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A Potpourri of Bank Regulatory News

On the latest episode of The Bank Account, Jonathan and I discuss a veritable hodgepodge of new regulatory pronouncements, including the CFPB’s small dollar loan rule and the OCC’s guidance on CRA ratings.  But before we got to the bank regulatory issues, Jonathan first had to seek my opinion on the new Florida Gator jerseys (pictured).  I’m actually fairly proud in my restraint.  For the handful of listeners who enjoy this banter, I encourage you to view these rejected Florida Gator uniforms.  For those that wish we’d stick with banking, I assure you my interest in discussing college football has reached another low after this weekend.

the-bank-accountWe also encourage our listeners to check out the American Bankers Association’s new podcast, the ABA Newsbytes Podcast.  While we’re happy for you to listen to our podcast over and over again, we recognize that it has diminished value starting with the third listen, and encourage you to explore other podcasts as well.

The potpourri of topics discussed include:

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Webinar on Eliminating Bank Holding Companies

On Thursday, October 12, 2017, Atlanta Partner, Robert Klingler, will be presenting a webinar on the Pros and Cons of Bank Holding Companies.  The webinar is hosted by Strafford and will begin 1:00pm Eastern on October 12, 2017.

In April of this year, Bank of the Ozarks, a $20 Billion, NASDAQ-listed, bank holding company, announced its plan to eliminate its holding company, which was completed in June.  In July, BancorpSouth, a $15 billion, NYSE-listed, bank holding company, announced its plan to eliminate its holding company.  With the inclusion of BancorpSouth Bank, only four of the 115 banks with more than $10 billion in assets don’t have a holding company; but that number has doubled in the last six months.

With Jonathan Hightower, Rob previously addressed many of these issues on The Bank Account podcast episode in which they addressed the question “Do Banks Need a Bank Holding Company?

Eliminating a holding company can often be done without limiting the permissible activities of the organization, with the potential for reduced regulatory oversight, simplified financial reporting, and consolidated governance.  However, the holding company structure can also offer significant capital flexibility, particularly for institutions under $15 billion with trust preferred securities or institutions under $1 billion that can take advantage of the Small Bank Holding Company Policy Statement.   Depending on the status of the applicable banking statutes, a holding company structure can also provide significant corporate governance benefits, including facilitating stock repurchases and avoiding super-majority voting thresholds for certain transactions.

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Basel III Treatment of DTAs and MSAs

We have heard, read and seen (and internally had) some confusion regarding the joint proposed rulemaking regarding the potential simplification of the capital rules as they relate to Mortgage Servicing Assets (MSAs) and certain Deferred Tax Assets (DTAs).

In addition to simply being complicated regulations, the regulators also have two proposed rulemakings outstanding related to these items. In August 2017, the banking regulators jointly sought public comment on proposed rules (the “Transition NPR“) that proposed to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Then, in September 2017, the banking regulators jointly sought comment on proposed rules (the “Simplification NPR“) that proposed to alter the limitations on treatment of MSAs and certain DTAs (and also addressed High Volatility Commercial Real Estate or HVCRE loans).

The Simplification NPR also addressed the interplay of the Simplification NPR and the Transition NPR. The Simplification NPR provided that the Transition NPR, if finalized, would only remain effective until such time as the Simplification NPR became effective. Accordingly, the Simplification NPR, if adopted, will ultimately control, with no transition periods for MSAs and certain DTAs following January 1, 2018.

Net Operating Loss DTAs

Importantly, neither the Transition NPR nor the Simplification NPR have any affect on the Basel III capital treatment net operating loss (NOL) DTAs. DTAs that arise from NOL and tax credit carryforwards net of any related valuation allowances and net of deferred tax liabilities must be deducted from common equity tier 1 capital. Through the end of 2017, the deduction for NOL DTAs are apportioned between common equity tier 1 capital and tier 1 capital. In 2017, 80% of the NOL DTA is deducted directly from common equity tier 1 capital, while the remaining 20% is separately deducted from additional tier 1 capital. Starting in 2018, 100% of the NOL DTA will be deducted from common equity tier 1 capital.

The end of the transition period will have the effect of lowering the common equity tier 1 capital ratio of all institutions with NOL DTAs, although the tier 1 capital and leverage ratios should remain unchanged. This impact is entirely unaffected by the adoption (or non-adoption) of the Transition NPR and/or Simplification NPR.

