• Addressing Silent Government Intervention During the Credit Crisis
  • October 31, 2008 | Authors: Jerome Walker; Jacob "Jake" A. Lutz
  • Law Firms: Troutman Sanders LLP - New York Office; Troutman Sanders LLP - Richmond Office
  • It has been well documented that the current crisis has eroded bank capital, created stresses on bank liquidity, threatened credit quality, strained the infrastructure and resources of the banking institutions, increased their administrative costs due to the need to conduct more and better underwriting and due diligence, and sharpened the focus on collection efforts.  During this crisis, bank supervisory agencies will increase their supervisory efforts rather than focus on public enforcement actions.  This means that examiners will ask more questions, seek more information, increase the level and frequency of their communications, monitor reports more closely, and intervene in the operations of banking institutions much more frequently, with the goal to help rather than penalize the banking institutions.

    Outside counsel can often play an integral role in helping banking institutions reach their goals and address concerns of their bank supervisory agencies.  To help its banking clients, Troutman Sanders established a Credit Crisis and Government Intervention Task Force with expertise in all of the legal areas banking institutions will need to weather the storm, including the six areas addressed below.

    1. Identify Capital Sources and Implement a Capital Restoration Plan

    First, the volatility of the stock market has had a dramatic impact on the capital of banking institutions, even banking institutions that were formerly well capitalized.  To protect the banking industry from capital related problems and to provide an early warning to the bank supervisory agencies, the Federal Deposit Insurance Corporation Improvement Act of 1991 requires Federal bank supervisory agencies to take prompt corrective action when a banking institution’s capital ratio falls below required levels.  See 12 U.S.C. 1831o.  For example, the Federal bank supervisory agency will notify the banking institution if its capital falls below a certain level.  Upon notification, the banking institution must file a written capital restoration plan typically within 45 days of the date the banking institution receives notice or is deemed to have notice that the banking institution is undercapitalized, significantly undercapitalized or critically undercapitalized.  See 12 C.F.R. 6.5; 12 C.F.R. 325.104; 12 C.F.R. 208.44. Undercapitalized means the banking institution has a total risk-based capital ratio that is less than 8%, a Tier 1 risk-based capital ratio that is less than 4% or a leverage ratio that is less than 4% (less than 3% if the banking institution is rated 1 in its most recent examination).  Significantly undercapitalized means the banking institution has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or a leverage ratio that is less than 3%.  Critically undercapitalized means the banking institution has a ratio of tangible equity to total assets that is equal to or less than 2%.  In any of these cases, the banking institution is in dire need of capital and must act promptly; the bank supervisory agencies will make sure that the banking institution moves quickly or face even greater and more public intervention.  Troutman Sanders lawyers are able to both help identify capital sources and help banking institutions draft and implement capital restoration plans.

    2. Provide Sufficient Evidence That Assets Are Strong

    Second, media reports have, almost on a daily basis, reminded the public how bad the crisis is.  Nervous bank customers and investors understandably wonder whether their funds and assets are safe.  These legitimate, and in some cases not so legitimate, concerns have caused volatility and liquidity strains on banking institutions.  In some cases, customers have moved their deposits, including insured deposits, and their investment products from banking institutions that are perceived to be weak to banking institutions that are perceived to be strong.  In other cases, investors have lost confidence in what they perceive to be the value of bank assets, even those bank assets that independent reports suggest are strong.  During an economic crisis, bank supervisory agencies pay extremely close attention to liquidity risk because liquidity problems typically reflect problems in other areas.  In these cases, not only do banking institutions need to shore up their deposit base, but they also need to provide sufficient evidence to prove to investors and the bank supervisory agencies that the assets of the banking institutions are strong.  In some cases, the evidence is provided through due diligence and a review of the assets of the banking institution.  In other cases, the evidence is provided through an analysis of the law that governs the rights of creditors or investors of the banking institutions.

    3. Credit Administration and Restructuring

    Third, the downturn in the economy has taken its toll on bank customers, both individuals and businesses.  This toll has been reflected in increased default rates, reductions in the value of collateral and failures to meet certain financial covenants.  Each of these events threatens the credit quality of the portfolios of the banking institutions.  Bank supervisory agencies will want to know that banking institutions are proactive in addressing these problems, including making certain that the banking institutions are in a strong position should legal redress be necessary.  No matter what type of banking institution is involved, asset quality will be monitored by the bank supervisory agencies, and asset quality will impact on both the component and composite parts of the examination rating of the banking institution.  This will mean that the demands on the credit administration and restructuring departments of the banking institutions will undergo enormous stress testing in real time.  Troutman Sanders can assist both departments review loan documents, evaluate collateral, understand the rights and remedies of the banking institutions, modify documents, restructure credits and obtain new collateral.

    4. Remove Pressure on Infrastructure and Resources

    Fourth, while many banking institutions have adequate infrastructures and resources to handle the problems caused by the credit crisis, many banking institutions do not.  Even those banking institutions with adequate infrastructures and resources will come under enormous stress and strain.  During a credit crisis, bank supervisory agencies typically prefer banking institutions to have an infrastructure and resources that can handle any problems that arises, including those unforeseen problems that quickly unfold during a crisis.  One option that is available to banking institutions is to divide the labor between internal and external resources.  As inside lawyers will need to be available for business executives while the business executives review business plans and develop strategies, Troutman Sanders attorneys can make sure necessary legal reviews are performed on a timely basis.  This team approach can relieve the pressure on internal infrastructures and resources, and allow banking institutions to cover more ground quickly and efficiently.

    5. Remove Pressure on Earnings and Expenses

    Fifth, another fall out of the credit crisis will be the increased administrative costs of banking institutions due to the need to conduct more and better underwriting and due diligence.  In some cases, the increased administrative costs will cut deeply into the banking institution’s expected profits because the banking institution will have priced the service without taking into account the added costs, particularly the added time that internal staff will have to spend monitoring the credit and the changes that will have to be made to the systems of the banking institution.  Bank supervisory agencies closely monitor both the expenses and profits of banking institutions during a credit crisis.  Even on new credits, the banking institution will face a dilemma because, one the one hand, if the banking institution does not change its pricing, it may not be able to capture its costs.  On the other hand, if the banking institution changes its pricing upward, then it may not be able to compete.  In the case of the costs associated with certain legal functions, such as document review and drafting, compliance and regulatory, a viable option that is available to the banking institution is to outsource certain functions that are normally conducted inside and enter into an arrangement with external lawyers where the volume of work is increased in exchange for a fair discount on the legal fees, therefore cutting the administrative costs to the banking institution.  Please contact Troutman Sanders to discuss alternative billing options that allow the client to control and manage its legal expenses better.

    6. Recover Potential Losses

    Sixth, in those unfortunate cases where defaults have occurred and the earnings and capital of the banking institutions are suffering, the bank supervisory agencies will require the banking institutions to develop a plan to limit their losses and take appropriate actions to protect their interests.  In many of those cases, those actions will mean that the banking institutions will need to turn to experts in restructuring, bankruptcy and litigation.  Often the bank supervisory agencies will want to receive reports on the actions the banking institutions have taken to improve their positions.  Those reports, for example, may indicate whether the banking institution has increased its general reserves, whether it has created any specific reserves, whether it has restructured any credits, whether it has commenced any litigation, whether any of its customers has filed bankruptcy, whether any of its customers who were in a default position has brought the payments current, and whether any customers have actually paid off the credits.  These are the types of services that Troutman Sanders restructuring, bankruptcy and litigation attorneys routinely provide to their clients.