• What's A Bank To Do When The Regulators Come Knockin'?
  • May 29, 2009 | Authors: Stephen M. Klein; Kumi Yamamoto Baruffi; Jane H. Kaufman
  • Law Firm: Graham & Dunn PC - Seattle Office
  • The Changing Regulatory Environment

    Over the past year, as the economy has continued to deteriorate, the bank regulatory environment has become more and more challenging. Many “experts” have predicted that as many as half the banks in the United States will be under some form of administrative action by year-end. Based on what we are seeing out there, that may become a reality.

    As we get deeper into the recession, more current bank examinations uncover more problems, reflecting continuing credit deterioration. In part, this is purely a function of the economy, stressed borrowers and collateral values. In part, it probably reflects the increased scrutiny and caution of the bank examiners, who are concerned about missing any problems.

    Plummeting Examination Ratings

    As a result of this enhanced scrutiny and economic deterioration, exam ratings have continued to plummet. A “2” rating is the new “1” which is now the rating to embrace and be proud of. Double-downgrades from “1” to “3” and “2” to “4” from prior exams are commonplace. Offsite temporary downgrades between exams also are proliferating based on deterioration in Call Report numbers.

    What does this mean? Well, a “3” rating gets you either a state action or Memorandum of Understanding (“MOU”). A “4” or”5” rating gets you a Cease and Desist Order (“C&D”), means you probably no longer meet “well-capitalized” status, and shuts you down from taking brokered deposits and significantly increases your deposit insurance premiums. As one of our clients points out, the difference between a “4” and “5” rating is worth fighting for since a “5” puts you in “distinguished” company status and under enhanced scrutiny.

    The Best Defense is a Good Offense

    How do you avoid a bad report card? Well, if your asset quality is bad, you have a problem. However, on the margin you can take a number of proactive steps to improve your rating, including:

    • Identifying and properly classifying your problem assets.
    • Enhancing your loan files and documentation.
    • Ordering appraisals for property timely and as often as necessary.
    • Strengthening collateral positions on problem loans.
    • Being forthright and upfront with the regulators to build credibility.
    • Aggressively restructuring and/or disposing of problem assets.
    • Raising capital, if possible.
    • Improving your balance sheet and off balance sheet liquidity.
    • Understanding your liquidity position; stress test it; having a contingency funding plan.

    While these steps are not a guarantee that you will avoid all regulatory pitfalls, they could, on the margin, make the difference in your overall “CAMELS” rating, whether you get an administrative action, the type and severity of such action, the tone of the exam report and the timeframe to get out from under such action.

    What If You Get a Proposed Administrative Action?

    Our research and experience shows that most administrative actions have certain “core” features. However, you can negotiate specific provisions and timeframes to reflect your particular bank’s situation.

    The regulators are anxious to get these administrative actions in place, particularly since they have been internally and externally criticized for not acting quickly enough. However, we advise our clients to try to negotiate terms that they believe they can live with and meet. Remember, the regulators have extensive powers to enforce violations of formal “written agreements”, including the assessment of civil money penalties, removal of officers and directors, and, in extreme cases, termination of deposit insurance. While few of these additional enforcement powers have been used recently, given the changing economic and regulatory environment, history may not be a good predictor of future action. So be careful to what you agree. Obviously, you should utilize experienced counsel to guide you through this foreign process.

    Disclosure Considerations

    C&D Orders are placed on the issuing federal bank regulator’s website and are therefore public. Accountants will require their disclosure in your notes to financial statements. MOUs and state enforcement actions are not per se publicly disclosed. However, our recent experience is that accountants are typically requiring disclosure in financial statements, particularly if there are capital requirements or dividend restrictions. Also, many public companies are disclosing any form of administrative action as a matter of prudence and conservative practice in today’s economic environment.

    When Will It All End?

    Most prognosticators suggest that the economy will not bottom out until year-end. If this is the case, more current exams will undoubtedly reflect this continued deterioration in credit portfolios and underlying collateral values. So, more administrative actions should be expected until the cycle ends and economic recovery begins. In the meantime, you will need to deal with a challenging regulatory environment, with overworked and highly stressed examiners trying to cope with an unprecedented environment.

    While the regulatory environment has been difficult, we must admit it has not been hostile. However, with real estate values continuing to tumble and capital almost impossible to access, some of the demands by regulators seem unreasonable. We think everyone needs to adjust their sights and let things play out a bit and stabilize. Time should be everyone’s ally.