Similarly, other aspects of NOL DTAs are unaffected by the proposed rules. Specifically, (i) GAAP still controls the appropriateness of valuation allowances in connection with the DTA, (ii) tax laws still control the length of time over which DTAs can be carried forward, and (iii) Section 382 of the Internal Revenue Code still controls the limitation (and potential loss) of DTAs upon a change in control of the taxpayer.

Temporary Difference DTAs

Unlike Net Operating Loss DTAs, DTAs arising from temporary differences between GAAP and tax accounting, such as those associated with an allowance for loan losses and other real estate write-downs, can be included in common equity tier 1 capital, subject to certain restrictions. To the extent that such DTAs could be realized through NOL carryback if all those temporary differences were deemed to have been reversed, such DTAs are includable in their entirety in common equity tier 1 capital. Essentially, to the extent the temporary difference DTAs could be realized by carrying back against taxes already paid, then such DTAs are fully includable in capital. Carryback rules vary by jurisdiction; while federal law generally permits a bank to carry back NOLs two years, many states do not allow carrybacks.

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Storytelling by Walt

Storytelling by Walt

October 5, 2017

Authored by: Robert Klingler

As Jonathan and I mentioned on our podcast on succession planning a few weeks ago, our patriarch and founding father, Walt Moeling, formally retired at the end of 2016.  However, his knowledge and influence continue to permeate almost everything we do (and he still has the same office down the hall).  One of the ways that influence can be seen continues to be in our use of stories originally told to us by Walt.  Of course, his story telling ability has been noticed, including by the press. Several years ago, as part of our succession planning, we began chronically some of those stories.  What follows is what I wrote two years ago…

In early 2010, our clients were dropping like flies, with one or two clients failing every Friday. Even as one client entered receivership, we were each likely working with three or four others that were on the same path. (Each was a horror movie, and we knew exactly how it would play out, even if our clients held out optimism each time that, for whatever reason, their story would play out differently.)

Walt and I were on the phone with one such client who had just passed the 2% leverage ratio threshold, and was in discussions on next steps.  The executives were worried about how their employees would handle the receivership. Walt, as usual, slipped into a story about another (former) client that had been a client for years. Whenever Walt called, the president’s administrative assistant, Nancy, would answer the phone and chat with Walt before tracking down the bank’s president. Walt shared how he had listened as Nancy became increasingly depressed as the bank’s condition had deteriorated.

In his best Southern belle, falsetto, voice, Walt would demonstrate the decreasing pep in Nancy’s voice. From an upbeat “Good Morning, Walt!” to more and more depressing “Oh, Walt, things are hard, but we’re trying.” In the weeks leading up to that client’s receivership, Walt himself became increasingly saddened by Nancy’s stress. Calls now usually started “Oh, Walter, things are rough.

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Regulators Propose Simplification of Capital Rules

the-bank-accountOn the latest episode of The Bank Account, “Adding HVADC to our Banking Alphabet Soup,” Jonathan and I are joined by colleague Jerry Blanchard to discuss the new capital rules proposed by the federal banking regulators on September 27, 2017.  The newly proposed regulators propose to overhaul the HVCRE regime with a “new and improved” HVADC regime, while also increasing the amount of Mortgage Servicing Assets (MSAs) and Deferred Tax Assets (DTAs) that can be included in Tier 1 Capital.

As discussed yesterday, the new HVADC rule would likely expand the scope of loans that require elevated risk-weighting, but reduce the risk-weighting from 150% to 130%.  In addition, the new rules would eliminate the need (or risk-weighting benefit) to require borrower contributed capital (and to retain any internally generated profits from the project for the life of the loan).

The proposed rule for MSAs and DTAs would require 250% risk-weighting for such assets (as contemplated in the original BASEL III rules as of January 1, 2018 and proposed to be delayed in August), but would also allow financial institutions to include MSAs and DTAs as capital, each up to 25% of Tier 1 Capital (with no separate aggregate cap amongst them).

