A Gift for the New Year:

Awareness

"Let us not look back in anger, nor forward in fear, but around in awareness."        - James Thurber*

One December holiday season gift I always look forward to is the public release of the OCC Semiannual Risk Perspective by the Office of the Comptroller of the Currency.

I like it because bank examiners are in the unique position of seeing the operational insides of every bank they visit, and collectively, they scrutinize the entrails of every bank in the nation.  It's a privilege denied to those of us on the outside, who peer from the public galleries or only know the inner workings of the bank in which one works.  This privilege allows bank examiners to accurately gauge the range and variations of banking practices in the industry and to compare notes on risk-taking behaviors horizontally, both within and across banking markets.

It's not that I don't trust the instincts of the business and trade press.  In fact, I would argue that there were many times when the investigative reporters from the Wall Street Journal,  New York Times, Washington Post, Bloomberg News, or the American Banker bested the examiner corps at their own game by unearthing significant banking issues that the then-chagrined regulators were later obliged to address.

No, what gives me pause and what makes it difficult to digest the relentless media "chatter" at face value, is the composition of the analysis stream within the business and trade press.  The pieces written by consultants, politicians, and spokespeople for special interests who have a tendency to raise conjecture, philosophical tilt, or even nonsense to the level of conventional industry wisdom.

Such as the "yelling fire in the theater" pieces that implicitly (or even shamelessly) (and, of course, conveniently) call for the specialized services of the author or his/her professional services firm.  Or the predictable flurry of subject-specific think pieces that precede any major subject-specific banking conference that, I guess, are written to help channel interest towards the author's booth in the grand exhibition hall or to gin up an attentive audience for a panel discussion at said banking conference.

So, occasionally, it's nice to take a break from the "spin" machines.  As the great actor Walter Brennan used to say when referring to his Old West gun-slinging prowess:  "No brag, just fact."  That's (refreshingly) what you get with the OCC's Semiannual Risk Perspective.

[Most of you are probably not old enough to remember Walter Brennan (sigh), so here's the bit captured on YouTube.]

I encourage you to read the entire document.  It's a well-organized, well-developed, and well-presented 41 pages.  In these times of Dodd-Frank Act massive missives, it's a comparatively quick read.

Too busy or can't handle reading it on the screen of your mobile device?  Here's the "Reader's Digest" version:

The OCC Semiannual Risk Perspective explores three key risk themes and provides the following guidance to bank management and boards of directors:

1)  Strategic risk remains high for many banks as management teams search for sustainable ways to generate target rates of return or struggle to implement their strategic plans effectively.

"Banks’ boards of directors and senior managers should ensure that strategic planning and product approval processes appropriately consider expertise, management information systems, and risk controls for the banks’ business lines and activities.  Banks also should incorporate management succession and retention of key personnel into their strategic planning process.

Compliance programs should keep pace with the volume and complexity of regulatory changes, as well as the changing nature of bank customers and transactions."

2)  Operational risk is high as banks adapt business models, transform technology and business processes, and respond to increasing cyber threats. 

"Bankers should maintain heightened awareness and appropriate resources to identify and mitigate cyber threats and vulnerabilities, and should incorporate cyber-resilience planning and controls into their business continuity planning and testing.

Bankers should also ensure that risk management of third-party relationships is commensurate with the breadth, complexity, and criticality of these arrangements as outlined in OCC Bulletin 2013-29.   As banks experience increased system and process interconnectedness, as well as increased concentration risk when vendors consolidate, they need to identify and monitor risks of third-party relationships and ensure resilience against business disruption.

 Banks also should identify and assess cross-channel payment, operational, and compliance risks, and ensure their ability to measure, monitor, and control risks associated with new activities."

3)  Competitive pressures, the need for revenue growth, and the ongoing low interest rate environment continue to complicate bank risk management.

"Banks’ boards of directors and senior managers need to monitor elevated [loan and investment] policy exceptions to established underwriting standards and be alert to the product terms that layer on additional risks.  ALLL [Allowance for Loan and Lease Losses] processes should be reviewed to determine whether additional qualitative adjustments are needed to reflect the increased risk in loan portfolios.

Banks with significant concentrations in longer term assets should assess their vulnerability to a sudden rise in interest rates.  Banks also need to assess how nonmaturity deposits (NMD) react to rising rates and consider the uncertainty of depositor behavior in their model assumptions and resulting risk exposure.

Banks should ensure investment decisions meet their fiduciary customers’ investment objectives, needs, and risk tolerances.  It is also important to ensure that the oversight of the retail nondeposit investment sales program includes an assessment of the product platform’s appropriateness for the bank’s client base. "

*Thanks to the Financial Services Roundtable SmartBrief for the introductory quotation.

Have a safe, sound, and prosperous New Year everyone! 

Milestone and Millstone

 (Part 2)

The previous National Bank Examiner blog post Milestone and Millstone (Part 1) recapped the milestone judicial decision regarding the legal liability of bank directors under the North Carolina business judgement rule in a case involving the failure of the Cooperative Bank of Wilmington, North Carolina.  This blog post deals with the millstones borne by bank examiners in the form of blemished or uneven bank supervisory policy guidance.  Policy guidance that really needs to be addressed across all bank regulatory agencies if this judicial decision survives the appellate process.

If what bank examiners do (or do not do) in the performance of their examining duties, their CAMELS ratings, and their subsequent followup activities, are going to be legally mapped to the question of whether a bank director does (or does not) have legal liability in a failed bank receivership scenario, then (at least) two things ought to change.

Specifically, there is a need to address a fundamental structural flaw in the Uniform Financial Institutions Rating System (UFIRS), in terms of appropriately weighing today's immediate problems against today's risks (tomorrow's problems) in its numerical CAMELS composite and component ratings.

And second, there is a need to install policy guardrails, consistent across all bank regulatory agencies, that appropriately balance standardized calibrated escalation of adverse examination findings with the boundaries of examiner/field office discretion and latitude in using moral suasion as a bank supervisory tool.


 UFIRS: A job half-completed is an incomplete job.

The Uniform Financial Institutions Rating System (UFIRS) was originally created in 1979 as an internal rating system, used by federal bank regulators, for uniformly evaluating the soundness of financial institutions and to identify those institutions requiring special supervisory attention.   Supervisory agencies derived composite ratings for each financial institution from a subsidiary set of component ratings for Capital adequacy, Asset quality, Management, Earnings, and Liquidity (the old CAMEL ratings system)

Composite ratings ranged on a scale from "1" (sound in every respect), to "2" (fundamentally sound), to "3" (exhibits some degree of supervisory concern), to "4" (exhibits serious financial or managerial deficiencies that result in unsatisfactory performance), to "5" (exhibits critically deficient performance).

The original UFIRS considered both banking practices and performance, but the rating standard, or rubric, driving the determination of a financial institution's composite rating was the bank's record of performance and the "snapshot" evaluation of bank soundness derived from the bank's latest examination results.   While risk was considered implicitly in the old CAMEL rating system, the progressive adoption of risk-focused supervision by banking supervisors over the years since 1979 argued for making risk assessment in the UFIRS clear and explicit.

So on December 19, 1996, the Federal banking agencies issued the 1996 Revision of the UFIRS.  The major changes included an increased emphasis on the quality of risk management practices and the addition of a sixth component rating called "Sensitivity to Market Risk".  The CAMEL rating system became the CAMELS rating system and the evaluation standards for component ratings now included explicit consideration of processes to identify, measure, monitor, and control risks.

