11 Observations from the Regulatory Exam Trenches

observations from the regulatory trenches

Safety and soundness exams are the toughest they have been in years

It has been over four months since the collapse of Silicon Valley Bank.  It seemed obvious at the time that regulators were going to change their posture towards banks.  No examiner in charge wants to have their regulatory career blemished by a bank failure.  The post-mortem on Silicon Valley Bank  published by the Federal Reserve at the end of April was highly critical of the examiners at the Federal Reserve Bank of San Francisco for failure to effectively enforce guidelines.  

Many of our clients at Invictus have gone through regulatory exams over this four-month stretch.  And, as expected, regulators have become far more aggressive with community banks.  Below are some of our observations beyond just enhanced supervisory focus on liquidity.

1. Banks with CRE concentrations are especially in the crosshairs.  Elevated regulatory pressure on banks with CRE concentrations is not a new thing, but it is more intense now and it is becoming more holistic regarding capital and liquidity.  If you are above the 100/300 percent thresholds and your last exam was a breeze, prepare for a much tougher exam this time around.  They will want to know how you are “managing your CRE concentration risk.”  

2. Expectations for stress testing of banks with CRE concentrations has increased in several ways.  First, there is much greater emphasis on reconciling stress test results back to earnings and capital.  Two, regulators want to see how banks reconcile stress test results back to the CECL allowance.   

3. It is particularly important to properly quantify the number of uninsured deposits you have.  Many banks have incorrectly reported this line item on the call report.  Other banks have misclassified uninsured deposits in the eyes of the FDIC.   You need to have a firm handle on these calculations.

4. Speaking of uninsured deposits, every bank should calculate and track their Uninsured Deposit Coverage ratio on a regular basis.  That ratio is equal to your remaining available liquidity (both on and off-balance sheet) divided by your uninsured deposits.  Two months ago, if I wrote this, I would have told you that the minimum ratio should be 100 percent.  I am now hearing from banks that regulators want this ratio even higher at 125 percent.  If you are under these thresholds, you should have a plan and narrative ready to go.

5. You may NOT even get the opportunity to respond to concerns that are identified.  We observed several instances in which examiners issued MRAs and MRIAs without giving Management an opportunity to defend the bank.  What this really means is that it would be a big mistake to take a passive approach to your upcoming exam.  The more prepared you are, the better off you will be.

6. The MRAs have become more aggressive.  In many cases, they require banks to de facto commit to reducing the size of the balance sheet over a period of time.  We have also observed more MRAs requiring banks to write new strategic plans (also another way of saying you need to de-leverage in most cases).  

7. Banks without robust capital plans which include early warning indicators are more vulnerable to criticism, especially if they have a CRE concentration and/or a liability sensitivity to rising interest rates.  There has been an increased emphasis to see that internal capital limits considered the Bank’s funding strategy.  In other words, capital and liquidity should be more tightly connected!

8. If you are out of compliance with your policy limits in your asset/liability model on either NII or EVE sensitivity, even if it is under the scenario in which interest rates decline, you need a plan in place to address it.  The board should be notified and involved in this on a regular basis.  No more handwaving.

9. Regulators are being tough on banks who are looking to switch regulatory capital frameworks (i.e., transition from CBLR to Basel III or vice versa).  They will want to understand your motives, so communication is key.  Banks who are proactive about communicating these plans with regulators in advance and properly update their capital plans will find that their plans will be better received.  

10. Also, I know of multiple CBLR banks which have recently been instructed by regulators to set internal capital limits above the 9 percent threshold.  So (a) beware of switching to CBLR if you think 9 percent will be your new internal limit and (b) be proactive and pre-emptive in defending your internal limits if you are already a CBLR-filer and you have an exam coming up.

11. I have very recently noticed that on more than one occasion, the regulators were critical of the composition of the board of directors.  More specifically, they are making remarks regarding the lack of expertise, particularly in risk management.  My broader hypothesis about this is that the regulators want to see that there is a bit more separation between the board and Management and that they want the Board to be better stewards of the bank’s capital in these instances.  In all cases, it involved banks who recently graduated into a different asset size threshold, such as crossing the $1.0 or $5.0 billion asset mark.  It may also mean that your board should not be overly concentrated on local business leaders and you may need to start allocating a couple of seats toward individuals with banking experience.  

The bottom line is the more prepared you are, the better your exam will go.  Even if your bank has its challenges and regulatory findings are inevitable, you can still control the materiality and seriousness of the findings by having the right analyses, processes, and plans in place prior to their arrival.  

If you have an upcoming safety and soundness exam or you have recently completed an exam and have MRAs that need to be addressed, we are happy to have a consultative discussion with you.  Invictus has substantial experience and expertise in many of these areas, especially with managing CRE concentrations, stress testing, and capital planning.  Please reach out to Patti Casaleggio at pcasaleggio@invictusgrp.com  to schedule your free consultative session today.


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