The 5 Things You Need To Know To Prepare For Your Next Regulatory Exam

“Exams ain’t what they used to be.”  Poor grammar, but a true statement. As a financial institution examiner for more than 30 years, I can attest to that.  No longer do the examiners show up unannounced on Monday and send rookie examiners to stand behind each teller and count and balance cash, while more senior examiners took control of the note vault and loan documentation.  You will receive an extensive request list for records and documentation, including raw loan data files in a specific format, and a request for electronic credit file documentation once the regulators have determined the scope of the loan review.

Much of the financial information in the Report of Examination will have already been completed off-site based on the most recent quarterly Report of Income and Condition, and preliminary exam report comments will have been prepared in advance by an analyst located in the regulator’s office.  Those comments and financial data will be verified by the on-site examiners.  So what do you need to be doing well in advance of your next exam?

1. Maintain comprehensive, well-organized electronic loan files to facilitate examiner review, minimize examiner questions, and alleviate examiner fatigue in “reading the story”. Since the late 1990’s, examiner loan review has been automated and subject to more off-site review.  The loan review examiners may be on-site with examiners connected to the bank’s network, or may be off-site in the regulator’s office, or even at the examiner’s home VPN’d into a secure network.  This fact makes it essential that loan files be adequately documented so that examiners may determine the credit quality of the loan – pass or adversely classify – with a minimum of credit officer involvement.

What has changed?  Credit quality has improved since the financial crisis.  The FDIC’s Quarterly Banking Profile for the Second Quarter 2015 indicates that the quarterly charge-off rate for the industry and community banks is the lowest in nearly a decade.  Additionally, banks’ loan grading systems have vastly improved over the years and credit standards have been tightened since the financial crisis. The loan review may even be conducted by relatively inexperienced examiners.  Senior examiners will analyze policies and methodologies associated with the Allowance for Loan and Lease Losses (ALLL), to ensure that appropriate reserves are maintained.

2. Make sure your ALLL policy and methodology are well documented and in compliance. Be prepared to answer questions about the bank’s readiness to implement CECL. Examiners will place more emphasis on the bank’s methodology and policies for calculating the ALLL and the bank’s preparedness for the Current Estimated Credit Losses (CECL) standard.

3. Have an adequate and reasonable process for back-testing and stress-testing for all key models utilized by the bank (ALLL, IRR, Liquidity, and Credit). Since 1997 when the Sensitivity component was added to the CAMEL rating, the requirement for banks to measure sensitivity has become more sophisticated and complex, with methodologies based on verifiable reasonable assumptions. Interest Rate Risk (IRR) is a significant factor in the bank’s viability. The bank’s processes for back-testing and stress-testing are becoming subject to increased scrutiny, and the fact that the bank’s model passed muster at the last examination, is no assurance that it will be satisfactory at the next exam.

4. Make sure accurate and complete documentation (including contracts, agreements and due diligence) is maintained for outsourced functions and all required Currency Transaction Reports (CTRs), Suspicious Activity Reports (SARs), loan approvals and denials, and disclosures. Your bank will be subject to examinations of your Information Technology systems, including in-house systems, mobile banking, and functions outsourced to vendors.  Data breaches and systems vulnerability have been in the news lately and you should ensure that appropriate security is in place for in-house systems and services provided by vendors.  Unauthorized exposure of customer data can result not only in financial risk but also significant reputational risk. Your bank will also be examined for compliance with the Bank Secrecy Act/Anti-Money Laundering statutes and Consumer Protection regulations.  Compliance with these statutes and regulations is critical, and violations can result in significant civil money penalties.

5. Communicate! Maintain active and constant communication with examiners leading up to, during, and after the exam. Make sure you retain records or evidence (emails, etc.) of files and/or discussions in regard to the pre-exam request list or off-site analyst. At the start of the exam or before if scheduling permits, meet with the Examiner-in-Charge (EIC), Asset Manager, and Detail/Operations Manager, and include key bank personnel contacts so that everyone is familiar with the examination process and expectations.

At the close of the examination, the examiners will conduct an exit meeting with management and summarize the results of the exam and tentative rating of each CAMELS component.  If proper communication has been maintained throughout the exam, the results should come as no surprise; however, if there are disagreements, this is an opportunity to resolve any differences.

There are several companies that can assist you with developing appropriate pre-exam preparation and support, exam responses, and compliance with enforcement actions.  One such company with extensive banking and regulatory experience is FSRA which offers a wide range of services to ensure compliance with state and federal regulations and guidance.

