This was supposed to be the year that the country's largest banks began operating under a new capital regime, marking the completion of the most ambitious bank regulatory undertaking in recent memory.

Regulators initially planned the "parallel run" under the Basel II capital standards for 2006. Now they plan to spend most of 2007 hustling to get ready for a test run that would begin in 2008, and no one seems terribly surprised that the project is already two years behind schedule.

This is, after all, bank regulation, which at its fastest pace can seem plodding. Regulations are written, revised, revised again, tweaked, and fine-tuned before finally being released. And though that may sound like criticism, banking regulators are likely to regard it as praise. Good regulation, the thinking goes, needs cellaring.

Preparing for Basel II has not shouldered aside a long list of regulatory priorities for this year. How regulators will enforce the Bank Secrecy Act remains a big issue. How the Federal Deposit Insurance Corp. will solve the question of industrial loan companies - and how legislators and lawmakers will handle the larger philosophical question of the appropriate intersection of banking and commerce - is of keen interest.

Still, bankers worry less about the regulatory priorities they can see than the ones they can only feel, and right now it feels like consumer issues are in the ascendancy. That's at least partly because of the November elections, as most observers expect the 110th Congress to be more interested in a conversation about consumer protection than the 109th was.

But the changing mood is not solely the result of changes on Capitol Hill. In a time of general economic prosperity and a booming housing market, it is hard to sustain public attention on unscrupulous lenders and questionable products. Now that the economy seems shaky, the housing market is flitting between a soft and a hard landing, and short-term interest rates are up, questions about the consequences of ill-advised credit - once considered a problem only at the margins - are likely to go mainstream.

"There is increasingly a concern not only with respect to the disadvantaged, but the middle class generally, that will demand attention," said Chuck Muckenfuss, a partner in the Washington office of Gibson, Dunn & Crutcher LLP. "The elections will obviously have an impact, but I think this would have been the case without regard to the changes in Congress."


Because of product innovation and a growing pool of lenders, consumers have more access to credit than ever, and they have been taking advantage of that access.

At the end of 2001, U.S. consumers had aggregate nonmortgage debt of $1.8 trillion, according to the Federal Reserve Board. At the end of October that figure was $2.4 trillion. Commercial banks constitute the largest lending group, holding $710 billion of that debt, while savings institutions hold $107 billion.

Credit analysts have been anticipating weakness in consumer credit quality for several years, and the cracks are starting to appear. That may be the catalyst for policymakers to focus on bank lending - as well as on what steps regulators have been taking to monitor that lending.

"Some of the products, practices, and marketing techniques in the lending industry broadly deserve additional scrutiny," said Michael Stevens, the senior vice president for regulatory policy at the Conference of State Bank Supervisors. "If we can deal with this in the regulatory environment, then we save the industry of having to deal with a broad, sweeping legislative approach that causes difficulties for everyone."

Regulators were not blind to consumer issues last year. They released guidance in late September on banks' responsibilities to their borrowers when it comes to alternative mortgages, and lending data released after the guidelines have shown increasing delinquencies in those products.

"The agencies were right on in identifying nontraditional mortgages as an area that was appropriate to issue some additional guidance," said Julie Williams, the chief counsel at the Office of the Comptroller of the Currency. "What we need to do now is make sure the guidance is faithfully and consistently implemented."

Many of the alternative mortgages originated in the past four years merely delayed, rather than eliminated, financial pain. This is the year in which the front-end low rates will start expiring in massive numbers, and the payment shock triggered by the expirations could feed popular outrage about the products. There are already more discussions about suitability, which generally suggests that a lender bears some responsibility for whether customers end up with products that are appropriate for their financial situation.

Suitability is a "concept that has been used in the securities industry, and I wouldn't be surprised if the bank regulators or the Hill borrowed that concept," said D. Jean Veta, a partner in the Washington office of Covington & Burling LLP. "Regulators typically are keenly aware of what is happening on the Hill and don't want to be regarded as asleep at the switch."

The OCC remains a touchstone in the increasingly intense debate on how banks treat their customers. It supervises most of the country's largest banks, and three years ago it wrote controversial rules that articulated sweeping powers to preempt state laws, many of which were designed to protect consumers.

(The Supreme Court is considering whether the OCC's supervisory and enforcement authority extends to the operating subsidiaries of national banks. A decision could come as early as March.)

Officials at the regulator are cognizant of increasing interest in consumer protection, but they say the issue is not new to them.

"When you look at the shift of the composition of the types of business that particularly the larger banks conduct these days, if you go back six to 10 years, you see a growth and evolution in various retail lines of business," Ms. Williams said. "It is something that we have been aware of and sensitive to for some time, and it is not a sensitivity that has sprung into existence since early November of 2006."

