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New Basel III Capital Rules Contain Pitfalls for S Corporation Banking Organizations

July 17, 2012

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As the industry gains a greater understanding of the proposed Basel III capital rules, some management teams are identifying potential problems for their organizations in the rules. One such problem is the broad-based dividend restrictions and the consideration of how those restrictions may impact S Corporations.

Many states recognize in their banking laws and regulations that a different set of standards should apply in determining dividend restrictions for S Corporation banking institutions and their holding companies. Because the taxable income of these entities is passed through to the shareholders of the organization, it is expected that these entities will pay distributions that allow their shareholders to fund their personal tax liabilities attributable to the taxable income of the organization.

The proposed Basel III capital rules have a number of dividend restrictions. Most bankers are familiar with the dividend restrictions imposed under Prompt Corrective Action, but the new capital rules also contain dividend restrictions if the organization is not in full compliance with the requirement to maintain the required capital conservation buffer: a requirement for banking organizations to maintain common equity Tier 1 capital equal of 2.5% of total risk-weighted assets in addition to the minimum risk-based capital requirements.

If a banking organization does not maintain the full capital conservation buffer, it becomes subject to restrictions on the payment of dividends and on payments of discretionary bonuses to executive officers. These restrictions increase as the organization’s capital conservation buffer decreases, and if the organization does not maintain a capital conservation buffer of at least 1.25% of risk-weighted assets, it will be able to pay dividends of no more than 20% of its eligible retained income in dividends, subject to receiving a waiver of these restrictions from its regulators. Eligible retained income is defined as the organization’s net income for the previous four quarters, net of dividends and discretionary bonus payments to executive officers during that period.

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FDIC Lawsuits: Avoiding the Worst Outcome

June 26, 2012


While the FDIC lawsuits paint a picture of inattentive, runaway directors and officers, a number of the practices that the FDIC found objectionable could be found at many healthy institutions. 

In the wake of over 400 bank failures since the beginning of 2008, the FDIC is well underway with its process of seeking recoveries from directors and officers of failed banks who the FDIC believes breached their duties in the course of managing those institutions. As of mid-May 2012, the FDIC had filed lawsuits against almost 30 groups of directors and officers alleging negligence, gross negligence and/or breaches of fiduciary duties. While the litigation filed by the FDIC tends to sensationalize certain actions of the directors and officers in order to better the FDIC’s case, there are lessons to be learned.

Some of the take-aways from the FDIC lawsuits are fairly mechanical: carefully underwrite loans, avoid excessive concentrations, and manage your bank’s transactions with insiders. However, there are two major themes that are more nuanced and which are present in almost all of the lawsuits. Those themes relate to the loan approval process and director education.

Develop a thoughtful loan approval process. As evidenced by the recent piece published on, a spirited debate among industry advisors is currently taking place with respect to whether directors should approve loans or not. On the one hand, many attorneys believe directors have a duty to consider and approve (or decline to approve) certain credits that are or would be material to their banks. Regulation O requires approval of certain credits, the laws of some states require approval of some loans, and there is a general feeling among many bank directors that they should be directly involved in the credit approval process. In addition, many bank management teams believe that directors should “buy in” with them to material credit transactions.

On the other hand, the FDIC litigation clearly focuses on loan committee members who approved individual loans that did not perform. This should give pause to directors in general and loan committee members in particular. It is now the belief of many legal practitioners that the practice of approving individual loans when the loans are not otherwise required to be approved by the directors paints a target on the backs of the loan committee members. The FDIC may be able to target directors who participated in the underwriting of a credit (or were deemed to have done so given their involvement in the approval process) when they did not have the expertise necessary to do so. Some practitioners argue that the directors should instead focus on the development and approval of loan policies that place appropriate limits on the types of loans and the amounts that the bank is willing to make. This policy would be consistent not only with safe and sound banking principles but also with the board’s risk tolerance, and it would be appropriate to seek guidance from management and outside advisors on the development of the policy. The idea is that it is much more difficult to criticize a policy than an individual credit decision with the benefit of hindsight.

