The current regulatory climate facing community banks is extraordinarily challenging, in part because of the Dodd-Frank Act. This Financial Services Alert highlights current regulatory and supervisory challenges that community banks face, such as management and board succession planning, capital issues, asset valuation challenges and potential liquidity problems.
This Alert also highlights potential challenges that community banks may face due to the Dodd-Frank Act. On October 5, 2010, Pepper Hamilton issued a Financial Services Alert, “Dodd-Frank Act Will Have Specific Effects on Community Banks,” which outlined the potential effects that the Dodd-Frank Act likely would have on community banks. Since that time, federal regulatory agencies have issued numerous proposed regulations to implement the Dodd-Frank Act. This Alert discusses how these developments have the potential to impact community banks.
Pepper Points: As a result of the Dodd-Frank Act, community banks have the potential to lose a significant amount of fee income and the potential to be subject to more stringent regulations with regard to consumer financial laws. Clarification of preemption standards in the Dodd-Frank Act and in Office of the Comptroller of the Currency (OCC) rulemaking could affect whether community banks with a national charter can preempt state laws. In addition, the Dodd-Frank Act and resulting rulemaking implement new requirements for banks that engage in securitization to retain a portion of the credit risk associated with such securitization; however, there is an exception from the risk retention requirement for loans sold to Fannie Mae and Freddie Mac while they are in conservatorship. The Dodd-Frank Act and related rulemaking also dictate new Federal Deposit Insurance Corporation (FDIC) assessment rules that have the potential to lower the assessment rates that community banks pay. The Dodd-Frank Act’s repeal of Regulation Q has the potential to cause problems for community banks in their completion of Call Reports and could potentially increase funding costs. The Dodd-Frank Act also amends Regulation CC in a way that will require community banks to update systems and forms in accordance with new regulations on availability of funds. Because community bank staffs are smaller than those of large banks, it will be more difficult for community banks to absorb the costs of updating systems and forms. Indeed, the Dodd-Frank Act has the potential to impact community banks in a number of ways, and this Alert highlights those impacts.
Current Regulatory and Supervisory Challenges
A. Management and Board Succession
Compliance with the Dodd-Frank Act is not the only challenge currently facing community banks. Indeed, many community banks are facing numerous additional challenges, including management succession planning. While careful management succession planning is an important component of carrying a strong organization into the future, incumbent senior management and boards of directors understandably often spend more time and attention focusing on more immediate indicators of well-being, such as current financial performance. However, by not addressing succession planning as a highest-priority item, an entity may harm its financial prospects over the long run.
Regulators also expect to see management succession plans in place that are analyzed at least annually as well as when other circumstances dictate further review or revisiting of the plan. By not having internal candidates ready to assume senior management positions, entities may be forced to “pay up” in order to entice outsiders to leave known situations to pursue an unknown opportunity. Also, if an entity must hire outsiders for senior management positions, it is likely that it will take such new hires an additional amount of time to understand the workings and culture of the entity.
In addition to maintaining current management succession plans, community banks must also review, at least annually, the need to recruit new board members. Community banks should evaluate the likely retirement dates of current board members and develop plans to replace those members who are likely to retire in the near future. Entities should develop plans that consider the expertise and background of departing board members in order to ensure that potential new members will facilitate a well-rounded board with a broad base of knowledge.
In difficult economic times, maintaining high capital levels can be a challenge for community banks. As discussed in the October 2010 Financial Services Alert, in general, small bank holding companies with less than $500 million in assets are exempt from the Dodd-Frank Act’s restriction on counting trust preferred securities as an element of Tier 1 Capital. Nevertheless, in today’s current regulatory climate, regulators are increasingly concerned about banks having sufficiently high capital levels. Given this environment, it is likely that many community banks may struggle to maintain capital levels satisfactory to regulators.
Given the challenges some community banks may face in keeping capital levels high, some community banks operating as S corporations may consider switching from an S corporation to a C corporation to attract new capital and investors. In general, to elect status as an S corporation, a corporation must have no more than 100 shareholders, only have one class of stock, and not have any ineligible shareholders (e.g., C corporations and partnerships). As such, a community bank that has elected to be treated as an S corporation has a limited pool from which to attract new investors and new capital. These restrictions do not exist for C corporations, which could be an attractive option for community banks seeking to raise additional capital through new investors.