The drafting work done by the Interagency CAMEL Working Group of the Federal Financial Institutions Examination Council (FFIEC) was admirable, and the revised, risk mangement-sensitive component rating definitions remain quite good and continue to be germane and very useful.  But when the proposed UFIRS revisions were considered by the FFIEC Task Force on Supervison (the senior staff supervisors within each federal banking agency), the Task Force on Supervision chose to retain the performance-based context of the existing composite rating definitions. 

"4. Composite Rating Definitions.  The composite rating definitions parallel proposed changes for component descriptions and ratings. The revised composite rating definitions contain an explicit reference to the quality of overall risk management practices.  The basic context of the existing rating definitions is being retained.  The composite ratings would continue to be based on a careful evaluation of an institutions managerial, operational, financial, and compliance performance." (my emphasis) 

The FFIEC Task Force on Supervision, and later the agency heads themselves, took a nicely remodeled home and placed it on the old, creaky performance-based UFIRS composite rating foundation.

Performance is fundamentally retrospective... it looks back from the present to the past.  It's a lagging indicator.  Quality of risk management is prospective, looks forward in time, and can be a leading indicator.  The focus on performance, as the composite rating bottom-line, relegates, in a de facto manner, the evaluation of the quality of risk management practices to an important, but still secondary consideration.  So at the end of the day, the UFIRS composite and component ratings present a time-distorted view of intrinsic bank soundness.

Why is this a millstone for bank examiners?  One only needs to look at the seeds of the recent financial crisis.  The erosion of credit underwriting standards, particularly in the real estate sector, and the pursuit of hot money funding drove unprecedented banking performance in terms of profitability and growth.  Until late July 2007, when the credit markets first started to lock-up and the banking system began its inexorable march toward financial crisis and taxpayer bailout.

When confronted with a situation where a bank exhibits superior performance metrics but questionable risk management practices, which aspect drives the component and composite ratings under the UFIRS?  The basic context of the UFIRS emphasizes performance.

This was underscored by the Office of the Comptroller of the Currency (OCC) at the time in OCC Bulletin 97-14 , a follow-up on common questions and answers about the 1996 revised UFIRS :

"How do the revised rating system and the OCC's supervision by risk program interrelate?

They exist in tandem... The CAMELS rating system remains a measurement of the bank's current overall financial, managerial, operational, and compliance performance.  (all emphasis mine)  Supervision by risk prospectively assesses not only the quality of risk management and the quantity of risks, but also the direction of risk."

Even in the current Bank Supervision Process section of the Comptroller's Handbook, the OCC reinforces this concept:

"The major distinction between the RAS [Risk Assessment System] and rating systems is the prospective nature of the RAS. The rating systems primarily provide a point-in-time assessment of an institution’s current performance. (my emphasis) The RAS reflects both a current (aggregate risk) and a prospective (direction of risk) view of the institution’s risk profile."

How to fix this structural weakness in the UFIRS?  Although CAMELS composite ratings are enshrined in the granite bedrock of certain federal statutes, the means by which they are arrived at are not.  I would suggest creating explicit sub-ratings, for analytical purposes, within each CAMELS component rating.  One for performance and one for risk management.  Then, to be conservatively prudent, use the worst of the two sub-ratings to drive the individual CAMELS component ratings and, ultimately, roll those up into the composite rating of the bank.  I think this would be a small step forward by providing a more accurate measure of a bank's intrinsic soundness.


Will Character Bank Supervision Go the Way of Character Lending in Banking?

The Cooperative Bank case highlights the fact that there can be significant variation in the intensity of bank supervisory followup on examination criticisms.  This case appears to be an extreme example, likely complicated by the policy of alternating annual examinations between the FDIC and the North Carolina banking commissioner's office.

But, in general, individual examiners, individual field offices, even individual bank regulatory agencies, differ on the degree of patience shown regarding the pace and effectiveness of bank management's resolution of examination criticisms.

Factors such as the seriousness of the criticism; the urgency associated with the risks involved; the potential for a criticism to balloon into something larger and more dangerous; the confidence the examiner or field office has in the capabilities of the bank's executive management and board of directors; and the physics of the corrective action process (particularly those involving significant data processing changes, multiple vendors, and/or changes in business culture) ---- all of these things, and many more, play into the calculus of the bank supervisory followup on examination criticisms.

But there need to be boundaries.  And those boundaries need to be lined with policy guardrails and a robust quality assurance process.  In this respect, I believe that the Office of the Comptroller of the Currency (OCC) has ably dealt with this issue in its old and new Matters Requiring Attention (MRA) guidance when read together with the OCC's Enforcement Action Policy.

A character loan is a type of unsecured loan whose repayment is premised on the borrower's reputation and the bank's past experience with the borrower.  Is there still a place in banking for character lending?  Yes, but there should be a backstop in the form of demonstrable indications of the ability to repay.

Character bank supervision is premised on the reputation and perceived abilities of a bank's executive management team and the bank regulatory agency's past experience with them.  Is there still a place for character bank supervision in banking by the temperate use of moral suasion prior to resorting to harsher enforcement measures?

Absolutely!  The overwhelming majority of examination criticisms are corrected in this manner.  But there need to be policy guardrails that limit bank management's use of dilatory tactics that may stem from either their unwillingness or inability to correct examination criticisms.  Policy guardrails that also limit a bank regulator's supervisory office from countenancing unresolved examination criticisms over an extended period of time by buying into repeated unfulfilled promises, vague assurances, and incomplete (or ineffective) progress.

Milestone and Millstone
(Part 1)

What a difference you can make in the meaning of a word by changing just one simple letter!  The thought immediately came to mind when reading this final sentence from a story in the New York Times, titled Failed Bank's Broken Vows Mean Little, reporting on the fallout from an adverse federal court ruling against the Federal Deposit Insurance Corporation (FDIC) dismissing one of their failed-bank director liability lawsuits:

"If this ruling is widely followed, it could mean that if a bank can somehow get a 2 rating from the examiner, it can safely ignore anything else the examiner says."

The failed bank in question was the Cooperative Bank of Wilmington, North Carolina.  When the FDIC-supervised, state-chartered bank failed in June 2009, it had $974 million in total assets, 24 branches, a loan production office, and a mortgage company.  Its lending focus was commercial real estate loans and residential land acquisition, development, and construction loans in eastern North Carolina and eastern South Carolina.  Much of the lending was for investment or second homes along the coast.  Loan growth, during the final years, was funded from wholesale sources -- brokered deposits and Federal Home Loan Bank advances.  The initial estimate of loss to the Deposit Insurance Fund was $217 million, but as of  December 2013, it was $293 million -- an increase of  35% over the initial estimate.

A Material Loss Review (MLR) is required, by federal statute, to be conducted by the appropriate Inspector General's office for bank failures where substantial costs are incurred by the Deposit Insurance Fund.  The Cooperative Bank MLR recaps the bank supervisory history of the bank prior to its failure.  The MLR is breathtaking, but not in a good way.

Remember the interagency commercial real estate lending guidance, issued in 2006, that established bank supervisory tripwires of 100% of capital for construction, land development, and other land loans (ADC loans), and 300% of capital for rapidly-rising non-owner occupied commercial real estate lending activity?  Well, at year-end 2007, those figures were 469% and 584% respectively for the Cooperative Bank.  And, due  largely to the capital burn incurred near the end of its life, the concentration of ADC loans at the end of 2008 was 912% of capital.

