Examiners may have an agenda, but you don’t always have to follow it
By Steve Cocheo, executive editor,
When a bank’s latest examination indicates “matters requiring
attention,” or worse, board and management have to know their ground
The bank’s CEO looked at the document, written in typical agency boilerplate. He was puzzled.
Everyone at the table knew, as they sat there in the conference room on a Thursday afternoon, that the bank was going to fail that Friday. It was irrevocable; a done thing.
Yet the examiners had handed this agreement to him as if the bank were a going concern.
“Isn’t this a corrective program for the bank?” he finally asked.
The examiner in charge said, yes, that was so.
The CEO pondered this, and then responded, “I’m not sure we’re going to get much corrected between now and 6 p.m. tomorrow night.”
This anecdote comes from the current case files of banking attorney Jeffrey Gerrish. He likes to kid banking regulators that they’ve adopted a “paper for all” strategy. He believes that, in today’s environment, federal examiners are out to hang some kind of regulatory order, be it formal or informal, on every institution they visit.
Gerrish blames the attitude on regulators’ fear of being second guessed, and their desire to cover their rear ends at all times. Gerrish, now chairman of Gerrish McCreary Smith LLC, a consulting firm and law firm, started his banking career as an FDIC attorney suing directors, years ago. As a result, he knows both sides.
The regulators’ attitude isn’t surprising, said Gerrish. During a recent ABA telephone briefing he observed that most bankers and directors have never seen anything like current conditions.
“It’s tougher out there than I have seen in a 35-year career,” said Gerrish. “From the regulators’ standpoint, unprecedented times require unprecedented actions. So what we’re seeing right now is a significant ramp-up in aggressive tactics by the regulators.”
At the time of the late September telephone briefing, FDIC’s problem bank list had passed the 400 mark. Gerrish considers that count understated.
“I think there’d be a lot more than that,” said Gerrish, “if they could get them examined faster.” Gerrish predicted that the FDIC’s list will top 1,000 in time.
Gerrish was a panelist during the ABA America’s Community Bankers Council director telephone briefing, “Directors and Regulators: Understanding The Examination and Enforcement Process.” (To order CDs of the Sept. 23 event, go to www.aba.com/teleweb/tb092309.htm) Gerrish spoke of what he’s been seeing in enforcement activity in his travels around the country, and advised bankers and directors on how to approach enforcement actions in the new environment.
Watch out for the snowball
Often, Gerrish said, banks are finding themselves victims of a “snowball effect.” Failure to identify fully the bank’s troubled credits means credit problems haven’t been flagged. Examiners will find those. Inadequate flagging of credits means the bank’s allowance for loan and lease losses hasn’t kept up. Examiners will find that. In turn, said Gerrish, once the bank, on regulatory order, catches up on those fronts, then capital becomes diminished.
“This probably results in some adverse publicity,” said Gerrish, “which creates liquidity pressures. And then, all of the sudden, the snowball starts going downhill. Management that was brilliant two years ago running a CAMELS 1-rated bank now appears to be a bunch of idiots running a 4- or 5-rated bank.”
Such a drastic shift in circumstances can leave a bank’s board “pretty much shell-shocked.”
Even if things are not that dramatic for most banks, conditions for many of them have changed drastically.
For example, regulators are now expecting to see 12% risk-based capital, and 9% tier one capital. Gerrish said his firm recently had a regulatory proposal placed before a client that called for 14% tier one. “I called the regulator to see if that was a typo,” said Gerrish. It wasn’t.
He urged bankers to prepare their boards for such possibilities.
Gerrish offered seminar listeners other tips for preparing for, and surviving examinations. One was to utilize self-assessments.
“Can you identify your problems before the regulators come in?” he asked. “If so, you will have credibility—and an adequate loan loss reserve.” If not, the “snowball effect” kicks in.
As Gerrish envisions it, a self-assessment is not an attempt to project what the bank’s CAMELS rating comes to. Instead, it’s more fundamental—identify problem credits.
He also urged bankers to note disagreements with examiners early on, and with specificity. This point has two sides. First, Gerrish warned that any issue in the examination process that is not documented has not happened. On the other hand, any examiner criticism or complaint that comes up in the regulators’ exit meeting that the board or management doesn’t respond to likely will be documented. Failure to speak up at that time can see the bank bound to the course of action discussed.
(Gerrish offers additional tips for free; e-mail him at
You’re in the driver’s seat
In the enforcement process, said Gerrish, bankers may think the regulators are in control, but for much of the process the board is in control. That statement may be news to many directors and bankers. Here is how Gerrish explains it:
“You may not think you’re in control when the regulators come in and pound the table, telling you that you ‘don’t get it’ or that ‘you’re not taking it seriously. But the board has to make a decision about what is in the best interests of the bank. It should ask:
‘Do we consent to this informal action? Do we consent to this formal action?’
