Bank Lawyer's Blog

False Promise

Former FDIC Chairman Bill Isaac once called Franken Dodd "the worst piece of financial legislation in modern history" and blasted the law's "Durbin amendment," in particular, as "pure and simple, special-interest politics."

I think the Durbin amendment is really a terrible precedent," Isaac says. "It weakens the banking industry at a time when we need it strong, and the folks who supported the Durbin amendment should be ashamed of themselves."

The subsequent cap placed on interchange fees by the FRB in response to Turban Durbin's amendment caused many bankers and credit union executives, and their trade group representatives, to predict that the only result would be to fatten the pockets of retailers at the expense of both financial institutions and their customers. Over five years down the road, that dire prediction appears to have been spot on, according to a recent opinion piece in the American Banker by the CEOs of the ICBA, CUNA, and NAFCU (people who sometimes are at each others throats on bank vs. credit union issues).

The price controls lawmakers were able to impose on those providing electronic payment options have resulted in an $8 billion annual handout to retailers that they have not passed on to consumers. Five years after the Federal Reserve issued a rule to implement the amendment, retailers have kept most of this revenue — an estimated $32 billion — for themselves.

While Congress may have thought this legislation would provide a benefit to consumers, data from a survey of merchants contained in a recent Federal Reserve Bank of Richmond study indicates that the amendment is simply not working as intended. The report found that "few merchants are found to reduce prices or debit restrictions as debit costs decrease." This just reinforces the argument that the Durbin amendment is essentially a merchant handout from Congress.

Consumer research echoes the reality that retailers are not passing on this revenue in the form of savings for customers. In September, Phoenix Marketing International conducted its fourth annual survey of nearly 2,000 consumers and found that the vast majority of shoppers have not experienced a price drop at the point of sale. In fact, in each of the 15 categories measured, at least 92% of shoppers reported that prices rose or stayed the same over the past year.

The authors further assert that the retailers' trade association claims of several years ago that retailers were passing along the savings to customers, and, more recently, that the fee reduction benefited banks and credit unions, as bald-faced lies.

A study released last week by the Credit Union National Association reported estimated reduced revenue of $1.1 billion for credit unions resulting from Dodd-Frank's regulatory costs, all of which the report attributed to the swipe fee provision. Real data in the form of costs of processing changes and declining fees since 2011 debunks claims that credit unions and small banks below $10 billion in assets are not feeling the pinch. Further, there has been a decline in the interchange rate since the price controls went into effect. It continues to remain around 4 or 5 cents below where it was pre-Durbin, according to a survey by the National Association of Federal Credit Unions.

The authors conclude that rather than trying to blow smoke up the nether regions of financial institutions and consumers, perhaps retailers' time would be better spent figuring out ways to pass along the savings on interchange fees to consumers. Don't believe that conclusion any more than you should the retailers' claims. What financial institutions really want is the repeal of the Durban amendment and the Fed's limit on interchange fees. That won't happen in 2016, but perhaps the next Pontifex Maximus of the Disunited States of America can spare a moment from building "the greatest border wall of all time, a wall that will make the Great Wall of China look like Tom Sawyer's picket fence" to promote some Republican-sponsored legislation to benefit community banks and credit unions for a change, instead of the Wal Marts and Home Depots of the world.

Yes, I know: and perhaps pigs will sprout wings.

Trickle Down Guidance

From the FDIC's Office of Inspector General comes an interesting little tale that may have slipped by your attention while you and the family were reveling in the latest bloviations from the walking, talking hairdo that is THE GREATEST SHOW ON EARTH, I PROMISE YOU!!!

The entire incident was triggered by a false alarm about a possible security breach of a third party service provider (TSP) that turned out to be some pesky adware. However, the FDIC IG, operating on the premise that no (non)crisis should ever go to waste, used its investigation of the incident to uncover sloppy security breach incident response policies and procedures by all concerned, including not only the bank and TSP, but by the FDIC's own Risk Management Supervision field office (RMS) as well.

The entire "Case Study" by the IG is less than two pages long, so I won't reiterate it in detail. However, I will use it to bleat about a couple of additional points of my own. The first concerns the application of the FFIEC Interagency Guidelines Establishing Information Security Standards to TSPs.

The Case Study observes:

The InteragencyGuidelines require FIs to develop and implement a risk-based response program to address incidents of unauthorized access to customer information. The Interagency Guidelines also provide that FIs’contractual arrangements shall require that TSPs implement appropriate measures to meet the Interagency Guidelines objectives.

