United States: Nutter Bank Report, December 2015

The Nutter Bank Report is a monthly publication of the firm's Banking and Financial Services Group.

Headlines
1. Interagency Guidance Recommends Banks Review CRE Risk Management Strategies
2. Federal Reserve Announces Changes to Safety-and-Soundness Surveillance Program
3. FAST Act Provides Annual Privacy Notice Relief; Extends Exam Cycles for Some Banks
4. Federal Reserve Warns Holding Companies on Shareholder Protection Arrangements
5. Other Developments: Examination Guidance and Credit Risk 

1. Interagency Guidance Recommends Banks Review CRE Risk Management Strategies

The federal banking agencies have issued new guidance to banks on prudent risk management practices for commercial real estate ("CRE") lending activity. The interagency "Statement on Prudent Risk Management for Commercial Real Estate Lending" released on December 18 outlines supervisory expectations for managing CRE lending risks based on existing regulatory guidance on risk management practices. For example, the new guidance points out that banks that succeeded in managing CRE credit concentrations during difficult economic cycles were ones that had generally established appropriate loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a board committee. According to the agencies, these banks also had developed lending strategies, limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate in light of changing market conditions, and adopted strategies to ensure capital adequacy and allowance for loan losses that supported the lending strategies and were consistent with the level and nature of risk in the CRE portfolio. The guidance recommends that banks consider conducting global cash flow analyses based on reasonable rental rates, sales projections, and operating expenses to ensure that each CRE borrower has sufficient repayment capacity to service all loan obligations, and perform market and scenario analyses of CRE loan portfolios to quantify the potential impact of changing economic conditions on asset quality, earnings and capital. The guidance advises all banks to review their policies and practices related to CRE lending and consider whether their risk management practices and capital levels are commensurate with the level and nature of their CRE concentration risk. The new CRE guidance is available here.

     Nutter Notes: The new CRE risk management guidance emphasizes that examiners expect to see ongoing oversight by a bank's board of directors, who should have sufficient information to assess whether the bank's lending strategy and policies continue to be appropriate in light of changes in market conditions. According to the guidance, examiners also expect banks to maintain underwriting discipline and exercise prudent risk management practices that identify, measure, monitor and manage the risks arising from their CRE lending activity. The agencies said they have noticed an easing of CRE underwriting standards, and banks should expect examiners' reviews of CRE lending activities to focus on implementation of the principles in published regulatory guidance relating to identifying, measuring, monitoring and managing concentration risk in CRE lending activities. The new CRE risk management guidance includes a list of existing regulations and published guidance on CRE lending. In particular, banks are encouraged to review the interagency "Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices" issued in December 2006 for a discussion of examiners' expectations for concentration risk management practices. Banks should expect examiners to scrutinize potential risks associated with CRE lending during 2016, according to the new guidance – especially those banks that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals. The guidance advises that, where examiners find inadequate risk management practices and capital strategies, the agencies will ask banks to develop a plan to identify, measure, monitor and manage CRE concentrations, reduce risk tolerances in their underwriting standards, or raise additional capital to mitigate CRE risk.

2. Federal Reserve Announces Changes to Safety-and-Soundness Surveillance Program

The Federal Reserve has recently revised its safety-and-soundness surveillance program (the "Surveillance Program") under which it monitors adherence to regulations and guidance by all state member banks and top-tier holding companies, produces financial industry analysis and targets certain institutions for enhanced supervisory attention. The Surveillance Program enhancements announced on December 10 include new risk classification algorithms that provide examiners and other supervisory staff with early signals of a bank's or holding company's risk-taking and a new early-warning model for holding companies that complements the existing early-warning model for financial weaknesses at state member banks. The program has also been revised to reflect the Federal Reserve's responsibility since 2011 for savings and loan holding companies. According to the Federal Reserve's announcement, a Federal Reserve Bank may communicate some of the Surveillance Program monitoring results to a specific institution, but generally will not share the information with the public or other institutions. According to the Federal Reserve, the objectives of the Surveillance Program include targeting high-risk institutions and institutions with emerging financial difficulties for enhanced supervisory attention, identifying low-risk institutions and applying a more streamlined supervisory approach to them, and detecting possible regulatory violations and departures from supervisory guidance. Additional details about the Surveillance Program are described in Federal Reserve Supervisory Letter no. SR 15-16 (Dec. 10, 2015) (click here to view the Supervisory Letter).