There is an old axiom in banking supervision - banks tend to decay, not explode. As you can see in the graphic below, however, the bank immediately went from a CAMELS composite rating of  "2" (fundamentally sound) to a "5" (critically deficient) - what bank examiners call a "triple jump".  The bank failed seven-months after the commencement of  its final examination - with the ink barely dry on the bank's final examination report and Cease & Desist (C&D) Order.

A fine "triple jump" might earn you a gold medal in the summer Olympics, but will get you nothing but a big, ugly black eye in the banking supervision business.

And compounding the bank supervisory sin, was the chutzpah/hubris displayed by the then FDIC Director of Supervision and Consumer Protection, Sandra Thompson, in her unapologetic three short paragraph (!) response to the MLR.

If I were a FDIC attorney, well-schooled in the legal doctrine of contributory negligence, my supervisor would have to be pointing a gun into my back to get me to walk into a courtroom in this case.  But walk in, the loyal, dedicated FDIC attorneys did - into a judicial buzz saw.  Now we have blood and guts everywhere.

There are (at least) two big issues that stem from Judge Terrence Boyle's dismissal of the FDIC's director liability lawsuit in this case.  The first, is the widely-publicized battlefield victory for community bank directors under the judge's generous interpretation of the North Carolina business judgement rule.  The second, drowned out in the applause by advocates for bank directors, is how this decision, if ultimately upheld, could impact the mechanics and dynamics of the bank examination and regulatory enforcement process going forward.

This National Bank Examiner blog post (Part 1) is devoted to the milestone for community bank directors.

The next National Bank Examiner blog post (Part 2) will be devoted to the millstone created for bank examiners and the bank supervisory process going forward.  Specifically, the need to address the structural flaws in the Uniform Financial Institutions Rating System (UFIRS), in terms of clearly delineating today's immediate problems from today's risks (tomorrow's problems) in its CAMELS Composite and component ratings.   The UFIRS has been held together with duct tape since it was issued thirty-five years ago in 1979... in the olden days before risk-based bank supervision.

And second, balancing standardized calibrated escalation of adverse examination findings with the boundaries of examiner/field office discretion and latitude in using moral suasion as a bank supervisory tool.  An issue that, I believe, the Office of the Comptroller of the Currency (OCC) has ably dealt with in its Matters Requiring Attention (MRA) Reference Guide

But first, the milestone:


A Battlefield Victory for Community Bank Directors

In an article published by the American Association of Bank Directors (AABD) titled Bank Directors in North Carolina and Elsewhere Breathe a Sigh of Relief, the author emphasizes that the court did not find self-dealing, fraud, or any other conduct that might constitute bad faith.  Moreover, the court found that the board of directors employed a rational decision-making process, even though (as in all bank decision-making) there clearly were risks involved.

The court, in its statement, states:

"Under the [North Carolina] business judgment rule, there can be no liability for officers and directors even when "a judge or jury considering the matter after the fact, believes a decision [my emphasis] substantively wrong or degrees of wrong extending though 'stupid,' to 'egregious' or 'irrational,' ... so long as the court determines that the process [my emphasis] employed was either rational or employed in a good faith effort to advance the corporate interests."

"... The record can simply not support a finding that the defendants' business purpose fell so far beyond lucid behavior that it could not even be considered "rational."  Although there were clearly risks involved in Cooperative's approach, the mere existence of risks cannot be said, in hindsight, to constitute irrationality.  Further, corporations are expected to take risks and their directors and officers are entitled to protection from the business judgment rule when those risks turn out poorly."

The AABD article continues:

"In fact, the court cited prior regulatory CAMELS ratings of “2″ for management, asset quality and market risk sensitivity as proof that the board had followed a rational process in its decision-making. That is, inasmuch as the examiners (banking experts) gave the bank satisfactory ratings after examining the details of management’s decisions on loan applications and other business matters, directors (who are not experts equivalent to examiners) should appropriately presume that their overall supervision of management and bank operations was acceptable to the regulators."

Tagging Bank Directors with the Power of Infallible Prophecy

It's worth sharing Judge Boyle's finding regarding the FDIC's claim that "the 'Great Recession' was not only foreseeable, but was actually foreseen by the defendants."  For the purpose of brevity, I've only redacted the bibliographical references.

"The Court discusses this claim only due to the absurdity of the FDIC's position. 

The FDIC relies on several pieces of evidence to support its claim that defendants foresaw the downturn in the economy as early as October 2006.  However, it ignores the unique historical factors happening at the same time including numerous economists and economic forecasters' prognosis of a strong economy going forward at that time.  See e.g. Chris Isidore, Goldman's chief to take on Treasury, "While that pace of growth is widely expected to slow, many economists see the economy remaining strong .... ").  Even as late as April 2007, the United States Treasury Secretary was pushing the idea that the economy was strong and healthy and that the housing market had reached its bottom.  Further, throughout 2007 and into 2008, North Carolina and national economists continued to publish upbeat economic forecasts.

 After the fact, Federal Reserve Chairman Ben Bernanke observed that "a 'perfect storm' had occurred that regulators could not have anticipated," and former Chairman Alan Greenspan confessed that "it was beyond the ability of the regulators to ever foresee such a sharp decline."   Further, the Federal Crisis Inquiry Commission has concluded that "[c]laims that there was a general failure of risk management in financial institutions or excessive leverage or risk-taking are part of what might be called a 'hindsight narrative."

In sum, the FDIC claims that defendants were not only more prescient than the nation's most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans. Such an assertion is wholly implausible. The surrounding facts, and public statements of economists and leaders such as Henry Paulson and Ben Bernanke belie FDIC's position here." 

And Then There's the Bigger Picture - Disparate Treatment

"It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered to be "too big to fail.".  Taking the position that a big bank's directors and officers should be forgiven for failure due to its size and an unpredictable economic catastrophe while aggressively pursuing monetary compensation from a small bank's directors and officers is unfortunate if not outright unjust."

The FDIC filed an appeal on October 2, 2014

Required Reading:
 Strategy and Risk Oversight

for Bank Directors

You can easily imagine many community bank directors, usually outside independent directors, saying:

"You know, I get the theory of risk management in banking, and yes, I understand and appreciate the 50,000-foot level sermons about risk, and sure, I'm slowly learning the jargon of the craft of risk management; but I still have an important question --- What practical actions should I personally be taking regarding risk oversight at my meetings of the bank's board of directors?"

To help answer that question, I came across a really terrific article titled Strategy and Risk Oversight, written by Charles Thayer, in the September 2014 issue of the Western Independent Bankers Directors Digest newsletter.  Besides being Chairman Emeritus of the American Association of Bank Directors, Charles is a highly respected banker with a long track record in the industry.  He is a prominent thinker and frequent speaker on issues of bank corporate governance.  

Being a bank director himself, he knows how the talk walks.

It's been said that wisdom is knowledge leavened with the lessons of practical experience.  It was applause-inducing to see Charles share his perspectives and weave the various lines of the risk oversight melody into a harmony of actual board-level practice.  His article deserves broader distribution.  Not an ounce of fluff in it, but a ton of value.

The link to the article is here: Strategy and Risk Oversight and a .pdf copy is here.

The link should work just fine, but unfortunately, some corporate IT firewalls will block access to the .pdf copy.

A Freudian Blip

There is a qualitative difference in the mentality and set of business values between practitioners of traditional international finance and those involved in what's called offshore finance.  Offshore finance takes place at the outer margins of the financial world and its proponents tend to take, let's say, a more expansive and elastic view of the generally-accepted concepts of legal and ethical behavior.