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New Proposed Capital Rules May Mean the Death of Highly Leveraged ADC Transactions

June 19, 2012

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Many bankers are spending their evenings attempting to work through the very dense and long Joint Notices of Proposed Rulemakings that together propose new capital standards for financial institutions.  Even though the proposed Basel III rules would not become effective until January 1, 2013 and the proposed risk-weighting rules would not become effective until January 1, 2015, bankers need to begin to understand how these rules will affect their capital planning now.  While the regulatory agencies are busily assuring bankers that the vast majority of financial institutions would have been in compliance if the proposed rules had been effective on March 31, 2012, the rules, as proposed, will certainly change how many financial institutions approach their capital planning and asset mixes.

One facet of the rule that may impact many community banks and their borrowers is the proposed risk-weighting of certain commercial real estate (CRE) loans.  While acquisition, development, and construction (ADC) lending has certainly fallen out of favor with regulators and bankers in recent years, many bank boards realize that a part of their long-term success will be a re-entry into this market.  Many lenders are very experienced in underwriting ADC loans and have deep relationships with successful real estate developers.  While bank boards are more cautious with respect to ADC and CRE lending concentrations, continuing to engage in lending activities that have provided good returns over the long-term still makes sense.

The Notice of Proposed Rulemaking entitled “Regulatory Capital Rules—Standardized Approach for Risk-Weighted Assets; Market Discipline and Disclosure Requirements” will apply to all banking organizations other than bank holding companies with less than $500 million in total consolidated assets.  As a part of the new risk-weighting rules, certain higher risk CRE loans will carry a 150% risk-weighting, as opposed to the standard 100% risk-weighting.  Those higher risk loans are proposed to be defined as a credit facility that finances or has financed the acquisition, development, or construction of real property, unless the facility finances:

(1)    one- to four-family residential property; or

(2)    commercial real estate projects in which:

i.    the LTV ratio is less than or equal to the applicable maximum LTV ratio in the agencies’ real estate lending standards (generally 65 to 80%);
ii.    the borrower has contributed capital in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and
iii.    the borrower contributed the amount of capital required under 2(ii) before the bank advances funds and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project (i.e., when permanent financing is obtained).

The proposed rule defines those ADC loans not meeting the criteria above as High Volatility Commercial Real Estate (HVCRE) loans.

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Regulators’ “No Stress” Message to Smaller Banks Only Tells Part of the Story

May 14, 2012

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On May 14, 2012, the Federal Reserve, FDIC and the OCC released a joint statement confirming that that banking organizations with total consolidated assets of $10 billion and under will not be required to conduct formal stress tests.  Management of many smaller banking organizations had been concerned that the stress testing required of larger banks would “trickle down” in an informal sense to smaller banks.  With this regulatory statement, that concern is alleviated, at least in the official sense.

We continue to believe that the heightened (or perhaps renewed) emphasis on risk management by the regulators will affect banks of all sizes.  It is likely that regulators, directors, and shareholders of all banks will want to confirm that management has identified the key risk factors affecting the institution and that the board has established the institution’s tolerance for accepting those risks and implemented any appropriate mitigants.

We recommend that banks of all sizes, even the smallest community banks, undertake an enterprise risk management analysis to identify the key risks facing the institution.  The board of the institution, as a subpart of its strategic planning function, should review those risks and establish the institution’s risk tolerance with respect to each category of risk (many consultants will capture this analysis in a “risk appetite statement”).  Establishing and understanding those risk tolerances will form a roadmap for setting and executing the institution’s strategic initiatives.  In implementing this analysis, some institutions may undertake some level of stress testing with respect to certain risks.

This risk management analysis is a natural adjunct to the self examination process used we recommend using in preparing for a regulatory exam (see our prior “Self Exam” post).  While the self exam process is typically more focused on the bank’s current position and past performance and this risk management analysis is more forward-looking, both processes require an introspective review.  Senior regulators have repeatedly confirmed to us (and we have seen in practice) that where banks take the initiative in implementing credible risk management programs and other pre-examination preparation, the examiners are much more likely to defer to the judgment of management and the board of the bank – with the result being a much better interaction with regulators (who, in an ideal scenario, can be a partner in the risk identification process).

