Footnoting Bank Supervision

Consider this press release from the Board of Governors of the Federal Reserve System,  the press release from Cullen/Frost Bankers, Inc., and this story in the San Antonio Express-News discussing the Fed's Order approving the acquisition of WNB Bancshares of Odessa, Texas by San Antonio, Texas-based Cullen/Frost Bankers, Inc.   

At December 31, 2013, WNB Bancshares had $1.5 billion in total assets and Cullen/Frost Bankers, Inc. had $24.4 billion in total assets.  This small acquisition would grow Cullen/Frost Bankers, Inc.'s total assets by only about 6%.

What catches your eye, tickles the antennae, and raises questions is footnote 33 on Page 19 of the Fed's merger approval.  It states:

"Cullen/Frost has committed not to engage in any expansionary activities, including branching within its existing market areas, until such time that the Board has deemed Cullen/Frost to have clearly developed a policy to support future expansion in its compliance program, including fair lending [my emphasis], and to hire additional staff with requisite knowledge and experience to manage and control the bank’s fair lending risk, which might be heightened by expansion." 

Now, if all factors were deemed satisfactory (the approval Order raises no compliance issues), why would the Fed even insert that footnote requiring the agreement of the bank to immediately refrain from any expansionary activities?   Not even one measly strip mall or street corner branch until the bank 'ups its game' in the area of compliance risk management, including the area of fair lending.  "No (more) soup for you!" as the old Seinfeld show character would say.

And what sets the mental klaxons sounding and sirens wailing is that one of the compliance management issues raised is fair lending.  Any bank examiner knows that fair lending is an electric and radioactive compliance issue - one of the few third rails of compliance supervision.  So much so that it ranks as high, or higher, on the compliance scale than another high profile compliance issue - Bank Secrecy Act/Anti-Money Laundering (BSA/AML) compliance.

Bottom line, you just don't raise the hypersensitive issue of fair lending and not be expected to explain, in detail, why you demanded this stand-still commitment from the bank.  The Fed has not offered an explanation and, so far as I know, no one in authority has requested one.

Direct talk (and action) by the Fed has been supplanted by oblique and hazy references coupled with a significant corporate commitment to refrain from further expansion, all buried in a footnote on page 19 of the approval Order.  The Fed's press release introduction doesn't even mention it.

The folks at the Fed in Dallas and Washington ought to be looking sheepishly down at their shoes; they lost bank supervision style points on this one.  I just hope that the Fed's new Large Institution Supervision Coordinating Committee (LISCC), which has bank supervision responsibility for our nation's systemically important financial institutions, doesn't contract this same malady.  The Captains of Finance, black-eyed and bloodied from years of public floggings a more direct approach to bank supervision, surely noticed this little gem.

Time for Bank Charter Reform?

Credit: "Plato's Cave" Kombo Chapfika, 2008

This week's superb article in the New York Times, Loans That Avoid Banks? Maybe Not  is notable not only for its content and analysis, but also for signaling modern implications for the basic existential question in our industry, "What is a bank?"

The triptych above entitled "Plato's Cave" gives a surrealistic interpretation to Plato's famous Allegory of the Cave (summary here).  The allegory's general concepts can be applied to the question: "What is a bank?" in the sense that we see the world  through a personal frame of reference and a collective frame of reference.  We also see that world through lenses that could be characterized as plain sight, microscopic (seeing things close up), telescopic (seeing things from a distance), and panoramic (the shape and spirit of the times we live in).  Because we perceive the world we live in through these various frames of reference and lenses, we are always challenged by the difficulty of distinguishing between what is apparent and what is real.

For example, the usual and customary way of sizing and ranking banks in the U.S. is by total balance sheet assets or total deposits.  That traditional way of sizing banks stems from our legal and accounting frame of reference about the form of a bank - cash, investments, loans, premises, deposits, borrowings, shareholder capital at risk, and a charter granted by a government authority.

A banker friend of mine in Miami, the Americas director for a large European bank, has for years sized and ranked his "bank" in the Florida marketplace as the sum total of the balance sheet assets of the subsidiary U.S. commercial bank, the parent's foreign branch in Miami, and the assets under management (AUM) of both entities.  In other words, in his formulation of bank size, the bank is the sum total of all of its customer-facing touch points... its spheres of financial marketplace influence.

