|September 1, 2014|
Previously published on August 26, 2014
I recently had the opportunity to lead a discussion of prudential regulators and examiners at a meeting of the Banking Law Committee of the American Bar Association. Our topic was identifying the more frequent issues and problems they are seeing in their examinations of smaller financial institutions. The regulators included one from the FDIC, FRB, and a state regulator. I also spoke with regulators and general counsel of the NCUA. All had similar concerns. These conversations revealed some “red flags” and actions to seriously consider.
All the regulators agreed that the principal areas of concern included violations of the Bank Secrecy Act (BSA), anti-money laundering rules (AML), and commercial real estate concentrations. Other problems, such as IT issues, were also identified. These are issues that have been of frequent occurrence and particular focus in the examinations of the smaller (less than $10 Billion) institutions.
One of the primary BSA issues, which has caused enforcement actions to be taken, is the weakness of the organization to perform proper or sufficient risk assessments. Performing proper stress testing is important in identifying areas that are weak and to support your position that a desired activity or concentration does not negatively impact your safety and soundness. The finding of insufficient stress testing gives the examiners concern that the institution’s culture on BSA is not adequate. This can impact your “M” (CAMEL) rating also.
Other weaknesses they see in the BSA area, which can lead to enforcement actions, include Know Your Customer (“KYC”) rules on both the deposit side and loan side. Given the growing fraud problems in the industry, KYC is higher on the list of concerns. You must also have controls in place to be sure that you are filing all required Suspicious Activity Reports (SARs). The examiners have found frequent weaknesses in those filings. Depending on severity and the actions and omissions of management, they may result in a more frequent issuance of corrective action and Consent Orders. To show that you are properly addressing these issues, you need to provide adequate training for all your staff. This will be reviewed by the examiners. Find and hold on to a knowledgeable BSA officer who can also perform customized training. They are in high demand.
Circumstances that can cause a more in-depth examination into BSA issues are when there is merger activity, significant growth in a product area or new products are being introduced, or if you hire a new BSA officer. Not all BSA problems will cause a Consent Order to be issued, but they may cause consideration and debate for such an order.
Potentially detrimental concentrations are closely monitored in examinations. The biggest concerns are in the commercial real estate loan (“CRE”) area. Stress testing is important here. Be sure you have adequate policies for CRE lending, and follow them. Violations have been found when the institution has a good CRE policy but then does not follow it in practice.
Test for various types of CRE. Not all CRE lending is equal, although the differences may not be what you think. It is a common belief that owner-occupied CRE is less risky than non-owner-occupied CRE. Some studies and reviews have found that, upon closer examination and testing that may not be the case. Generally, a regulator’s policy limits CRE concentration to 300 percent. You may have a greater concentration, but perform the stress tests and be ready to show that higher limits will not negatively affect your safety and soundness. This also goes for all other types of concentrations. Stress those portfolios and review the results in light of your capital. More and more importance is being placed on stress testing.
Besides operational risks, corporate governance is being examined closely. As always, documentation is highly important. But, also, is the issue of succession planning, which is a part of corporate governance. Give thought and planning to not only upper management succession, but also to what may be important middle management personnel like your BSA officer. Board composition is an important item to consider and plan for. Remember that succession may be caused by events other than a planned retirement.
An issue of growing concern is the financial market generally and its effect on liquidity. Liquidity has generally not been an issue. But there is concern that, given the low Fed funds rate, that there is a push to go for higher yields in the bond market. The concern there is that when interest rates rise, there could be a significant downward movement in the capital accounts as most of these securities are available for sale, and this marked-to-market through the capital accounts of the institutions.
Again, stress testing these portfolios and the internal rate of return is important. You should consider the interest rate risk and the internal rate of return exposure, and have a contingency plan in place. To further show that management is properly addressing these issues, describe it to your board in both dollar and percentage terms so that they truly understand the risks.
More emphasis is being given to the board’s awareness of the institution’s activities. It is not to promote micro-management by the board, but to ensure that the board is aware of all the issues that may affect the institution’s safety and soundness. It is incumbent on management to be sure that they truly understand the risks and rewards.
Consult with your advisors and plan ahead to avoid an enforcement action, or to properly respond to one that is being proposed during an exam. A proper, concerned response to the examiners by management and its legal and financial advisors can assist in mitigating enforcement actions, and thus be of value-added to the institution.