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2014 Banking ReportMinimizing risks and maximizing competitive advantage

1 DavisPolk Dodd-Frank Progress Report.

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2014 Banking Report

IntroductionIt’s been three years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was adopted, and implementation remains far from complete. As of February 3, 2014, only 201 of the 398 rules have been finalized, constituting roughly 50% of the legislation, when nearly 70% of deadlines should have been completed1.

As a result of the delayed yet ongoing rule-making process, 2013 was marked by continued uncertainty for bank executives and their boards. Bank leaders struggled to ready their institutions for implementation of the new rules amid lingering questions about whether impending regulations would even apply – and if or when they would actually materialize.

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Implementation of the long-awaited “Volcker Rule”Among the most anxiously anticipated sections of the Dodd-Frank Act was the long-awaited Volcker Rule, which the five major US regulatory agencies issued in December 2013. One of the cornerstones of regulatory regime, the rule prevents banking entities from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments on their own account. It also prohibits banks from having an “ownership interest” in a “covered fund” such as hedge funds and private equity funds.

While the final rule applies more broadly than the prior Notice of Proposed Rulemaking, what’s required will depend on an entity’s size and its scope of activities. In what can be seen as a nod to the difficulty banks face in implementing the requirements, regulators have given banks until July 21, 2015 to comply with the final rule. While boards and senior management will spend much of the coming year examining their compliance controls and ensuring that they are adequately prepared for full implementation, the Volker Rule requires immediate action for many institutions.

The requirement to divest covered funds by July 21, 2015 may have critical year-end accounting implications. First, investments in covered funds that are classified as held-to-maturity (HTM) may need to be reclassified out of the HTM portfolio. Additionally, to the extent fair value of the covered funds is less than their carrying value, the full amount of that impairment may need to be recognized as other than temporary impairment (OTTI) if the institution will be required to sell the investment prior to maturity. See our recent publication, “Volcker Rule: Potential accounting implications of the requirement to divest of ‘ownership interests’ in ‘covered funds,’” for additional information.

The prohibition against proprietary trading also may have very real business implications that need to be considered and may impact multiple functions within an institution, including accounting, treasury, internal audit and even some tax planning strategies. Some common areas of concern have included investment activity used for liquidity planning and hedging programs.

Luckily, some of the provisions of the Volker Rule were generally known before final issuance, which allowed some banks to prepare early, notes Jack Katz, Financial Services Global Leader.

“Although the Volcker Rule was only recently finalized, many banks have been preparing for the rule to take effect for over two years. These firms have shed their proprietary trading desks, refocusing on banking activities such as direct lending (primarily commercial and industrial loans) and evaluating investments in funds and other entities.”

– Jack Katz, Financial Services Global Leader

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3 strategic imperatives for banksDespite continued regulatory challenges and a sluggish economic environment, most institutions witnessed improvement in their financial conditions over the course of 2013. Bank earnings rose to new heights – reaching record levels. And asset quality continued to show improvement. In November 2013, FDIC chairman Martin J. Gruenberg noted that, generally, “…the upward trend in earnings…continued for the industry.” However, the sector did show some signs of softness, including reduced revenue from mortgage lending activity as the refinance boom drew to an end, resulting in a decline of year-over-year net income for Q3 2013 – the first such decline in 4 years.

On the whole, however, the banking industry continues to show strong signs of recovery: net operating income has risen year-over-year every quarter since the recession (with the exception of Q3 2013), credit quality improved while loan balances have grown, and we experienced a continued decrease in the number of institutions that failed or were deemed problematic, according to the FDIC’s Q3 Quarterly Banking Profile.

How will banks keep the momentum going? We outline three areas to focus on, in order to minimize risks and maximize your bank’s competitive advantage.

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Priority #1: Increasing capital

2 On Sept. 10, 2013, the Federal Deposit Insurance Corporation (FDIC) also published an interim final rule that revises its risk-based and leverage capital requirements for FDIC-supervised institutions. This rule essentially reproduces a joint final rule issued by the Office of the Comptroller of the Currency (OCC) and the Board of Governors of the Federal Reserve System. It allows the FDIC to proceed on a unified basis with other federal agencies.

