On May 14, 2012, the Federal Reserve, FDIC and the OCC released a joint statement confirming that that banking organizations with total consolidated assets of $10 billion and under will not be required to conduct formal stress tests. Management of many smaller banking organizations had been concerned that the stress testing required of larger banks would “trickle down” in an informal sense to smaller banks. With this regulatory statement, that concern is alleviated, at least in the official sense.
We continue to believe that the heightened (or perhaps renewed) emphasis on risk management by the regulators will affect banks of all sizes. It is likely that regulators, directors, and shareholders of all banks will want to confirm that management has identified the key risk factors affecting the institution and that the board has established the institution’s tolerance for accepting those risks and implemented any appropriate mitigants.
We recommend that banks of all sizes, even the smallest community banks, undertake an enterprise risk management analysis to identify the key risks facing the institution. The board of the institution, as a subpart of its strategic planning function, should review those risks and establish the institution’s risk tolerance with respect to each category of risk (many consultants will capture this analysis in a “risk appetite statement”). Establishing and understanding those risk tolerances will form a roadmap for setting and executing the institution’s strategic initiatives. In implementing this analysis, some institutions may undertake some level of stress testing with respect to certain risks.
This risk management analysis is a natural adjunct to the self examination process used we recommend using in preparing for a regulatory exam (see our prior “Self Exam” post). While the self exam process is typically more focused on the bank’s current position and past performance and this risk management analysis is more forward-looking, both processes require an introspective review. Senior regulators have repeatedly confirmed to us (and we have seen in practice) that where banks take the initiative in implementing credible risk management programs and other pre-examination preparation, the examiners are much more likely to defer to the judgment of management and the board of the bank – with the result being a much better interaction with regulators (who, in an ideal scenario, can be a partner in the risk identification process).
On May 19, 2011, the Government Accountability Office published its report on the federal banking regulators’ 2006 interagency guidance on commercial real estate concentrations. The GAO report concludes that federal banking regulators should enhance or supplement the 2006 CRE concentration guidance and take steps to better ensure that such guidance is consistently applied.
The GAO report indicates that the OCC and Federal Reserve agree with its recommendations, while the FDIC insists that it has already implemented strategies to supplement the 2006 guidance. A closer review of the OCC and Federal Reserve positions, however, would seem to suggest that the OCC and Federal Reserve agree the 2006 guidance should be enhanced, but don’t seem to have any issue with the inconsistent application of the current guidance, and may even suggest that over-reaching application of the 2006 guidance is necessary since it, in their opinions, doesn’t go far enough. Both the OCC and Federal Reserve indicated that they were reviewing whether higher capital requirements should be set for banks that have higher CRE concentrations.
The GAO report is a good read for any banker looking for the current collective position of the federal regulators with regard to commercial real estate concentrations (and especially with respect to how the 2006 guidance should be interpreted), but ultimately only highlights the discretion vested in each agency (as well as each examiner).
On February 5, 2010, the federal banking regulators and the Conference of State Bank Supervisors issued an Interagency Statement on the Credit Needs of Creditworthy Small Business Borrowers. The Statement builds upon principles set forth in the October 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts. After noting the overall decline in loans to small businesses and the reasons for that decline the regulators suggested that lenders may have become overly cautious with respect to small business lending. They encourage lenders to engage in prudent small business lending and that that examiners will not criticize lenders for working in prudent and constructive manner with small businesses.
The decline in small business lending has many reasons, not the least of which is that loan demand is actually down. Lenders are also naturally cautious of lending to those businesses that are reliant solely on cash flow that has slowed due to the slowdown in consumer spending and the decline ion the personal wealth of the owners of the businesses. Despite the assertions to the contrary by the regulators, lenders are concerned that there is a disconnect between statements from Washington, DC and what actually happens in the field when examiners are onsite at financial institutions. Our experience seems to show that local federal regulators do not see any upside in being flexible when faced with making decisions about how to rate credits. Lenders are therefore naturally reluctant to maker decisions based on guidance until they see it actually implemented on the ground.
Regulators and financial institutions have been trying for some time now to come to an understanding of what type of how workout strategies affect the classification of loans and the corresponding impact on estimates of loan losses. On October 30 the federal banking regulators published guidance on prudent commercial real estate loan workouts that addresses these issues. The guidance addresses some of the most contentious areas of disagreement between banks and examiners. One of those areas is the impact of a decline in value of collateral in situations where the borrower or guarantors have the ability to service the loan. The new guidance tells examiners that renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. This is a significant change from the manner in which examiners have been classifying acquisition and development loans in the past and time will tell exactly how the examiners will in fact deal with such loans in the future.