If a community bank is contemplating a switch from an S corporation to a C corporation, it should evaluate all of the potential tax-related ramifications of doing so. Some of these considerations include the manner and timing in which the entity would terminate its status as an S corporation. An entity considering such a switch should consult competent counsel to consider its options.
C. Asset Valuation
Lacking accurate asset valuation can also present a problem for community banks in the current economic environment. The continued decline in real estate values in many markets can make it extremely difficult for community banks to assess accurately the value of their collateral. Given the number of bank failures during the financial crisis, regulators will look to ensure that banks have adequately, and likely conservatively, valued loan risk based on the likelihood of repayment, and, in the event of default, accurate valuations of collateral. It is imperative for community banks to accurately monitor collateral value in line with regulators’ expectations to avoid informal or formal enforcement actions.
An additional challenge for community banks is to maintain and monitor liquidity levels in the current economic environment. As is the case for capital requirements, the current regulatory trend is for higher liquidity requirements. All banks, including community banks, should carefully monitor regulatory developments to keep in line with liquidity requirements.
In late 2010, the Basel Committee on Banking Supervision released the new Basel III framework, which contains liquidity guidelines that U.S. community banks could be required to follow in the future. As of the date of this Alert, it is not entirely clear how the Basel III framework will apply to U.S. banks, and specifically community banks. The Basel III framework requires banks to maintain a certain “liquidity coverage ratio” (LCR). The LCR requires banks to maintain enough highly liquid assets to cover 30 days of net cash outflows. It is a ratio that is meant to ensure that an institution has enough liquid assets to cover a short-term crisis. The Basel III framework also contains a “net stable funding ratio” (NSFR), which is a long-term ratio that measures how much stable funding an institution has to withstand a year-long liquidity crisis. The LCR would not become binding under the Basel III framework until 2015, and the NSFR would not become binding until 2018. It is unclear how U.S. regulators will implement the framework, however, it is a potential requirement that U.S. community banks should monitor.
The Dodd-Frank Act
In addition to the general challenges facing community banks in the current economic environment, these banks must now prepare themselves for implementation of the Dodd-Frank Act. Discussed below are certain aspects of the Dodd-Frank Act that may have an impact on community banks.
A. Interchange Income
The Dodd-Frank Act, by means of the so-called “Durbin Amendment,” will likely cause a loss of fee income to all banks, including community banks. The Durbin Amendment amends the Electronic Fund Transfer Act by inserting language regarding reasonable fees and rules for payment card transactions. The new language states that the Federal Reserve Board (FRB) “may prescribe regulations ... regarding any interchange transaction fee that an issuer may receive or charge with respect to an electronic debit transaction.” The Act goes on to state that the amount of any interchange fee “shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.”
Small issuers have an exemption from the provision of the Act regarding the restrictions on interchange fees. The restriction on interchange fees does not apply to issuers that, together with affiliates, have assets of less than $10 billion. Although smaller institutions are exempt from the interchange restrictions of the Act, it is likely that these smaller institutions will be forced to lower their interchange fees due to market pressures.
In December 2010, the FRB issued a proposed rule to establish debit card interchange fee standards. The proposed rule establishes standards for determining whether a fee is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. The FRB’s proposed rule has two standards that would apply to covered issuers:
(1) an issuer-specific standard with a safe harbor of 7 cents and a cap of 12 cents. If costs are in excess of 7 cents per transaction, the issuer can recover average variable costs up to 12 cents
(2) a cap of 12 cents applicable to all issuers.
As of the date of this Alert, the FRB has not finalized its rule regarding interchange income, but it is expected that the FRB will propose a cap greater than the 12-cent cap previously proposed. It is likely that the FRB will finalize its rule regarding interchange fee standards in the very near future and that the rule will become effective on July 21, 2011. The Dodd-Frank Act contains a directive that requires the FRB to issue final interchange fee standards by April 21, 2011, however, in a March 29, 2011 letter to the House Committee on Financial Services, Chairman Ben Bernanke indicated that the FRB would not be able to meet this deadline due to receiving more than 11,000 comments on the proposed rule.