My friend's sizing of his bank's presence in the Florida marketplace expands upon the formal and traditional definition of a bank by changing the frame of reference for his banking operation to be more aligned with the functions of a banking intermediary.  In a broad sense, a bank applies expertise (knowledge capital), technology, and, when necessary, their proprietary financial capital in a manner which meets the financial services needs of providers and users of funds in the marketplace.

The functions of banking can be exercised in several ways; first, by traditionally-defined bank financial intermediation where deposits are taken and bank credit is extended using the proprietary capital of the bank to absorb all risks; second, it can also be exercised via advisory or fiduciary services where the application of expertise is fee-compensated but non-operational risks are borne by the funds provider, or lastly, it could exercised through fee-compensated, customer-directed transaction services such as payments processing.

By changing the frame of reference about what is a bank, you, in essence, change how you view, plan, respond to marketplace developments like web-based crowdfunders, such as Prosper or Lending Club, or payments innovators, like PayPal, Bluebird, or virtual currency creators.

Certain observers of the peer-to-peer lending landscape, for example, have characterized the activity as a major threat to the banking industry - Too Big to Disintermediate? Peer-to-Peer Lending Takes on Traditional Consumer Lending   And as long as bankers consider this activity as separate from their existing preconceptions about the form of a bank, peer-to-peer lending could indeed be considered a growing threat.

But if bankers consider the activity consistent with the function of banking and treat it as a logical, technology-driven evolutionary development in the growth of banking itself, significant opportunities abound.  The opportunity to embrace it, subsume it, and add it to your menu of banking services is there.  

Some banks, like Titan Bank of Wells, Texas, BBVA Compass, and Congressional Bank of Bethesda, Maryland are dipping their toes in the water and are taking what are being characterized as small, calculated risks through partnerships with existing peer-to-peer lenders.

In an ideal government setting, however, the legal form of the banking charter granted by that government would slowly follow the evolving functions of banking in the financial services marketplace, so that proper and consistent prudential and consumer protection regulation can be applied to all providers of the same financial services.

In the United States, the powers granted by a bank charter are explicitly grounded in the Federal enabling legislation for federally-chartered banks.  Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), state-chartered banks are limited to the powers granted to federally-chartered banks, unless the FDIC approves exceptions on a case-by-case basis.

The time may be ripe for some bank charter reform.  While the political will is lacking, the mechanics of legislative bank charter reform could be as uncomplicated as changing the word "and" to "or" in a few places, and revisiting the corporate powers of national banks in 12 USC 24, including the incidental powers provision.

This would provide bank regulators a green light to cast the net wider and say to certain players in the shadow banking community, your activities are identical to, or closely resemble, what we have now legally defined as "banking".  You must now obtain a state or federal bank charter to conduct your business.  The result being, taking some of the "shadow" out of the new technology-driven shadow banking models.

There are some who have mused that shedding the traditional "strict constructionist" mindset of the existing national bank charter definitions and showing an innovative, well-reasoned and plucky application of administrative discretion, Tom Curry, the present Comptroller of the Currency and the chartering authority of federally-chartered banks, could obtain a roughly similar result.

Though he approached a similar issue from a completely opposite direction (deregulatory), does anyone still remember the feisty Comptroller C. Todd Conover and the "non-bank bank" controversy of the 1980's?

None of these new Web 2.X entrants into the shadow banking arena, at this point, present the kinds of macro-level financial stability concerns that would snare them into the orbit of the Financial Stability Oversight Council (FSOC) and thereby subject them to prudential supervision by the Board of Governors of the Federal Reserve System.

But their presence does undermine the concept of "competitive equality" in the marketplace for financial services.   Ideally, all providers of similar financial services should compete on as level a playing field as possible.  That includes all bearing the weight of their regulatory obligations equally.

The growing divergence between banking's legal form and de facto function, if left unchecked, will leave today's banking charter a slowly atrophying and increasingly irrelevant animal; condemned to living out its days in its own sad, dilapidated version of Jurassic Park.  Quaint specimens existing to help inform the world-view of historically-inquisitive visitors.

Stressed Out!

Credit: American Banker

The chart (above) comes from an engaging article by Victoria Finkle in the American Banker entitled Fed's Dodd-Frank Stress Test Results a Mixed Bag for Banks.  The chart lists the Dodd-Frank Act large bank stress test results under the Federal Reserve's most severe adverse macroeconomic and marketplace scenario.

