Tuesday, October 22, 2013

Bank Examiners and Reputation Risk

There have been a series of think pieces over the summer railing about the seemingly unfettered authority of bank examiners in the field to cite reputation risk as a means to steer bank executives away from business that, at least in the mind of the examiner, presents a significant level of reputation risk to the bank.  There's one piece on Examiners' Growing Misuse of  'Reputation Risk', another titled Bankers and Processors Are Not Moral Police, an another Is FDIC Waging Stealth Crackdown on Online Lenders?

The common theme being... how far should bank examiners go, in using their assessment of reputation risk to the bank, to question bank dealings with customers engaged in legal commerce, where the bank has already complied with its legal compliance obligations?

The Framework

Bank regulatory agencies have historically held themselves out as being rather agnostic about products, services, and customer relationships that are within the orbit of the legal powers granted in their bank charters, as long as the panoply of applicable risks, including compliance risk, are adequately identified, measured, monitored, and managed.  And, frankly, it's important that they stay agnostic in a banking system that is still loosely based on market capitalism.

But both bankers and regulators would also agree that the liquidity of the bank, indeed the very existence of every bank, is predicated on the confidence that depositors, creditors, and contractual counterparties have in the integrity of the operations of the bank.  The bank's ability to earn profits, internally generate capital, attract external capital, and other funding is dependent on the willingness of others to do business with it.  Public confidence in a bank is directly linked to its reputation in the marketplace.  So a bank's ability to manage the reputation risk presented by its customer relationships is a valid bank supervisory concern for regulators.

Former Comptroller of the Currency, Eugene Ludwig, characterized the situation very well in a piece called Reputation Risk Goes Well Beyond Bad Press:
"Reputation is a misunderstood concept, too often confused with a company's advertising or PR strategy. It is something much broader: the faith that outsiders — from counterparties, to shareholders, to regulators — have in a firm's ability to conduct itself well.  It's difficult to measure, because it is related to everything a company does in the public eye."

The latest attempt to strike an appropriate balance between choice and risk can be seen in the FDIC's recent Financial Institutions Letter 43-2013FDIC Supervisory Approach to Payment Processing Relationships With Merchant Customers That Engage in Higher-Risk Activities.:

"Facilitating payment processing for merchant customers engaged in higher-risk activities can pose risks to financial institutions; however, those that properly manage these relationships and risks are neither prohibited nor discouraged from providing payment processing services to customers operating in compliance with applicable law."

Reputation Risk

An examiner's rating of reputation risk is a tender topic precisely because the topic is fundamentally subjective.  This subjectivity is acknowledged, by the Office of the Comptroller of the Currency (OCC) at least, by the fact that its Risk Assessment System (RAS) does not ask examiners to derive conclusions regarding "Quantity of Risk" and "Quality of Risk Management" in the areas of Strategic Risk and Reputation Risk.  The examiners are simply asked to do the not so simple,... rate the aggregate reputation risk (high, moderate, low) and the direction of risk (increasing, stable, decreasing).

 As laid out in the OCC Community Bank Supervision Handbook, :
"Reputation risk is the risk to current or anticipated earnings, capital, or franchise or enterprise value arising from negative public opinion. This risk may impair a bank’s competitiveness by affecting its ability to establish new relationships or services or continue servicing existing relationships. Reputation risk is inherent in all bank activities and requires management to exercise an abundance of caution in dealing with customers, counterparties, correspondents, investors, and the community.
A bank that actively associates its name with products and services offered through outsourced arrangements or asset management affiliates is more likely to have higher reputation risk exposure. Significant threats to a bank’s reputation also may result from negative publicity regarding matters such as unethical or deceptive business practices, violations of laws or regulations, high-profile litigation, or poor financial performance. The assessment of reputation risk should take into account the bank’s culture, the effectiveness of its problem-escalation processes and rapid-response plans, and its deployment of media."

During the Examination

So where does that leave us with the hypothetical bank examiner who wrinkles her nose, or rolls his eyes, or openly opines about the unsavory nature of a customer's business?

Use the opportunity to demonstrate the extent of the bank's due diligence prior to the acquisition of the customer relationship and the risk management controls that have been installed subsequent to the establishment of the relationship.

As a big believer in the effectiveness of basic blocking and tackling, I recommend that you focus on the specific examination policy direction given to field examiners by the bank regulatory agency as it relates to reputation risk.  Use that as a tool to make your case that the reputation risk in a customer relationship is being managed appropriately at your bank.  Examiners are granted lots of scope in exercising their judgement, but they still have to follow their own rules.

So What are the Rules?

This is one area where specific guidance may vary widely among federal bank regulatory agencies, but for illustration purposes, here is the framework with which OCC examiners make their determinations of reputation risk for national banks and federal savings associations.

Those determinations are circumscribed through the use of an illustrative set of Reputation Risk Indicators.  These Reputation Risk Indicators are sorted into low/moderate/high reputation risk buckets.

The Reputation Risk Indicators can be accessed here.

Where the discussion you have with the examiner leads to at the end of the day will depend on many factors.  But just having that communications opportunity, and the ability to make your case, is an important step.   And remember, if you feel strongly that the reputation risk of your bank is being inappropriately rated, consider using the examination appeals process.  Ultimately, reasonable arguments will yield reasonable results.

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