dangers of regulator-focused banking a few years ago:
" Historically, as a bank regulator and bank examiner, your job was to calmly officiate in the marketplace for banking services.   As a member of a rule-making body, subject to statutory guidance and notice-and-comment rule-making, you helped establish the dimensions of the ball field and rules for player behavior.
 In your day-to-day job as a bank examiner, you were also an umpire or referee on the field who monitored player behavior, called out-of-bounds play, and penalized some for personal fouls.  And as a corollary part of the job of officiating, you sometimes had to sideline someone from the field of play or, in grave situations, ask the Federal Deposit Insurance Corporation (FDIC) to carry an ailing player off the field on a stretcher.  
The game itself, though, was played by teams of bankers, doing what bankers do well --- making a visible contribution to a safe, sound, and prosperous banking system that is earnestly attending to the legitimate credit needs and healthy growth of the most powerful economy on Earth.
Like any sports competition, the fans show up to the game to applaud the performance of the players on the field and appreciate the quality of the game play.  Every fan knows that when the game's center of attention becomes the officiating, there is something grossly wrong with the game." 

Banking Industry Responses

Owing to the increased regulatory overhead and this notable hypersensitivity to communications from bank regulators, we are seeing at least a couple of reactions.

First, all across the United States, bank boards of directors are being stocked with former regulators to help boards navigate the psychology of the regulatory and bank supervisory process.  The practice is becoming more and more common.

Second, banks are steering their consulting needs toward consulting firms whose staff roster contains a healthy number of former regulators, particularly those higher-profile ex-regulators, who walked the beat in their respective agency's Washington, D.C. headquarters.

We have seen a similar phenomenon in the defense-industrial complex, where former executives of the Department of Defense join the upper echelons of large defense contractors in order to help them understand the "process" and to leverage previous personal relationships so as to better compete for lucrative government contracts.

But the big difference between this phenomenon as it is manifest in the defense industry, versus the banking industry today, is that in the defense industry, it is in the pursuit of financial gain, not the avoidance of pain.





Friday, March 11, 2016

An Added Option for
 CRA Investment Test Credit


ken-thomas-and-sen-bill-proxmire
March 1995 - Used with permission



It was 1989 when the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) amended the Community Reinvestment Act of 1977 (CRA) and required the federal bank regulatory agencies to publicly issue CRA ratings (using a new 4-tiered rating system) and disclose written performance evaluations that outlined facts and data to support the agencies' ratings conclusions.  It was a very controversial statutory provision, as it was the first time in history that Congress "opened the kimono" on one facet of the otherwise confidential bank examination process and mandated that CRA examination ratings and CRA performance evaluations be made public as a matter of routine.  

In 1990-91, I was Deputy Comptroller for Compliance Management at the Office of the Comptroller of the Currency (OCC).  All of the federal banking agencies at the time were tasked with making the FIRREA statutory mandate operational by updating the CRA regulations; designing the form and content of these new CRA performance evaluations; testing the revised process with sample CRA examinations; and then training bank examiners nationwide on how to prepare the new CRA public disclosures.  We worked very hard to get it right under some very tight deadlines.

It was during that challenging process that I first met Dr. Ken Thomas.  He was (and still is)  America's foremost expert on the formal requirements and the important nuances of the Community Reinvestment Act.  Over the years, Ken has consulted with numerous banks and thrifts on CRA matters.  That's him standing to the left of former Senator William Proxmire.  Senator Proxmire was widely-credited with being the Father of the Community Reinvestment Act of 1977.  

Ken was in the OCC's public documents room, making copies of all of the CRA Performance Evaluations from the first round of CRA examinations done by the OCC under the new mandate.  He was checking to see how the examiners' final work product comported with the new FIRREA requirements and how consistent the CRA ratings and performance evaluations were among examiners (and among agencies).  I found him to be both a knowledgeable professional and an amiable fellow.  We have stayed in touch over the 26 years that have passed since that time.