I recently had a TSP respond to a financial institution's request that its agreement for technology services with the TSP (which services would give the TSP access to nonpublic personal information (NPI) of the bank's customers) contain a provision pursuant to which the TSP agreed to protect the security of the NPI with the brilliant argument that the TSP was not a financial institution and, therefore, was not required to comply with the Interagency Gudelines. I not-so-patiently relied that the Guidelines "recommended" that my client make them apply to the TSP via a contractual provision and, since my client took such "recommendation" seriously and incorporated such a requirement into its vendor management policy, if the TSP wanted to do business with the financial institution, its could either agree to the provision or not do business with the institution. The TSP's business people conceded the point and it added a provision to the agreement designed to meet this requirement.

This seems like a fairly common requirement, yet the TSP was a technology service provider that does a lot of work with banks. In the course of the discussion on this point, it was evident that if the vendor's representatives were telling the truth (I accepted their assertions at face value, since it did not alter my client's position whether or not they were truthful), we were the only bank to ever ask for this provision. If that is correct, then the regulators need to be a lot more diligent in their vendor management reviews, because there are a lot of agreements with this TSP that don't comply with the "recommendations" of the Interagency Guidelines. On the other hand, it was the TSP's lawyer putting forth this position, so maybe it was a bald-faced lie.

The IG's Case Study also noted that "[t]he Interagency Guidelines The federal banking agencies, including the FDIC, conduct periodic information technology (IT) examinations at FIs and their TSPs." Other regulatory guidance, such OCC Bulletin 2013-29, "recommends" that financial institutions place in their agreements with TSPs an acknowledgment by the TSP that such examinations are permitted and that the TSP will cooperate in the conduct of the same. I have always considered this a "belt-and-suspenders" approach, designed to ward off unnecessary delay, since the Bank Service Company Act gives the federal bank regulators this power to examine third party service providers. On the other hand, I have had a contract negotiator for one of the country's largest technology service providers tell me that their attorneys have taken the position that the law does not require the TSP to allow the bank's regulator to conduct such an examination. The TSP only permitted them out of the goodness of its heart, I suppose. Regardless, the agreement with the TSP should always have a provision that requires that the TSP to permit, and to provide reasonable cooperation in connection with, such examinations.

A final few nuggets I gleaned from the Case Study: (1) a contract with a TSP needs to require full cooperation with the financial institution in the event of security breach and other provisions that are designed to permit the financial institution to be able to meet its obligations the recommendations under another set of guidelines, the Interagency Guidance on Response Programs for Security Breaches; (2) as part of their initial and ongoing due diligence and monitoring of technology services providers, institutions would be well-advised not to neglect the TSP's security breach incident response programs, and make sure that the TSP complies with "cybersecurity best practices;"  and (3) just as the bank has a regulator looking over its shoulder and second-guessing it, so does the regulator. I'm not claiming that this is necessarily a bad thing, but you wonder how much of the effort in this area is directed toward placating Monday Morning Quarterbacks.

Rent-a-Charter vs. Strategic Alliance

In June 2004, I wrote a post about schemes by non-bank lenders, especially payday lenders, to "partner" with banks and thrifts in ways that would allow the non-banks to use the bank's or thrift's status to "preemept" "inconvenient state laws, such as those pesky usury limits. As I said at the time:

Apparently, the state-chartered banks involved in this practice are counting on the continued lack of objection by the FDIC, and the continued sympathy of state banking regulators who are eager to increase the number of state-chartered institutions that they regulate. In my opinion, this is a risky course.

I also pointed out at the time that national banks and federal savings banks could rest assured that their primary federal regulator would be scrutinizing their business arrangements with non-banks like Elizabeth Warren looking under her bed every night for a bad banker looking to steal all the cash she has hidden in the sock that she keeps under her pillow.

According to a recent client alert from Chapman and Cutler LLP, this bad old idea not only refuses to die, but has engendered state officials to take action to stop it in its tracks. While the alert discusses the State of Pennsylvania going after payday lenders who've aligned themselves with Native American tribes (which has been a problematic marriage for quite some time), it has wider implications for similar arrangements. In this instance, the Commonwealth of Pennsylvania alleged that the "true lender" for regulatory purposes was not a bank in Delaware that would have been exempt from Pennsylvania usury limits and licensing requirements but the non-bank website "originator" that did most of the origination work and derived most of the economic benefits from the loans. The authors note that in other jurisdictions, the court decisions have not been in lockstep on the issue of preemption, arrangements like the one challenged here are likely always to put the lenders in the regulatory crosshairs.

