For years, compliance regulation was well beyond the resources of many community banks. Full compliance was just too expensive, so bankers cut corners-and examiners seemed on board with, or at least tolerant of, this approach. But the regulatory mindset, which used to be rooted in supervision, has changed to one of enforcement.

Gone are the days when examiners would give bankers a proverbial pat on the head and tell them to get it right next time. Regulators believe the credit crunch has fallen disproportionately on "protected" groups. Their remedy is to no longer spare the rod. Now there is zero tolerance.

From 2000 to 2008, bank regulators made 30 referrals to the DOJ for prosecution; there were 46 referrals in 2010 alone. Recent compliance examinations have resulted in significant increases in the bases for enforcement actions. Examiners are reawakening previously dormant rules, and a broad expansion in the application of rules on Unfair Deceptive Acts or Practices has made it tough for bankers to determine what even constitutes inappropriate conduct these days.

The change in environment threatens the very existence of community banks. Faced with civil money penalties and other sanctions, bankers are dramatically increasing staff and investing in software that promises solutions. Such expenses come at an inopportune time for an industry still reeling from the economic downturn.

Some of my clients have vacated entire segments of consumer lending. They recognize that costs and the risk of civil money penalties associated with violations outweigh potential returns. Others have increased either their minimum loan thresholds or their charges. Still, bankers have not been able to recoup their costs. The real world impact of this regulatory sea change is to harm the people regulators are trying to help. Low- to moderate-income customers must either make do without credit they need, or forego other spending to offset the increased costs of used car, small business or emergency loans. In some cases, credit just won't be available except from high-fee nonbanks.

What (other than lobby Congress for safe harbors) should community bankers do? Bankers must be proactive. Regulators have begun providing outreach that identifies their areas of focus, and bankers should not be shy in engaging regulators outside the examination context to discuss these issues. As Michael Corleone in "The Godfather Part II" might have said: "Keep your friends close and your regulators closer." Such exchanges should not be limited to examiners, but also to regulatory decision-makers.

A critical assessment of compliance team skills also is a necessity. Determine areas when outside expertise is needed to fill gaps. Consider adding counsel to provide privilege. Learn the limits of existing technology systems-core systems are often not designed to provide compliance review data. Understand why examiners are asking questions and what answers systems provide.

More broadly, recognize that compliance examinations are now driven from an enforcement perspective. Once an examination begins, questions should be addressed by senior personnel. Answering questions with off-the-cuff responses that then become memorialized is a good way to get in trouble.

It is permissible to have counsel at certain interviews. Be cognizant of the feel of the examination. And be sure the bank vigorously responds to issues early.

At each step in the process, the costs of defense increase and the likelihood of success diminishes. One should not trust that the regulators will get it right. Until the pendulum swings back, bankers need to understand the new reality.

The current regulatory approach to compliance has led bankers to stop offering certain consumer loan products or to increase what they charge. We all lose if the cost of compliance forces regulated lenders to send customers to the back-alley loan shark. 

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.