A few observations... First, among these 30 large banks, the adverse scenario stress testing results vary widely.  Second, although almost all "passed" the adverse scenario stress test standard, you can see a significant variance in the degree of vulnerability among the players in the group.  Third, in an efficient market, (hopefully) those vulnerabilities would be reflected in the share prices of these banking giants.  Shares of banks with fortress balance sheets, relative to their peers, should command higher premiums.

Let's read the entrails of these large bank stress test results and talk about a "message within the message" as it relates to a totally different group of banks - community banks.  In particular, the role of stress testing in the context of the rapidly increasing pace of community bank merger and acquisition (M&A) activity over the last few months.

How many potential acquirors use adverse scenario stress testing to determine if a vulnerability discount needs to be included in the list of valuation "marks" when doing due diligence and determining an offering price?   ... particularly if folding in the target bank would weaken the pro-forma combined banking operation in an adverse scenario stress test.

How many potential community bank acquirees fail to include an adverse scenario stress test vulnerability premium  if the bank they are selling is contributing to the strengthening or fortification of the pro-forma combined banking operation in an adverse scenario stress test?  ... particularly if the purchase transaction involves an exchange-of-shares component.   Do you, as a seller, want to leave significant shareholder value potentially unaccounted for and left on the table?

How many potential community bank deal-makers are even looking at adverse scenario stress testing in the due diligence process?  How many model severe adverse scenarios through the balance sheet and P&L of the target bank or model those same scenarios through the pro-forma balance sheet and P&L of the proposed combined banking operation?

Sure, there's the loan, investment security, premises, etc. "markup/markdown" process on both sides of the target bank's balance (and off-balance) sheet, but those are generally in the context of conditions as they exist today.  Marks will likewise be adjusted for as-of date credit quality and possibly risk-adjusted so that those numbers account for required regulatory capital set-asides.  Interest rate risk given vaguely-defined directional assumptions about the term structure of interest rates might also be reflected.  But do the due diligence marks and external macroeconomic and marketplace variables come together in a structured, data-driven stress test?

If so, you wouldn't know it if you read the community bank M&A deal press releases.  These proclamations always seem to fit the same old M&A template - price-to-book value, price-times-earnings, earnings accretion timeframes, cost savings claims, the scope of the geographic footprint, leveraging talent, and, oh yeah, those deliciously vague "synergies".  Remember the definition of synergy from business school?  The whole is greater than the sum of its parts (e.g., 2 plus 2 equals 5).

In the fields of science and mathematics, the opposite of synergy is dysergy. Without solid adverse scenario stress testing in the due diligence process, a bank acquiror may be flirting with dysergy.  In the banking arithmetic we old-timers were taught, 2 minus 2 equals "you are now out of capital".   In dysergistic banking terms, the hole is deeper than the remainder of its parts (e.g., 2 minus 2 equals "a hole deeper than you ever imagined").

How do you integrate adverse scenario stress testing into the community bank M&A due diligence process?  Accept and internalize the fact that stress testing is more than a "best" or "helpful" practice, it is a core analytical competency for those community banks bent on acquisition or open to it.

Guidance and tools are available.  For example, the Office of the Comptroller of the Currency (OCC) provides excellent guidance to federally-chartered national banks and savings associations in two key guidance documents:  Community Bank Stress Testing:  Supervisory Guidance (OCC 2012-33) and Guidance for Evaluating Capital Planning and Adequacy (OCC 2012-16).  Though their requirements are targeted to federally-chartered depository institutions, the underlying concepts are fundamental, universal and generally applicable.

The OCC also provides national banks and federal savings associations access to specific stress testing tools for agricultural loans, acquisition & development loans, individual commercial real estate loans, and a portfolio commercial real estate stress test through its secure web site BankNet.  In addition, OCC's district and national experts are available for technical consultation and are only a phone call away.

Professional support is also available from other sources, including other bank regulatory agencies and trade associations.  There are professional services firms who use call report data to do rough, but reasonable, stress test modeling.  Others use defined data-sets from commonly-used vendor operating platforms.  Others offer true stress test customization at a higher price.

