M & A Generals,

 Be Sure to Attend to Your Rear Guard
(Part 1)

Photo by Sgt. 1st Class Kevin Bell

As M&A activity in the banking arena begins to heat up and acquisitive banks begin the new year by pursuing potential target banks, it's important to know that it's not all about the science of the deal.  There are two significant strategic risks that, if not properly attended to, could derail an acquisition – Community Reinvestment Act (CRA) performance and Bank Secrecy Act/Anti-Money Laundering (BSA/AML) compliance.  Both are mandatory consideration factors for regulators under the Bank Merger Act (BMA) for both institutions involved.  While solid due diligence assesses these factors for the target bank, many times these factors are under-appreciated for the acquiring bank itself, resulting in the potential for extended application processing times, conditional approvals, or worse.

In this article, we'll start with the issue of CRA.  Part 2, next week, will discuss BSA/AML and some general compliance management issues for both banks that could present setback risk to a deal.

First, CRA will become a higher profile bank merger consideration now that the effects of the financial crisis are wearing off.   Regulators apply the CRA tests and standards within something called a Performance Context.  One of the factors considered under Performance Context in the CRA regulation is “Institutional capacity and constraints, including the size and financial condition of the bank, the economic climate (national, regional, and local, safety and soundness limitations, and any other factors that significantly affect the bank's ability to provide lending, investments, or services in its assessment area(s)."

Let me be frank, CRA examinations during the economic downturn have been giving significant consideration to performance context, due to the dour economic climate, the stressed financial condition of most banks, and other factors impacting the bank's ability to provide lending, investments, and services in their assessment areas.  Now that the economy is turning up, performance context is changing as we speak and the CRA performance context leeway, provided by regulators in CRA performance evaluations, is now evaporating.

In addition to the challenges presented by evolving changes in CRA Performance Context, the extended examination cycles for CRA examinations can present an additional issue.  Most banks are on a 3-year CRA examination cycle, with adjustments to the cycle for banks with assets $250 million or less – 4 years if the present CRA rating is satisfactory – 5 years if outstanding.   These extended time frames between CRA examinations brings in the possibility that someone protesting the merger application will contend that the examination results are “stale” and do not fairly represent the current CRA performance of the banks involved.  

Be prepared to deal with that for both banks in the transaction.  Particularly in those higher-profile acquisitions which may tend to attract significant public attention.  My recommendation is that you not only tell your bank's story, but control your bank's story.  That doesn't mean distorting it, but it does mean responding immediately to all compliments and complaints, so that you are framing and defining the context of your bank's CRA performance, not someone else.  And all that needs to be documented in the CRA public file.

Make sure you have a fairly recent written CRA self-assessment, that is supported by specific current data on lending, investment, and service efforts (including any changes in assessment areas and performance context).  That self-assessment should also include a fair lending self-assessment as well as any planned CRA performance initiatives.  Don't forget to include staff training efforts and written feedback from community organizations or public officials that the bank may be working with.

In compliance management, the old saw about "a good offense is the best defense" applies.  Diligently attending to compliance responsibilities can be an insurance policy.  Many bankers disparage compliance costs as non-revenue producing expenditures, forgetting that they can help avoid serious out-year expenditures for reimbursement and restitution, civil money penalties, legal fees, reputation damage to the bank and the costs of lost opportunities.

Close the Foreign Parallel Bank Loophole

On December 14, 2012, the Board of Governors of the Federal Reserve System released a Notice of Proposed Rulemaking for Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies.  At 306 pages, it outlines a revised architecture of enhanced prudential standards for Foreign Banking Organizations (FBOs).  Those standards include risk-based capital and leverage requirements, liquidity standards, risk management and risk committee requirements, single-counterparty credit limits, stress test requirements, and a debt-to-equity limit for companies that the Financial Stability Oversight Council has determined pose a grave threat to financial stability.

In addition to implementing Dodd-Frank statutory requirements, the enhanced prudential standards reflect several lessons-learned from the financial crisis:

“Actions by a home country to constrain a banking organization's ability to provide support to its foreign organizations, as well as the diminished likelihood that home country governments of large banking organizations would provide a backstop to their banks' foreign operations, have called into question one of the fundamental elements of the Board's current approach to supervising foreign banking organizations – the ability of the Board, as a host supervisor, to rely on a foreign banking organization to act as a source of strength to its U.S. operations when the foreign banking organization is under stress.