He called me last year to ask if I would be willing to serve as one of the independent trustees of a new CRA mutual fund whose investment objectives are to invest in debt securities deemed to be qualified under the Community Reinvestment Act so that financial institutions subject to the CRA could receive Investment Test or similar credit with respect to their shares in the fund.  The new mutual fund is called The Community Development Fund.  I won't talk about the fund itself as legally all of the talking needs to take place through the Fund's prospectus.  I have no financial interest in the Fund beyond the Fund's established trustee fees and reimbursement of any travel expenses to attend Board of Trustee meetings.

I knew that there are already a couple of  CRA mutual funds in this space, so I asked what distinguishes The Community Development Fund from the others.  There was an awkward silence as if I had asked a stupid question (which I immediately realized I did).  You see, as the fund advisor, fund investors have direct access to Ken's consulting support (and the benefit of his CRA credentials) regarding earmarked CRA investments in the fund.  As an additional plus, Ken is a director of a community bank and has been for many years... so that means he has experienced the real-life challenges of CRA compliance for banks and thrifts.

Over my 37-year career as a federal bank regulator,  I had met many accomplished and outstanding bank consultants, like Ken, and I had also seen my share of consultants who were, like Texans are fond of saying, "all hat and no cattle".   Knowing him for 26 of those years, I could confidently say "yes" to his offer.


Monday, January 25, 2016

Thank you for bearing with me during this long period of radio silence on this blog.  A wonderful family Thanksgiving weekend in Miami was marred when I took a spill while walking with my wife and shattered the bones in my right forearm and wrist... rendering me unable to write or type until recently.  A thousand thanks go to a superb hand surgeon, Dr. Benjamin J. Cousins, and the excellent staff at the Mt. Sinai Hospital in Miami Beach... and of course, to my wife Tara, who is living the vow "for better or worse", and doesn't like it one bit!


Playing the Island Green

Image result for island green coeur d'alene


I always liked the concept of the "island green" in golf. It encapsulates, in one picture, the psychic dynamics of risk management in banking these days. A narrowly-defined field of play, with a pin (flag) in a cup, surrounded only by hazards. The objective? Put(t) a 1.68-inch golf ball into a 4.25-inch golf hole cup from a long ways away.

There is no neatly-clipped grass fairway to ease your forward progress, only the faint ovoid shape of the island putting green in the watery distance.  In some of those surrounding hazards, you lose your ball (in the water), and in others, your job is made harder (rough grass, sand bunkers, and obstructions, like trees).  Even a clear line to the pin requires the marshaling of absolute concentration, total situational awareness, and the precise muscle memory that comes from long periods dedicated practice and experience.

Today's risk management environment for banks stands in stark contrast to the "golden years" for the banking industry from the 1950's to the early 1980's when the old 3-6-3 rule prevailed.  Pay 3% on deposits, loan those deposits out at 6%, and then get to the golf course by 3 p.m.  That banking industry Elysium was besieged in 1980, when the Depository Institutions Deregulation and Monetary Control Act was enacted into law.  One piece of which was the phasing-out of government-administered price controls on deposit accounts.  Then, in 1982, another deregulation initiative, the Garn-St. Germain Depository Institutions Act, roughly leveled the competitive playing field between banks, savings and loans, and (by introducing money market accounts) money market mutual funds.

Given our collective experience since then, whether you judge the financial services deregulation of the early 1980's a net societal benefit (which I still do), you can surely agree that financial services deregulation significantly changed the existing landscape of the industry at the time.  We can also probably agree, that we created a bright-line tipping point or pivot point for the banking industry that defined a critical epoch in the industry's evolution.

But by removing price controls and increasing marketplace competition, we introduced "wobble" and uncertainty into the inertia of the industry; forcing changes in its momentum and trajectory.  Wobble which may likely have eventually reached some sort stable-state adaptation (as bankers got their new sea legs) if not for the destabilizing influences of economic events such as the Fed's inflation-fighting policy of stratospheric interest rates (and the resulting Recession of 1981-1982), the pesky Texas oil-patch crash, or the unwelcome real estate crisis in the New England states.

Instead of things getting less "wobbly" over time, things got even "wobblier", the big wake-up call coming with the declared insolvency of the Federal Savings and Loan Insurance Corporation (FSLIC) in 1987.