Where mainline international finance would shy away from unsavory and shady, but technical legal activities, the high priests of offshore finance use this gray-area of finance as the foundation for their industry.  The worst of the offshore players actually cross the line into facilitating illegal activities.

This very real distinction between the two is steadily being eroded, however, as international finance and offshore finance are increasingly being conflated and bleed into each other in certain mainstream international banking centres (not misspelled).   And in very recent and high-profile ways, this is getting some very large global banks into a costly heap of legal trouble. 

So it is with much dismay that I came across this piece, a couple of weeks ago, from FitchRatings: "Branch Resolution May Disrupt Credit Hierarchy".  The analysts at Fitch decided to use the recent seizure, by the Central Bank of Cyprus, of the Cyprus branch of  Tanzania-based FBME Bank Ltd. to make a broader point about the impact of host-country branch resolutions on the interests of bank creditors generally.  

"The ability of a local regulator to resolve foreign bank branches can lead to unequal outcomes for same-ranked creditors, and complicates cross-border resolution, Fitch Ratings says. Branch resolution rules in many countries including the US and EU can create a "first mover" incentive that may make orderly cross-border resolution more challenging.

The resolution of the Cypriot branch of FBME (not rated), a Tanzania-based bank, on 21 July under the domestic bank resolution law is an example of a national regulator independently placing a foreign branch into resolution. The branch was put into resolution by the Cypriot authorities after being named by the US Treasury as a "foreign financial institution of money-laundering concern". We believe the prospect of branch resolution has wider significance, even though FBME's circumstances are specific to that bank."

Now, wouldn't you think that there just might be an 'abetting suspected transnational criminal enterprises' exception to Fitch's macro-prudential global financial stability concerns when it comes to shutting down or "ring-fencing" host-country bank branches?

There is no moral equivalence between efforts to fight crimes, like money laundering and terrorist financing, and macro-prudential financial stability concerns.  The Fitch piece, in my opinion, is only making an indirect point that host-country pursuit of suspected criminal enterprises, could have an adverse impact on people or entities they owed money to.

Read this excerpt from FinCEN's announcement on this rogue offshore bank to get a feel for today's burst of high dudgeon:

 “FBME promotes itself on the basis of its weak Anti-Money Laundering (AML) controls in order to attract illicit finance business from the darkest corners of the criminal underworld.” said FinCEN Director Jennifer Shasky Calvery. “Unfortunately, this business plan has been far too successful. But today’s action, effectively shutting FBME off from the U.S. financial system, is a necessary step to disrupt the bank’s efforts and send the message that the United States will not stand by while financial institutions help those who intend to harm or threaten Americans.”

FBME’s business model is based on its weak AML controls. FBME changed its country of incorporation numerous times, partly due to its inability to adhere to regulatory requirements. It has established itself with a nominal headquarters in Tanzania. However, FBME transacts over 90 percent of its global banking business through branches in Cyprus. Finally, FBME has taken active steps to evade oversight by the Cypriot regulatory authorities in the recent past.

FBME openly advertises the bank to its potential customer base as willing to facilitate the evasion of AML regulations. In addition, FBME solicits and is widely recognized by its high-risk customers for ease of use. These facts, taken in concert with FBME’s extensive efforts over the years to evade regulatory oversight, illustrate FBME’s willingness to service the global criminal element."

This is the tame version of the FBME saga.  Read FinCEN's Notice of Findings for some real eye-opening details.  Any sympathy one might have for mainstream international banks, who may have processed transactions involving this alleged miscreant bank, should quickly evaporate.

In my opinion, the analysts at Fitch picked a poor example for a segue into their topic.  One would think that this FBME situation would be cause to congratulate government authorities, both in the U.S. and Cyprus, for being the sentinels of the reputation of international finance.

Given that this piece was issued during the European vacation season doldrums, when copy editors might have been sunning themselves in the Costa del Sol instead, the folks at FitchRatings might consider asking for a Mulligan.



Putting the Duel Back Into the

 Dual Banking System

In January, the Office of the Comptroller of the Currency (OCC) released a Notice of Proposed Rulemaking (NPR) to amend the existing 12 CFR 30 - Safety and Soundness Standards by establishing a set of formal safety and soundness standards specifically for national banks with total assets greater than $50 billion.  These proposed safety and soundness standards (called Appendix D) are based on the OCC's heightened expectations program.  The NPR also establishes explicit and enforceable standards for oversight by the boards of directors of these banks.  The public comment period is over and the OCC is digesting the responses received from the banking industry and the public.

The heightened expectations program was established to strengthen the governance and risk management practices in the OCC's largest national banks.  The gist of the heightened expectations program is that corporate governance and risk management practices in our nation's largest national banks need to be "strong", not merely "satisfactory".

Since the Federal Reserve and FDIC, federal regulators of state-chartered member and non-member banks respectively, have not followed the OCC's approach, it's probably safe to infer that they have staked their institutional expectations for bank corporate governance and risk management somewhere along the continuum between "satisfactory" and "strong", either in a blanket sense or on a bank-by-bank basis.  The potential liability to the boards of directors of these state-chartered banks are those already outlined in existing law, regulation, guidelines, and common law precedent.

With his effort to codify these safety and soundness standards in federal law, the Comptroller of the Currency has thrown down the gauntlet; metaphorically giving a glove slap to the faces of  regulators of the largest state-chartered banks, by implicitly fingering them as the bank supervisory custodians of lower (or at least unexpressed) expectations.  In more chivalrous days, such a derision of someone else's bureaucratic character would set the stage for an old-fashioned duel.

Except in this case, the Comptroller of the Currency will be holding a pistol with its barrel bent downward at a 90-degree angle, so that in whichever direction he points that pistol, he is likely to shoot himself in the foot.

Don't get me wrong, I am a big supporter of the OCC's effort to codify enforceable best-practice standards and install real accountability in our largest banks through the mechanism of heightened expectations.  See my previous blog posting - Strong Coffee and Weak Tea   But upon reflection, I now also strongly believe that doing so outside the forum of interagency cooperation, without an accompanying policy statement signifying interagency consensus, is the grandest of follies.  It could foreshadow a seismic change in the distribution of federal- vs. state-chartered banks among the population of banks with assets greater than $50 billion... a group small in number, but immense in banking marketplace presence.

At the present time, about two-thirds of the group have federally-chartered lead banks with the remainder having state-chartered lead banks.  Under the Comptroller's current informal version of his heightened expectations program those national banks are already being held to those higher expectations through the moral suasion exerted through the ongoing bank supervision process.  

The remaining banks in the group, the state-chartered banks, are not under the jurisdiction of the OCC and are therefore not subject to the heightened expectations program.  These state-chartered banks operate under governance standards presently outlined in law, regulation, and individual state or Federal Reserve or FDIC examination handbook guidelines.

The recent talk of Washington, among the Illuminati inside-the-beltway, has been the popularity of what have been called "tax inversions".  Where U.S. corporations are changing their tax domicile through mergers with other corporations in overseas jurisdictions with lower income tax rates; arbitraging their taxing authorities and thereby lessening their income tax burdens.  Something similar, onshore regulatory arbitrage, could happen if the Comptroller's heightened expectations guidelines are adopted in the Code of Federal Regulations without an explicit interagency policy backstop.

First, simply switching from a federal to a state bank charter in your home state makes the Comptroller's heightened expectations program go away - poof!  Second, as the "tax inversion" proponents have demonstrated, you do not have to move your operations to move your official corporate domicile.  In fact, there are many banks today where their official headquarters are in one city or state, while their corporate officers live and work elsewhere.  So the potential exists not only to convert to a state bank charter, but also to select any state bank regulator willing to roll out the Welcome Wagon in the states where the bank already has an established branch presence.