A bill put forth by Sens. Jon Tester (D-Mont.) and Bob Corker (R-Tenn.) to delay the effectiveness of the Durbin Amendment by 12 months to allow the FRB to study its effect on small banks and credit unions recently failed. The bill gained a majority in the Senate, but fell short of the 60 votes needed to prevent a filibuster. We will issue future Alerts as developments regarding interchange fee standards arise.
B. Consumer Financial Protection Bureau
The Dodd-Frank Act creates a new regulatory body that will be known as the Consumer Financial Protection Bureau (CFPB) that could increase community banks’ regulatory costs. The CFPB will be responsible for implementing and enforcing federal consumer financial laws consistently to ensure that all consumers have access to markets for financial products and that the market for consumer financial products and services are fair, transparent and competitive. The CFPB will have the authority to promulgate regulations applicable to banks of all sizes with respect to consumer financial laws. The CFPB, however, will only have examination and enforcement authority over banks with assets of more than $10 billion.
Although the CFPB will not have examination authority over banks with assets of less than $10 billion, its ability to promulgate regulations will have an effect on community banks. Because banks of all sizes will be subject to the CFPB’s regulations, compliance costs for community banks could rise as the CFPB implements a more stringent regulatory environment. Additionally, with regard to institutions with assets of $10 billion or less, the CFPB has the authority to require reports that it determines are necessary to support its role in implementing federal consumer financial laws and to assess and detect risks to consumers and consumer financial markets. The CFPB may also include examiners on a sampling basis of the examinations performed on institutions with assets of $10 billion or less to assess compliance with the requirements of federal consumer financial laws.
As of the date of this Alert, the President has not yet nominated a director of the CFPB. The CFPB is, however, continuing to move forward in its hiring of senior management. On May 2, 2011, 44 Republican senators sent a letter to the President indicating that they would not confirm any nominee to be CFPB director until the CFPB is “properly reformed.” The letter discusses three separate reforms:
- establishing a board of directors to oversee the CFPB
- subjecting the CFPB to the appropriations process, and
- establishing a safety-and-soundness check for the prudential regulators.
In addition, Republicans have introduced numerous pieces of legislation designed to amend the Bureau. Republicans have introduced legislation:
- to replace the bureau director with a commission composed of five bipartisan members
- to change the “oversight” majority of the Financial Stability Oversight Council to overrule a CFPB rule from a two-thirds majority to a simple majority, and
- move the CFPB into the Treasury Department.
C. Preemption Standards
The Dodd-Frank Act clarifies the standard for preemption of “state consumer financial laws,” a clarification that could affect the ability of community banks with national charters to preempt state law. The Act reaffirms that the proper preemption standard is the standard enunciated by the Supreme Court in Barnett Bank v. Nelson, 517 U.S. 25 (1996) (the “Barnett Bank standard”). The Act indicates that “state consumer financial laws” are only preempted if application of such law would have a discriminatory effect on national banks in comparison to the effect on state banks or the state law “prevents or significantly interferes with” the exercise by the national bank of its powers. The Act also eliminates preemption of state law for national bank subsidiaries, agents and affiliates, which reverses the Supreme Court’s holding in Watters v. Wachovia, N.A., 550 U.S. 1 (2007). In addition, the Act also eliminates field preemption for federal savings associations.
In May 2011, the OCC issued a proposed regulation implementing the preemption standards in the Dodd-Frank Act. The proposed rule rescinds the OCC’s regulation for the preemption of state law for national bank subsidiaries, agents and affiliates. This will force community banks with national charters that perform operations through subsidiaries, agents and affiliates to either conduct the operations of such subsidiaries, agents and affiliates at the bank level or have those entities comply with applicable state law.
The proposed rule provides that, as of July 21, 2011, federal savings associations are subject to the same preemption standards as national banks. Consequently, preemption determinations by a court or by the OCC under the Home Owners’ Loan Act with respect to federal savings associations must be made in accordance with the laws and standards applicable to national banks. Federal savings associations should become familiar with these standards to understand how state law will affect their operations.
