Stressed Out

A couple of weeks ago, FinCri Advisors warned that as a result of the stress tests administered to the nation's top 19 banks, community banks should batten down the hatches, stock plenty of ammo, concertina wire, bottled water, and condoms canned food, and otherwise prepare themselves for a "perfect storm of harsher exams, deposit flight, dry capital markets and share price declines." According to my observations and those of other bank attorneys with whom I speak and correspond, the "harsher exams" front has already moved in and appears parked directly over the community bank biz.

The reason for the harshness, according to former OCC Chief Counsel Brian Smith, is due to the fact that bank regulators are using the same methodology on small banks as they used on the "Gang of 19," including "examiner scrutiny of tangible common equity (TCE) and highly customized, portfolio specific analysis of an institution's ability to withstand economic stress."

This already has manifested itself in the field with examiner application of optional guidelines as required rules. "Banks are being more rigorously pressured to comply with various guidelines as if they were regulations," Smith says. He cites heavy examiner scrutiny of commercial real estate and directives to comply with previously optional lending guidelines on it.

"The institution says, ‘This is a business we really know, the guideline is not a fixed regulation and we are not too far off the norm,'" Smith relates. "The regulator says, ‘We issued the guideline, so you will comply.' If they don't, it manifests itself [negatively] in bank exam results, board meetings and supervisory reviews. They are taking more of a rulebook approach, even though the rules are not issued as rules. They are supervisory guidelines, suggestions for examiners, instructive/educational guidelines and not a final regulation."

I once heard a presentation by a "consultant" to banks that concerned the Interagency Information Security Guidelines that were adopted by the federal banking agencies to comply with the Gramm-Leach-Bliley Act. One critical aspect of the guidelines was dismissed by the lecturer as "merely guidance, not enforceable regulation." A compliance officer of a large regional bank shot up out of her chair like she'd just been "tased" and chirped that failure to follow the Information Security Guidelines violated the FDIC regulation to operate in a safe and sound manner. The "consultant" waived her off, but that bank treated the Guidelines as having the force of law for all practical purposes. To me, that was a safe, conservative approach.

It's simply not surprising to me that the examiners are treating guidelines as fixed-in-stone requirements. Flexibility might be a good thing for Shawn Johnson trying to pull off the splits on the balance beam. For a bureaucrat who wants to retain his or her present position and keep movin' on up in the agency, it's not so attractive a character trait. This should be expected by anyone who's been in the business of commercial banking for more than ten minutes. Banks may think that this is all unfair, but expect the regulators to remain dry-eyed while you complain about the cruel nature of it all.

One bank executive quoted in the FinCri Advisors article complains that applying the same stress test to smaller, "non-core" banks will give an unfair advantage to the top-level "core banks." This executive asserts that the core banks were able to negotiate the test criteria on a case-by-case basis, and, therefore, received a "tailor made" test that they were better able to pass. Small banks won't have that negotiating power. The executive claims that this will result in inaccurate test results that will be harder on the little guys. He also claims that by making the stress tests of the Big 19 transparent to the public, the big boys have a perceived imprimatur from the federal government that smaller banks will not have when their less-transparent tests are performed. Community bankers are worried about the potential flight of deposits from smaller banks to core banks. I think he has a point, but it's still too early to tell.

What sorts of other problems might arise from "harsher exams"? One I'm seeing is the push by regulators to have many smaller banks reduce concentration of assets (especially in commercial real estate loans), increase reserves, and/or increase capital levels. In a number of cases, this has put pressure on community banks not to renew existing lines of credit to many performing business borrowers and to divest assets (especially commercial real estate loans) that consist of performing loans. For all the talk of "dent and scratch" funds having been established to buy distressed assets, banks appear to be unloading the easier to sell, performing loans first, because they're quicker to sell and the bank doesn't have to absorb the haircut that would be necessary to sell the "dicey" loans.

Another problem that results from "harsher exams" is an increased amount of enforcement action (formal and informal) by bank regulators against community banks. Some of us who went through this drill in the 1980s believe that the enforcement actions are much more widespread and tougher today than they were the last time we went through this wave of "harshness." This time around, the federal bank regulators have a wider array of enforcement weaponry to unleash against their hapless victims regulated entities. Banks should be on top of the examination process long before the exam report is issued, and should be prepared to address the examiners' concerns on a point-by-point basis before an exam report is sent to Washington, D.C., because once it enters the beltway it ossifies to a hardness akin to titanium.

In the unfortunate event that enforcement action is initiated by the regulator, there is a dance that begins. As expected, the "Dancing Bear" will lead and you'll follow. However, the bank is not completely helpless (although it certainly will feel that way most of the time). For an excellent discussion of how to respond to proposed enforcement actions by federal banking regulators, I recommend a publication posted on the web site of national law firm ReedSmith, entitled (amazingly) "Responding to Proposed Enforcement Actions by the Federal Banking Agencies." (One of the authors, Joe Lynyak, is now at Venable LLP.) It contains an excellent discussion of what enforcement actions entail and appropriate considerations in responding to them. Unfortunately for many banks, it's a subject that more and more of them are finding to be of interest.

As for the stress tests on community banks, let's hope that Geithner is as calm when he announces the results as he was when he announced the results for the big boys.