It should have come as no great surprise that following the 2008 financial crisis, regulators were and continue to be extremely focused on capital adequacy. Increased levels of capital, regulators say, will make banks more resilient in the face of losses, will reduce risks of another crisis, and will lessen the chances that taxpayers will be asked to bail out lenders that are deemed too big to fail. Put simply, more capital equals a healthier banking system.

“Capital drives so much right now from the regulators’ perspective. Excluding statutory requirements, capital is the regulators’ be-all and end-all,” says Nichole Jordan,Banking and Securities Sector Leader.

On Sept. 24, 2013, the Federal Reserve Board issued two interim final rules2 that clarify how banks subject to the Dodd-Frank Act Stress Test requirements should incorporate the Basel III reforms into their capital and business projections.

The first interim final rule applies to bank holding companies with $50 billion or more in total consolidated assets. These banks must incorporate the revised capital framework into their capital planning projections and into the stress tests required under the Dodd-Frank Act using the transition paths in the Basel III final rule. The second interim final rule provides a one-year transition for most banks with between $10 billion and $50 billion in total consolidated assets, in order to allow time for them to incorporate the revised capital framework into their stress tests.

Smaller and less complex banks got a reprieve from several of the more onerous aspects of the Basel III capital accord – although they are not exempt from the overall increased capital requirements. The main areas of relief include the enhanced risk-weighting requirements for residential mortgages, an exemption for certain Trust Preferred Securities (TruPS), and the neutralization of Accumulated Other Comprehensive Income (AOCI). Regarding AOCI, banks must make an affirmative opt-out election on the institution’s first Call Report, FR Y-9C or FR Y-9SP filed after Jan. 1, 2015.

“Banks that do business in the United States need to ensure they have a minimum leverage ratio of 4%. They should also focus on the new Core Equity Tier 1 (CET1) ratio requirement, which starts at 4.5% beginning in 2015 and increases to 7.0% by 2019. ”

– Nichole Jordan, Banking and Securities Sector Leader

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How much is enough?According to Grant Thornton’s 2013 Bank Board & Executive Survey, most bank directors think their capital levels are adequate, though regulators might beg to differ. While 71% of respondents indicated that their banks’ capital levels are satisfactory, and they have no plans to raise capital over the next year, 42% indicated a longer-term need to raise capital to support either growth or to comply with Basel III. Of those that do plan to raise capital, half plan to do so through a private offering to existing shareholders, while 47% plan a secondary offering on the public market.

While a bank may not need to raise capital in response to Basel III, all banks should continuously revisit their capital planning since it is expected that regulators will continue to evaluate banks’ capital adequacy. Even with a one-year transition period for smaller institutions, all banks with $10 billion or more in total consolidated assets should begin assessing their regulatory capital requirements. These entities must determine whether Basel III will require the bank to raise additional capital, including considering the implications of Basel III in modeling future capital needs.

“As part of their modeling of the impact of Basel III, banks that do business in the US need to ensure they have a minimum leverage ratio of 4%. They should also focus on the new Core Equity Tier 1 (CET1) ratio requirement, which starts at 4.5% beginning in 2015 and increases to 7.0% by 2019,” says Jordan in highlighting the new CET1 measure.

U.S. banks have been subject to a leverage requirement of 4% for some time. The leverage ratio is calculated by dividing Tier 1 capital by the bank’s average total consolidated assets. But,

the Basel III leverage ratio takes into account both on-balance sheet and certain off-balance sheet assets and exposures, while U.S. leverage ratios in the past have measured only a bank’s on-balance sheet leverage.

“In the United States, banks that have a capital gap today will have a bigger gap under Basel III requirements, which are being phased in from 2015 to 2019,” Katz explains.

Action itemBanks need to examine their capital levels and ask a number of questions, including:

• How will my capital ratios be impacted by the changes in risk weights?

• How will I respond to those changes?

• Do I need to change my product mix or my underwriting? Should I even consider a strategy where the bank’s assets shrink in the short term?

• Do I need to adjust my risk tolerance in lending?

• Should I consider outsourcing certain functions or decrease operating expenses?