A problem loan workout can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions. The key to any loan workout is that the renewal or restructuring should improve the lender’s prospects for repayment of principal and interest and be consistent with sound banking, supervisory, and accounting practices.
On June 23, 2009, the FDIC issued Financial Institutions Letter FIL-33-2009, which contains final amendments to Part 363 of the FDIC’s regulations regarding annual independent audit and reporting requirements for insured institutions with $500 million or more in total assets. The amendments are intended to clarify what must be included in a Part 363 Annual Report. The reporting obligations differ between institutions with total assets, as of the beginning of the fiscal year, between $500 million and less than $1 billion, and of $1 billion or more. Unless otherwise noted the amendments became effective on August 6, 2009. We summarize the main elements of Part 363, as amended, below.
Audit Report Requirements
Part 363 requires the following to be included in the Part 363 Annual Report:
For institutions with total assets between $500 million and less than $1 billion
- Audited comparative financial statements;
- The independent public accountant’s report on the audited financials; and
- A management report containing (i) a statement of management’s responsibilities for preparing annual financial statements, establishing and maintaining adequate internal controls, and complying with safety and soundness laws and regulations pertaining to insider loans and dividend restrictions, and (ii) a management assessment of the institution’s ability to comply with laws and regulations relating to insider loans and dividend restrictions, stating management’s conclusion on compliance with the laws and regulations.
For institutions with total assets of $1 billion or more
In addition to the items required for institutions with total assets between $500 million and less than $1 billion, institutions with total assets of $1 billion or more must provide the following:
- The management report must also contain an assessment by management on the effectiveness of the institution’s internal controls over financial reporting that identifies the internal control framework, states that the assessment included controls to ensure financial statements were prepared in accordance with regulatory instructions, states management’s conclusion whether this internal control is effective, and discloses any material weaknesses in these internal controls; and
- The independent public accountant’s attestation report concerning the effectiveness of the institution’s internal controls over financial reporting.
On August 28, 2009, the FDIC published Financial Institution Letter (FIL) 50-2009 announcing that the de novo period for state nonmember institutions is increasing from three years to seven years. The new policy is in response to depository institutions insured fewer than seven years being overrepresented on the list of failed institutions in 2008 and 2009.
Bottom line
Pay attention to your business plans! First, banks less than seven years old must keep a close eye on how their performance matches up with the projections in the bank’s approved business plan. Second, such banks need to seek prior regulatory approval for an amended business plan if the bank expects to materially deviate from that plan. Third, such banks should be particularly mindful to avoid loan concentrations and to avoid using brokered deposits or other wholesale funding at levels not contemplated in their approved business plan.
Applicability
The new policy applies to existing newly insured institutions (banks less than seven years old). There is a general exception for de novo institutions that are subsidiaries of “eligible holding companies.” Eligible holding companies are those with consolidated assets of at least $150 million, BOPEC ratings of at least 2 for bank holding companies and an above average or “A” rating for thrift holding companies, and at least 75% of their consolidated depository institution assets comprised of “eligible depository institutions.” An “eligible depository institution” is one that received a 1 or 2 composite rating and compliance rating at its most recent exams, has a satisfactory or better CRA rating, is well-capitalized, and is not subject to any type of regulatory enforcement action. Even for subsidiaries of “eligible holding companies,” the FDIC has retained discretion to extend the new policy to this set of eligible holding companies.
Heightened capital requirements
Newly insured banks are required to maintain a Tier 1 leverage ratio of 8% during the de novo period. Under the new policy, all banks less than seven years old will be required to maintain this heightened ratio.
On April 24, 2009, the Federal Reserve published a white paper describing the process and methodologies employed by the federal banking supervisory agencies in their forward-looking capital assessment of large U.S. bank holding companies. The white paper is thin on new details, but does provide a base for understanding the stress tests being undertaken of 19 bank holding companies with total assets in excess of $100 billion.
