Regulation and Compliance: Ready for Review

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Anticipating what’s new for your community bank’s next field examination

By Karen Hoffman

Benjamin Franklin famously said that “by failing to prepare, you are preparing to fail.” This is particularly true for community banks preparing to undergo their next regulatory safety and soundness or compliance examination. The better prepared, the less likely they are to run afoul of the continually shifting regulations.

Regulators and industry consultants agree that community banks are generally doing a great job handling their regulatory oversight and requirements. As David Barr, spokesperson for the FDIC, points out, “a vast majority of community banks remain well-rated and exhibit satisfactory corporate governance programs and compliance management systems.”

Toney Bland, senior deputy comptroller for community and mid-sized banks for the Office of the Comptroller of the Currency, chimes in that from a “safety and soundness perspective, banks have really focused on strengthening their balance sheets.”

Overall, consultants say, community banks are doing well in fundamentally educating themselves on and implementing the large volume of new federal rules and regulations, and changes in existing rules and regulations. Nonetheless, the regulatory agencies and industry consultants do offer several insights on how community banks can better prepare for their next round of regulatory examinations.

Here are several timely suggestions to consider based on recent regulatory trends they see.

Be aware of existing or emerging risk concerns. In the past couple of years, regulators have become more interested in risk management, strategic and capital planning, succession planning, compliance (particularly Bank Secrecy Act compliance), third-party relationships and interest rate risk, according to David Baris, partner for BuckleySandler LLP in Washington, D.C. The federal banking agencies effectively “forewarn banks of their concerns through bulletins, changes in examination manuals, speeches and testimony,” he says.

Baris points out that the OCC semi-annual risk perspective report in June identified several hot issues examiners are focusing on industrywide:

  • intensifying competition for limited lending opportunities;
  • loosening underwriting standards, particularly as to indirect auto lending and leveraged lending;
  • thoughtful strategic business and new product planning;
  • electronic bank fraud and cyberthreats;
  • Bank Secrecy Act and anti-money laundering activities;
  • net interest margin compression; and
  • increased operational risks.

Bland of the OCC agrees that “one of the biggest issues” for bank examiners is evaluating operational risk, especially with eyes toward the current financial environment where loan underwriting terms are changing. Implicit in managing operational risk is for banks to continue to maintain adequate capital and a solid balance sheet, he says. “It’s not just about looking at the returns but having the due diligence and risk management folks involved.”

From a “safety and soundness perspective, banks have really focused on strengthening their balance sheets.”
—Toney Bland, Office of the Comptroller of the Currency

Additionally, Bland advises community banks to reach out to examiners and regulators to discuss potential risks when they are considering new products and services.

Tread carefully with loan growth and underwriting. As Barr points out, most community banks—close to 75 percent—are now growing their loan portfolios. The first-quarter 2014 edition of the “Quarterly Banking Profile” notes that year-over-year loan growth at community banks reached 6.6 percent, which outpaced industry loan growth of 3.6 percent over the same time period, he says. And nearly two-thirds of this growth is centered in nonfarm, nonresidential real estate and commercial and industrial loans.

“Simplifying the life of an examiner by having a well-organized loan file that is easily accessible will go a long way to having a positive examination result.”
—David Baris, regulatory consultant

“Coming after a long period of economic weakness including in real estate markets, a return to loan growth is regarded in general as a welcome development,” Barr offers. “So far, the underwriting surveys our examiners complete do not reveal widespread or significant concerns about loan underwriting. However, as the expansion proceeds and bank lending continues to gain steam, sound principles of loan underwriting and concentration management must be remembered.”

While acknowledging that most community banks do a good job of managing the risks in their loan portfolios, Barr points out that risks in loan portfolios are dynamic and must be continually managed. Maintaining strong internal bank practices and controls over underwriting and credit administration are essential safeguards to avoid major losses and disruptions.