The legislative remedy to the industry's instability came in the form of  the systemic risk reduction and accountability measures in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).  Then came the Financial Services Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act [GLBA]).  Though rolling back the provisions of the Depression-era Glass-Steagall Act for a small group of megabanks and securities houses, GLBA imposed significant new regulatory requirements on all banks (regardless of size) related to customer financial privacy, information security, and anti-pretexting.  Later, after America was attacked, came the USA PATRIOT Act of 2001, strengthening Bank Secrecy Act anti-money laundering and anti-terrorist financing requirements.

All these pieces of legislation, and their implementing regulations, created new legal obligations for banks and bankers.  These new, and stricter, rules of player behavior were overlayed onto an already challenging game.  The game's fairways, now made narrower by these new rules, also became minefields, subjecting banks and their officers and directors to escalating levels of legal liability.

Fast forward to today.  From the smoldering ruins of the financial markets meltdown and the Great Recession, the Dodd-Frank Act rolls out a foundation-shaking increase in financial services regulation.   The control of industry "wobble" is now called macroprudential banking supervision and new regulatory policy goals are "financial stability and resilience".   Larger capital buffers, the Volcker Rule, the too-big-to fail fixes... all remedies targeted to the problems we experienced during the Great Recession.

In addition, there is a new Sheriff in town, called the Consumer Financial Protection Bureau (CFPB), aggressively policing both old and new consumer compliance rules and establishing evolving standards of fair play.

Dodd-Frank, like the deregulatory legislation of the 1980's, may also have brought us another new, epoch-defining, bright-line regulatory tipping-point for the industry... but a flip-side version of it... with all the uncertainty and unintended consequences to financial services market structure and competition that accompanied the earlier tipping point.

This epoch may be seen by banking historians as the time when, with good intentions and reacting to our legitimate and painful experiences, the American republic began a period of over-engineering banking regulation.  Even senior financial services regulators have admitted to not being sure how the interconnectedness of the 390 required Dodd-Frank Act rulemakings will play out in terms of impacts, implications, market distortions, unintended consequences, and undesired results.  So much also depends on how bank examiners, while in the banks, interpret and apply the rules (and whether they are applied consistently).  Those bridges, we all assume, will be crossed when we get to them.

But the danger is:  Is it being over-engineered in a manner similar to what we see with ponderous Pentagon weapons systems?  Having to accommodate so many desirable specifications, that the final product is prohibitively expensive and does few of its mission-critical functions well.  The Pentagon's Zumwalt-class Destroyer program is instructive in this respect.

Dodd-Frank is accelerating a trend that was already slowly, but steadily, gaining traction and momentum.  While chartered banks are dutifully trying to integrate these new regulations and with most being squeezed by suboptimal profitability, heirloom system platforms, and legacy thinking; the players in the shadow banking arena are attracting capital, gaining yardage, and spreading their wings (at least relatively speaking) in less restrictive airspace.

The robust growth in fintech and shadow banking is a dashboard warning indicator for regulatory over-engineering.  Anyone who has been a parent of teenagers knows that the excessive restriction of a natural inclination breeds circumvention.  It's an immutable Law of Nature.

A near-zero tolerance, over-engineered banking regulatory environment that ties the hands of the "business entities presently legally defined as banks" threatens to pretty much take away the banking game's metaphoric golf fairways altogether.  So that, at every hole, bankers, when they tee-up, are playing to an island green.

I have no doubt that the banking industry will rise to this occasion, as it always has.  You see, there is an additional aspect to the game of golf that provides a virtuous lesson for everyone who plays it.  The game is always played forward, never backward.






Tuesday, October 6, 2015


The Missing Volkswagen Moment

Image result for volkswagen logo



This discussion applies to those offending large banks operating primarily out of New York, Charlotte, London, Frankfurt, and Zurich; their insurance company accomplices, shadow bank allies, credit rating agency enablers; and the (thankfully only a handful) of their regional bank understudies... all of whom formed the nucleus and spawned the genesis of the financial crisis that ultimately brought on the Great Recession.  

When it comes to the reputation of banking and bankers in the U.S. today, the general public has a bifurcated perception of the banking industry.  They hold generally positive views of community and regional banks, but continue to hold distinctly negative views of our nation's largest banks as a group.  A perception that is likely to linger indefinitely until the previously bad-acting banks create their own "Volkswagen Moment".