Contribution of this article was provided by Scott Smith, Scott is a Managing Director with Financial Services Risk Advisors.  The author can be contacted at Scott@FSRAdvisors.com.  FSRA is a risk management advisory practice specializing in audit, risk, compliance, and strategic initiatives for banks and financial institutions.  For more information on FSRA visit their website at www.FSRAdvisors.com.

We are all familiar with TBTF, but is “Too small to Succeed” a reality?

In a recent letter to Ashville, NC based Ashville Savings Bank (ASBB) CEO Susanne DeFerie, activist investor Lawrence Seidman asserted that the bank is “too small to succeed” and should therefore immediately begin locating an acquirer.  Mr. Seidman raises and important question currently being contemplated in the board rooms of community banks around the country: is “too small to survive” a reality?

We can use Mr. Seidman’s investment in ASBB as an example to help answer this question.  According to American Banker, Mr. Seidman owns 6% of the shares of ASBB, worth approximately $6.23 million as of August 20, 2015 (the day before he wrote his letter).  Let’s compare that investment to one of similar size in ASBB’s neighbor institution, North Carolina based Bank of America (BAC), which is positioned firmly in TBTF territory.  The market value of Mr. Seidman’s investment in ASBB would have purchased him approximately 0.0035% of Bank of America on the same day, or approximately 372,687 shares.  At its most recent year-end, Bank of America reported a diluted earnings per share after extraordinary items (DEPS) of 36 cents, making Mr. Seidman’s hypothetical share of earnings worth approximately $134,000.  By comparison, ASBB reported a DEPS at their most recent year-end of 59 cents a share, making Mr. Seidman’s actual share of earnings worth approximately $155,000.

As we have shown, Mr. Seidman benefitted from an additional $21,000 share of earnings by placing his investment in the smaller bank over the larger one; however, an investor cannot spend hypothetical dollars locked up in DEPS, so we need to look at actual return on investment over the same period.  From December 31, 2014 to August 20, 2015 ASBB shares appreciated $2.22 resulting in a market value gain on Mr. Seidman’s investment of approximately $583,000.  Over the same period, bank of America shares decreased $1.17 per share, meaning that even adjusting for the three quarterly dividends of 10 cents a share that Mr. Seidman would have been entitled to, his hypothetical investment in the large bank would have lost $324,000 in value. Mr. Seidman benefitted more than $900,000 in less than eight months by investing in a small bank over the large one.

Finally, we need to look at optics to better understand the argument for “too small to succeed”.  Small banks are not able to take advantage of the operating efficiencies occurring from the economies of scale enjoyed by the large banks.  Both Bank of America and ASBB had abysmal efficiency ratios for their size at the most recent quarter, however Bank of America’s was nearly 20 points lower than that of ASBB; and, ASBB’s efficiency ratio in the mid-80s is significantly higher than the average for its peers.  The argument exists that small banks are less able to handle the increased cost associated with a business model more reliant on branch networks, the ever increasing regulatory burden, and outsized employee bases that suppress revenue per employee numbers well below that of their larger counterparts.  These arguments all have merit as larger banks are able to compartmentalize employee costs, and where Bank of America would have a department of hundreds of employees performing accounting reconciliations for example, where each employee in the department might be expected to perform 1,000 reconciliations a month, ASBB might only have one employee who handles all of their reconciliations, which might only be 200 a month.  Bank of America is significantly more efficient in its 1:1000 ratio than ASBB in its 1:200 ratio, and where the only thing the employee at Bank of America worries about is perform reconciliations each day, the ASBB employee is likely to “wear several different hats”.  There are however, no lack of competent resources out there like FSRA, that allow small banks options to outsource many of their operations and compliance tasks, allowing them to pay for only the service that they use, without carrying excess cost.  At ASBB, a reduction of $1.2 million a year in operations expense would bring its efficiency ratio in-line with that of its peers in the mid-60s, and coincidently would return an additional $74,000 a year to Mr. Seidman.  $1.2 million may seem like a lot for a small bank, but remember a mid-60s efficiency is only the peer average meaning that 50% of banks that size are doing even better.

We can conclude, that while the old operating model of self-contained operations, and high head count for “small” banks may not survive, there is absolutely a place for nimble, customer focused, high ROI “small banks” to continue to service their customers who have grown accustom to personal service with a smile, and shareholders who value a solid return on their investment. By re-evaluating their strategy, migrating to a more efficient operating model, and developing options where they pay for only the service that they use, small banks are able to not just merely survive, but succeed.