“There will not be an enforcement action against your bank without either the consent of the board of directors, or the regulators going through a year-long administrative proceeding. Such proceedings involve a hearing before an administrative law judge and more.”
It’s not that the board can stonewall the regulators. Administrative proceedings are open, and any resulting cease-and-desist order, even if agreed to in the end, is published, and therefore can produce bad publicity. Management and the board will expend time and money on the process.
(Public regulatory agreements and orders are on the regulators’ websites, and are also sent out electronically to the media. Some days, regulators send out a stream of such announcements.)
“So you do have the option of answering, ‘Thanks but no thanks’,” and then fighting orders out in administrative proceedings, if the bank can stand the bad publicity, said Gerrish.
Gerrish detailed both the informal enforcement process, and the formal path.
Sometimes moving-on works best
While informal enforcement actions come in different forms and names, depending on severity and the agency involved, they share certain characteristics. One is that they are private, and not disclosed by the regulators.
And another, surprising to some, is that they are not enforceable.
Gerrish acknowledges the impression that they are enforceable.
“Take a Memorandum of Understanding,” he said. “It looks like a contract. But in reality it’s not an enforceable document. If the bank violates it, the only thing that the regulators can do is step up enforcement, and move to a more-formal action.”
Other informal enforcement actions include board resolutions—where the board agrees to take agreed-upon actions and formalizes it through board records—and commitment letters—a term often used by state regulators—which list agreed-upon “corrective actions.”
“You’ll think, ‘Why would you ever fight over something that’s not enforceable?’,” asked Gerrish. “Generally, you’re right. Most of the time the best option is to cut a deal the bank can live with, and move on.”
But sometimes, matters aren’t so simple. Even an informal action may change the bank’s circumstances.
For instance, if the bank is involved in a bank-stock loan, the lender likely has certain covenants in the loan contract. “Even an informal action may be a breach,” said Gerrish.
Directors and officers liability insurance is another issue. Gerrish pointed out that while the carriers don’t receive copies of exam reports or private regulatory orders, they do send questionnaires that must be completed. A typical question is: “Are you subject to any informal or formal regulatory enforcement action?”
Gerrish urged bankers and directors to think of such broader issues before determining how they’ll respond to a proposed informal order.
Enforceable enforcement actions
One means of determining where in the enforcement cycle your bank is going to find itself when examiners next arrive is the bank’s ratio of classified assets to capital, according to Gerrish.
“If you have a ratio under 40% these days, generally, you are probably looking at nothing—maybe a letter indicating the bank has matters needing attention,” said Gerrish. Above 40%, however, things get stronger. Past the 60% mark, the bank is likely looking at a formal action. Gerrish said the exact threshold depends on what else is going on in the bank. In his day at FDIC, he said, thresholds were higher—FDIC staff didn’t begin to worry until the ratio was 75% or above. This is further testimony to how things have changed.
Once the bank has passed into “formal” territory, some options remain to avoid bad publicity. State-chartered banks, for instance, may be able to convince FDIC to let their state regulator issue the enforcement actions; state actions at certain levels may not be published. Gerrish said that while FDIC will at times agree to this, the Federal Reserve, which regulates state banks that belong to the Federal Reserve System, has generally not been willing to defer to the state authorities.
Beyond the matter of publicity, formal enforcement actions are enforceable. Different regulators use different techniques and differing terminology, said Gerrish. The Comptroller’s Office favors “formal agreements,” while the FDIC favors “cease-and-desist” orders, for instance.
[A special category of enforcement are “prompt corrective action” rulings, which kick in based on numerical thresholds built into federal banking law.]
Gerrish said the language in these documents is improving, especially at FDIC and the Comptroller’s Office. The language has been growing somewhat less inflammatory, he said. This is more in keeping with the tone used in Federal Reserve documents.
Nevertheless, bankers and directors will find a great deal of legal boilerplate in formal enforcement documents that often doesn’t relate directly to anything going on in the bank. Most have a paragraph or two demanding more active participation from the bank’s board. Gerrish noted that recent changes at FDIC can expose the bank to publicity earlier than used to be the case.
Taking issues up the line
In the wake of the previous banking crisis, federal regulators adopted appeals processes for banks objecting to the way they were handled in the examination process. Agencies’ programs differ in approach, structure, scope, and purpose. (The ABA telephone briefing featured a segment by Larry Hattix, ombudsman at the Comptroller’s Office.)
Many community banks are regulated by FDIC, and Gerrish warned that the insurance agency revised its appeals process in August. He said it seems to effectively cut off the formal appeals process for FDIC banks if they fall below 1 and 2 CAMELS ratings.
Gerrish said that for the other banks, “the theory may be that ultimately you are either going to agree to corrective action or you’ll enter into administrative litigation with the agency, and that’s where you’ll get your due process.” BJ
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