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Sharing Directors Brings Added Experience to Your Board but Could Cause Problems

Many financial institutions, particularly community banks, have enhanced the experience level of their boards by adding a director who is a banker or serves on the board of another financial institution. In general, utilizing a director who has current experience with another financial institution is a great way to add valuable perspective to a variety of issues that the board may encounter. In addition, as private equity funds made substantial investments in financial institutions, they often bargained for guaranteed board seats. The individuals selected by private equity firms as board representatives often serve on a number of different bank boards. As market conditions have led to increased bank failures, however, a problem has resurfaced that may cause some financial institutions to take a closer look at nominating directors who also serve other financial institutions: cross-guarantee liability to the FDIC.

The concept of cross-guarantee liability was added to the Federal Deposit Insurance Act by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). The pertinent provision states that any insured depository institution shall be liable for any loss incurred by the FDIC in connection with:

  • the default (failure) of a “commonly controlled” insured depository institution; or
  • open bank assistance provided to a “commonly controlled” institution that is in danger of failure.

This means that if two banks are “commonly controlled” and one of them fails, the other bank can be held liable to the FDIC for the amount of its losses or estimated losses in connection with the failure. As many of us see each Friday, the amounts of these estimated losses are often quite high. In fact, the FDIC’s estimated losses for 2011 bank failures were approximately 20 percent of total failed bank assets for the year. Accordingly, the prospect of cross-guarantee liability can be a tremendous financial issue for the surviving bank.

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FDIC Weighs in on Director and Officer Removal of Bank Documents

Following the failure of over 400 financial institutions since the beginning of 2008, the FDIC has clarified its expectations with respect to collection and retention of bank documents by directors and officers of troubled or failing financial institutions for the purpose of explaining or defending their conduct. The FDIC’s Financial Institution Letter (FIL) released today sets forth the FDIC’s position that “[d]irectors and officers of troubled or failing financial institutions who remove originals or copies of financial institution records under such circumstances breach their fiduciary duty to the institution.” Presumably the FDIC would also object to a director or officer of a healthy bank copying and removing bank documents if the FDIC concludes that it is being done for improper purposes, although the FIL does not specifically address that issue.

Even though the guidance comes late in the game, we believe it is helpful for the FDIC to articulate its position on this matter to provide clarity to industry participants. We are disappointed, however, that the FDIC chose to issue this broad guidance through a financial institution letter (which cites no statutory authority or judicial decisions in support of its position) rather than through a formal rulemaking process whereby affected parties could offer comments.

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The Next Wave of FDIC Consent Orders

Just as many bankers believed that the worst of the enforcement environment was behind them, a threat of “new” Consent Orders for some state non-member banks has arisen. These “new” orders are not reflective of banks for which the regulators have identified new problems but are instead based upon the FDIC’s apparent decision that orders that were “led” by state regulators are not adequate for the FDIC’s enforcement purposes. To illustrate this point, the new orders we have seen thus far have been substantively consistent with the existing state orders.

This movement by the FDIC comes at an unfortunate time given overall downward trend in the number of FDIC consent orders being issued as banks continue to identify and manage their problems. From a practical standpoint, the publication of a new FDIC order may result in perception that a bank’s condition is worsening when in fact the bank is well on its way to compliance with the existing state order.

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A Director’s Guide to Corporate Governance 101

March 8, 2012


The day when the board’s focus was limited to approving loans and marketing the bank in the community is long past. Today’s boards face a wide array of complex tasks, and, accordingly, the composition, structure and organization of the board must all be geared to facilitate the board’s performing its duties and functioning properly. This process today is lumped under the heading of “corporate governance.”

(For a printer-friendly version of this post, including a sample Director Self Assessment form, please click here.)

The concept of functioning properly, of course, is in the mind of the beholder, but it clearly includes the board’s performing its primary duties of enhancing shareholder value, selecting, compensating and overseeing management and implementing risk management policies.

Boards of publicly traded banks are now fairly well acclimated to the issues comprising corporate governance, and bank regulators are now bringing many of these issues into the community bank board rooms. The regulatory exam almost always includes as its foundation an assessment of the strength of the board, whose oversight is considered critical to the proper functioning of a healthy bank. As a result, it is important for community bank directors to understand corporate governance principles, which fall under three broad categories.

