Bankers should be wary of the effects of a regulatory race to the bottom

Bloomberg News

President Trump's bank deregulation agenda has been the most aggressive in recent history.

His chosen leaders at the FDIC and OCC are in an apparent regulatory rescission race to the bottom, with the increasingly politicized Fed following closely behind.

Instead of applauding these extreme deregulatory efforts, bankers, especially those with M&A aspirations, should maintain their current compliance culture.

Like today's politics, the regulatory pendulum can be sharply whiplashed, perhaps with a vengeance, by the November congressional midterms and certainly the 2028 presidential election.

Trump's excessive deregulation began with the "DOGE-ing" of the regulatory workforce, especially at the FDIC and OCC. Fewer cops on the beat inevitably means less proactive enforcement by an increasingly inexperienced staff.

Because many regulations are size based, another stealth deregulation initiative is simply raising asset thresholds. The OCC proposed increasing heightened supervisory standards from $50 billion to $700 billion, reducing the number of covered banks from 38 to just eight. Notably, the three big 2023 Fed and FDIC bank failures were in the $100 to $250 billion range.

So-called "risk-based supervision" is looking more like politically based supervision.

CRA and fair lending provide pendulum examples ranging from excessive overregulation to balanced regulation in the middle to delayed regulation, self-regulation, and the ultimate of no regulation at the other extreme.

Former President Biden and his friends at the Fed advanced the most extreme re-regulation in banking history, the 1,500 page, October 2023 CRA Final Rule.

How bad was it? For the first time, the industry's leading trade groups united and legally challenged their three prudential regulators. Not the CFPB, but the very same regulators doing safety and soundness, compliance and other exams. Prudential regulators, probably realizing the industry's district court victory could be upheld at the appellate level and perhaps even by the Supreme Court, rescinded this excessive regulation.

With more than 50 years in the industry, I have come to believe that bankers understand the need for compliance and safety and soundness regulations. But, only if they are fair: smart, balanced and just.

The best example is the 1995 CRA reform package still in effect today, which has survived multiple presidencies and more than a dozen congresses. Other than a needed modernization, the 5% Deposit Reinvestment Rule, to prevent branchless banks from their $40 billion of annual weblining of our biggest cities, this 30-year proven law works well.

Communities receive $500 billion of reinvestment annually, community groups benefit from $100 billion Community Benefit Agreements and banks maintain a 98% CRA exam pass rate. Such good public policy strikes a fair balance between community and industry interests.

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No administration or Congress would ever be so politically suicidal as to suggest repealing CRA. This 1977 all-American law simply requires banks to serve their entire community, including the low- and moderate-income people who represent 40% of all Americans.

Trump's deregulation-driven FDIC and OCC appointees devised a stealth strategy, call it "delayed deregulation." They maintained existing CRA regulations but materially weakened enforcement by stretching normal two-to-three-year exam cycles to five-to-six years for FDIC-regulated banks under $3 billion and adopting risk-based, discretionary exam scheduling for OCC community banks.

CRA is mainly enforced through exam frequency and the adverse branching and M&A consequences of a failing rating. Unlike safety and soundness, there are no ongoing performance reporting requirements. The exam itself is the regulation.

My analysis of tens of thousands of CRA performance evaluations since 1990 documents that examiners faced with an unusual five-to-six-year exam cycle almost always base ratings on the most recent two-to-three years of performance. A CRA supervisory slow-walk with a five-to-six-year exam cycle effectively means a two-to-three-year examiner look-back, with a prior two-to-three-year "CRA dead zone." 

To counter this criticism, resourceful regulators proposed off-site mid-cycle reviews, the regulatory equivalent of appraising a house based on how it looks on Google Maps. This results in lower demands on regulators and time and cost savings for pre-exam-cramming bankers. Community reinvestment likely suffers, one reason this will be near the top of the rescission list for any future repopulated regulatory regime.

An even more extreme form of deregulation is "self-regulation," where banks are examined based on their own performance goals. CRA's optional strategic plan, or SP, exam procedures represent banking's only self-regulation, a concept I have criticized. Fewer than 100 banks have gone this route, although the OCC's recent proposal further relaxing SP standards will likely increase that number.

How does self-regulation work? Instead of community development loans and investments each meeting the 30-year-old unofficial industry "outstanding" standard of 1% of assets, an SP bank might conclude it deserves an outstanding rating at just 0.5%. The OCC took this a step further by recently suggesting even lower 0.2% to 0.4% outstanding goals.

Kind of like my Wharton students deciding my 90% to 100% "A" curve should begin at 75%, or even lower.

It's therefore not surprising that SP banks historically received more than three times the rate of outstanding ratings compared to the rest of the industry, 44% vs just 14% since 1990. Can you say CRA grade inflation?

The most extreme form of Trump deregulation is simply no regulation at all. Compliance examples besides the CFPB's effective dismantling include the FDIC's and OCC's removal of fair lending disparate impact analyses as well as the FDIC's elimination of public notice and comment requirements for branch applications. The elimination of insider-disclosure requirements for branch proposals may increase self-dealing risk.

Because the Department of Justice applies a five-year "look-back," and subjective CRA examiners can overweight prior-year performance, bankers should keep their feet firmly on the compliance pedal. The excuse that "the Trump deregulatory dog ate my compliance homework" will not work in today's volatile and unpredictable regulatory environment.