More so than any other business, the banking world has been overdosed on regulatory prescriptions.
The Dodd-Frank Act and international Basel III accord are just two landmark laws that in recent years have added to an ever-expanding list of rules intended to protect the safety and soundness of financial markets. These include, but are not limited to, heightened capital requirements, liquidity demands, restrictions on derivatives trading, pushback on on ventures that go beyond traditional and vanilla banking services, and stress tests.
In response, banks have not just ramped up compliance and risk management efforts, they have shuttered branches in risky geographies, retreated from market-making activities, cut formerly profitable correspondent banking relationships, and closed their doors to what some consider unsavory of high-risk businesses (from strip clubs to marijuana dispensaries).
Unfortunately for bankers, 2016 is likely to bring even greater regulatory scrutiny and rulemaking, with their inevitable demands for additional risk mitigation and controls. This year, however, there is a twist. As election-year politics heat up, so too are post-crisis calls to break up big banks, as are desires to resurrect the Glass-Steagall Act, a Depression-era law repealed by the Clinton Administration in 1999.
A modernized take on the legislation has a smattering of bipartisan support, initially introduced by Senators Elizabeth Warren (D-Mass.), John McCain (R-Ariz.), Angus King (I-Maine), and Maria Cantwell (D-Wash.). It would separate traditional banks—with savings and checking accounts insured by the Federal Deposit Insurance Corporation—from riskier financial institutions that offer services such as investment banking, insurance, swaps dealing, and hedge fund and private equity activities.
Enter the presidential candidates—specifically on Team Democrat—who are debating amongst themselves on the best way to bring the hammer down on still-vilified big banks.
“If a bank is too big to fail, it is too big to exist. If Teddy Roosevelt, the Republican trust-buster, were alive today, he would say ‘break ’em up.’ And he would be right.”
Bernie Sanders, Democrat, Presidential Candidate
Bernie Sanders, in particular, came out swinging last week. Pledging support for a new Glass-Steagall, he also laid out plans to, within the first 100 days of his administration, require that the Treasury Department establish a “Too-Big-to Fail” list of commercial banks, shadow banks and insurance companies whose failure would pose “a catastrophic risk to the economy” barring taxpayer bailouts. Within one year, these institutions would be “broken up.”
“If a bank is too big to fail, it is too big to exist,” he said. “If Teddy Roosevelt, the Republican trust-buster, were alive today, he would say ‘break ’em up.’ And he would be right.”
His party rival, Hillary Clinton, has a similar, but far from identical approach. Clinton has been elusive on committing to a preemptive downsizing of the largest banks, but does pledge to let failing banks fail, dividing them into reasonable pieces through subsequent resolution proceedings.
Perhaps reacting to the fact it was repealed with her husband’s signature, Clinton doesn’t share Sanders’ zeal for a return of Glass-Steagall, pointing out on the campaign trail that “shadow banks” like AIG and Lehman Brothers, contributing culprits of the financial crisis, were hardly the sort of big commercial banks that would be covered.
“It is election year, let’s just hope to get out with as little damage as possible,” says James Kaplan, a partner with the law firm Quarles & Brady. He frets that big-bank witch hunts are not exclusive to any political party in the current election cycle: “Banks provide a prime target for demagogues of every stripe.”
The key to a safer banking system, Kaplan says, is not more regulation, but better risk management. “Clearly regulators, since the crisis, have been pushing the industry to make their compliance and risk management processes more robust,” he says. “Certainly, because of Dodd-Frank, banks hold more capital, which is certainly a positive. Although it hasn’t been tested, I think the Orderly Liquidation Authority is an advance. We at least have a resolution plan for failing banks now, and we didn’t before.”
“You can be big and have a great risk management approach, with board-level compliance and risk committees,” he adds. “That’s where you do the work that will protect your institution in an economic downturn or crisis. It should take place at the biggest bank, the smallest bank, and all of them in between.”
THE RISKS AHEAD
The following is from the Office of the Comptroller of the Currency’s most recent “Semi-Annual Risk Perspective.”
Primary supervisory concerns remain generally unchanged but evolve as competition for banking products and services increases. Strategic, underwriting, cyber-security, compliance, and interest rate risks (IRR) remain the OCC’s top supervisory concerns. Risks associated with underwriting and cyber-security are increasing, while strategic, compliance, and IRR remain stable.
Many banks continue to face strategic challenges growing revenues to meet target rates of return in a slow-growth, low interest rate economic environment. Many banks are reevaluating risk tolerances and business models.