By Volkswagen Moment, I mean a purposeful emulation of Volkswagen's frank public response thus far to the deception it perpetrated on unsuspecting diesel engine car owners and government environmental regulators when it was revealed that its engineers purposely installed "defeat devices" in those cars.  The Volkswagen CEO at the time, Walter Winterkorn, admitted to the misconduct; apologized to its customers, employees, and the public; committed to cooperate fully with the authorities; and pledged to make amends for its actions in order to rebuild trust in the company:

“The irregularities that have been found in our Group’s diesel engines go against everything Volkswagen stands for. At present we do not yet have all the answers to all the questions. But we are working hard to find out exactly what happened. To do that, we are putting everything on the table, as quickly, thoroughly and transparently as possible. And we continue to cooperate closely with the relevant government organizations and authorities. This quick and full clarification has the highest priority. We owe that to our customers, our employees and the public. Manipulation and Volkswagen – that must never be allowed to happen again.

Millions of people all over the world trust our brands, our cars and our technologies. I am deeply sorry that we have broken this trust. I would like to make a formal apology to our customers, to the authorities and to the general public for this misconduct. We will do everything necessary to reverse the damage. And we will do everything necessary to win back trust – step by step.

In our Group, more than 600,000 people work to build the best cars for our customers. I would like to say to our employees: I know just how much dedication, how much true sincerity you bring to your work day after day. Therefore, it would be wrong to cast general suspicion on the honest, hard work of 600,000 people because of the mistakes made by only a few. Our team simply does not deserve that."

Now let's look at the role of large financial institutions in the origination and/or distribution of low-doc/no-doc/fake-doc subprime mortgages prior to the Great Recession.   Many of those loans were made to NINAs (borrowers with No Income/No Assets) then packaged into complex and toxic CDO (Collateralized Debt Obligation) securities with integrated or attached derivatives and then marketed to mostly institutional investor chumps.  It was like the Volkswagen "defeat device" deception and misconduct, except that Volkswagen's misconduct is unlikely to drag down the world economy.

While we've had dribs and drabs of muted individual apologies mentioned in passing during press interviews from the Captains of Finance in the major banking centers around the world, there has been no unified, publicly cathartic, apology from the major players involved.  Certainly none as definitive and forceful as that made by Volkswagen.

Instead, the Captains of Finance (and their lawyers) have chosen to fight a long, numbing war of attrition with their checkbooks, forcing regulators and injured customers to spend money and time to flush out their wrongdoings before they ultimately settle things out of court.  This behavior has been wittingly abetted by a U.S. Department of Justice which has held only a handful of small-fry individuals accountable and boasts not a single high-profile banker prosecution.

As the New York Times noted in a 2011 story:

"This stands in stark contrast to the failure of many savings and loan institutions in the late 1980s.  In the wake of that debacle, special government task forces referred 1,100 cases to prosecutors, resulting in more than 800 bank officials going to jail. Among the best-known: Charles H. Keating Jr., of Lincoln Savings and Loan in Arizona, and David Paul, of Centrust Bank in Florida."

Even former Federal Reserve Chairman Ben Bernanke has been recently critical:

  "...but it would have been my preference to have more investigation and individual action, since obviously everything that went wrong or was illegal was done by some individual, not by an abstract firm."

So all that brings me to a much more pleasant part of the discussion, a recent speech by Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the Single Supervisory Mechanism.  The title of her September 28, 2015 speech was: Reintegrating the banking sector into society -- earning and reestablishing trust.

The speech is a must-read for anyone who has thought about this issue, as it presents an excellent analysis of the topic and a useful road-map of recommended actions for bankers (and regulators) to use, going forward, to help rebuild the trust of the public.

However, the effectiveness of these actions will fall well short of their potential in the absence of a critical prerequisite:  a public admission of prior misconduct; an apology to customers, shareholders, and the public; and a commitment to both make amends for the past misconduct and take steps to ensure that it doesn't happen again.

We won't be able to sweep away the lingering public suspicions and the empty feeling of incomplete justice without some kind of collective emotional closure on the painful and costly events of the past.  In other words, the parties involved still owe everyone a Volkswagen Moment.