“We expect our examiners to challenge imprudent risk-management practices as warranted,” Barr says. “Our expectations for risk management are not for the use of expensive enterprise risk models for community banks. Rather, they are longstanding expectations for prudence and good governance that any community bank can meet.”
Baris says, “Simplifying the life of an examiner by having a well-organized loan file that is easily accessible will go a long way to having a positive examination result.”

Stay on top of interest rate risk. Barr believes that perhaps “the most significant emerging risk for banks in the coming years relates to how a period of increasing interest rates may affect them.” A historically low interest rate environment has created significant earnings pressures.

Until recently, community banks have gotten less scrutiny of their interest rate risk management, contends Jim Kleinfelter, president and senior consultant for Young & Associates Inc. in Kent, Ohio. “But now, the regulators are raising the bar … and rates can’t stay at this level forever.”

Revisit Bank Secrecy Act activities. Lately, you cannot pick up a local newspaper without reading about the extension of the drug highway into the Midwest, and regulators are reading the same stories. Concerns over the expansion of money laundering operations into smaller or more rural communities are driving more interest in Bank Secrecy Act reporting requirements.

Virginia B. Wilson, partner with the accounting and consulting firm Butler Snow LLP of Memphis, Tenn., agrees that examiners seem to have placed a renewed emphasis on Bank Secrecy Act issues. For example, she says, examiners appear to be reviewing transactions that might be structured to avoid money laundering rules, including transactions that occur several months apart. Also, official checks and cashier’s checks are being more closely examined, especially when the payee and remitter are the same.

“Examiners seem to be suggesting that banks document in the file that these types of transactions have been reviewed and if an SAR was not filed, what was the reasoning behind the non-filing,” she concludes. “Examiners are closely reviewing transactions that would not have been likely to be reviewed in the recent past.”

J. Paul Compton Jr., partner at the law firm Bradley Arant Boult Cummings LLP of Birmingham, Ala., sees heightened BSA compliance examination as a pivotal challenge for community banks “because the rules are sometimes vague and frequently shifting.” Community banks should “take no comfort in the fact that they received high marks in their last exam” or that a longtime customer has never posed a problem, he advises.

“Examiners are closely reviewing transactions that would not have been likely to be reviewed in the recent past.”
—Virginia B. Wilson, regulatory consultant

“Just because you’re dealing with a known customer, you still need to file that Suspicious Activity Report,” Kleinfelter recommends.

Train employees on new rules. It’s no secret, Bland, the regulator, admits: There has been a lot of “angst and concern” from community banks this past year over complying with the Consumer Financial Protection Bureau’s new ability-to-repay and qualified mortgage rules. Wilson, the consultant, agrees that community banks are still “quite challenged” handling ability-to-repay and qualified mortgage compliance, adding that “this is and will continue to be a critical area.”

In terms of preparing for their compliance examinations, Wilson says community banks need to show they have been diligent and pro-active in adapting their policies and systems for the new rules, including allocating sufficient compliance resources for them.

Anna DeSimone, president of Bankers Advisory, a lending compliance consulting firm in Belmont, Mass., believes qualified mortgage rules constitute a “key area for training.”

“We’re starting to see examiners demanding a capital plan be in place.”
—Donald D. Hutson Jr., regulatory consultant

Engage directors and top-level executives. It’s critical that senior executives and directors are aware of any potential bank examination issues, especially high-level or strategic concerns like capital planning and interest rates risk, according to Donald D. Hutson Jr., national financial services partner for the accounting and consulting firm BKD LLP in Louisville, Ky.

“We’re starting to see examiners demanding a capital plan be in place,” Hutson says. “Banks need to make sure their board is engaged in these issues.”

Prior to an examination, Baris recommends community banks take basic steps to document their overall risk-management and strategic and capital planning processes, and demonstrate the compliance involvement and commitment of their boards of directors and senior management. “Documentation of the bank’s decision-making process, including at the board and board committee level, is essential,” he says.


Karen Epper Hoffman is a financial writer working from Europe.

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