Bank mergers are increasingly subject to official and public scrutiny. As a result, conscientious bankers are updating their once minimal due-diligence procedures. These revisions have led to substantially stronger asset-valuation techniques, coupled with rigorous reviews of loan portfolios and overall credit risks.

Despite these advances, due-diligence undertakings often overlook regulatory compliance. Increasingly, regulators and special-interest groups are focusing on compliance matters in reviewing or contesting consolidations.

Further, many banks are encountering unpleasant post-merger surprises from substandard or incompatible compliance systems at acquired institutions.

Transition Team's Role

Regulatory compliance will assume an even greater importance beginning in 1993, when senior management will be required to certify the effectiveness of compliance programs, as mandated by Congress in the Federal Deposit Insurance Corporation Improvement Act of 1991.

In an ideal world, a thorough compliance review would be incorporated into very due diligence, so that compliance risks could be factored into merger negotiations.

In practice, however, the first opportunity to address some of these compliance issues comes with the designation of transition teams responsible for managing the merger.

For example, a bank may create separate teams to direct consolidation of retail banking, trust activities, or back-office operations.

Transition teams traditionally have concentrated on eliminating redundancies and harmonizing operations. But current legislative, regulatory, and community demands highlight a need for added focus.

Compliance assurance procedures have become imperative goals for every transition team. They are:

* To review the compliance organization of the acquired institution and develop a plan for consolidation of compliance responsibilities.

* To assess the current status of compliance at the acquired institution.

Goals of Compliance Team

As transition teams are fielded to oversee the consolidation of business, operational, and administrative functions, management must assure that the merger of compliance responsibilities is also addressed.

This analysis may be completed as a separate project, or may be incorporated in the responsibilities of the team that is overseeing consolidation of the legal or audit functions.

One goal of the compliance transition team is to review the structure of the compliance systems at each institution.

For instance, one institution may have a centralized compliance department, while the other may have a decentralized structure. The transition team should evaluate the benefits and weaknesses of each approach, and recommended a plan for consolidating the compliance responsibilities to best meet the interests of the combined entity.

When the plan is adopted, it should be well documented and should include justifications for the transition team's recommendations.

The compliance transition team should also coordinate with each of the other transition teams that have responsibility for combining business units, to assure that each consolidation efforts incorporates both regulatory and compliance-related concerns.

Thus, as retail lending operations are merged, someone is clearly designated as being responsible for assuring compliance with relevant laws such as the Truth in Lending Act.

Review from the Top Down

Assessing the current status of compliance requires a comprehensive, top-down compliance review of the institution being acquired.

This should entail a review of written policies and procedures, together with an assessment of whether the policies and procedures are enforced effectively.

For each area targeted, a thorough audit-style approach should be used to assess the adequacy of compliance. This type of review, similar to those completed by bank examiners, begins with a general overview of the organization's commitment to compliance, and then proceeds downward to a review of sampled transactions.

Prudent Opening Moves

A prudent preliminary step is a review of any prior compliance reports, such as regulatory examination reports, reports by independent examiners, and internal audit.

Compliance areas noted as deficient in the reports reviewed should be added to the list of compliance areas receiving timely in-depth review.

Additionally, a review of any attempts to correct compliance weaknesses will give the transition team insight into management's commitment to compliance systems.

|Yes' and |No' Answers

Transition team members and staff should review written policies and procedures for the compliance areas that will receive in-depth examination. These policies and procedures should be compared not only with those of the acquirer, but also with the requirements set forth in applicable regulations and regulatory policy statements.

It is most useful and efficient to employ a checklist approach. All regulatory requirements should be phrased as "yes" or "no" questions. An experienced reviewer can then read the written policies and quickly note any discrepancies or omissions.

An added benefit of such a review is that the accuracy of the acquirer's compliance policies may be similarly scrutinized.

In consultation with bank compliance officers, the results of this investigation may result in the revision of written, institutionwide compliance policies.

Testing the Waters

No compliance system is useful unless faithfully followed by line employees. The transition team must audit specific transactions to determine the actual effectiveness of such compliance policies and procedures.

This type of review may be streamlined by relying on recent internally or independently prepared examination work papers and reports. Or internal or independent examiners trained in compliance review and regulatory affairs may be used to complete reviews of targeted areas.

If internal or independent compliance reviews have recently been completed by the acquiree, the corresponding reports and work papers may be relied upon. The degree of reliance must be determined by a judgmental review of their professional appearance, as well as an audit of the work performed.

Such an audit requires that a sample of the same transactions tested in the prior report be selected and compared with the prior report.

Through review of these prior reports, the transition team may conclude that the reports accurately represent the state of the acquiree's current compliance performance. If that is the case, then the transition team should document its assessment of the acquiree's compliance, along with any suggested improvements.

If the prior reports are determined to be unreliable, or glaring compliance exceptions and irregularities are present, the transition team should implement a new, detailed compliance examination of the areas involved.

If prior audit reports are insufficient or nonexistent, the transition team should direct a thorough review of the targeted areas. The review should utilize techniques that are similar to these used by federal examiners.

These techniques should be geared not only to uncovering compliance irregularities, but also toward highlighting potential problems and discovering costly inefficiencies. These reviewers should recommend solutions or action plans to correct the deficiencies noted.

Though often overlooked in merger due-diligence procedures, compliance assessment may have as much of a bottomline impact on the acquirer as any asset valuation.

The transition team may also play a vital role in improving the compliance system of the combined institution.

It makes little sense to change from one deficient compliance system to a different, but equally deficient one. A prudent transition team should also consider whether an evaluation of the acquirer's compliance systems would be warranted, as well.

Better compliance by the combined entity can be another important efficiency achieved by the merger. Though compliance violations may initially appear innocent and unconnected, they often snowball and require costly resolutions - far costlier than resources spent on early detection or prevention.

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