At a minimum, banks will need to integrate into their capital planning and strategic planning processes an analysis of where they stand relative to Basel III requirements and make plans to address any capital needs. The federal banking agencies have a number of resources available for banks in assessing regulatory capital, including a recently released a capital modeling tool for community banks. All community banks should familiarize themselves with this new tool.

A sound capital planning process includes:

• Reviewing applicable capital requirements.

• Developing, implementing and utilizing a capital planning analysis.

• Assessing gaps.

• Making a plan to remediate.

• Monitoring progress against that plan at set periodic intervals.

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The wave of residential refinancing receded considerably in 2013, and the continued low-rate environment has compressed the net interest margin for most institutions. As a result, bank executives are turning to new, expanded or modified product offerings and service lines (such as specialized loan products, longer-term loans and loans to industries outside their markets or expertise) to improve performance. The regulators’ concern is that many banks — particularly smaller community banks — may not have performed the upfront risk analysis required in their zeal to address net interest margin compression. Moreover, as rates rise and competition for loans increases, banks must be diligent in maintaining their underwriting standards.

As with any new opportunity, it’s critical to make sure that the risks are appropriately assessed and priced. New products and services may have a totally different risk profile than the bank’s traditional fare – which the bank may be ill-equipped to manage.

Moreover, banks may lack the necessary controls, risk-management processes, expertise and appropriate information systems needed to effectively monitor and manage these new products and services. Many banks cut personnel sharply during the financial crisis, and may no longer have the skills and resources they need in-house. Banks that fail to adequately manage these risks may suffer credit losses, compliance issues and tarnished reputations – all risks highlighted in the OCC’s Fall 2013 Semiannual Risk Perspective.

Priority #2: Managing credit quality

Getting into new products? Consider the risks Banks reaching for yield in today’s environment may see new products and services as a solution to reduced margins and stalled growth. However, failing to fully understand the risks can cancel out any benefit to the bottom line. Common risks that may arise when introducing a new product or service include the following:

• Strategic risk: Will the new product/service pose risk to earnings or capital in the event of poor business decisions or implementation?

• Reputation risk: Will the new product/service cause risk to earnings or capital in the event of negative public opinion?

• Credit risk: Will the new product/service lead to risk to earnings or capital due to failure of obligors to meet the terms of contracts or failure to perform as agreed?

• Transaction risk: Will the new product/service cause risk to earnings or capital due to problems with product/service delivery?

• Compliance risk: Will the new product/service pose risk to earnings or capital due to violations of laws, rules or regulations, including internal policies and procedures?

• Other: Will the new product/service pose risk to earnings or capital related to interest rates, liquidity, foreign currency translation or other factors?

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Action itemAs banks look for new sources of income, it is imperative that they demonstrate the ability to manage the associated risks. Banks should not only be extremely diligent about following their underwriting standards, but also should be looking for new ways to shore them up.

A well-managed plan for expansion into new products, services or markets will include the following:

• Clearly communicate the growth strategy to regulators and the board.

• Develop risk plans that address risks particular to any new areas the bank is getting into.

• Ensure sustained board and senior management oversight.

• Manage and monitor credit risk.

• Clearly document lending policies and procedures.

• Confirm that diversification/concentration management and controls align with established risk tolerances.

• Undertake stress testing and risk monitoring.

• Strengthen underwriting and documentation standards.

• Confirm that adequate loan review programs are separate from credit extending units/personnel.

“Risk pricing of loans is absolutely critical, and can’t fall by the wayside as banks seek to win new business. Regulators fear that banks competing to win customers by matching rates may be so doing without regard for risk profiling,” says Graham Dyer, senior manager in Grant Thornton’s National Professional Standards Group. “If and when future loan losses surface, will banks have been compensated for the risk they assumed?”

“The bank’s executives and board need to understand what the bank’s strategy is. This should be part of any annual strategic planning the bank is doing. The bank’s board should ensure that a full cross-section of its committees, including its risk committee, enterprise-risk-management committee and audit committee, as applicable, are involved in making sure the organization has all its risks covered,” says Katz.

Katz also suggests that banks look closely at the skills of their boards and management teams, and consider whether they need additional board or management expertise given their growth strategies and the complexity of the industry.