Between the warming rhetoric on consumer protection and its stance on federal preemption, the OCC has found itself in a ticklish spot. The agency's argument that it has been an effective consumer advocate has not been received well by advocacy groups that lament the displacement of state laws designed to protect consumers.

"We may not be communicating as effectively as we might to tell folks what we do, and that we are active and committed across a variety of functions," Ms. Williams said. "Telling our story better in all those respects is important."

She also points out that there are statutory limitations on what the OCC can do. It has taken enforcement actions under the "unfair or deceptive acts and practices" language of the Federal Trade Commission Act, but rule-writing authority that would define those principles for banks rests with the Fed.

Advocacy groups also have pointed to credit-card disclosures and solicitations as one area in which banks ill-treat current and potential customers, and that's another area where the Fed has sole rulemaking authority.

In fact, the Fed has a continuing project to revise its Regulation Z, which implements the Truth-in-Lending Act, and two years ago it issued a specific inquiry on disclosures for "open-ended credit products" - the Fed's way of saying credit cards. It hopes to issue a proposal for revising disclosures as early as midyear.

"We're seeking to ensure that consumers fully understand the terms of their credit-card plans," said Scott Alvarez, the general counsel at the Fed. "We believe in disclosures here, but we are beginning to think that we might have disclosure overload. We want to get back to the basics - what do consumers need to know to make basic decisions? What do they look for? What's the most effective way to do it? It's really a bottom-up review."


The consumer agenda to this point is largely intangible, but already bankers can see an increasing sense of urgency in regulators' attempts to get the new capital regime in place. The idea - to square capital with risk - turns out to be an enormously complex task. The confusing taxonomy alone is proof that the effort has outgrown the "Basel II" characterization.

"I'm expecting to see a process for capital analysis that could very well include three different capital regimes: Basel II, Basel IA, and Basel I," said Scott Polakoff, the Office of Thrift Supervision's deputy director. "We think three regimes would not be illogical, given the varying complexities of the financial industry today."

That doesn't even take into account the two versions of Basel II - advanced and standardized - and no one is quite satisfied with the project's broad outline.

Small-bank claims that they will be at a disadvantage against large banks led to a Basel IA compromise that regulators published for comment last week. Large banks say the expense of training personnel and adjusting systems to accommodate the new standards far outweighs any benefit, especially since regulators seem insistent on preserving leverage ratios that preclude capital relief. And banks and some lawmakers say keeping the leverage ratios will put U.S. institutions at a disadvantage against foreign banks.

Over the past six months business groups have found bashing regulation as anticompetitive to be a winning strategy, and it's not hard to find bankers - or bank lobbyists - willing to admit privately their hope that the Basel effort is about to implode.

But that is likely just wishful thinking.

"Basel II has to happen, simply because the agencies have too much invested in this issue, and as a practical matter, they don't have a choice but to implement it," said Gil Schwartz, a partner at Schwartz & Ballen LLP. "Slowing it down is possible, but the agencies have a way of wearing opponents down over time."

The idea that Basel might be slowed further is eminently realistic, given the proposal's history. Agency officials are gathering comments until the end of March, and they hope to put out a final rule in the third quarter. Even at this late stage, it's an ambitious undertaking.

"We're going on seven years on this, and it is surprising that we are facing 2007 and I don't think anyone is in a position to safely predict the outcome on several very fundamental questions," said Mr. Stevens of the state supervisors group.

According to Mr. Alvarez, "we've got to get away from the current system for large banks, because it is providing them incentives to sell their low-risk assets" and keep the high-risk ones. "What we are trying to do through Basel II is to better ensure the safety and soundness of banks by making capital requirements reflect actual risk."


One of the year's trickiest regulatory problems remains largely out of regulators' reach.

An amendment tucked into last year's defense authorization bill caps at 36% the annual percentage rate, including fees, that lenders can charge military members and their dependents. Sen. Jim Talent, R-Mo., who narrowly lost a re-election bid in November, sponsored the amendment in hopes of stamping out payday lending around military bases.

The measure directed the Department of Defense to implement the statute, which has probably done more than anything in recent memory to awaken the industry's affection for its traditional federal banking regulators.

Bankers know their regulators. Regulators know the bankers. But the insular world of bank regulatory policy has little inkling of what the Department of Defense might do, and even less claim on the rulemaking process.

It's hard to miss the irony: An industry that has generally preferred federal lending standards now finds that it is about to get them - from the Pentagon.

"I don't blame banks for not wanting uniform federal standards being established by the Department of Defense," said John Ryan, the executive vice president of the state supervisors group and a frequent critic of federal preemption.

Though it must consult with banking regulators as it writes the rules, the Defense Department gets to make the important decisions.

"All four of the federal banking agencies have formed a working group to offer some perspective," Mr. Polakoff said. They are "working with DoD to try to appropriately narrow as much as possible the scope of the Talent amendment."