Adverse scenario stress testing should be part of your community bank M&A due diligence "to-do" list and part of your proforma combined operation modeling.  Wise buyers and sellers ought to be adding vulnerability premiums or a vulnerability discounts to pricing models to holistically account for risk, support capital planning objectives, and buttress strategic contingency management imperatives.

Banks are Social Networks

You might wonder what went through the mind of James W. Marshall, who discovered a gold nugget in the American River on January 24, 1848.  It's doubtful that he fully realized that his discovery would set set off the great California gold rush and the hordes of "49-ers" who would jump start the fortunes of what would shortly become the great State of  California.

Roll the clock forward to early 21st century Silicon Valley, California and what Wikipedia calls Web 2.0 - the second stage of the development of the World Wide Web - characterized especially by the change from static web pages to dynamic or user-generated content and the growth of social networking.  Today, we are living through Web 2.0's own evolution: Mobile Web 2.0 - services that integrate the social web with the core components of mobility - personal, localized, always-on, and ever-present.

The list of these Web-based social networks, though presently dominated by the likes of Facebook, Twitter, and LinkedIn, is growing continuously.  Each is seeking to add value (and riches to their founders) by metaphorically finding gold nuggets in attractive niches within our global social geography.  In the management consultant lexicon, the sponsors of Mobile Web 2.0 are sorting themselves into well-known commercial categories - scale players, niche players, and the occasionally successful "all-in" risk-takers - the disruptors.

Bankers have not been silent about the rising competitive threats to their industry. The trade publications have long been running warning pieces of the Paul Revere genre ("The British are coming! the British are coming!").  Most pointing out that the banking industry may soon be caught in the middle of a classic military pincer movement... with peer-to-peer lending and crowdfunding threatening the asset side of the balance sheet and the numerous nonbank-sponsored online payments alternatives laying siege to the liability side.

Other authors, like Francisco Gonzalez, Chairman and Chief Executive of the global Spanish bank BBVA, recently raised the starkest of choices:  Banks need to take on Amazon and Google or die.  He warns that banks need to turn to their vast array of accumulated customer data and leverage it to provide customers "exactly what they want, precisely how and when they need it."

Even others, like the recent article, The Next Big Thing You Missed:  How Starbucks Could Replace Your Bank, focus on the creeping encroachment of bank-like services like prepaid card channels and Lego-like snap-together banks, like Simple.

Almost everyone in the industry is raising red or yellow flags about what I'll call an emerging synthetic banking system.  Don't even bother to paint the emerging competition as "shadow banks", these "synthetic banks" are perfectly prepared to fight hand-to-hand combat in the bright sunshine of both Main Street and Wall Street.

Unfortunately, the odds may favor the invaders over time, as they have neither the ponderous weight of government banking regulation, nor high sunk-costs in legacy operations.  Akin to that of ancient Rome, the invaders may also be aided by the inertia of our industry's business culture - where, inevitably, denial always precedes defense.

What's a classic bank to do?  The famous general Sun Tzu, in his classic The Art of War, advised "Know yourself and you will win all battles".  That self-knowledge should begin with the fact that fundamentally:  All banks are social networks.  Your customers are to you, like "followers" are to Twitter, or  "connections" are to LinkedIn, or "users" are to Facebook.  Your customers are networked to your bank because they have chosen you as a trusted advisor and provider of needed financial services.

In the present stage of the banking industry's Mobile Web 2.0 development, the bulk of the emphasis has been on non-social, vertical networking (bank customer-to-bank).  Because we are talking about confidential financial affairs, this vertical communications channel is both "armored" and "hardened" to provide the requisite account privacy, security and other safeguards.  Within the armored and hardened vertical communication channels, many banks are making great strides in improving customer engagement and loyalty to the bank.

There is also a non-armored and non-hardened part of the vertical (bank customer-to-bank) communication channel that passes for social networking by many banks - the Twitter, LinkedIn, and Facebook fluffy marketing stuff, non-specific customer assistance, financial literacy education, public service announcements, and those happy, giggly posts like "It's Friday, we here at AnyBank want you to have a terrifically enjoyable weekend!"

That's a centralized customer communications model that talks "at" people and not really "with" people.  There is an audience lurking, but unfortunately not interacting among themselves, within 'the social network that is a bank'.