Purpose and Effect of the Stress Tests
The stress tests are designed as the first part of the Capital Assistance Program to demonstrate which institutions the government believes will need to raise additional capital. If a stress test demonstrates that an institution requires additional capital, the institution will be required to enter an agreement to issue convertible preferred securities to the U.S. Treasury in an amount sufficient to meet the capital shortfall under the TARP Capital Assistance Program. Each such institution will then be permitted up to six months to raise private capital in public markets to meet their capital needs, and would be able to cancel the obligation to the government without penalty. Participants would also be given the opportunity to convert their existing TARP Capital Purchase Program preferred stock into the convertible preferred stock to be issued under the TARP Capital Assistance Program (such a conversion would not affect the institution’s Tier 1 capital, but could affect the institution’s tangible common equity and their dividend obligations).
The FDIC has apparently decided not to wait to see if Congressman Frank’s TARP Reform and Accountability Act becomes law, and has published a one page Financial Institution Letter on January 12, 2009 calling for state nonmember banks to monitor their use of capital injections, liquidity support and/or financing guarantees obtained through the recent government financial stability programs.
The FDIC notes that in exchange for government funds, capital and guarantees being used to support banking institutions, “banks are expected to document how they are continuing to meet the credit needs of creditworthy borrowers,” and reference the Interagency Statement on Responsible Lending. (As a reminder, the Interagency Statement applies to all financial institutions, and not just those that have participated in the government financial stability programs.) The FDIC expects that state nonmember banks will deploy any funding received from these programs to “prudently support credit needs in their market and strengthen bank capital.”
Potentially in response to the political and public criticism of whether the government financial stability programs are working, the FDIC calls for state nonmember banks to: (a) implement a process to document how these funds were used; and (b) to describe their utilization during bank examinations. Moreover, banks are encouraged to summarize such information in published annual reports and financial statements in order to “provide important information for shareholder and public evaluation of participation in these programs.”
Last week, the federal government provided several updates on the status of the Troubled Asset Relief Program: the Third Tranche Report to Congress (December 2nd); a speech by SEC Chairman Cox (December 4th); the first Section 105(a) Report to Congress (December 5th); and a speech by Treasury Interim Assistant Secretary Kashkari (December 5th). We have highlighted the more important components of each update below.
Third Tranche Report to Congress
The Third Tranche Report to Congress provides the basic factors that the Treasury will use in analyzing whether an institution should be supported under the Systemically Significant Failing Institutions (SSFI) Program. It was under the SSFI Program that Treasury closed a $40 billion transaction with AIG on November 26, 2008. Participation in the SSFI Program will continue to be on a case-by-case basis, based on these and other factors:
- The extent to which the failure of an institution could threaten the viability of its creditors and counterparties because of their direct exposure to the institution.
- The number and size of financial institutions that are seen by investors or counterparties as similarly situated to the failing institution, or that could otherwise be likely to experience indirect contagion effects from the failure of the institution.
- Whether the institution is sufficiently important to the nation’s financial and economic system that a disorderly failure would, with a high probability, cause major disruptions to credit markets or payments and settlement systems, seriously destabilize key asset prices, significantly increase uncertainty or losses of confidence thereby materially weakening overall economic performance.
- The extent and probability of the institution’s ability to access alternative sources of capital and liquidity, whether from the private sector or other sources of government funds.
It seems unlikely that the Treasury will include any financial institutions other than the largest ones in the SSFI Program, unless an institution can make a strong case that its stability is critical to the overall stability of the nation’s financial and economic system.
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On November 12, 2008, the FDIC, Federal Reserve, OTS, and OCC jointly issued an Interagency Statement on Meeting the Needs of Creditworthy Borrowers. This new release is a broad statement that covers both lending practices and restructuring mortgages and addresses dividend policies and executive compensation. We encourage every bank CEO to carefully review this Interagency Statement as an initial glimpse into the direction that the federal banking regulators appear to be headed.
As we’ve previously noted in our commentary, we believe that any future regulations will be placed on the industry as a whole and not merely on those that participate in the TARP Capital program. We believe this Interagency Statement lends credence to our position. While the Interagency Statement initially notes the Treasury’s program to make new capital widely available, the Interagency Statement provides that “it is imperative that all banking organizations and their regulators work together to ensure the needs of creditworthy borrowers are met,” and that “each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention and reassess the incentive implications of its compensation policies.”
For bankers already planning to participate in the TARP Capital program, this Interagency Statement may provide some guidance (and comfort) as to what the regulators will expect regarding expansion of the flow of credit and modification of residential mortgages.
For bankers who were not planning to participate in the TARP Capital program, this Interagency Statement may lead to a reconsideration of the relative risks of participating versus not participating.