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HVCRE Gets a Reboot

HVCRE Gets a Reboot

September 27, 2017

Authored by: Jerry Blanchard

As we mentioned just a couple of weeks ago, the federal banking regulators have taken aim at the risk weighting rules for High Volatility Commercial Real Estate (“HVCRE”) loans that went into effect back in 2015. In a proposal published on September 27, 2017, the regulators seek to simplify the approach in several ways. First, the existing HVCRE definition in the standardized approach would be replaced with a simpler definition, called HVADC, which would apply to credit facilities that primarily finance or refinance ADC activities. Second, an HVADC exposure would receive a 130 percent risk weight.as opposed to the 150% risk weight for HVCRE exposure under the existing rule. The tradeoff though is that HVADC would apply to a much broader set of loans. For example, as compared to the HVCRE exposure definition, the proposed HVADC exposure definition would not include an exemption for loans that finance projects with substantial borrower contributed capital and consequently removes the restriction on the release of internally generated capital.

The definition of “primarily finance” means credit facilities where more than 50 percent of loan proceeds will be used for ADC activities. So for example, multipurpose facilities where more than 50 percent of loan proceeds finance non-ADC activities, such as the purchase of equipment, would not be considered HVADC.

As with the HVCRE rule, there are certain exemptions. HVADC would exempt permanent loans, community development loans, loans for the purchase or development of agricultural land and loans for one to four family residential.  Thus, lot development loans and loans to finance the ADC of townhomes or row homes would not be considered HVADC but raw land loans and loans to finance the ADC of apartments and condominiums generally would be considered HVADC.

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Putting the Success in Succession

Putting the Success in Succession

September 26, 2017

Authored by: Robert Klingler

the-bank-accountOn the latest episode of The Bank Account, Jonathan and I draw from personal experiences at Bryan Cave as well as the experiences of our bank clients for a discussion about succession planning.  Succession planning is rarely a top regulatory concern, but good succession planning requires time to implement.  Accordingly, boards (and managements teams) should always be looking at (and planning for) a future where one or more executives (and/or board members) decides to retire.  With the age of the CEO often being a primary contributor to the decision to sell the bank, succession planning should be a fundamental part of the strategic planning discussion.

A few alternative titles we kicked around for this episode include:

  • Paying Millennials in Avocado Toast: The Podcast About Succession Planning
  • Succession Planning for Banks
  • The Bryan Cave Model: How Walt Moeling & Kathryn Knudson Rocked Succession Planning (and how you can too!)
  • “We” Mode: Smart Succession Planning
  • Succession Planning: Why It’s Important and How To Do It Right
  • Big Team, Little Me:  Succession Planning Tips
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Finding the Unicorn in Lender Liability Litigation

September 14, 2017

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Investors frequently talk in terms of trying to find the next unicorn, that small start-up company that is going to turn into a billion dollar valuation.  Lawyers are like that as well, always looking for that new decision where a court opens a crack in the door of some long held legal theory. Something like this occurred in the 1980’s when the courts in California held that a party could bring a tort action for the breach of the obligation of good faith. The courts were expanding a doctrine that then existed only in the area of insurance contracts. The expansion of this theory to noninsurance contracts generated universal criticism by other courts and scholars across the US and after a ten year experiment the California Supreme Court reversed its earlier decision for the following reasons: (1) the different objectives underlying the remedies for tort or contract breach, (2) the importance of predictability in assuring commercial stability in contractual dealings, (3) the potential for converting every contract breach into a tort, with accompanying punitive damage recovery, and (4) the preference for legislative action in affording appropriate remedies. [See: Blanchard, Lender Liability: Law, Practice and Prevention, Chapter 4, Bad Faith Tort Claims]

When a party enters into a loan agreement or a promissory note, one understands what the consequences of a breach might be. If a lender is found to have improperly failed to fund under a line of credit it knows that it may have to pay compensatory damages to the borrower. Likewise, guarantors understand that if the borrower fails to pay the underlying obligation the guarantor must step in and pay the obligation.  Our commercial banking industry is built on this understanding that parties will need to put the nonbreaching party into as good of condition as they would have been if there had been no breach. Damages for breach are therefore predictable.

The unicorn for borrowers counsel today is to tag a lender with punitive damages. This has traditionally been a difficult endeavor. Courts almost uniformly dismiss breach of fiduciary duty claims because absent some unusual set of facts, the normal lender/borrower relationship is not a fiduciary one. Lenders owe no special duty to borrowers or guarantors to advise them on whether a particular business transaction for which the borrower is obtaining funds is a “good” one or not. Fraud claims are a bit easier for a borrower to keep from being dismissed but such claims are subject to heightened pleading standards and require specificity in making the claim, a general claim of “fraud” without more will be dismissed.

