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Nothing to Bank On

The banking industry is bracing for a slew of regulatory actions.
Rob Garver, CFO Magazine
March 1, 2007

In the depths of the Great Depression, Solomon A. Smith, the longtime head of Chicago's Northern Trust Co., made a point of carrying an umbrella to work every day, rain or shine. It was his way of conveying an impression of caution and preparedness in an era when bank failures were a common occurrence.

To this day, commercial bankers tend toward pessimism when assessing their business, but given the experience of the past several years, in which double-digit earnings growth has been so common as to be almost unremarkable, even the most wary now leave their umbrellas at home. "It has been a very nice run for banks," says Carl R. Tannenbaum, chief economist for LaSalle Bank/ABN AMRO in Chicago. "Credit losses are still extremely low, and as a result it has been a wonderful period for financial-services companies and their earnings."

Indeed, 2006 began with banks posting average year-over-year earnings growth of 9 percent in the first quarter, jumping to 17 percent in the second quarter. Earnings growth held steady at 15 percent above previous-year levels in the second half of the year. The good times also extended to executive pay. Birmingham, Alabama-based Compass Bancshares reported fourth-quarter earnings up 15 percent from 2005, and a few days later announced an options grant to CEO D. Paul Jones Jr. worth $11.2 million.

While there are some concerns, such as a flat yield curve, upward-creeping mortgage-delinquency rates, and potential instability in the Middle East producing oil-price shocks, the general sense among bankers and analysts is that the industry's strong performance will continue. "We are all wondering what is going to knock us off of this nice Goldilocks path we're on," says Tannenbaum. "But in general it should be another good year for banks."

There is one sticking point, however: increased regulation. Regulatory agencies are currently preparing a number of significant reforms, including new bank-capital requirements, the implementation of a new premium structure for federal deposit insurance, and a new law placing restrictions on lending to members of the U.S. Armed Forces (see "Off Base?" at the end of this article). Bank executives are also concerned about potential regulatory action in other areas, such as rules addressing predatory mortgage lending and new guidance on cash reserves to cover bad loans. In addition, the Democratic takeover of Congress has created some uncertainty about the direction of future legislative efforts, including consumer-protection statutes and personal-bankruptcy rules.

Even taken together, these regulations may not be enough to stop the banking juggernaut. But bankers will undoubtedly spend much of the next year assessing the likelihood and impact of new rules, while at the same time trying to keep earnings growth on its upward trend.

Bracing for Basel
At the top on the list, particularly among larger banks, is the U.S. regulators' expected finalization of rules for implementing the new Basel Accord (Basel II), an internationally negotiated agreement on bank-capital requirements. "Without a doubt the most important regulatory issue this year is going to be what will happen with Basel," says Wayne Abernathy, executive director for financial institutions policy for the American Bankers Association. "We're going from talk to action. The regulators are showing every sign of going forward in earnest."

Simply put, bank capital is the amount of money banks are required to hold in reserve for every dollar of loans they make. Capital requirements differ for various bank assets — they are higher for unsecured credit-card loans, for example, than for loans to a sovereign government. But in every case they have a direct impact on how much it costs a bank to make a particular loan.

Basel II was designed to allow banks to take advantage of modern risk-management techniques to assess their true capital needs, a move that was at first widely expected to result in banks having to hold less capital. To comply, the largest U.S. banks have been required to invest in state-of-the-art technology, and many second-tier banks have made similar moves to stay competitive. However, compared with their counterparts in other countries, U.S. regulators have been slow to implement Basel II, and they have repeatedly said that they do not expect it to result in a net decrease in bank capital.

This has frustrated bankers. "Among the large banks that are in the mandatory-adoption category, there is a good bit of concern," says Malcolm D. Griggs, executive vice president for Fifth Third Bancorp in Cincinnati. "Under the current proposals, banks are required to spend the moneyÂÂ…but if capital can't float down [to the level the new risk-management systems recommend] then bankers have to ask what we're getting for this." What they are getting so far, finance executives say, is a poor return on their investment. "We see some improvement in risk management," says Thomas P. Gibbons, CFO of The Bank of New York, "but certainly not to the level of the expenditure that has been made."