Where is the horizontal (bank customer-to-bank customer) networking?  I'm talking about the kind of horizontal networking that makes the social networks (like Twitter, LinkedIn, and Facebook) so popular and highly-used?  Where is the bank customer-to-bank customer horizontal communication interactions on financial or business topics of mutual or common interest?

If you don't think it is possible to have business-like social networking, just look at the success (and soaring stock price) of LinkedIn.com.  Horizontal social interaction is where 'the social network that is a bank' is not being profitably leveraged enough to check the competitive pressures from both banks and nonbank/synthetic banks.

How can a bank build revenue from these horizontal social interactions?  Consider the power of lightly-moderated online forums.  Let's take for instance, and for the sake of discussion, your neo-entrepreneur customers who run innovative internet-based or "brick-and-click" businesses.  They share a common social bond as far as the operations of their businesses are concerned.

In a lightly-moderated online forum, you would have customers sharing thoughts, ideas, and problem-solving among other people with common business interests and who also share a common financial product provider (remember they are already your bank customers).  This pool of horizontal online social interactions provides an avenue to promote the availability of the bank's credit, payments, treasury, and investment/wealth management services opportunistically in the context of the shared business needs of a specific customer segment.

Moreover, it's also an excellent opportunity to refer customers to vetted outside professional services providers... some of whom may also be (now very grateful) bank customers.  Lastly, it also provides valuable customer feedback on the quality of your own banking products or may reveal gaps in your menu of financial product offerings.  Therein lies the untapped potential of a true social network.

Add a high-touch component to the high-tech approach with occasional physical social events over coffee and snacks, luncheons with guest speakers, or wine-and-cheese evenings to further cement a sense of affiliation and relationship with the bank.

By verticalizing confidential personal financial matters in armored and hardened channels and horizontalizing social interactions among bank customer segments with common interests, both virtually and physically, you have the potential to capture some share of that person-to-person networking allure that the Facebooks, Twitters, and LinkedIns presently offer.

Thinking about your bank as a social network is not a cure for the constant competitive pressures coming from the emerging synthetic banking system, but not losing yardage (and hopefully gaining yardage) can keep you in the game.

Officially Distorted

 

Recent controversy about the officiating at the Sochi Winter Olympics sparked a thought about how the 2008 financial crisis, and the aftermath we are living in today, have, hopefully, only temporarily distorted the traditional role of bank regulators in the marketplace for banking services.

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 rulemaking body, subject to statutory guidance and notice-and-comment rulemaking, 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 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 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. None of the fans came specifically to see the game officials... except maybe the spouses, kids, or significant others of the officials themselves.

But you pick up any national or banking trade media publication these days and there are tons of copy tilted toward the topics of regulation, compliance, and policing unsavory banking behavior and only a smattering of news coverage about trends, tools, and techniques for scoring the game's goals.

Every fan knows that when the game's center of attention becomes the officiating, there is something grossly wrong with the game.  The game should be about the bankers and not the officials.  Hell, even the officials on the field, diligently doing their jobs, would  prefer the spotlight shine on the players and the goals of the game itself.   How many bank regulators relish the prospect of being summoned up to Capitol Hill for congressional video replays of every close call they make (or should  have made) in the scrum down on the playing field?

Like the Polar Vortex that brought us one of the chilliest winters in recent memory, the regulatory "Big Chill" on the banking marketplace seems to be showing small signs of a Spring thaw.  Although there do seem to be a couple of exceptions to this hypothesis.... the activities of the Consumer Financial Protection Bureau and the continuing gang-beating of the global megabanks.

First, while there is still much to do on the Dodd-Frank Act implementation, the outlines of major unfinished rules are generally visible, and there are signs that the rulemaking process is beginning to slowly wind down.  Regulators appear to be just as fatigued with this seemingly endless process as the banking community.

Second, bank enforcement actions are being terminated by regulators at a rapid clip as the level, and direction, of bank prudential risk metrics are improving as banks have finally worked through most of their legacy problems.

Third, bank merger and acquisitions (M&A) activity has been popping in the last few months.  Acquisitive-minded  banks have emerged from their financial storm shelters as the climate seems to be more hospitable.  In 2013, the average unasssisted community bank acquisition crept out of the discount-to-book zone and rose to around 1.2X book value and 25X earnings.