The issues described above-- growth over time in U.S. financial stability risks posed by foreign banking organizations individually and as a group, the need to minimize destabilizing pro-cyclical ring-fencing in a crisis, persistent impediments to effective cross-border resolution, and limitations on parent support-- together underscore the need for enhancements to foreign bank regulation in the United States.”

A handy CliffsNotes-like table, created by the Fed, summarizes the proposed new prudential requirements:

Table 1—Scope of Application for FBOs 

Global assets	U.S. assets	Summary of requirements that apply
> $10 billion and < $50 billion	n/a	• Have a U.S. risk committee.
		• Meet home country stress test requirements that are broadly consistent with U.S. requirements.
> $50 billion	< $50 billion	All of the above, plus:
		• Meet home country capital standards that are broadly consistent with Basel standards.
		• Single-counterparty credit limits28.
		• Subject to an annual liquidity stress test requirement.
		• Subject to DFA (Dodd-Frank Act) section 166 early remediation requirements.
		• Subject to U.S. intermediate holding company (IHC) requirements:.
		○ Required to form U.S. IHC if non-branch U.S. assets exceed $10 billion. All U.S. IHCs are subject to U.S BHC capital requirements.
		○ U.S. IHC with assets between $10 and $50 billion subject to DFA Stress Testing Rule (company-run stress test).
> $50 billion	> $50 billion	All of the above, plus:
		• U.S. IHC with assets >$50 billion subject to capital plan rule and all DFA stress test requirements (CCAR).
		• U.S. IHC and branch/agency network subject to monthly liquidity stress tests and in-country liquidity requirements.
		• Must have a U.S. risk committee and U.S. Chief Risk Officer.
		• Subject to nondiscretionary DFA section 166 early remediation req

What's missing from this proposed enhanced supervisory architecture for foreign banks is the opportunity to subject foreign parallel bank arrangements to supervision by the Board of Governors of the Federal Reserve System.

Foreign parallel banks are bank ownership structures where one or more banks in the United States are affiliated by common ownership, through natural persons or their instrumentalities, with banks in one or more foreign countries.  There are many of these ownership structures spread throughout the United States.  These foreign parallel bank ownership arrangements do not come under the present technical definition of a FBO.  But because of the close ownership ties, they can act like one.  These parallel bank structures can avoid Federal Reserve supervision altogether.

Let me give you one example, two of the largest private-sector banks in Venezuela, Mercantil Servicios Financieros CA (MSF) and Banesco Banco Universal CA (BBU), both have commercial bank affiliates headquartered in Coral Gables, Florida --- Mercantil Commercebank, N.A. and Banesco (USA).  Through intermediate holding companies, Mercantil Commercebank is directly owned by MSF and both MSF and Mercantil Commercebank are subject to full supervisory oversight as a FBO by the Federal Reserve Bank of Atlanta.

Banesco (USA), on the other hand, is beneficially owned by the owner of BBU in Venezuela, Juan Carlos Escotet.  Since there are no direct corporate connections between BBU and Banesco (USA), and since Banesco (USA) is a state non-member bank without a U.S. bank holding company, the Banesco-related entities, BBU and Banesco (USA), are not subject to Federal Reserve FBO oversight. 

So what? you may ask.  Well, it comes down to an issue of fairness and equal treatment for the two U.S. domiciled banks in this example.  In the arena of FBO supervision, home country bank supervisors are expected to have a robust program of comprehensive consolidated supervision (CCS).  The state of that home country supervision program feeds into the Fed's Strength of Support Assessment (SOSA) for each FBO.  If a country has not been conferred CCS status by the Federal Reserve, the Fed will typically disallow any entry of new foreign banks into the United States or constrain significant expansion of existing foreign bank presences in the U.S.  Venezuela does not have CCS status and it is not likely to receive such status in the intermediate future.

