As they prepare to enter 2013, few issues have riveted the attention of retail bankers as much as the onslaught of new rules and regulations emerging from the Dodd-Frank law of 2010. A common complaint is the rising costs of compliance in the wake of this legislation and others promulgated following the 2008-2009 financial crisis. Such concerns have only been heightened by the re-election of President Barack Obama and his Democratic administration to a second term.
What can bankers now expect from the regulatory agencies in the next four years? Under the theory that it takes a regulator to know a regulator, BAI Banking Strategies sat down a few days after the November 6 election with former Comptroller of the Currency Eugene A. Ludwig, who currently heads the Promontory Financial Group consulting firm in Washington, D.C. During his tenure at the agency under President Bill Clinton from 1993-1998, Ludwig was known for his assiduous enforcement of fair lending laws.
In the following interview, Ludwig said he anticipates “a much steadier, and maybe even a bit more moderate, direction and tone” from the regulators post-election. But he also acknowledged that he is sympathetic to banker concerns about “excess” burdens, particularly when emanating from community banks, and that the regulators are unquestionably taking a more skeptical, probing approach to the industry. “The benefit of the doubt is not something financial institutions should rely on,” he said.
Q: What does the re-election of President Obama mean for banks? Will there be even more regulations and an increase in enforcement actions from various regulators, including especially the Consumer Financial Protection Bureau (CFPB)?
Ludwig: The biggest change is essentially no change. It will be “steady as she goes,” with the implementation of the Dodd-Frank rules that haven’t yet been implemented. We will have a robust but somewhat cautious CFPB, which is what we’ve seen so far. I do think that we’re in a serious regulatory enforcement mode. But having said that, I don’t think the pendulum will swing much further or, from a banker’s perspective, get much worse. I anticipate a much steadier, and maybe even a bit more moderate, direction and tone.
Q: Bankers, large and small, are expressing a lot of discomfort about an onslaught of regulations and enforcement actions since the passage of Dodd-Frank. What is your view of the complexity and intensity of this new level of bank regulation?
Ludwig: I’m very sympathetic to bankers’ concerns about excess burden. Since my days as Comptroller of the Currency, I have been particularly concerned about the disproportionate effects of regulation on small banks, and I know our regulatory agencies remain sensitive to that burden. However, Dodd-Frank does require a number of new rules that add burdens on small as well as large banks. So, in the short run at least, there will be some additional burden. However, I would urge the regulators to be sensitive to smaller bank needs and realities.
Despite the additional burden, I am still a big believer that banks will get through this period on their feet. This is a bit of the pig-in-the-python situation, where eventually the regulatory backlog will make its way through the system. But while it’s going through, there’s a lump. At the same time, I have a lot of confidence in the quality and energy of our banking organizations. They will get through this, and when they do, they will be stronger for it.
For one, banks have tremendous experience in adapting to regulatory reform; in the past twenty years, they’ve had to do it several times. For another, the state of American banking has improved dramatically since the crisis. Institutions are better capitalized, better managed and more attentive to risk. And finally, you can’t have a growing, job-creating economy without a strong financial system and the financial system can’t be so over-regulated that it can’t function. So, I think we will get to a new equilibrium in which banks can both live with and thrive in; it’s just going to take time.
Q: Bank examiners and supervisors are taking actions bankers say unnecessarily discourage them from lending. Do you think the examiners and supervisors are too likely to be excessive in how they enforce regulations?
Ludwig: I think there is always a danger of fighting the last war; it’s part of human nature. Crises happen when systems fail in unexpected ways and there is always an impulse to compensate strongly for earlier mistakes. The key is to have regulations that discourage us from being unnecessarily strict in bad times and inappropriately lax in the good ones.
One of the most obvious issues has to do with loan-loss reserves. We have accounting rules that actively prevent bankers from creating a buffer against losses that aren’t manifest in their recent loan history. It’s the definition of making bankers fight the last war. Changing those rules to give bankers more discretion (and require more disclosure) would go a long way towards protecting banks and customers from the next downturn.
Allowing bankers to take charge of their Allowance for Loans and Lease Losses (ALLL) should ease pressure for creating excessive capital buffers. The ALLL is a better financial buffer for most going-concern purposes than capital is, as loan-loss reserves are intended to be drawn down in a storm. This is not to say capital is not important, but it is a question of using multiple tools for the best outcome.
Q: Retail bankers are very concerned about how the CFPB will oversee consumer protection laws. What do you think of how the CFPB’s role is defined in law and how do you assess the job they are doing so far?
