Publications & Resources

July/August 2010
Regulatory Changes & Restructuring

Understanding the Ins and Outs of Community Bank Enforcement Actions

By James M. Rockett

Introduction

Many banks are confronting the daunting but increasingly familiar refrain from their regulators: the bank’s risk profile and CAMELS ratings warrant an enforcement action. Just how should a bank respond to a regulatory crisis? We will examine these issues and recommend ways to confront a regulatory crisis.

Preparing for the Examination

The first line of defense is to have a strong risk management program that is supported by the necessary resources to be effective. It should be the highest priority of the institution to self-identify regulatory shortcomings, demonstrating to regulators that the bank understands regulatory requirements, identifies problems and addresses them forcefully.

Preparations for an examination should include an extensively documented analysis of the risk elements of the loan portfolio, processes and procedures for managing credit risk and ALLL methodology. Management of the bank should meet with the lead examiners to review the bank’s current status in advance to set expectations.

Management should carry on a dialog with examiners as they conduct the examination. They should try to learn what the regulators are looking for and find out before the exit interview if significant problems have been spotted. If regulatory concerns are identified during an examination, be sure to immediately respond to those matters, regardless of how insignificant they may initially seem to be.

Avoiding Denial

The most frequent reaction of bankers to identification of regulatory deficiencies is to either flatly deny the problem or to minimize it. Often this can be out of frustration or anger. However, nothing will create a greater backlash from regulators than adopting a response of denial.

Trends and Types of Regulatory Enforcement Action

Of late, asset quality is the primary component of the CAMELS ratings and significant deterioration of assets will result in a composite 3 or, more probably, a 4 rating. Such a rating will result in a regulatory enforcement action (which, in turn will cause reputation risk and impact the Liquidity component). The range of enforcement actions is from informal to formal and can include consequences for individual directors or officers.

Interim CAMELS Downgrade: It is becoming more common for a bank to receive notification of an interim reduction in the composite CAMELS rating between exams. This notice may also include a “troubled condition” designation and a limitation on accepting brokered deposits.

Troubled Condition Designation: The troubled condition designation is significant because it results in a bank being unable to appoint executive officers or directors without prior regulatory approval. Moreover, once found to be in troubled condition, the institution may not make severance payments without first obtaining regulatory approval.

Brokered Deposit Limitations: If a bank’s capital calculations under FDICIA falls, or is deemed to be, below “well capitalized,” the bank will be limited in the rates that it can pay on deposits (not more than 75 bps over the national rate) and will not be permitted to accept brokered deposits without prior FDIC approval.

Informal Enforcement Proceedings: The most common informal process is a memorandum of understanding or MOU. The MOU will specify corrective actions required to be taken by an institution within specified periods of time. An MOU is not a “public” document and therefore its terms not available for review by the general public on the website of the banking agency.

Formal Enforcement Proceedings: The primary formal enforcement action is an order now customarily called a Consent Order, which are published on regulatory websites. Orders are designed to prevent continuing unsafe and unsound banking practices and violations of law. A lesser form of formal enforcement proceedings is a formal written agreement, which has the same legal effect as an Order but appears less threatening. Other formal actions include removal or prohibitions against directors, officers, employees or other institution affiliated parties (IAPs) from future participation in the banking industry. The regulatory agencies can also issue capital directives under the Prompt Corrective Action provisions of FDICIA.

Civil Money Penalties: If the regulatory agency believes that the bank or its IAPs have willfully violated laws or regulations, they will seek civil money penalties. This process commences with a 15 day letter which gives the target the opportunity to demonstrate that CMPs are not appropriate. When confronting CMPs various mitigating issues are raised by the target.

Before and After the Enforcement Action

Once regulators spot deficiencies, the bank should undertake frequent, open and detailed communications with the regulators seeking to avoid a harsh outcome. It is important for the bank to “get out in front” of the regulators by anticipating their issues and their solutions. The bank should embark on a series of self-directed remedies. By doing so, the bank will demonstrate its serious intent to remedy the deficiencies and it will be prepared for compliance with regulator imposed requirements.

When a draft enforcement action arrives, the precise wording of the documents is very important and should be examined, carefully considered and negotiated. Particular focus should be on the timing requirements since the bank does not want to commit to timing which was not possible.

Once an enforcement action is in place, the bank must devote resources for complying with the enforcement action. Specific roles must be established using a matrix that assigns tasks, responsible persons and specific time frames. The bank’s board will establish an independent compliance committee to monitor results and hold persons responsible for compliance.

James M. Rockett is partner with Bingham McCutchen LLP. He can be reached at 415-393-2025 or james.rockett@bingham.com.