No clear rule has emerged although regulatory challenges almost certainly are more likely to be made when excessive interest rates and/or abusive sales or collection practices are involved. In this case, the loans imposed interest rates of 200% to 300%.

The alert notes that even though the court's decision involved only a motion to dismiss Pennsylvania's action, and that is a long way from a judgment on the merits, the red flags for financial institutions involved in such relationships are clear "because it demonstrates that plaintiffs will continue to raise the “true lender” theory and courts will not necessarily dismiss at an early stage (for failure to state a claim upon relief can be granted) “true lender” claims solely because a bank is the named lender on the loans, at least where there are allegations that the originating bank does not have substantive duties or an economic interest in the program."

In order to mitigate the risk of claims based on the “true lender” doctrine, companies that engage in internet-based lending programs through an arrangement with one or more banks should consider how the programs are structured. For example, consideration should be given to operations where the bank has substantive duties and/or an economic interest in the program or loans. We are aware that some internet-based lending programs are considering structural changes of this nature.

The firm also advises institutions to make certain that they comply with regulatory guidance governing relationships with service providers. They cite FIL-9-2016 and related FDIC guidance. I'd also suggest taking a look at the OCC's Bulletin 2013-29.

Or, for a change of pace, a bank considering one of these schemes might decide to take its entire capital to The Bellagio in Vegas, walk up to nearest roulette wheel, and lay it all on "00." I mean, if you like dancing along the razor's edge with insured deposits, you might as well go all-in. Plus, you get free booze as long as your money lasts. To hedge your bet, you might want to hold back enough to buy a one-way ticket to Havana (regular flights from the States start soon) just in case that method of income-generation doesn't work out as well as a strategic alliance with a non-bank payday lender.

Activist Investors Betting On Bank Mergers

It appears that "activist" investors are turning to banks because they, like many of the rest of us close to the banking sector, think that there will be continued consolidation of the banking industry in the U.S., and what better way to make yourself some hard-earned profits than buying shares in a business and then pushing its board to sell the family farm so you can cash out. Some of you may remember that this model business plan was why the FDIC apparently soured on relying on "private equity" investors to help it clean up the mess after the last banking meltdown.

According to reporters in the St. Louis Post-Dispatch, "[a]ctivist investors are putting the U.S. banking sector in their crosshairs, betting that headwinds whipping through the industry will accelerate consolidation among lenders." The authors cite the rapid uptick in such "activist campaigns" in the financial sector last year, and observe that the "activists" are turning their attention from insurance companies and other non-bank financial businesses to commercial banks.

Hedge funds such as Ancora Advisors, Clover Partners and Seidman & Associates are buying up stakes in lenders across the U.S., from community banks to large regional lenders.

Driving these investments is the view that ultra-low interest rates, lagging returns on equity and tough regulations will push more banks to merge, with buyers willing to pay a hefty multiple to a bank’s tangible book value. Activist investors interviewed by Reuters say another factor is exposure to energy-related loans, which is driving down the valuations of certain banks and making them all the more vulnerable to a takeover.

“Bigger banks are back in the market doing deals,” said Ralph MacDonald, a partner at law firm Jones Day, who specializes in mergers and acquisitions.

U.S. bank mergers and acquisitions volume rose 58 percent last year to $34.5 billion, according to Thomson Reuters data.

The authors think that Zions and Comerica are likely targets. Both "Systemically Important Financial Institutions" had under performing returns on equity last year. That alone makes them prime targets for "activists."

The firm believes that any bank earning a 12 percent or less return on tangible common equity needs to consider whether it can prosper as an independent institution, PL Capital co-founder Richard Lashley said in an interview.

A bank’s exposure to falling energy prices makes it even more vulnerable, he noted. But another key factor is a bank’s ability to maneuver through a climate where low rates are compressing net interest margins, and stricter regulations are increasing costs.

“Management teams and boards are just exhausted,” said Lashley, who is based in New Jersey. “It’s not fun to run a bank anymore.”

However, the article also contains a quote from a community bank chief that indicates that the trend to consolidate is not just for SIFIs.

“My phones are ringing off the hook with calls coming in from banks wanting to sell,” said Pat Hickman, the CEO of Happy State Bank, a lender in the Texas panhandle. “And one of the primary reasons is regulation.”

Yes, it's not fun to run ANY bank anymore, not just the large ones. Whether your a big bank or a small one, publicly traded or privately held, pressured by "activist" investors or simply by the facts of life: as we said a few weeks ago, 2016 will very likely be the year of the bank merger.