Ludwig: As the result of the creation of the CFPB, this is now the era of the compliance officer. Compliance officers and compliance programs are enormously important to that organization because the CFPB has, in a sense, a fairness mandate. This is not unlike what we see in other countries, England and Australia, for example, but the idea of a devoted agency with that purpose is new for the U.S. Compliance officers have to concern themselves with more than the just black-letter legal requirements; they also have to help their organizations avoid unfair, deceptive, or abusive acts or practices.
I would like to see, and I would personally encourage, the CFPB to focus on non-banks, because non-banks remain under- and even un-regulated. That’s the low-hanging fruit where many consumer issues arise. Because banks historically have been regulated, their practices tend to be several notches better than those of non-banks. It’s in the interest of the country to level the playing field.
Q: Bankers contend that they are viewed with hostility and suspicion by the regulators. Do you think they have a point?
Ludwig: Well, it’s a little bit of a chain reaction. Bankers are currently near the bottom of the heap in reputation in the public’s mind and that has a way of reverberating through the government to the regulatory agencies. Furthermore, as a result of the crash and the number of failures in banking, regulators are more skeptical than ever. The benefit of the doubt is not something financial institutions should rely on. The examiners and supervisors of every regulatory agency want the institutions to show them what the facts are and they’re going to be probing and skeptical.
People forget that it’s really the non-banks that primarily got the country in trouble. Just look at the list of the ones that really failed: AIG, Fannie Mae, Freddie Mac, Bear Stearns and Lehman Brothers. They’re not banks. While there have been instances where banks violated the rules, the public conflates any and all financial institutions into “the banking sector,” and that’s both unfair and counterproductive, since the regulatory apparatus actually makes banks much safer institutions than non-banks conducting the same activities. But put together with the events of the financial crisis, that makes for a very skeptical and wary regulatory mechanism.
Q: Banks are complaining about all the data requests they get from the CFPB and many suspect the agency is engaged in a fishing expedition to find reasons to bring actions against them. What is your impression of these data requests and how they will be used?
Ludwig: First, I think the enthusiasm for data, not just by the CFPB and the banking regulators but by the Office of Financial Research, is part of the new reality. We are in a much more data-driven environment than in the past. The Federal Reserve, which has emerged as the most powerful regulatory body, is an economist-driven organization. That approach has a lot of virtue, and supervision and regulation are always better when they’re informed by actual evidence. But that kind of academic rigor requires a lot of data. So, it’s not just CFPB that wants information.
Ultimately, the industry will be able to handle the intensified interest in data very well because, after all, systems in our modern technological age are up to the task. The problem is getting the right systems up and running to deal with requests in an efficient fashion. And that gets to my point about the pig-in-a-python. We’re certainly going through a period of a couple of years where getting those systems off the ground is going to require an investment of both time and money. But, they will get working soon. And institutions that do so sooner and better will have a competitive advantage over those that don’t.
Q: How do you view the Administration’s approach to fair lending and what do you think the future holds in terms of the kinds of enforcement actions that are likely to occur?
Ludwig: Nobody cares more about fair lending than I do. I brought 27 fair lending cases when I was Comptroller, versus one in the agency’s prior 129 years of existence. I’m very hopeful the Administration will be thoughtful. The slavish application of rules like disparate impact can punish entities that don’t discriminate at all, that actually reach out and try to help people who otherwise wouldn’t have fair access to credit. We have to face up to the socioeconomic differences in this country and be true to the facts in these matters. If good-hearted people aren’t sufficiently thoughtful, they may end up prosecuting cases that really shouldn’t be brought.
Q: Banks are very worried about that too. Is there anything banks can do to reduce the likelihood this will happen?
Ludwig: Banks should be especially careful to ensure that old and new products are offered in ways that are sensitive to the “law of unintended consequences,” which could result in disparate treatment or impact. Of course, this is very difficult, but the issue of unwarranted discrimination is a national priority and will be a priority of the CFPB.
We should also strongly encourage policy makers to face up to challenges that may exacerbate the situation. So for example, the Basel III capital rules, the QM and QRM rules may create problems in home lending. If we place too much of an emphasis on high down payment requirements, we are going to disadvantage low- and moderate-income borrowers who may otherwise pose a very low credit risk.
What banks will have to do is face up to the realities of their own numbers and think about how they can be creative in extending fair credit within the bounds of the law and good practice. The regulatory agencies will be sympathetic to their good-faith efforts to achieve a positive outcome.
Mr. England is a contributing writer to BAI Banking Strategies and the author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance.
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