The regulators' conservative approach has also created concern about competitive imbalance. European banks, for instance, have already begun operating under Basel II, and are being allowed to take full advantage of new risk-management methods to lower their capital requirements. "The key issue for our clients is what happens to them now that Basel is final everywhere but here," says Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc., a Washington, D.C.-based consultancy, adding that one concern is that U.S. banks may be undercut in terms of loan pricing.


Meanwhile, the new Basel rules may have a broader effect than originally thought. Last September, U.S. regulators announced a plan to require about 20 large banks to move some assets held on their trading books onto their banking books. The change is significant because banks' trading assets are subject to much lower capital requirements than those held on the banking book, meaning that the proposed rule would drive up capital costs. In a letter to the agencies, Bank of America (BofA) treasurer J. Chandler Martin wrote that the rule, which is expected to be finalized this year, would "impose substantially increased operational costs on banks while providing information to investors that will be, at best, of little value, and at worst, confusing."

Premium Pressures
One of those bank agencies — the Federal Deposit Insurance Corp. — is causing angst in another area. The methods used by the FDIC to keep the Deposit Insurance Fund, which covers the vast majority of insured U.S. bank deposits, sufficiently capitalized were revamped last year. Whereas most banks previously paid little or nothing for federal deposit insurance, now premiums will be charged to maintain the fund's target capitalization level of $1.25 for every $100 of insured deposits.

At the end of the first quarter, and for each quarter thereafter, banks will receive a bill from the FDIC. At the moment, most banks are expected to pay between 5 and 7 basis points on each dollar of deposits. Future premium payments will fluctuate with deposit growth and will depend, in part, on a bank's risk of failure as assessed by regulators.

Banks claim, however, that the new premium structure is overly expensive and will raise their cost of funds, thus driving up the cost of credit to borrowers. Large banks are particularly bothered by the new arrangement. Because of more-sophisticated risk management, and because their risk is generally much more spread out, says Griggs, large banks simply present a lower danger of failure than small banks.

However, large banks will pay premiums at the same rate as smaller banks. "As with many issues facing the banking industry, you see a bit of a difference between community banks and large or regional banks," he says. "We feel that the proposal actually puts a burden on the larger banks to subsidize the deposit insurance of smaller banks."

Who's In Charge?
One development that small and large banks will be watching with equal concern is the Securities and Exchange Commission's response to recent federal banking guidance on how to account for the reserves held against loans that default.

Banks all carry a balance-sheet item called an allowance for loan and lease losses, which has been the subject of recurrent battles between regulators and the SEC. The problem is that where bank regulators see a sizable reserve as prudent management, the SEC sees an opportunity for banks to manage earnings. "The new guidance is certainly welcome after being debated for a number of years," says Jack Wixted, chief regulatory officer with PNC Financial Services Group. "The concern is making sure the SEC is on the same page as the agencies, especially as the credit cycle turns."

In 2001, the SEC accused SunTrust Banks of managing earnings through its reserve accounting, forcing the bank to restate earnings and irritating bank regulators, who had been encouraging banks to increase reserves due to rising default rates.

The new guidance appears to strike a balance between the bank regulators' contention that reserving against bad loans is a judgment call that requires some discretion and the SEC's desire to prevent reserves from turning, during lean years, into a slush fund for earnings-strapped banks. "While that is certainly welcome guidance from the regulators, hopefully the SEC won't [supersede them]," says Wixted.

Congressional Action?
Whether the new Democratic Congress will supersede regulators remains to be seen. But early indications are that, unlike the energy sector and other industries bracing for a more aggressive Congress, banking is unlikely to see extensive changes under the new leadership. "There is certainly a more activist agenda," says Joe Belew, president of the Consumer Bankers Association. "But banking has always been mostly bipartisan, and most of the attention will remain focused on the issues and consumers' rights."

In fact, both chairmen of the relevant committees, Rep. Barney Frank of Massachusetts on the House Financial Services Committee and Sen. Chris Dodd of Connecticut on the Senate Banking, Housing, and Urban Affairs Committee, have long and generally cordial relationships with the financial-services industry, and are not expected to champion major increases in regulation. Still, both men have pledged to address specific issues.