     Nutter Notes: Under the Surveillance Program, the Federal Reserve maintains an "Outlier List" that identifies emerging risks at state member banks and top-tier holding companies based on algorithms used to generate risk classifications of "Low," "Moderate" or "High" for individual risk and performance dimensions (such as capital, liquidity, credit, earnings and operations). The Outlier List includes all state member banks and top-tier holding companies (those that file FR Y-9Cs only) categorized as High risk within at least one risk or performance dimension. The Outlier List initially targeted community and regional banking organizations, but the Federal Reserve said that it is expanding and customizing the algorithms for banks and holding companies of differing size and complexity. The Federal Reserve also maintains a "Watch List" under the Surveillance Program, which identifies emerging financial weaknesses at state member banks and top-tier holding companies. The Watch List includes all state member banks and top-tier holding companies with a most recent composite safety-and-soundness rating consistent with financial viability, but a surveillance grade of "D" or "F," suggesting the possibility of deterioration in examination or inspection findings in the future. The Federal Reserve uses a statistical model to assign a surveillance letter grade (A, B, C, D, or F) reflecting the bank's condition relative to others with the same composite safety-and-soundness rating. Two grades are assigned to each bank, one reflecting the estimated probability of a downgrade to a worse rating class and another reflecting the estimated probability of critical undercapitalization or failure. The Federal Reserve similarly assigns a surveillance letter grade to each top-tier holding company reflecting its condition relative to others in the same rating class, as indicated by the estimated probability of a downgrade to a worse rating class.

3. FAST Act Provides Annual Privacy Notice Relief; Extends Exam Cycles for Some Banks

President Obama has signed a bill into law that amends existing annual privacy notice requirements under Title V of the Gramm-Leach-Bliley Act and extends the exam cycle from 12 to 18 months for qualifying institutions, among other things. The bill known as H.R. 22, the "Fixing America's Surface Transportation Act" or "FAST Act" (designated as Public Law no. 114-94 as of December 4) provides an exception to the annual privacy notice requirements for banks and other financial institutions that have not changed their policies and practices with regard to disclosing nonpublic personal information from those disclosed in the most recent privacy notice delivered to consumers. Those qualifying banks and other financial institutions will no longer be required to provide another privacy notice until such time as the institution changes its privacy policies or practices. The purpose of the amendment according to a congressional statement is to reduce confusion among consumers that can occur when they receive annual privacy notices. The FAST Act also amends the Federal Deposit Insurance Act to increase the qualifying asset threshold for banks eligible for 18-month on-site examination cycles from $500 million to $1 billion.

     Nutter Notes: In addition, the FAST Act amends Title VI of the JOBS Act to raise the threshold for mandatory Securities and Exchange Commission ("SEC") registration of savings and loan companies from 500 shareholders of record to 2,000 shareholders of record (with no limitation on the number of non-accredited investors) and to raise the threshold for a savings and loan company to terminate its registration from 300 to 1,200 shareholders of record. The new law also simplifies the SEC registration process by amending the SEC's Form S-1 registration statement, which is the registration form typically used for registering a new offering of securities, to allow smaller companies to incorporate by reference any documents filed with the SEC after the effective date of the Form S-1. The FAST Act amends the Federal Home Loan Bank Act to allow privately insured credit unions to be eligible for membership in the Federal Home Loan Bank System. The FAST Act also amends the Fair Credit Reporting Act to eliminate the requirement that state and local child support agencies and courts notify an obligor 10 days before retrieving a consumer report for purposes of determining the appropriate level of child support payments, or enforcing a child support order, award, agreement or judgment.