So Venezuela's present CCS status impacts bank supervisory deliberations on any significant expansion plans by Mercantil Commercebank, N.A.   Banesco (USA), on the other hand, can expand subject only to State of Florida and the FDIC approvals.  The Fed, its CCS criteria, and its SOSA process being totally out of the picture.  

Structures not subject to Federal Reserve supervision, through the use of foreign parallel banks, is a loophole in the foreign bank supervision fabric.  A loophole that could become more attractive as prudential standards for FBOs become stricter, such as those now being proposed in the Notice of Proposed Rulemaking.  The Foreign Bank Supervision Enhancement Act of 1991 was supposed to centralize the supervision and examination authority over foreign bank operations squarely with the Federal Reserve Board.  The indirect operations of foreign banks, through parallel bank arrangements, have effectively called that into question.

A foreign parallel bank arrangement may not technically look like a duck, dressed in drag like it is; but if it quacks like a duck, the Fed should call it a duck.

A Year of Proud Achievement,
 but an Embarrassment of Riches...

Artist: Kate O'Connor

Surfing occ.gov over the holidays, I saw that the OCC's Fiscal Year 2012 Annual Report has been published.  Surprisingly, the availability of this important document was unheralded by an OCC press release.  Every national bank and savings association CEO and board member should read it, as it puts perspective to the enormous amount of work done by the staff and management of the Office of the Comptroller of the Currency during the last year.

Like corporate annual reports, the OCC Annual Report celebrates and extols successes and achievements.  And since the OCC is one of the Federal agencies at the epicenter of the effort to help manage through the debris of the financial crisis and help build the architecture to (hopefully) keep it from happening again, those successes are critically important to the nation's financial and economic health.

The list of achievements and initiatives is impressive.  In addition to critical ongoing bank and thrift supervision work and the sensitive integration of the former Office of Thrift Supervision (OTS) into the OCC, there were international capital and liquidity standards;  Dodd-Frank rule-makings (including stress testing, use of credit ratings, adjusting lending limits to include derivatives, and the Volcker Rule rule-making);  implementing the Mortgage Foreclosure Agreement;  highlighting the emergent role of operational risk as a headline risk;  high-profile enforcement actions in the areas of the Bank Secrecy Act and unfair and deceptive banking practices;  and guidance on capital planning and stress testing for community banks.   The Oscar nominee for best 2012 OCC communications initiative is the publication of the Semiannual Risk Perspective, which points out threats to bank safety and soundness and makes for a great input document for bank capital planning purposes.

Stumbles (like HSBC and JPMorgan Chase) have been re-framed as fumble recoveries (enhanced expectations for corporate governance and an internal appeals process), as they should be.  The fumble is the unrecoverable past, the recovery is the most important... it is the actionable future.

It isn't until you get to the back of the Annual Report that a breathtaking moment hits the reader.  The OCC's statement of financial position shows an investment portfolio of $1.38 billion!  Putting it in some sort of perspective, it comes out to $361,000 per full-time equivalent OCC employee.

The reader's eye then immediately wanders over to what used to be called Comptroller's Equity, but is now called Net Position.  That stash represents the cumulative net excess of the OCC's (and the former OTS's) assessment and fee income over the the cost of agency operations over the years.   At $1.07 billion, this accumulated amount is then sliced into some pretty generous reserve allocations.  Generous considering the Comptroller's unfettered pricing flexibility to adapt his assessment schedule to any “ foreseeable, but rare events” and then collect those assessments twice a year.  Some smoothing through the use of reserves is wise to avoid whipsawing national bank and thrift assessments, but at some point, necessary prudence becomes hoarding behavior.

Net Position is also understated from a market value perspective, since it doesn't include the “hidden reserve” represented by the value of the former OTS headquarters property.  The former OTS headquarters is prime commercial property adjacent to the White House.  The carrying value for the land and building is $23 million, the market value is exponentially higher.

Shortly after former Comptroller C. Todd Conover's 1981 swearing-in, he noticed a similar situation.  A Reagan conservative and staunch proponent of banking deregulation and government efficiency, he saw that his Comptroller's Equity was well in excess of the agency's needs.  He proceeded to “dividend” a significant chunk back to the national banks.   Comptroller Curry has an opportunity to do something similar with assessment rebates or the like.