Oliver Ireland, a partner at Morrison & Foerster LLP, said the rule has the potential to become "one of the biggest issues we've seen in an awful long time" in the industry. "The authority they have is very broad. They'd have to exercise a lot of discipline to limit it to the payday lenders around military bases, which are the core problem."

Bankers worry that they can easily run afoul of the law, and their concern is magnified by the criminal liability the statute carries. The rules are due in October - hardly more than the blink of an eye for bank regulation.

"Rule-writing in the financial-transaction world, especially in retail, is a very difficult task, because the market is continually innovating, and there are millions of transactions and thousands of different products and account relationships that will be regulated," Mr. Ireland said. "Even for somebody who is experienced and knowledgeable in the area, writing the rules on this time frame would be difficult and challenging."

Anticipation of the new regulations might trigger more angst than the regulations themselves.

"I've got to believe that DoD is going to do the right thing in terms of not being oppressive," Mr. Schwartz said. "I know they don't have a lot of experience in the area, but they are reaching out to the banking agencies and I find it hard to believe that it will be a big deal."


A more pressing decision is what the Federal Deposit Insurance Corp. will do with the ILC applications from Wal-Mart Stores Inc. and Home Depot Inc. The agency's moratorium on such applications will expire Jan. 31, and the FDIC board has a meeting tentatively scheduled for that date.

The decision is of intense interest to those in and out of banking. It strikes a number of sensational chords, not the least of which is Wal-Mart, which is popularly imagined to be a destructor-in-waiting for small businesses and community banks.

The FDIC's decision is squarely at the intersection of some pretty important philosophical and operational questions, said Paul Lee, a partner in the New York office of Debevoise & Plimpton LLP.

"It goes to core philosophy of how one establishes a financial regulatory system, and it also goes to core observations about how the competitive landscape will operate in the financial sector," Mr. Lee said. "People come down strongly on both sides of those two vectors."

When the FDIC announced a six-month moratorium on ILC applications in July, about the only people in the industry who did not see it as an implicit request for guidance from Congress were FDIC officials.

Last month Rep. Barney Frank, D-Mass., sent FDIC Chairman Sheila Bair a letter signed by over a hundred House members asking her to extend the moratorium. Many observers say that the FDIC will agree to do just that, and that the real question is how long it will keep the congressional window open. The FDIC has a statutory responsibility to act on applications it receives, and it cannot wait forever.

In the meantime, there's precious little in its statutes around which to construct a legal argument to reject the applications.


Though there could be more important policy questions in the offing, the Bank Secrecy Act and anti-laundering requirements may remain the most pressing regulatory priority for bankers.

Thus far BSA enforcement has revolved largely around the procedures banks follow and the infrastructure they use to stay in compliance, but the focus of the effort is shifting increasingly to how effective the procedures and infrastructure are.

"How you go about looking at transactions that come through the banks is far more complex than simply going through the policies and procedures," said Paul Pilecki, a lawyer at Winston & Strawn LLP. "As the examinations get a little more sophisticated and banks get a little more sophisticated in how they think about the potential exposure, it really mushrooms."

In other words, bank regulators are not letting up.

"People were assuming we'd reach a plateau at some point, and I don't think we've reached that plateau yet," Mr. Lee said. "Within corporations, people are in a continuous-improvement mode, and if you were a regulator, you would also have a view that there ought to be continuous improvement."


Final rules required by the Fair and Accurate Credit Transactions Act on affiliate marketing and identifying red flags in consumer accounts are expected this quarter. Of greater interest and complexity is the Fed's risk-based pricing proposal expected as early as the end of the quarter. The proposal would implement a part of the statute requiring banks to tell borrowers when they do not get the best possible loan terms. That is, to say the least, tricky business for both regulators and banks.

The Fed also must write rules implementing last year's legislation restricting Internet gambling; that effort is slated for the third quarter. The Fed is also working with the Securities and Exchange Commission on defining which securities activities banks can conduct, and which they must conduct through brokerage subsidiaries. A final rule could also happen in the third quarter.

In addition to the policy items on the agenda, regulators say they continue to address the problem of an aging work force. Mr. Polakoff estimated that 25% of OTS examiners are eligible for retirement, so remaining adequately staffed is a big internal priority.

But concerns about the work force have not prevented the agency from planning for the future.

"The largest concentration of federal savings banks in sheer number is in the Illinois-Ohio-Indiana footprint, and we think it's appropriate to have a regional office location with a permanent regional director in that footprint," Mr. Polakoff said.

So the OTS plans to reopen its Chicago regional office almost five years after shuttering it in a budget-cutting move. Regulators have a busy year in store, but apparently not too busy for a little de novo effort of their own.

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