For Frank, affordable housing and predatory mortgage lending are near the top of his list. In a December press conference, he pledged "to remove obstacles from the banks, deregulate where that is appropriate, and at the same time ask them to move into more socially responsible activities."

In Dodd's case, given his intention to seek the Democratic Presidential nod in 2008, individual subcommittee chairs will probably be given significant leeway to pursue their own agendas. And Dodd's own agenda may be tabled. For example, the longtime critic of the credit-card industry — for lax lending practices that allow borrowers to drift into serious financial difficulties — insisted last December that he wasn't "running around trying to come up with additional regulations" to rein in the industry. In addition, although Dodd has promised to examine the trillion-dollar hedge-fund industry, he has stopped short of saying that he expects to introduce legislation that would expand regulation of that sector.


Consumer Concerns
Of course, there is always the possibility that there will be a shift in regulatory agencies' attitudes toward bank products and services in response to the perceived wishes of lawmakers. When Congress speaks, says Wixted, "regulators read those signals, and it flows downstream pretty quickly."

That's particularly true of regulations involving consumer lending. One in particular that bankers fear is the introduction of a suitability requirement for mortgage lending. Suitability rules, a fixture in the world of securities broker-dealers, would create a fiduciary duty on the part of the loan officer underwriting a mortgage, requiring the bank to assure that it was actually in the interest of the borrower to accept the loan.

Democrats in Congress have expressed some interest in suitability requirements, but have fallen well short of proposing legislation. Late last year, however, federal banking regulators released new guidance on how banks will be expected to underwrite nontraditional mortgage products. Their rules placed more emphasis on requiring that the loan officer educate the borrower about the terms and conditions of the loan before it is finalized.

Some states are going one step further. Ohio recently passed a law creating a quasi-suitability standard that would require the loan officer to "make reasonable efforts" to obtain a financing arrangement "advantageous" to the client, and to obtain proof that the borrower will be able to repay the loan. Pennsylvania's proposed law would create a similar duty for lenders.

In Their Own Interest
Of course, bankers won't spend all their time playing defense this year. For example, the FDIC's recent extension of a moratorium on granting limited banking licenses, known as industrial loan company (ILC) charters, to nonfinancial companies is being cheered in banking circles. The ILC charter, which is being sought by such companies as Wal-Mart and Home Depot, is anathema to bankers, who view it as an unacceptable breach of the divide between banking and commerce. The FDIC's delay gives banks a full year to lobby Congress for a law restricting ILC ownership to financial firms, an effort that got a boost from the January 29 introduction of the Industrial Bank Holding Company Act of 2007, which would do just that.

Meanwhile, BofA, possibly accompanied by some allies, will continue to lobby Congress for an increase in the cap on the percentage of U.S. deposits that can be held in a single institution. BofA is approaching the current 10 percent limit, and is concerned that the existing law will stifle future growth.

Of course, it is growth that shareholders expect from BofA and its counterparts. And while bankers won't get everything they want from Congress and regulators, neither will those looking to tighten bank regulation. As a result, though it may be slowed, the banking juggernaut appears ready to roll through 2007.

Rob Garver is a freelance writer based in Virginia.


Off Base?

Banks active in consumer lending are keeping a nervous eye on the Department of Defense, which finds itself in the unfamiliar position of having to write regulations for financial services as the result of an amendment slipped into last year's defense authorization bill by Jim Talent, the former Republican senator from Missouri.

The Talent Amendment sets a 36 percent cap on the annual percentage rate that can be charged for loans to members of the military and their dependents. The law is intended to go after predatory unregulated payday lenders, which often open up shop on the outskirts of military bases. It is written in a way that defines a loan's APR as including late fees and other charges, which can easily drive some legitimate credit-card offerings above the annual rate.

The law is causing concern, partly because of the difficulty in determining which customers are covered and which may become covered due to activation or enlistment. Should it be implemented as written, says Joe Belew, president of the Consumer Bankers Association, a very large number of institutions may "throw up their hands" and try to avoid providing services to the military. — R.G.





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