Lastly, based on my unscientific poll, bank consultants, on the community bank beat, who practice in the regulatory relations arena are getting fewer phone calls from bankers desirous of those specific services.  Inquiries now tend to tilt towards corporate governance, regulation implementation, expert witness, and due diligence work.

I think if this "Washington Spring" is real, the roles of the players and the officials should start normalizing over the next three years or so.

Like sports officiating, banking regulation and supervision was not meant to be a public limelight and celebrity status area of professional practice.  The public attention should deservedly go to the competitors in the marketplace.  And again like sports officials, their professional satisfaction should come from being tacitly appreciated for the fair, dedicated, and quietly professional execution of their official responsibilities.

Strong Coffee and Weak Tea

On January 16, 2014, the Office of the Comptroller of the Currency (OCC) released a Notice of Proposed Rulemaking (NPR) to amend the existing 12 CFR 30 - Safety and Soundness Standards by establishing a set of formal safety and soundness standards specifically for the 21 national banks and federal savings associations with total assets greater than $50 billion.  These proposed safety and soundness standards (called Appendix D) are based on the OCC's heightened expectations program implemented for large national banks after the financial crisis.

The heightened expectations program was established to strengthen the governance and risk management practices in the OCC's largest banks.  The heightened expectations are that corporate governance and risk management practices in our nation's largest national banks need to be strong, not merely satisfactory.

The proposed guidelines set forth the minimum standards for the design and implementation of an institution’s risk governance framework and provide minimum standards for oversight of that framework by the board of directors.  The guidelines include provisions regarding:

• The roles and responsibilities of those organizational units that are fundamental to the design and implementation of the risk governance framework. These units are front line units, independent risk management, and internal audit. Together, these units should establish an appropriate system to manage risk taking.
• A comprehensive written statement that articulates the bank’s risk appetite, which serves as a basis for the risk governance framework. This statement should include both qualitative components and quantitative limits.
• Board of directors’ oversight of a bank’s compliance with safe and sound banking practices. The board should ensure that the bank establishes and implements an effective risk governance framework that complies with the guidelines.
• Active board oversight of a bank’s risk-taking activities. This includes establishing accountability for management’s adherence to the risk governance framework. The board should also evaluate management’s recommendations and decisions by questioning, challenging, and, when necessary, opposing, management proposals that could lead to excessive risk taking or pose a threat to safety and soundness.
• Composition of the board of directors. A board of directors should have at least two independent members who are not part of the bank’s or the parent company’s management.

The OCC is stepping out in front of the other federal bank regulatory agencies with specific and enforceable safety and soundness guidelines.  You may have a different opinion, but frankly, prior to the OCC's heightened expectations program, governance and risk management guidance from all of the federal bank regulatory agencies read like little sermonettes - long on concepts and generalities, short on specifics and practical application.  This present high level of clear communication and transparency regarding OCC's expectations for large national banks is unique and refreshing among the federal bank regulatory agencies.  No hole cards and no guessing.  

Regarding the proposal... First, you cannot appreciate the sheer ecstasy that comes from finally being able to read a post-financial crisis Notice of Proposed Rulemaking that does not run several hundred pages in length.  This NPR is (only) 79 pages long.

Second, this NPR could as easily have been called the "Banking Consultant Screamingly Delicious Increase in Profits Regulation".  Bank consulting firms have already been engaged in the existing informal heightened expectations initiative, but now I anticipate that the combination of formalizing these safety and soundness standards in the Code of Federal Regulations and waving the stick of legal enforcement will have the boards of large banks further shoring up their fiduciary responsibility bona fides by requesting (and paying for) deeper dives.

The first four major provisions of the proposal (bulleted above) are the strong coffee. Read the details in the NPR and I think you will agree.  These are some meaty governance and risk management requirements that are very challenging to implement in large and complex organizations.

I thought the strong coffee provisions of the NPR were well thought out and organized.  My major concern centers on the approval of the resource budgets for what the NPR calls "independent risk management" and the "internal audit" functions.

While the board approves the appointment, removal, compensation, and salary adjustments for the Chief Audit Executive (CAE) and Chief Risk Executive (CRE), the specific language in the proposed regulation amendment itself is silent as to who is approving their resource budgets.  Resource budgets are a major determinant of the efficacy of these critical control functions.