The latter option might even be attractive to those national banks with corporate domiciles in New York State.  In the State of New York, given the recent banker-bashing pyrotechnics by state officials, the state-level regulatory arbitrage calculus is more complicated... on one hand, there is the fire, and on the other hand, the frying pan.  By moving a corporate domicile to a different state and changing the home-state/host-state equation, the 1997 Nationwide Cooperative Agreement (signed by all state bank regulators) kicks in and at least the prospect exists for the state-level regulatory dynamics to change significantly.

The bane of bold leadership is that the Comptroller of the Currency becomes, by definition, a pioneer.  Pioneers were an important part of what made this country great.  But every pioneer weighed the implications of go-it-alone leadership against the benefits of collective action.

As hard and frustrating as the interagency agreement process can be, the OCC needs to push harder for an interagency policy statement on this topic because the ramifications of going-it-alone could radically change the present stasis in the balance of the dual banking system and put OCC on a slippery slope of becoming less relevant.  As the old saying points out, sometimes the lone pioneer is the guy lying face down in the mud with an arrow in his back.

Is the Show About to Start?

The banking industry and its observers have been talking about it since the U.S. officially emerged from the financial crisis and the follow-on Great Recession --- When are interest rates going to begin to normalize and, given that we used several novel (and untested) monetary policy tools in the U.S., will the path to interest rate normalization be fraught with unanticipated negative consequences for the banking industry?

The government-administered suppression of short-term interest rates through the Federal Reserve's Zero Interest Rate Policy (ZIRP) and its half-nelson push-down on rates along the longer end of the yield curve through three cycles of quantitative easing (QE) seems to be coming to a close.  The Federal Open Market Committee's (FOMC) own consensus projections show 2015 as likely to herald the first upticks in the federal funds rate in many years.

After seeing a significant drop in the headline unemployment rate over the last year to 6.1% (busting through Ben Bernanke's 6.5% reference point), last week Fed Chairman Janet Yellen, in congressional testimony, uttered a phrase - a  caution really - that should reverberate in the sanctums of bank Asset-Liability Committees (ALCOs) across the globe:

“If the labor market continues to improve more quickly than anticipated by the Federal Open Market Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid [my emphasis] than currently envisioned,”

Also trying to make the case that the old show might soon be over and that the new show might be potentially surprising, are the respected intellects at Cumberland Advisors, who noted in a recent analysis piece - "Tapering is Now Tightening", that beginning this month, Federal Reserve System purchases of government debt falls below the volume of monthly U.S. government debt issuance.  The Fed is no longer fully absorbing new U.S. government debt issuance.

In a related piece, entitled "Hope is not a Strategy", they also present the case that the odds of a significant and surprising spike in interest rates, rather than a more interest rate risk-manageable moderate ramping-up of interest rates, may not be inconsequential.

For community banks, the emerging visibility of an interest rate tipping point, is a better news/bad news scenario.  The better news is that macro-structural net interest margin compression may ease up.  Banks have been suffering ongoing and painful net interest margin compression over the last few years, caused largely by the Fed's repression of interest rates, yield curve flattening, and the dropping loan volumes suffered during the economic decline phase of the Great Recession. Thankfully, at least loan volumes are slowly rising again.

This suffering has prompted many community bank boards of directors, particularly those in competitive and price-sensitive geographies, to seriously consider throwing in the towel and trying to sell out.  Rationally thinking that a reasonable return to stockholders in this environment appears out of reach -  at least without taking imprudent risks or taking on the uncertain payback of re-engineering their business models.  The noxious brew of net interest margin compression, flat non-interest revenue, and escalating non-interest expenses - largely due to new (or more forcefully emphasized) regulatory expectations has changed the underlying economics of the small community banking model.

It's only small consolation to the average community bank that there was a partial offset to margin compression via increased liquidity and safety preferences on the part of anxious consumers and businesses.  Surging pools of non-maturity transaction deposits helped lower the interest expense side of the net interest margin equation.

Enter the latest Semiannual Risk Perspective recently issued by the Office of the Comptroller of the Currency.  Unlike its previous editions, where its counsel regarding interest rate risk could be likened to a yellow flashing caution light; the tone of the current edition changes to a red flashing warning light - stop and look both ways before proceeding.

Previous editions of the Semiannual Risk Perspective repeatedly warned community banks against engaging in what I'll call "down and out banking" - attempting to increase asset yields by moving down the credit quality scale to fund less-creditworthy obligors and by moving out along the yield curve by extending maturities in order to capture incremental yield.  In one case, as rising rates impact variable-rate portfolios (or short maturity fixed rate), it's a formula for transforming interest rate risk into credit risk as marginal borrowers cope with the stress of higher debt service requirements.  In the other case, you flirt with underwater securities portfolios and the liquidity and credit-risk issues that come with the territory.

The Semiannual Risk Perspective makes a teachable moment out of this by highlighting a couple of sobering statistics - National banks with less than $1 billion in total assets have increased long-term asset concentrations from 17% in 2006 to 31% at year-end 2013 --- almost a doubling.  And by the way, that's an average.  I'd love to see the median long-term asset concentration and the range, so that we could get some visibility about where the top half lives.  Any call report data miners out there?

Moreover, strong deposit inflows, uneven loan growth, and net interest margin pressure has created a situation where the growth in investment securities portfolios in those same banks has been centered in mortgage-backed securities - creating the potential for duration extension in a rising rate environment.

And let's not forget the bank capital management gymnastics that will come from the new capital rule effective January 1, 2015.  Smaller banks have a one-time, irrevocable option to neutralize certain Accumulated Other Comprehensive Income (AOCI) components - essentially unrealized gains and losses on available-for-sale securities.  If the option is not selected, AOCI will be incorporated into the Common Equity Tier 1 capital ratio.

This AOCI neutralization creates both "shadow capital" - market value gains that could be converted into measured regulatory capital at the expense of the future income stream - and "shadow losses" - market value losses that could erode measured regulatory capital if liquidity or other risk management imperatives forced the unexpected disposition of some, or all, of these available-for-sale securities.  This "shadowy" regulatory capital treatment needs to be incorporated into real world capital planning, including in stress test scenarios.

Lastly, there's the issue of  "The Surge" in non-maturity transaction deposits and how elastic those balances will be in a rising interest rate environment.  Historical balance analysis has only limited benefit as we are in uncharted waters here.  In a ZIRP and QE environment, there is little opportunity cost to a consumer or business to keeping a boatload of cash idle in a transaction account at a bank.  That equation changes in an interest rate normalization scenario.  How it changes remains to be seen.  But one thing is probably sure, human nature tends toward the hopeful outcomes in life and probably in interest rate risk modeling too... and as the folks at Cumberland Advisors mentioned - hope is not a strategy.

For important background regulatory guidance documents on interest rate risk, please consult the 2010 interagency Advisory on Interest Rate Risk Management and the 2012 update Frequently Asked Questions.

Note to Readers:  Thank you for bearing with me during this period of radio silence on The National Bank Examiner blog.  Under the theory that two tires on the same axle go bald at a similar rate, I had to have surgery to replace my other hip joint.  Result: a wonderful success.  Goodbye to the chronic pain of arthritis.  Thank you, Dr. Courtney Sherman, of the Mayo Clinic in Jacksonville, Florida!

