As is true after virtually every period of financial turmoil, Congress is considering significant changes in the regulatory matrix governing the banking industry. It is difficult enough for Washington banking insiders to follow the bouncing ball on proposed legislation; from the vantage point of a typical bank director it must be close to impossible.
Virtually every piece of the federal government regulatory apparatus was created in response to a real or perceived financial crisis. The greater the perceived financial crisis and the more specific the causes, the greater the likelihood that Congress will legislate.
If past is prologue, regulatory reform legislation for this session of Congress should be expected to bolster consumer protection; tighten capital and lending standards; remove authority from regulatory agencies not deemed to have been sufficiently engaged; and, almost certainly, create a new agency. Indeed, all these topics have been included in various legislative proposals. But 2010 is not a typical year, and it is not yet clear that the traditional pattern will be followed. Regardless, there are subject areas that will receive more intense regulatory scrutiny. Areas I encourage bank directors to address within their organizations include:
Adequacy and quality of bank capital. This is no time for banks wishing to survive to try to skate by with marginal levels of capital. Though 8% capital to assets has long been a standard for adequate capitalization, banks should establish a comfortable cushion to allow for the possibility of unexpected asset quality issues. Also important is the quality of capital. Regulators and financial markets alike have become skeptical of any element of capital other than net common equity. This has been particularly true for some institutions after the poor performance of certain trust-preferred issues. For banks that are marginally capitalized, I strongly suggest going to the market for additional capital even if it means a certain level of diminution for existing shareholders. Absent an ability to attract new capital, an institution should seek to curtail growth until a comfortable level of capital has been achieved.
Underwriting and fee arrangements on retail financial products. In this category there are three subjects that should receive careful focus. The first involves commercial real estate lending. Over the last decade there has been a troubling concentration of commercial real estate among community and midsize regional banking organizations. Regulators that were focused on residential mortgage lending in past examinations are now focusing on commercial real estate lending. An important starting point for a commercial real estate portfolio is to have current appraisals that reflect recent valuations in the local market. The second subject involves subprime mortgage lending. Most banks have reduced their subprime lending. For those that have not, further involvement in this market will be a red flag. Third, directors should be wary of fees on financial products ranging from overdrafts to credit cards or other retail loans. Bank board members should ensure that their bank's fee schedules are comfortably within recent regulatory guidance and established industry parameters.
Liquidity. The recent crisis has shown that assumptions about liquidity (particularly short-term funding markets) can be flawed. Directors should ensure that assumptions are realistic, appropriate for the various liquidity needs of their bank's business lines, and that backup sources of liquidity really will be available if needed. A good approach is to seek ways to diversify sources of funding.
Compensation. Bank directors should be aware of the extent to which incentive compensation is utilized throughout the bank. The Federal Reserve is finalizing guidance that is particularly aimed at the largest banks, but all of the agencies expect boards to understand the use of incentive compensation and monitor it to ensure that it is not causing employees to take risks beyond the bank's risk appetite and ability to manage. This understanding should go beyond senior management (e.g., mortgage lending department). In general, compensation should be aligned with longer-term performance objectives.