The Supplementary Information section of the NPR indicates that, for internal audit functions (and CAEs) reporting to the Board's audit committee, the board, the board audit committee, or its chair, would oversee resource budgeting (among other functions).  On the other hand, for the CRE (and the administration of the "indpendent risk management function"), the CEO oversees the resource budgeting.  This disparity should be fixed in order to create equivalency in the checks-and-balances framework for both critical control functions.  The Board of Directors, or committee thereof, ought to approve, the appointment, removal, compensation, salary adjustment, and resource budgets for the CAE and the CRE.  

The weak tea is the fifth major provision of the NPR:  A board of directors should have at least two independent members who are not part of the bank’s or the parent company’s management.

That just doesn't square with a meaningful interpretation of the concept of credible challenge, published corporate governance best practice recommendations, and the elevated post-financial crisis public interest in the operations of these banking giants.  This specific proposal only serves to re-enact Custer's Last Stand at the Little Bighorn, except in the boardrooms of our largest banks, as the two independent directors will be seriously out-gunned by inside board members who run the daily operations of the bank.

Best practice for corporate audit committees, for example, is to have them consist of independent directors.  Two independent directors would not make a credible audit committee in our nation's largest banks.  Banks of this size, and weighing their systemic impact on the national and global economies, should ideally have a majority of directors be independent directors, not a symbolic lonesome twosome.

Hopefully, respected best practice organizations like the American Association of Bank Directors , the National Association of Corporate Directors, and the Conference Board can inform this process with their long experience and expertise on board-level governance by submitting comments on this provision of the NPR.

Otherwise, as a peripheral issue, it will also be interesting to see if there are any bank regulatory geopolitical ramifications to all of this.  As of 9/30, there were 33 banks with total assets over $50 billion.  21 of them are national banks and federal savings associations.  That leaves 12 state-chartered banks and savings associations that are supervised, at the federal level, by the Federal Reserve or the Federal Deposit Insurance Corporation (FDIC).  These state-chartered banks and savings associations were not subject to the informal heightened expectations program and will not be subject to the legally enforceable safety and soundness standards outlined in the NPR. 

I've railed about the OCC's excessive "rainy day" reserves (a FY 2012 net position of over $1 billion) in past blog postings.  I'm biting my tongue now on the topic.  Any tiny movement between federal and state bank charters in banks of this size can be seismic in terms of bank supervision workday impact as well as the number and geographic distribution of large bank examiners. 

Overall, this NPR is a bold example of leadership by Tom Curry, the Comptroller of the Currency.  In the same tradition of the leadership the agency exhibited in the previous amendment to the OCC's safety and soundness standards.  In February 2005, the OCC added Appendix C to 12 CFR 30 - Standards for National Banks' Residential Mortgage Lending Practices.  Those rules may have come a little late given the froth and craziness in the mortgage markets prior to the financial crisis, but it was also a courageous step by an Acting Comptroller of the Currency to do what needed to be done, at a time when timidity ruled in the interagency bank regulatory forum.

What's Wrong with Being Balkan?

On December 14, 2012, the Board of Governors of the Federal Reserve System released a Notice of Proposed Rulemaking (NPR) for Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies.  At 306 pages, this portion of Regulation YY outlined a revised architecture of enhanced prudential standards for Foreign Banking Organizations (FBOs).  Those standards include risk-based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, single-counterparty credit limits, and stress testing requirements.

Well, it's been over a year now and the only sound coming from the Fed at this point is the sound of crickets chirping in an empty room.   The effort to implement these prudential standards has been reportedly stymied by objections by certain foreign countries, foreign bank lobbying groups, and trade associations representing large U.S. banks who fear in-kind retaliation - "reciprocal responses" for the diplomatically inclined.  62 discrete comment letters have been filed to-date by various entities, along with 925 form letters.

The major sticking point is the requirement to establish a U.S.-domiciled Intermediate Holding Company (IHC) for banks with total global assets exceeding $50 billion and whose non-branch assets in the U.S. exceed $10 billion.  All IHCs would be subject to U.S. Bank Holding Company (BHC) capital standards. Additionally, U.S. IHCs with assets between $10 billion and $50 billion would be subject to Dodd-Frank Act (DFA) company-run stress testing requirements.  IHCs with assets greater than $50 billion would be subject to all DFA stress-test rules and be subject to monthly liquidity stress tests and in-country liquidity requirements.