Footnoting Bank Supervision

Consider this press release from the Board of Governors of the Federal Reserve System,  the press release from Cullen/Frost Bankers, Inc., and this story in the San Antonio Express-News discussing the Fed's Order approving the acquisition of WNB Bancshares of Odessa, Texas by San Antonio, Texas-based Cullen/Frost Bankers, Inc.   

At December 31, 2013, WNB Bancshares had $1.5 billion in total assets and Cullen/Frost Bankers, Inc. had $24.4 billion in total assets.  This small acquisition would grow Cullen/Frost Bankers, Inc.'s total assets by only about 6%.

What catches your eye, tickles the antennae, and raises questions is footnote 33 on Page 19 of the Fed's merger approval.  It states:

"Cullen/Frost has committed not to engage in any expansionary activities, including branching within its existing market areas, until such time that the Board has deemed Cullen/Frost to have clearly developed a policy to support future expansion in its compliance program, including fair lending [my emphasis], and to hire additional staff with requisite knowledge and experience to manage and control the bank’s fair lending risk, which might be heightened by expansion." 

Now, if all factors were deemed satisfactory (the approval Order raises no compliance issues), why would the Fed even insert that footnote requiring the agreement of the bank to immediately refrain from any expansionary activities?   Not even one measly strip mall or street corner branch until the bank 'ups its game' in the area of compliance risk management, including the area of fair lending.  "No (more) soup for you!" as the old Seinfeld show character would say.

And what sets the mental klaxons sounding and sirens wailing is that one of the compliance management issues raised is fair lending.  Any bank examiner knows that fair lending is an electric and radioactive compliance issue - one of the few third rails of compliance supervision.  So much so that it ranks as high, or higher, on the compliance scale than another high profile compliance issue - Bank Secrecy Act/Anti-Money Laundering (BSA/AML) compliance.

Bottom line, you just don't raise the hypersensitive issue of fair lending and not be expected to explain, in detail, why you demanded this stand-still commitment from the bank.  The Fed has not offered an explanation and, so far as I know, no one in authority has requested one.

Direct talk (and action) by the Fed has been supplanted by oblique and hazy references coupled with a significant corporate commitment to refrain from further expansion, all buried in a footnote on page 19 of the approval Order.  The Fed's press release introduction doesn't even mention it.

The folks at the Fed in Dallas and Washington ought to be looking sheepishly down at their shoes; they lost bank supervision style points on this one.  I just hope that the Fed's new Large Institution Supervision Coordinating Committee (LISCC), which has bank supervision responsibility for our nation's systemically important financial institutions, doesn't contract this same malady.  The Captains of Finance, black-eyed and bloodied from years of public floggings a more direct approach to bank supervision, surely noticed this little gem.

Time for Bank Charter Reform?

Credit: "Plato's Cave" Kombo Chapfika, 2008

This week's superb article in the New York Times, Loans That Avoid Banks? Maybe Not  is notable not only for its content and analysis, but also for signaling modern implications for the basic existential question in our industry, "What is a bank?"

The triptych above entitled "Plato's Cave" gives a surrealistic interpretation to Plato's famous Allegory of the Cave (summary here).  The allegory's general concepts can be applied to the question: "What is a bank?" in the sense that we see the world  through a personal frame of reference and a collective frame of reference.  We also see that world through lenses that could be characterized as plain sight, microscopic (seeing things close up), telescopic (seeing things from a distance), and panoramic (the shape and spirit of the times we live in).  Because we perceive the world we live in through these various frames of reference and lenses, we are always challenged by the difficulty of distinguishing between what is apparent and what is real.

For example, the usual and customary way of sizing and ranking banks in the U.S. is by total balance sheet assets or total deposits.  That traditional way of sizing banks stems from our legal and accounting frame of reference about the form of a bank - cash, investments, loans, premises, deposits, borrowings, shareholder capital at risk, and a charter granted by a government authority.

A banker friend of mine in Miami, the Americas director for a large European bank, has for years sized and ranked his "bank" in the Florida marketplace as the sum total of the balance sheet assets of the subsidiary U.S. commercial bank, the parent's foreign branch in Miami, and the assets under management (AUM) of both entities.  In other words, in his formulation of bank size, the bank is the sum total of all of its customer-facing touch points... its spheres of financial marketplace influence.

My friend's sizing of his bank's presence in the Florida marketplace expands upon the formal and traditional definition of a bank by changing the frame of reference for his banking operation to be more aligned with the functions of a banking intermediary.  In a broad sense, a bank applies expertise (knowledge capital), technology, and, when necessary, their proprietary financial capital in a manner which meets the financial services needs of providers and users of funds in the marketplace.

The functions of banking can be exercised in several ways; first, by traditionally-defined bank financial intermediation where deposits are taken and bank credit is extended using the proprietary capital of the bank to absorb all risks; second, it can also be exercised via advisory or fiduciary services where the application of expertise is fee-compensated but non-operational risks are borne by the funds provider, or lastly, it could exercised through fee-compensated, customer-directed transaction services such as payments processing.

By changing the frame of reference about what is a bank, you, in essence, change how you view, plan, respond to marketplace developments like web-based crowdfunders, such as Prosper or Lending Club, or payments innovators, like PayPal, Bluebird, or virtual currency creators.

Certain observers of the peer-to-peer lending landscape, for example, have characterized the activity as a major threat to the banking industry - Too Big to Disintermediate? Peer-to-Peer Lending Takes on Traditional Consumer Lending   And as long as bankers consider this activity as separate from their existing preconceptions about the form of a bank, peer-to-peer lending could indeed be considered a growing threat.

But if bankers consider the activity consistent with the function of banking and treat it as a logical, technology-driven evolutionary development in the growth of banking itself, significant opportunities abound.  The opportunity to embrace it, subsume it, and add it to your menu of banking services is there.  

Some banks, like Titan Bank of Wells, Texas, BBVA Compass, and Congressional Bank of Bethesda, Maryland are dipping their toes in the water and are taking what are being characterized as small, calculated risks through partnerships with existing peer-to-peer lenders.

In an ideal government setting, however, the legal form of the banking charter granted by that government would slowly follow the evolving functions of banking in the financial services marketplace, so that proper and consistent prudential and consumer protection regulation can be applied to all providers of the same financial services.

In the United States, the powers granted by a bank charter are explicitly grounded in the Federal enabling legislation for federally-chartered banks.  Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), state-chartered banks are limited to the powers granted to federally-chartered banks, unless the FDIC approves exceptions on a case-by-case basis.

The time may be ripe for some bank charter reform.  While the political will is lacking, the mechanics of legislative bank charter reform could be as uncomplicated as changing the word "and" to "or" in a few places, and revisiting the corporate powers of national banks in 12 USC 24, including the incidental powers provision.

This would provide bank regulators a green light to cast the net wider and say to certain players in the shadow banking community, your activities are identical to, or closely resemble, what we have now legally defined as "banking".  You must now obtain a state or federal bank charter to conduct your business.  The result being, taking some of the "shadow" out of the new technology-driven shadow banking models.

There are some who have mused that shedding the traditional "strict constructionist" mindset of the existing national bank charter definitions and showing an innovative, well-reasoned and plucky application of administrative discretion, Tom Curry, the present Comptroller of the Currency and the chartering authority of federally-chartered banks, could obtain a roughly similar result.

Though he approached a similar issue from a completely opposite direction (deregulatory), does anyone still remember the feisty Comptroller C. Todd Conover and the "non-bank bank" controversy of the 1980's?

