This is the time of year when bank boards of directors and management begin the strategic planning process for the following year. There will be few years in the careers of any of us that will provide as many seemingly one-time events as will this coming year, 2012.
There are four separate, but related, environmental factors that bank management should bear in mind to when doing next year's planning: implementation of the Dodd-Frank Legislation; expanded expectations for bank risk management capability; a soft economy/ flat yield curve environment; and regulatory uncertainty.
Every year banking organizations need to consider the external factors that will affect their strategic direction, but rarely, if ever, will so many major externalities affect the industry as in 2012.
As many as 400 separate new regulations will be issued to implement the Dodd-Frank legislation, many of which are already past the legislatively mandated due date for completion. This is not unexpected, as the timetable outlined in the statute was unrealistic. But the pace of approval and issuance of the new regulations is bound to pick up in 2012. For strategic planning purposes, there are two important factors to consider.
Each institution should select a point person to track the issuance of the new regulations. There are many sources available to follow and keep track of the issuance of the regulations and one person in every institution should be responsible.
Creation of the new Consumer Financial Protection Bureau will forever change the tone and tenor of banking regulatory compliance. A prime focus of the new law is to ensure that consumers are given fair treatment by financial institutions, which reflects the impression that banks have been running roughshod over their customers to this point. The CFPB is now armed with an expanded Unfair, Deceptive and Abusive Acts and Practices statute that will place additional regulatory burdens on all banks. Banks will need to change their approach to compliance from "following the letter of the law" to "fairness" in order to be consistent with these new expectations.
Regulators have been identifying new and more sophisticated ways to measure and manage risk exposure for banks; however, many of the tools and guidelines have been narrowly defined. Dodd-Frank now mandates the creation of risk committees for banks with assets in excess of $10 billion. Smaller banks are encouraged to set up committees as well.
In addition, stress testing of bank models and portfolios is also a new requirement for certain banks and an expectation for most banks. A new term, "enterprise risk management," has been introduced in the lexicon of bank terminology. It refers to the practice of identifying, managing, and mitigating risks on an institution-wide basis. If the term ERM is not common terminology in your institution now, it likely will be a year from now.
The bank business model is designed to convert deposits of varying maturities and duration into loans and investments. Banks are classic financial intermediaries. They convert savings into loans and investments. That is their societal purpose and the reason they are accorded significant government protection and regulatory requirements.
The bank model to achieve that purpose presumes a yield curve with a gradual but consistent slope offering progressively higher rates for longer maturities. That type of slope allows banks to assume a certain level of interest rate risk exposure in order to achieve a profitable margin on lending and investments. That model will be very difficult in 2012.
The Federal Reserve has promised to maintain its target rate for Fed Funds at close to zero for all of 2012 and most of 2013 and has rearranged the investments in its portfolio to drive down longer term rates. Therefore the yield curve for interest rates will be flat for all of the upcoming year, which will put pressure in loan margins.
In addition, the soft economy will likely generate minimal demand for loans. So what are the strategic choices? The dangerous trap that banks should avoid is increasing their risk appetite to reach for loans that will generate the historic interest rate margins they have usually enjoyed. But by definition, loans that offer the highest rates also carry the greatest risk. High margins in 2012 will likely result in high loss ratios in future years.
The alternative to achieving strong interest rate margins is to look for new ways to achieve additional fee income. But fee income also can generate regulatory and reputational risks. The recent flack over fees on debit cards is a reminder that banks need to carefully review their fee income strategies.
Rarely have we had so little continuity in the ranks of our Washington-based regulators. Both the FDIC and the Office of the Comptroller of the Currency are functioning with interim leaders. There are two vacancies on the Federal Reserve Board and no apparent nominees forthcoming. The CFBP is also functioning without a confirmed leader. But bank examinations are continuing on their normal rotation.
With uncertainty about the direction of leadership in Washington, examiners will likely be unusually cautious. This is not an environment in which requests for leniency or flexibility on regulatory issues are likely to be favorably received. If you have regulatory problems, address them very aggressively and get them behind you.
All years bring new challenges but none is likely to match 2012.
Mark W. Olson has been a Federal Reserve governor, chairman of the PCAOB and chairman of the American Bankers Association. He is co-chairman of Treliant Risk Advisors, LLC and can be reached at molson@treliant.com.