Here was the Fed's rationale as outlined in the NPR:

"Actions by a home country to constrain a banking organization's ability to provide support to its foreign organizations, as well as the diminished likelihood that home country governments of large banking organizations would provide a backstop to their banks' foreign operations, have called into question one of the fundamental elements of the Board's current approach to supervising foreign banking organizations – the ability of the Board, as a host supervisor, to rely on a foreign banking organization to act as a source of strength to its U.S. operations when the foreign banking organization is under stress.

The issues described above-- growth over time in U.S. financial stability risks posed by foreign banking organizations individually and as a group, the need to minimize destabilizing pro-cyclical ring-fencing in a crisis, persistent impediments to effective cross-border resolution, and limitations on parent support-- together underscore the need for enhancements to foreign bank regulation in the United States.”

Comment letters on the proposed Fed regulation were rich with accusations that this would create "balkanization" in the global banking system.  Timothy Adams, representing the Institute of International Finance (IIF) included this in his comment letter to the Fed objecting to the rule:

"... Regulatory fragmentation can be seen through the increasingly national approaches in key reform areas, such as provisions for resolution of failing firms, and capital and liquidity requirements. Differentiation in the implementation of globally agreed standards and domestic bias in supervisory practices, have also contributed to a sense of financial "Balkanization"... "

The joint comment letter submitted by The Clearing House, the American Bankers Association, and the Financial Services Roundtable, included the following:

"The Associations believe that the Proposal's approach, which would necessarily involve the balkanization of a sizable share of the global banking system along national borders, could both impair economic recovery and growth and increase, rather than diminish systemic risk."

Referred to in a couple of other comment letters is a quote from current Governor of the Bank of England and Chairman of the Financial Stability Board (and former Bank of Canada Governor) Mark Carney:

"Left unchecked, these trends could substantially decrease the efficiency of the global financial system. In addition, a more balkanized system that concentrates risk within national borders would reduce systemic resilience globally."

Folks, may I have permission to speak up and support the terms "balkan" and "balkanization"?  Using the terms "balkan" and "balkanization" as accusations, epithets, and terms of derision, masks the fact that spreading your risk (and your risk cushions) represents an important concept in the field of prudent risk management.  The U.S. learned many years ago... you don't anchor your entire Pacific Fleet in Pearl Harbor.

In most of the letters arguing against the proposed regulation, there is a certain idealistic and Utopian tone to how the global financial system, and its system of global regulatory coordination, works.  Prudential supervision, from a host country banking supervisor's perspective, is worrying about how to deal with the downside of risk as it impacts the constituency who appointed you to be their steward.  Sure, one can go overboard on protecting ones own citizenry, but there is a middle ground... and I believe the Fed tried to find it.  Maybe as the good work of constructing a global regulatory framework nears that Utopian ideal and when the bad memories fade about how imperfect the global financial system presently is, then it may be time to peel back the national ring-fencing of risk, capital, and liquidity.

Some of the comments against the proposed Fed regulation also seem to assume, with a prophet's degree of certainty, that all that needs to be known about macro-prudential risk is indeed known.  And I think that is because the global financial crisis painted the macro-prudential risk landscape with brilliant hues.  The problems presented in the aftermath of the financial crisis were so stark and easily visible (if not blindingly so) to everyone... liquidity stresses, market collapse, credit quality deterioration, etc.  These risk issues, having leviathan proportions, served to provide unmistakable targets for problem resolution, risk remediation, and regulatory action.

As we all know, the financial crisis and the concurrent economic slump are slowly becoming rear-view mirror issues and the condition of bank balance sheets is slowly improving.  The risk landscape will no longer provide such obvious and actionable cues.  Quickly departing are the days when risk management priorities are handed to bankers (and bank regulators) like low-hanging fruit.

We are moving into a business environment where the emerging risk cues will either be small, subtle, and creeping, or alternatively, immediate, surprisingly radioactive, and potentially explosive.  The direction and momentum of the banking industry itself also seems to be changing by moving away from the protective inward focus that comes from nursing your wounds, apologizing for past sins, and paying fines for violating laws.  Force projection, as the generals and admirals call it, will begin to make a stronger comeback this year, particularly in the regional banks.

We are getting back to expecting the unexpected... that's why it's so important to implement all of the Dodd-Frank Act enhanced prudential standards as soon as possible.