Banks are easing credit underwriting standards and practices, including structure, terms, pricing, collateral, guarantors, and loan controls in response to competitive pressures and growth objectives. This easing is particularly evident in high-growth loan segments, such as indirect auto, C&I, and multifamily CRE.
The ongoing low interest rate environment poses additional concerns as banks reach for yield by extending asset duration trends. Deposit stability, a significant component of IRR modeling, is difficult to assess because of recent deposit inflows and the potential for increased competition for retail deposits. The low interest rate environment continues to pressure net interest margins as asset yields decline and the cost of funds has stabilized at historic lows.
Cyber-threats, reliance on service providers, and resiliency planning remain concerns particularly in light of heightened global threats.
Regulatory amendments and reliance on third parties continue to create challenges for bank consumer compliance functions. Bank Secrecy Act (BSA) risk also continues to increase as criminal behaviors evolve and criminals leverage technology innovations.
The OCC’s NRC is monitoring several risks that warrant awareness among bankers and examiners. These risks have the potential to develop into broader systemic issues and may already raise concern at individual banks. The risks include:
Exposure to oil- and gas-related sectors (e.g., service, office, and hotel sectors) as well as direct exposure to exploration and production firms.
Increasing loan concentrations in multifamily CRE and non-depository financial institution sectors.
The appropriateness of allowance for loan and lease loss (ALLL) levels and methods given loan growth, easing in underwriting, and layering of credit risk.
Banks’ ability to exit balance-sheet positions because of declining market liquidity.
Implementation of the new integrated mortgage disclosure requirements under the Truth in Lending Act of 1968 and the Real Estate Settlement Procedures Act of 1974.
Source: Office of the Comptroller of the Currency
A focus on compliance risk management will certainly be needed as the regulatory pressures on banks escalate in the New Year. In its Semiannual Risk Perspective, released in December, the Office of the Comptroller of the Currency itemized key concerns.
National banks and federal savings associations continue to face strategic challenges to growing revenues to meet target rates of return in a slow-growth, low interest rate environment, the regulator warned. In response, many banks are easing credit underwriting standards and practices, and reaching for yield by loosening underwriting. Others have reached for yield to boost interest income with decreasing regard for interest rate or credit risk. Business operating models are under increasing pressure as bankers seek to launch new products, leverage technology, reduce staffing, outsource critical activities, and partner with firms unfamiliar with the bank regulatory environment. The OCC’s warning: “Banks may not always adapt risk management and control processes to these changing business strategies.”
Bank Secrecy Act, anti-money laundering controls, and the risks inherent with an expanded reliance on third-party relationships are perpetual, and increasing, concerns. And, lest they think otherwise, cyber- security sits near the top of the risk pyramid. Banks may not be adequately incorporating resiliency considerations—including recovery from cyber events—into their overall governance, risk management, or strategic planning processes, the OCC report says.
“They understand that risk management is critical,” Kaplan says of regulators (unlike the unnerving rhetoric of politicians). “Some of the things they are prescribing for the industry, like stress tests; enhanced capital and buffers; and better processes for risk assessment and compliance are all positive and should be done in the right way by banks.” He is concerned, however, by what can easily become an onerous supervisory approach, especially in the hands of the Consumer Financial Protection Bureau.
“I’m worried that the prescriptive and punitive nature of their approach often casts too large a net,” Kaplan says. “And, they may be susceptible to this new populism that says banks, particularly the big banks, are the problem and we have to ride hard on them. When they make the move into being too prescriptive in terms of what our business is like, especially the traditional banking business, it is damaging.”
The CFPB, the youngest regulator and already one of the most important in the financial services industry, will be closely monitored by Benjamin Diehl of the law firm Stroock & Stroock & Lavan. Credit discrimination, mortgage lending disclosures, underwriting standards, and debt collection will continue to issues. In the coming months, despite an already aggressive enforcement posture, the CFPB could finally release comprehensive debt collection rules. The CFPB had expected that pre-rule activities for the two-year-old rule proposal would wrap up by the end of 2015.
“They will do something,” Diehl says. “They have not forgotten about it and continue to pursue debt collection actions in the interim.” He cites an additional concern: the continual blurring of the line between creditor and collector. The existing Fair Debt Collection Practices Act distinguishes between an original creditor and a debt collector.
California law, however, largely applies to both equally, an omen for what may come soon. “The industry is mindful of the need to monitor debt collection practices, but the distinction you see in the federal statutes is going to be increasingly diminished,” Diehl says. That may be even more bad news for banks.