None of these new Web 2.X entrants into the shadow banking arena, at this point, present the kinds of macro-level financial stability concerns that would snare them into the orbit of the Financial Stability Oversight Council (FSOC) and thereby subject them to prudential supervision by the Board of Governors of the Federal Reserve System.

But their presence does undermine the concept of "competitive equality" in the marketplace for financial services.   Ideally, all providers of similar financial services should compete on as level a playing field as possible.  That includes all bearing the weight of their regulatory obligations equally.

The growing divergence between banking's legal form and de facto function, if left unchecked, will leave today's banking charter a slowly atrophying and increasingly irrelevant animal; condemned to living out its days in its own sad, dilapidated version of Jurassic Park.  Quaint specimens existing to help inform the world-view of historically-inquisitive visitors.

Stressed Out!

Credit: American Banker

The chart (above) comes from an engaging article by Victoria Finkle in the American Banker entitled Fed's Dodd-Frank Stress Test Results a Mixed Bag for Banks.  The chart lists the Dodd-Frank Act large bank stress test results under the Federal Reserve's most severe adverse macroeconomic and marketplace scenario.

A few observations... First, among these 30 large banks, the adverse scenario stress testing results vary widely.  Second, although almost all "passed" the adverse scenario stress test standard, you can see a significant variance in the degree of vulnerability among the players in the group.  Third, in an efficient market, (hopefully) those vulnerabilities would be reflected in the share prices of these banking giants.  Shares of banks with fortress balance sheets, relative to their peers, should command higher premiums.

Let's read the entrails of these large bank stress test results and talk about a "message within the message" as it relates to a totally different group of banks - community banks.  In particular, the role of stress testing in the context of the rapidly increasing pace of community bank merger and acquisition (M&A) activity over the last few months.

How many potential acquirors use adverse scenario stress testing to determine if a vulnerability discount needs to be included in the list of valuation "marks" when doing due diligence and determining an offering price?   ... particularly if folding in the target bank would weaken the pro-forma combined banking operation in an adverse scenario stress test.

How many potential community bank acquirees fail to include an adverse scenario stress test vulnerability premium  if the bank they are selling is contributing to the strengthening or fortification of the pro-forma combined banking operation in an adverse scenario stress test?  ... particularly if the purchase transaction involves an exchange-of-shares component.   Do you, as a seller, want to leave significant shareholder value potentially unaccounted for and left on the table?

How many potential community bank deal-makers are even looking at adverse scenario stress testing in the due diligence process?  How many model severe adverse scenarios through the balance sheet and P&L of the target bank or model those same scenarios through the pro-forma balance sheet and P&L of the proposed combined banking operation?

Sure, there's the loan, investment security, premises, etc. "markup/markdown" process on both sides of the target bank's balance (and off-balance) sheet, but those are generally in the context of conditions as they exist today.  Marks will likewise be adjusted for as-of date credit quality and possibly risk-adjusted so that those numbers account for required regulatory capital set-asides.  Interest rate risk given vaguely-defined directional assumptions about the term structure of interest rates might also be reflected.  But do the due diligence marks and external macroeconomic and marketplace variables come together in a structured, data-driven stress test?

If so, you wouldn't know it if you read the community bank M&A deal press releases.  These proclamations always seem to fit the same old M&A template - price-to-book value, price-times-earnings, earnings accretion timeframes, cost savings claims, the scope of the geographic footprint, leveraging talent, and, oh yeah, those deliciously vague "synergies".  Remember the definition of synergy from business school?  The whole is greater than the sum of its parts (e.g., 2 plus 2 equals 5).

In the fields of science and mathematics, the opposite of synergy is dysergy. Without solid adverse scenario stress testing in the due diligence process, a bank acquiror may be flirting with dysergy.  In the banking arithmetic we old-timers were taught, 2 minus 2 equals "you are now out of capital".   In dysergistic banking terms, the hole is deeper than the remainder of its parts (e.g., 2 minus 2 equals "a hole deeper than you ever imagined").

How do you integrate adverse scenario stress testing into the community bank M&A due diligence process?  Accept and internalize the fact that stress testing is more than a "best" or "helpful" practice, it is a core analytical competency for those community banks bent on acquisition or open to it.

Guidance and tools are available.  For example, the Office of the Comptroller of the Currency (OCC) provides excellent guidance to federally-chartered national banks and savings associations in two key guidance documents:  Community Bank Stress Testing:  Supervisory Guidance (OCC 2012-33) and Guidance for Evaluating Capital Planning and Adequacy (OCC 2012-16).  Though their requirements are targeted to federally-chartered depository institutions, the underlying concepts are fundamental, universal and generally applicable.

The OCC also provides national banks and federal savings associations access to specific stress testing tools for agricultural loans, acquisition & development loans, individual commercial real estate loans, and a portfolio commercial real estate stress test through its secure web site BankNet.  In addition, OCC's district and national experts are available for technical consultation and are only a phone call away.

Professional support is also available from other sources, including other bank regulatory agencies and trade associations.  There are professional services firms who use call report data to do rough, but reasonable, stress test modeling.  Others use defined data-sets from commonly-used vendor operating platforms.  Others offer true stress test customization at a higher price.

Adverse scenario stress testing should be part of your community bank M&A due diligence "to-do" list and part of your proforma combined operation modeling.  Wise buyers and sellers ought to be adding vulnerability premiums or a vulnerability discounts to pricing models to holistically account for risk, support capital planning objectives, and buttress strategic contingency management imperatives.

Banks are Social Networks

You might wonder what went through the mind of James W. Marshall, who discovered a gold nugget in the American River on January 24, 1848.  It's doubtful that he fully realized that his discovery would set set off the great California gold rush and the hordes of "49-ers" who would jump start the fortunes of what would shortly become the great State of  California.

Roll the clock forward to early 21st century Silicon Valley, California and what Wikipedia calls Web 2.0 - the second stage of the development of the World Wide Web - characterized especially by the change from static web pages to dynamic or user-generated content and the growth of social networking.  Today, we are living through Web 2.0's own evolution: Mobile Web 2.0 - services that integrate the social web with the core components of mobility - personal, localized, always-on, and ever-present.

The list of these Web-based social networks, though presently dominated by the likes of Facebook, Twitter, and LinkedIn, is growing continuously.  Each is seeking to add value (and riches to their founders) by metaphorically finding gold nuggets in attractive niches within our global social geography.  In the management consultant lexicon, the sponsors of Mobile Web 2.0 are sorting themselves into well-known commercial categories - scale players, niche players, and the occasionally successful "all-in" risk-takers - the disruptors.

Bankers have not been silent about the rising competitive threats to their industry. The trade publications have long been running warning pieces of the Paul Revere genre ("The British are coming! the British are coming!").  Most pointing out that the banking industry may soon be caught in the middle of a classic military pincer movement... with peer-to-peer lending and crowdfunding threatening the asset side of the balance sheet and the numerous nonbank-sponsored online payments alternatives laying siege to the liability side.

Other authors, like Francisco Gonzalez, Chairman and Chief Executive of the global Spanish bank BBVA, recently raised the starkest of choices:  Banks need to take on Amazon and Google or die.  He warns that banks need to turn to their vast array of accumulated customer data and leverage it to provide customers "exactly what they want, precisely how and when they need it."

Even others, like the recent article, The Next Big Thing You Missed:  How Starbucks Could Replace Your Bank, focus on the creeping encroachment of bank-like services like prepaid card channels and Lego-like snap-together banks, like Simple.