  • Board Assessment—Is the board properly structured to provide optimal oversight to the bank?
  • Director Independence—Is the board able to effectively review management recommendations and make its own independent decisions regarding the bank’s strategy?
  • Management Review and Compensation—Does the bank have the right management team, and are those individuals compensated in a way that incentivizes them to implement the bank’s strategy?

Board Assessment

A review of hundreds of regulatory memorandums of understanding (MOUs) and consent orders has produced a clear starting point: Virtually every formal action begins with the requirement that the board increase its involvement and conduct an assessment of the performance and composition of management. The board’s assessment function, however, begins with the directors themselves. This self-assessment by the board is a logical starting point to ensure top board performance.

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Directors and the Exam Process: Get Involved Early

February 8, 2012

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My colleagues and I frequently meet with bank boards that have received very sobering reports from their bank’s examiners. While the directors’ responses to bad examination reports vary greatly, there is one emotion that is nearly universal: a feeling of helplessness. As a result, directors almost always express a desire to get involved in the exam process after they receive negative feedback from the examiners, whether through requesting meetings with higher-level regulators, appealing the exam findings, or fighting a proposed enforcement action. Unfortunately, those actions, particularly if taken after a final examination report is issued, seem to have little positive impact on the examination process and may even prove to be harmful to the bank.

The good news, however, is that there is a way for directors to get involved in the regulatory examination process that can have a meaningful positive impact. Discussed below is our top recommendation for directors to be involved in the examination process. We believe early, proactive involvement can positively impact the outcome of a regulatory examination and also enhance the board’s understanding of regulatory criticism.

While most directors’ first contact with examiners is at the examiners’ exit meeting with the board, we suggest director involvement earlier in the examination process. There should be one or more outside directors present at the examiners’ preliminary exit meeting with management. During this meeting, the examiners will present their preliminary findings from the examination. In addition to highlighting the engagement and availability of the bank’s directors, attending this meeting allows the directors to understand the key issues in the examination. By hearing the examiners deliver their findings first hand, the directors will have a better sense of the seriousness of the issues being identified. Finally, directors will be able to ask questions of the examiners that might not be easily asked by members of management; e.g., asking for an interpretation of a regulation.

By attending this preliminary exit meeting, directors are also able to ensure that the bank’s board has a timely understanding of the issues presented by the examiners. Members of the bank’s executive management team have a natural tendency to relay examination criticisms to the board through their own point of view. Management may fear adverse action by the board as a result of regulatory criticisms or may feel so strongly about their point of view that they tend to “water down” the comments of the examiners. By having outside directors attend the meeting, those directors can deliver an independent report of the regulatory criticisms to the board.

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Self-Exam: Improve the Health of the Bank and its Standing with Regulators

February 2, 2012

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Doctors recommend various self exams to catch disease early, so it can be treated before it’s too late. As it turns out, a self examination can be good for the health of a bank as well. My colleagues and I recommend that our banking clients and friends undertake a regular self examination in order to identify potential internal and external challenges that the bank may face. As discussed more thoroughly below, these self examinations can also be very helpful when the bank’s doctor (your friendly regulator) comes in for a check-up.

Enlist internal audit

To initiate the self examination, the audit committee of the bank’s board of directors should charge management with preparing a report that outlines the current and projected status of the bank’s key areas of risk. Ideally, the bank’s internal audit function will take the lead in performing the examination and preparing the related report. In order to maximize the value of this report, the audit committee should direct management to deliver the report at least 60 days prior to the bank’s next scheduled regulatory exam. The self examination report, in its most basic form, should cover the areas that are the focus of the bank’s regulators: CAMELS (capital, asset quality, management, earnings, liquidity and sensitivity to market risk). The report should also address any key areas of risk identified by the directors.

Analyze your market

In addition to analyzing the typical CAMELS components and other areas of risk, a very important part of the self examination process is a market study. The report should present facts, trends and projections related to the market area in order to define the opportunities and challenges being faced by the bank’s customers. While many bank directors have a good feel for market trends, we have found that this data, when presented with specific facts and trends, can inform the board’s discussions of a variety of topics a great deal. It can also provide the bank with support for dealing with its examiners, who conduct their own market analysis prior to each examination.

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