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Throughout 2013, interest rates remained at or near historic lows, compressing net interest margins and creating fierce competition among banks for higher yielding assets. Many banks are now turning to aggressive interest-rate strategies, such as extending asset or loan maturities or increasing holdings of riskier investments. Yet with these types of strategies come growing exposures to rising interest rates. And given the Federal Reserve Bank’s commitment to taper and eventually eliminate the quantitative easing program, interest rates are likely to increase.

“The need to successfully manage interest rate risk and its impact on capital and earnings is an age-old bank challenge,” remarks Katz.

“With long-term assets and short-term liabilities, the liabilities are likely to reprice before assets. Banks risk going out long on interest rates and then finding themselves underwater. At the same time, the short-term loans don’t earn them anything. They’re between a rock and hard place,” says Katz.

Jordan adds, “The key is that banks manage that risk for all different types of scenarios. Some banks benefit from rising interest rate environment and manage toward it. Regulators have been saying for a while that long-term rates will go up. Their concern is that, because banks have not worried about this for six years, they may not have the people, policies and systems in place to manage it.”

The OCC is focused on interest rate risk as a top operating risk facing banks right now, especially given that many banks have underwritten higher-yield or longer-term loans to earn more in interest. When interest rates increase, “banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion,” cautions the OCC 3.

Priority #3: Managing interest rate risk

Regulators will be confirming that banks have taken the appropriate steps to monitor and manage their risk related to fluctuating rates, and will want to see that banks are focused on this area of vulnerability. Stress tests are a useful tool to provide insight into a bank’s exposure to risk, while at the same time, assessing how well capitalized the institution is. Management should take heed, however: stress testing doesn’t have to be time-consuming or complex for smaller organizations. Yet the process can prove quite valuable in determining a bank’s capital needs and risk exposures.

Grant Wilson, director of Commercial Credit Risk Credit in the Credit and Market Risk Division of the OCC, addressed stress testing at the 2013 AICPA National Conference on Banks & Savings Institutions. He said “stress testing can be used by corporate boards and executives to establish and monitor strategy; set risk tolerances; evaluate lines of business; and maintain a sound capital planning program. Stress tests should make reasonable assumptions about potential adverse external events such as changes in real estate values, capital market prices, interest rates and general economic conditions.”

It’s worth noting that the Dodd-Frank Act did not require stress tests for banks below $10 billion, but they are encouraged, appropriate, and increasingly seen by the regulators as a cornerstone of an effective risk management system.

3 Office of the Comptroller of Currency, Semiannual Risk Perspective, Fall 2013.

Action itemWhile managing interest rate risk is highly complex, doing the following will help ensure a well-managed program:

• Be prepared to demonstrate to regulators your interest-rate-risk management plans and to support key assumptions used in modeling.

• Maintain documentation of how the bank considered the results of the models.

• Establish risk controls and limits.

• Monitor and report risk.

• Ensure adequacy of internal controls and audit.

• Consider whether to add certain expertise to your board or management team.

• Banks that are not already stress testing should begin to do so.

• For public banks, evaluate whether your interest rate risk disclosures appropriately tell your story.

20172016

20152014

ContactsJack KatzGlobal Leader Financial ServicesT 212.542.9660E jack.katz@us.gt.com

Nichole JordanNational Banking & Securities Industry LeaderT 212.624.5310E nichole.jordan@us.gt.com

Graham DyerSenior ManagerNational Professional Standards GroupT 214.561.2385E graham.dyer@us.gt.com

Author’s note: We wish to acknowledge the many contributions of our colleagues in the Banking practice to this report. In particular, we are grateful for the valuable suggestions of Jamie Mayer and Molly Curl.

Looking ahead

The Dodd-Frank reform process will continue to unfold throughout 2014. At the same time, Basel III will usher in a host of additional changes and regulatory priorities.

“Banks shouldn’t lose sight of the big picture in the sea of compliance requirements,” says Jordan. “They need to stay rigorously focused on the fundamentals that underpin their financial stability: capital, credit risk and interest rate risk. Those institutions that do so will be poised to compete – and win – upon full implementation of the new rules and going forward.”

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