The proposed rule also addresses the preemption of “state consumer financial laws.” The proposed rule eliminates the OCC’s preemption regulation that provided that state laws that “obstruct, impair, or condition” a national bank’s powers were not applicable to national banks. The OCC indicates in the proposed rule that this standard has created ambiguities and misunderstandings regarding the preemption standard articulated in the Supreme Court’s decision in Barnett Bank. The proposed rule instead indicates that the standard for preemption is the Barnett Bank standard. The OCC cautions that the Barnett Bank standard does not simply ask whether a state law “prevents or significantly interferes with the exercise by a national bank of its powers.” Instead, the OCC indicates that the Barnett Bank standard encompasses the whole test for conflict preemption, not just the “prevents or significantly interferes” standard in Barnett Bank. The OCC also specifically indicates that, because the Dodd-Frank Act preserves the Barnett Bank standard, all OCC rules and interpretations consistent with the Barnett Bank standard are preserved.
The Dodd-Frank Act also imposes procedures and consultation requirements with regard to OCC preemption determinations made after July 21, 2011. The Act requires the OCC to make preemption determinations for state consumer financial laws on a case-by-case basis under the Barnett Bank standard. In the process of making case-by-case determinations, the OCC must first consult with the CFPB. The Act also requires the existence of “substantial evidence” for the OCC to make a preemption determination. The Dodd-Frank Act requires any preemption determination to be made specifically by the Comptroller, as the Act states that preemption determinations according to the Barnett Bank standard “shall not be delegable to another officer or employee of the Comptroller of the Currency.” The Dodd-Frank Act also requires the OCC to conduct a periodic review every five years after issuing a preemption determination. The OCC has not proposed any new rules to address the determination process; however, the OCC does acknowledge in its commentary to the proposed rule that, going forward, after July 21, 2011, these procedural requirements will become effective. We will issue future Alerts as developments about the OCC procedural process for preemption determinations arise.
Community banks with national charters should monitor finalization of the proposed rule for any further clarification or changes to preemption standards going forward. Such banks should also monitor OCC preemption determinations after July 21, 2011 to gain a sense of whether anything will really change with regard to the preemption standards the OCC follows. At this point, it appears that those standards may remain largely the same.
The Dodd-Frank Act requires securitizers of asset-backed securities, including residential mortgages, to maintain at least 5 percent of the credit risk of such securities, which could affect the ability of community banks to securitize loans. There is, however, an exception to the credit risk retention requirement for loans sold to Fannie Mae and Freddie Mac while they are in conservatorship and for “qualified residential mortgages.” Finalization of this aspect of the proposed rule would be a benefit for community banks that sell their loans to Fannie Mae and Freddie Mac, as they would not be required to retain any credit risk for such loans. This aspect of the proposed credit risk retention rule, however, seems to conflict with the Obama administration’s previously stated goal of reducing the roles of Fannie Mae and Freddie Mac, as it would likely result in upward pressure on the number of loans sold to the government-sponsored enterprises. As such, community banks should monitor finalization of the rule to see whether this exception to the credit risk retention requirement stays intact.
In addition, there is an exception to the credit risk retention requirement for “qualified residential mortgages.” In April of 2011, the OCC, the FRB, the FDIC, the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA), and U.S. Department of Housing and Urban Development (HUD) issued a proposed rule to implement the credit risk retention requirements of the Dodd-Frank Act. The proposed rule, among other things, lists requirements for a mortgage to meet the definition of a “qualified residential mortgage.” One of the requirements includes a 20 percent down payment, which would exclude many residential mortgages from this definition. Originally, comments on the proposed rule were due on June 10, 2011, but shortly before the original due date, the federal agencies announced an extension of the due date for comments until August 1, 2011. Securitizers of asset-backed securities should take advantage of the extension of the comment period to ensure that their views are heard by the federal agencies before a final rule implementing the credit risk retention requirements is promulgated.