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Why Your Board Should Stop Approving Individual Loans

In this the new era of banking, our clients are continually looking for ways to enhance efficiency and effectiveness at all levels of their organizations. This line of thinking has led to the revolution of the bank branch and the adoption of many new technologies aimed at serving customers and automating or otherwise increasing process efficiency. Perhaps most importantly, however, banks have begun to focus on optimizing their governance structures and practices, particularly at the board level.

(A print version of this post if you’d like to print or share with others is available here.)

As we discuss this topic with our clients, the conversation quickly turns to the role and function of the bank’s director loan or credit committee, which we refer to herein as the “Loan Committee.” We continue to believe that Loan Committees should move away from the practice of making underwriting decisions on individual credits absent a specific legal requirement, and here we set forth the position that this change should be made in order to enhance Board effectiveness, not just to avoid potential liability.

Ensuring Board Effectiveness

Whenever we advise clients with regard to governance, our fundamental approach is to determine whether a given course of action helps or hinders the Board’s ability to carry out its core functions. Defining the core functions of a Board can be a difficult task. Fortunately, the staff of the Board of Governors of the Federal Reserve System recently outlined its view of the core functions of a bank Board. We agree with the Federal Reserve’s outline of these functions as set forth in its proposed guidance regarding Board Effectiveness applicable to large banks, which was based on a study of the practices of high-performing boards. Based on our experiences, many of the concepts expressed in that proposed guidance constitute board best practices for banks of any asset size. The proposed guidance indicates that a board should:

  • set clear, aligned, and consistent direction;
  • actively manage information flow and board discussions;
  • hold senior management accountable;
  • support the independence and stature of independent risk management and internal audit; and
  • maintain a capable board composition and governance structure.

We believe that an evaluation of the board’s oversight role relative to the credit function is a necessary part of the proper, ongoing evaluation of a bank’s governance structure. As it conducts this self-analysis, a board should evaluate whether the practice of underwriting and making credit decisions on a credit-by-credit basis supports its pursuit of the first four functions. We believe that it likely does not.

Considering Individual Credit Decisions May Hinder the Committee’s Ability to Set Overall Direction for the Credit Function.

We have observed time and time again Loan Committee discussions diving “into the weeds” and, in our experience, once they are there they tend to stay there. In most Loan Committee meetings, the presenting officer directs the committee’s attention to an individual credit package and discusses the merits and challenges related to the proposal. Committee members then typically ask detailed questions about the particular financial metrics, borrower, or the intended project, assuming that any discussion occurs at all prior to taking a vote.

While it may sometimes be healthy to quiz officers on their understanding of a credit package, focusing on this level of detail may deprive the Loan Committee of the ability to focus on setting direction for the bank’s overall loan portfolio. In fact, in many of the discussions of individual credits, detailed questions about the individual loan package may in fact distract from the strategic and policy questions that really should be asked at the board level, such as “What is the market able to absorb with regard to projects of this type?” and “What is our overall exposure to this segment of our market?”

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Frenemies: Gaining Efficiency Through Shared Services

the-bank-accountBryan Cave colleagues Ken Achenbach and Sean Christy join Jonathan and me on this episode of The Bank Account to examine the ability of banks to gain efficiency through shared services.  Throughout the business environment, business are looking to out source all non-core competencies.  Ken and Sean explore the opportunity for banks to similarly explore the opportunity for banks to join forces to purchase outsourced services and invest in technology platforms together. By working together, banks can leverage buying power and share the burden associated with evaluating their vendor options.

You can follow most of us on Twitter.  Jonathan is @HightowerBanks, I’m @RobertKlingler, and Sean is @SeanChristy.  Following Ken on Twitter is difficult, as he has, so far, refused to access that part of the internet.  Our producer, Sam Katz, is @SamathaJill1.

Note:  This episode was recorded before the University of Florida announced it was cancelling this weekend’s football game against Northern Colorado due to Hurricane Irma.  The Gators drought in offensive touchdowns will therefore continue at least another week.  We hope everyone stays safe.

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