Almost everyone in the industry is raising red or yellow flags about what I'll call an emerging synthetic banking system.  Don't even bother to paint the emerging competition as "shadow banks", these "synthetic banks" are perfectly prepared to fight hand-to-hand combat in the bright sunshine of both Main Street and Wall Street.

Unfortunately, the odds may favor the invaders over time, as they have neither the ponderous weight of government banking regulation, nor high sunk-costs in legacy operations.  Akin to that of ancient Rome, the invaders may also be aided by the inertia of our industry's business culture - where, inevitably, denial always precedes defense.

What's a classic bank to do?  The famous general Sun Tzu, in his classic The Art of War, advised "Know yourself and you will win all battles".  That self-knowledge should begin with the fact that fundamentally:  All banks are social networks.  Your customers are to you, like "followers" are to Twitter, or  "connections" are to LinkedIn, or "users" are to Facebook.  Your customers are networked to your bank because they have chosen you as a trusted advisor and provider of needed financial services.

In the present stage of the banking industry's Mobile Web 2.0 development, the bulk of the emphasis has been on non-social, vertical networking (bank customer-to-bank).  Because we are talking about confidential financial affairs, this vertical communications channel is both "armored" and "hardened" to provide the requisite account privacy, security and other safeguards.  Within the armored and hardened vertical communication channels, many banks are making great strides in improving customer engagement and loyalty to the bank.

There is also a non-armored and non-hardened part of the vertical (bank customer-to-bank) communication channel that passes for social networking by many banks - the Twitter, LinkedIn, and Facebook fluffy marketing stuff, non-specific customer assistance, financial literacy education, public service announcements, and those happy, giggly posts like "It's Friday, we here at AnyBank want you to have a terrifically enjoyable weekend!"

That's a centralized customer communications model that talks "at" people and not really "with" people.  There is an audience lurking, but unfortunately not interacting among themselves, within 'the social network that is a bank'.

Where is the horizontal (bank customer-to-bank customer) networking?  I'm talking about the kind of horizontal networking that makes the social networks (like Twitter, LinkedIn, and Facebook) so popular and highly-used?  Where is the bank customer-to-bank customer horizontal communication interactions on financial or business topics of mutual or common interest?

If you don't think it is possible to have business-like social networking, just look at the success (and soaring stock price) of LinkedIn.com.  Horizontal social interaction is where 'the social network that is a bank' is not being profitably leveraged enough to check the competitive pressures from both banks and nonbank/synthetic banks.

How can a bank build revenue from these horizontal social interactions?  Consider the power of lightly-moderated online forums.  Let's take for instance, and for the sake of discussion, your neo-entrepreneur customers who run innovative internet-based or "brick-and-click" businesses.  They share a common social bond as far as the operations of their businesses are concerned.

In a lightly-moderated online forum, you would have customers sharing thoughts, ideas, and problem-solving among other people with common business interests and who also share a common financial product provider (remember they are already your bank customers).  This pool of horizontal online social interactions provides an avenue to promote the availability of the bank's credit, payments, treasury, and investment/wealth management services opportunistically in the context of the shared business needs of a specific customer segment.

Moreover, it's also an excellent opportunity to refer customers to vetted outside professional services providers... some of whom may also be (now very grateful) bank customers.  Lastly, it also provides valuable customer feedback on the quality of your own banking products or may reveal gaps in your menu of financial product offerings.  Therein lies the untapped potential of a true social network.

Add a high-touch component to the high-tech approach with occasional physical social events over coffee and snacks, luncheons with guest speakers, or wine-and-cheese evenings to further cement a sense of affiliation and relationship with the bank.

By verticalizing confidential personal financial matters in armored and hardened channels and horizontalizing social interactions among bank customer segments with common interests, both virtually and physically, you have the potential to capture some share of that person-to-person networking allure that the Facebooks, Twitters, and LinkedIns presently offer.

Thinking about your bank as a social network is not a cure for the constant competitive pressures coming from the emerging synthetic banking system, but not losing yardage (and hopefully gaining yardage) can keep you in the game.

Officially Distorted

 

Recent controversy about the officiating at the Sochi Winter Olympics sparked a thought about how the 2008 financial crisis, and the aftermath we are living in today, have, hopefully, only temporarily distorted the traditional role of bank regulators in the marketplace for banking services.

Historically, as a bank regulator and bank examiner, your job was to calmly officiate in the marketplace for banking services.   As a member of a rulemaking body, subject to statutory guidance and notice-and-comment rulemaking, you helped establish the dimensions of the ball field and rules for player behavior.   In your day-to-day job as a bank examiner, you were also an umpire or referee on the field who monitored player behavior, called out-of-bounds play, and penalized some for personal fouls.  And as a corollary part of the job of officiating, you sometimes had to sideline someone from play or, in grave situations, ask the Federal Deposit Insurance Corporation (FDIC) to carry an ailing player off the field on a stretcher.

The game itself, though, was played by teams of bankers, doing what bankers do well - making a visible contribution to a safe, sound,and prosperous banking system that is earnestly attending to the legitimate credit needs of the most powerful economy on Earth.

Like any sports competition, the fans show up to the game to applaud the performance of the players on the field and appreciate the quality of the game play. None of the fans came specifically to see the game officials... except maybe the spouses, kids, or significant others of the officials themselves.

But you pick up any national or banking trade media publication these days and there are tons of copy tilted toward the topics of regulation, compliance, and policing unsavory banking behavior and only a smattering of news coverage about trends, tools, and techniques for scoring the game's goals.

Every fan knows that when the game's center of attention becomes the officiating, there is something grossly wrong with the game.  The game should be about the bankers and not the officials.  Hell, even the officials on the field, diligently doing their jobs, would  prefer the spotlight shine on the players and the goals of the game itself.   How many bank regulators relish the prospect of being summoned up to Capitol Hill for congressional video replays of every close call they make (or should  have made) in the scrum down on the playing field?

Like the Polar Vortex that brought us one of the chilliest winters in recent memory, the regulatory "Big Chill" on the banking marketplace seems to be showing small signs of a Spring thaw.  Although there do seem to be a couple of exceptions to this hypothesis.... the activities of the Consumer Financial Protection Bureau and the continuing gang-beating of the global megabanks.

First, while there is still much to do on the Dodd-Frank Act implementation, the outlines of major unfinished rules are generally visible, and there are signs that the rulemaking process is beginning to slowly wind down.  Regulators appear to be just as fatigued with this seemingly endless process as the banking community.

Second, bank enforcement actions are being terminated by regulators at a rapid clip as the level, and direction, of bank prudential risk metrics are improving as banks have finally worked through most of their legacy problems.

Third, bank merger and acquisitions (M&A) activity has been popping in the last few months.  Acquisitive-minded  banks have emerged from their financial storm shelters as the climate seems to be more hospitable.  In 2013, the average unasssisted community bank acquisition crept out of the discount-to-book zone and rose to around 1.2X book value and 25X earnings.

Lastly, based on my unscientific poll, bank consultants, on the community bank beat, who practice in the regulatory relations arena are getting fewer phone calls from bankers desirous of those specific services.  Inquiries now tend to tilt towards corporate governance, regulation implementation, expert witness, and due diligence work.

I think if this "Washington Spring" is real, the roles of the players and the officials should start normalizing over the next three years or so.

Like sports officiating, banking regulation and supervision was not meant to be a public limelight and celebrity status area of professional practice.  The public attention should deservedly go to the competitors in the marketplace.  And again like sports officials, their professional satisfaction should come from being tacitly appreciated for the fair, dedicated, and quietly professional execution of their official responsibilities.