If the proposed rule is finalized with a requirement that a qualified residential mortgage have a 20 percent down payment, it could have a negative impact on community banks and their customers. Community banks that engage in securitization will want to try to originate as many qualified residential mortgages as they can so they will be required to retain as few mortgages as possible and securitize as many mortgages as possible. This motivation would likely result in banks having a significantly smaller applicant pool to draw from, as many homebuyers, especially first-time homebuyers, will not be able to afford the 20 percent down payment required for qualified residential mortgages. This, in turn, will likely further tighten already tight credit conditions for potential borrowers. Additionally, the costs of obtaining a non-qualified residential mortgage would likely increase under the proposed rule, as lenders will likely charge higher interest rates to offset the increased risk they would experience as a result of the requirement to maintain 5 percent of the credit risk of non-qualified residential mortgages.
E. New FDIC Insurance Rules
The Dodd-Frank Act changes the assessment base for FDIC deposit insurance and may reduce the assessment rates that community banks will pay due to an FDIC rule that would require large banks to pay higher assessment rates. The new assessment base will be tied to total assets less tangible equity instead of deposit liabilities. The Dodd-Frank Act also changes the minimum reserve ratio for the FDIC deposit insurance fund to 1.35 percent of estimated insured deposits or the assessment base. In February 2011, the FDIC approved a final rule on Deposit Insurance Assessments, Dividends, Assessment Base and Large Bank Pricing. This final rule creates a Large Bank Pricing System in which insured depository institutions with at least $10 billion in total assets will have increased assessment rates. As larger banks pay more, it is anticipated that most community banks will pay lower assessment rates as a result of this final rule. In a Financial Institutions Letter discussing this final rule, the FDIC went so far as to state that “[n]early all of the 7,600-plus institutions with assets less than $10 billion will pay smaller assessments as a result of this final rule.” The final rule was effective as of April 1, 2011. For a more detailed discussion of this final rule, see Pepper’s February 17, 2011 Financial Services Alert, “FDIC Approves Final Rules on Insurance Fund Assessments.”
F. Repeal of Regulation Q
The Dodd-Frank Act repeals, in its entirety, the section of the Federal Reserve Act that serves as the FRB’s authority to issue Regulation Q, which prohibits the payment of interest on demand deposits. The repeal could impact community banks in several ways. Based on the Dodd-Frank Act’s repeal of its authority, the FRB issued a proposed rule in April 2011 to repeal Regulation Q. Comments were due in May 2011. The proposed rule would eliminate Regulation Q effective July 21, 2011.
The completion of Call Reports is one potential problem for community banks, and, in fact, all banks, due to the repeal of Regulation Q. Call Reports will need to be changed and guidance will need to be issued with regard to the reporting of interest-bearing demand deposits. Another potential problem could arise with regard to regulatory guidance and precedent relative to what has not been considered interest under Regulation Q. The payment of non-interest equivalents is not taxable, while the payment of interest is taxable. Community banks should monitor whether regulatory guidance as to what is and is not considered interest under Regulation Q is done away with, as such a regulatory decision could impact the taxable nature of certain payments.
The repeal of Regulation Q also has the potential to increase funding costs for community banks. If banks are no longer restricted from paying interest on demand deposit commercial checking accounts, they may start paying interest on these accounts to attract funding. Funds in these accounts will then likely shift from institutions that are not paying interest to those that are paying interest. This will likely cause community banks that need to retain these sources of funds to also start paying interest, thereby driving up their funding costs.
G. Regulation CC
The Dodd-Frank Act amends the Expedited Funds Availability Act and increases the minimum next-day availability requirement for deposits made by check from $100 to $200. This change will require community banks to make changes to systems and forms and also require additional training that will only add to the work that community banks must undertake to prepare for compliance with the Dodd-Frank Act.
In March, 2011, the FRB issued a proposed rule that would remove references to $100 as the minimum amount that must have next-day availability in the commentary and model forms for Regulation CC and instead refer to “the minimum amount.” The proposed rule indicates that the increase is expected to take effect on July 21, 2011, regardless of whether the FRB or the CFPB have amended Regulation CC. As such, community banks should prepare to implement this change by July 21, 2011.
Timothy R. McTaggart and Michael J. Callaghan