Deregulation and reregulation, all in one fell swoop.
That's what we got on Aug. 9, when the four federal banking agencies issued guidelines on safe and sound banking practices and mandated procedures for enforcing the guidelines.
The action drew little notice for two good reasons: The banking industry is healthy, and the regulators wrote the guidelines in broad, general terms so as not to micromanage the industry or impose new regulatory burdens.
But in a recession the virtually unfettered powers that the regulators gained from the new procedures will probably move to front and center.
In the FDIC Improvement Act of 1991 Congress directed the agencies to adopt safety and soundness rules. The philosophy of this crisis-induced law was: "Tell the regulators to tell the bankers what to do. Don't let the bankers talk back." Saner heads prevailed last year when Congress allowed the regulators to issue guidelines, instead of mandatory rules. But the don't-let-the-bankers-talk-back approach remained intact.
The regulators took almost four years after the '91 law was passed to issue the guidelines. The 48 brief standards address nine subjects: internal controls and information systems, internal audit system, loan documentation, credit underwriting, interest rate exposure, asset growth, executive and director compensation, asset quality, and earnings.
Under the guidelines a community institution need not have "a full-scale internal audit function" if it has a "system of independent reviews of key internal controls."
Loan underwriting, the guidelines say, should be "prudent" and consider concentrations of credit risk and the character, creditworthiness, and collateral offered by borrowers. There is no discussion of loan-to-value ratios or any other specific underwriting criteria. Executive, employee, and director pay should not be excessive. Holding companies are not covered by the guidelines at all.
As general and vague as these guidelines are, they substantially broaden the safety and soundness concept. Until now, bank actions usually became problems only if they threatened the capital or viability of an institution. Now, all 48 standards are, by themselves, safety and soundness issues.
The big news may be the procedures for dealing with potential violations of the guidelines. Previously, if regulators found a safety and soundness problem in an institution, they had a number of alternatives, ranging from discussions to cease and desist orders. If the board and management could not agree with the regulators on whether there was a serious problem or on the remedy, the bank was entitled to a hearing before an administrative law judge and, to a limited degree, in court. The agency had to prove that the institution engaged in an unsafe or unsound banking practice or violated a law or regulation, and had to justify the remedial action it wanted the institution to take. These procedures are still on the books.
The enforcement procedures for the new guidelines add a powerful new weapon to the regulatory arsenal. Now, if the agency finds that a bank has run afoul of one or more of the guidelines, it can require the bank to submit a compliance plan. The bank can disagree on whether there is a problem or offer its own plan to correct it. But the agency can ignore the bank, demand that it produce a plan acceptable to the agency, and set a time frame to correct the problem.
If the agency does not accept the bank's plan or believes the bank's implementation is not good or quick enough, it will order the bank to correct the deficiency its way and add any other mandate it sees fit, such as restrictions on asset growth or on interest rates offered to depositors, higher capital ratios than required by regulation, or executive changes.
Thus the agency has the right to decide by itself, without any independent review, whether a bank is in compliance with the safety and soundness guidelines, whether the agency should require the bank to submit a compliance plan, whether the bank's compliance plan is acceptable, whether the bank meets the terms of the compliance plan, whether the agency should issue an order against the bank, and what remedial actions will be required in the order.
If the agency believes the bank has failed to meet the terms of the order, it may sue the bank or seek civil fines from the bank's directors and officers. In either case, the order itself cannot be challenged; only the bank's compliance with the order is at issue. And under the civil fine provisions in federal banking law, the agency doesn't have to prove that a director or officer willfully or knowingly violated the order. All it has to prove to levy substantial fines is that the bank violated an order and that the director or officer participated in the violation. Merely serving as a director at the time the violation of the order occurred may be sufficient to prove participation.
The brief and vague guidelines, coupled with the lack of an independent review of the agencies' decisions, mean the agencies can do pretty much whatever they want. This, in turn, opens up the guidelines and procedures to uneven application by the four agencies, by regional or district offices in each agency, and by examiners. It may also add to the chances that examiners will second-guess good-faith business decisions made by directors and officers.
To understand how to avoid a safety and soundness compliance plan or order, a bank first needs to learn how the agencies will use this new authority. We have asked examination and enforcement people from the four agencies what factors would lead them to direct a bank to develop a compliance plan or to issue an order to correct a safety and soundness problem. In talking to us the regulators emphasized how new this authority is and how much their decision would depend on the circumstances of each case. They also noted how much flexibility they now have to choose among the various enforcement tools.
The regulators indicated that two factors would usually be paramount in deciding whether to use the new safety and soundness procedures. First, the violation itself: Is it serious or just technical? Can it be fixed quickly? Must it be fixed quickly to keep the bank viable?
Second, the relationship between the examiners and management: Do the examiners have confidence in management and the condition of the bank? Does management agree that there is a problem and agree to change policies or otherwise quickly fix the problem?
If a bank already has a prompt corrective action or a cease-and-desist or other supervisory order in place, or is responding to an examination report, the agency can allow a bank to add the compliance plan to that order or response. Because undercapitalized institutions would already be under prompt-corrective-action orders, these safety and soundness procedures would be applied mainly to institutions that are adequately or well capitalized.
Congress mandated these procedures in the '91 law, and only Congress can make major changes in them. But, despite the ambitious bank deregulatory legislation pending in both the House and the Senate, neither house is considering any change to these top-down, "the regulator is always right" procedures. Neither house is considering the due-process problems that arise whenever a federal agency is the sole reviewer of its own order.
Though the regulators may be well-intentioned, they, like bankers, are human beings and make mistakes.
In the heat of dealing with a troubled bank, the regulators can go overboard, perhaps keeping a bank out of, or forcing it to withdraw from, profitable businesses, or imposing operating restrictions that worsen rather than improve the bank's condition.
One is reminded of Lord Acton's maxim "Power tends to corrupt and absolute power corrupts absolutely." With no third-party review, the regulators could inadvertently cause - rather than prevent - insolvencies and practice the very micromanagement that the broadly worded guidelines were meant to avoid.
Our concern is not only to avoid arbitrary action, but also to ensure appropriate and reasoned supervisory action. If an agency has to prove its case before an impartial administrative law judge, its staff is more likely to initiate cases only against appropriate parties, and to request remedies that have been carefully thought out, than if the agency does not have to prove its case to any third party. The banking system and the economy will be on sounder footing if, in formulating enforcement actions that can have dramatic effects on bank operations, the agencies are subject to the scrutiny and judgment of independent administrative law and court judges.
Mr. Baris is a partner and Mr. Simon an associate at the law firm of Kennedy & Baris in Washington. Mr. Baris is also executive director of the American Association of Bank Directors.