4. Federal Reserve Warns Holding Companies on Shareholder Protection Arrangements

The Federal Reserve has recently issued guidance cautioning bank holding companies and savings and loan holding companies about certain risks related to arrangements structured to protect the investments made by holding company shareholders in holding company stock (referred to as "shareholder protection arrangements"). The Federal Reserve warned in Supervisory Letter no. SR 15-15 published on December 3 that shareholder protection arrangements could have negative implications on a holding company's capital or financial position, or limit the holding company's ability to raise capital in the future, resulting in the Federal Reserve's objection to such arrangements. Examples of shareholder protection arrangements that have raised supervisory concerns include those in which a holding company agrees to provide an investor with cash payments compensating for the difference between the stock price paid by an investor and a lower price paid by subsequent investors, or with additional shares of stock for minimal or no additional payment if the holding company issues shares at a lower price than that paid by the investor. The new guidance recommends that any holding company that is engaged in capital raising efforts or is considering the implementation or modification of a shareholder protection arrangement should review the new guidance and ensure that supervisory concerns are addressed. The new guidance on shareholder protection arrangements is available here.

     Nutter Notes: The Federal Reserve's new guidance also expresses concerns about shareholder protection arrangements under which existing shareholders are able to acquire additional stock at significant discounts to market value in a new offering if any shareholder crosses a specific ownership threshold; investors with less-than-majority control are granted the contractual right to restrict or prevent the holding company from issuing additional stock; or the holding company's board of directors has the authority to nullify stock purchases under certain circumstances, require the holding company to repurchase the stock of the company from a new owner of the stock, or take other actions that would significantly inhibit secondary market transactions in the stock of the holding company. The Federal Reserve may object to shareholder protection arrangements of these types or others that have the potential to impose additional financial obligations on a holding company or restrict the primary or secondary market for the holding company's stock, according to the new guidance. The new guidance advises that the Federal Reserve may direct a holding company's board of directors to modify or remove a shareholder protection arrangement that gives rise to safety and soundness concerns. Required corrective actions may vary depending on the facts and circumstances, as well as applicable state and federal laws and regulations, corporate charters and by-laws, and other considerations, according to the new guidance.

5. Other Developments: Examination Guidance and Credit Risk 

  • FDIC and OCC Revise Examination Guidance

The FDIC has revised its Compliance Examination Manual to include new guidance about Matters Requiring Board Attention, a section of the Report of Examination that directs banks to important information about weaknesses in a compliance management system, and guidance on evaluating the impact of consumer harm on examination and supervisory activities, among other things. The revised Compliance Examination Manual is available here.

     Nutter Notes: The OCC announced on December 3 that it has issued updated guidance on its risk assessment system to clarify the relationship between the risk assessment system and CAMELS ratings, among other things. The updates are reflected in the "Bank Supervision Process," "Community Bank Supervision," "Federal Branches and Agencies Supervision," and "Large Bank Supervision" booklets of the Comptroller's Handbook. Additional details from the OCC are available  here. 

  • Federal Banking Agencies React to Basel Committee Guidance on Credit Risk

The Basel Committee on Banking Supervision published a consultative paper on December 10 titled "Revisions to the Standardized Approach for Credit Risk," which is the Basel Committee's second published guidance document on the subject. On the same day, the federal banking agencies announced that the Basel Committee's proposed revisions would apply primarily to large, internationally active banking organizations and not to community banking organizations, and that the agencies will consider the proposals in a manner consistent with the U.S. banking agencies' notice and comment process.

     Nutter Notes: The Basel Committee first proposed in December 2014 to drop explicit references to external credit ratings in its proposal for weighting credit risks. The Basel Committee's latest proposal is a reaction to concerns about the complete removal of references to ratings, and the revised proposal reintroduces external ratings to a limited extent.

Originally published on December 30, 2015

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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