Managing Through Regulatory Enforcement

Leading a federally insured financial institution through a regulatory enforcement order will most assuredly rank as the most trying challenge of a bank executive’s career. Excepting instances of fraud, egregious mismanagement or blatant disregard for regulatory direction, banks generally enter into regulatory agreements under extraordinary financial stress borne from aggressive lending during boom times, followed by the inevitable borrower fallout resulting from a punishing economic downturn. As a rule, banks in this category fall into “troubled condition,” and for many, the very viability of the institution is called into question.

For these institutions, the toxic blend of regulatory pressure, capital depletion, shareholder unrest and director dissatisfaction serves to exacerbate an already untenable situation, dampening the morale of executives and employees alike. Furthermore, management must swiftly redirect its talents and skills from production and growth strategies to loss mitigation and strengthening the bank’s risk management and control infrastructure. Most importantly, management must exercise tremendous care to not only attend to the regulatory and operational matters at hand, but to exude confidence to all of the bank’s stakeholders that the bank will survive and ultimately emerge as a stronger institution.

Regulatory Risk Management Stage #1 – Avoidance

The optimal strategy for avoiding the regulatory penalty box is to avoid excessive risk taking, particularly in the areas of credit and liquidity management. Many of today’s troubled institutions pursued growth strategies that involved the loosening of traditional loan underwriting standards, and fueled that growth with high-cost, unstable non-core funding. Many of these banks built up concentrations of loans exceeding prudent capital multiples, thereby compounding losses as those sectors were economically harmed.

Perhaps a bank’s most guarded asset is its reputation. Publicized distinction as a “troubled institution” heightens a bank’s reputation risk, undoing, in most cases, decades of hard work and goodwill in the community, and leading to the defection of loyal customers.

Banks with robust risk management and control practices utilize a blend of employee risk officers and qualified third party risk management advisors to conduct internal audits, loan review and stress tests, and ensure that bank policies and procedures are current and sound. A suggested best practice is for internal and external advisors to maintain direct lines of communication with the board of directors; ideally with the board’s Audit Committee Chairman.

Regulatory Risk Management Stage #2 – Notification

The initial reaction upon learning of a regulator’s intent to place an institution under a written agreement is generally one of frustration and denial, quickly followed by the desire to appeal for less stringent supervisory action.

Legal costs quickly mount as the bank solicits advice and digs in to fight the oncoming reprimand. An appeals process is provided for via the regulatory ombudsman; however, in certain economic cycles, the regulatory position tends to be firm and an appeal becomes a fruitless endeavor. The upside to the appeals process is that the bank can use the extra time to its advantage – tackling the voluminous paperwork requirements from the draft agreement.

Upon notification, regardless of the bank’s position on seeking an appeal, management must immediately take steps to discontinue the criticized activities. This involves serious planning and often includes the elimination of certain core functions (i.e. residential construction lending) and by extension, the elimination or reassignment of personnel. Many banks have reassigned idle lending staff to problem loan management, but this can create borrower relationship conflicts, and in many cases, the customer-service and growth-oriented skill sets that make good lenders do not transfer to the tough-minded independence required of loan workout specialists.

The senior management team must come together to plan a comprehensive strategy that will successfully carry the bank through this difficult period. At the forefront will be communication – the timing and the message, not only to bank staff, but with customers, shareholders, regulators and media; and operational implications – who will handle the paperwork avalanche versus who will oversee bank operations. A formal communications plan needs to be developed quickly and actively managed throughout the process.

The overwhelming process is best facilitated with the retention of experienced regulatory remediation advisors, who will shoulder the heavy lifting and will understand regulatory expectations while the management team continues running the bank. The advisory team will work with management to assign responsibilities, prepare timelines, develop an issue tracking matrix, enhance board communication, and rewrite updated credit and financial policies, draft strategic and capital plans, conduct board and management reviews, and prepare all other reports required in the extremely limited time frames provided under the agreement.

Regulatory Risk Management Stage #3 – Action

Management will need the full support of the board of directors to achieve compliance with the requirements of the agreement. Most banks are required to form a Compliance Committee of the Board to oversee all the elements of the written agreement. Directors will devote more time to bank activities, often times while seeing their fees and the value of their equity investment reduced. Thought must be applied to the conflicting objectives of raising additional capital to cover projected loan losses versus dilution of existing shareholders. Management will wrestle with the conflicting objectives of shrinking the balance sheet in an effort to maintain capital ratios, versus the need to keep performing interest earning assets on the books. The bank may wish to sell branches, but must ensure adequate liquidity, particularly with core deposits. The bank will want to reduce its level of non-performing assets, but will not want or be able to sell them to investors at “bottom fishing” prices. The bank will want to cut expenses, but will find this difficult in the face of mounting FDIC premiums, legal and audit fees. Ultimately, the bank will seek to recalibrate its balance sheet to promote diversification and a return to traditional underwriting standards.

Importantly, the bank MUST meet all regulatory guidelines within the time constraints in the agreement, or it will face further and more severe regulatory action. To meet this challenge, bank management needs to get organized, assign an executive sponsor to each initiative, develop weekly status reporting, review each deliverable for regulatory compliance and establish a formal reporting system for management, the board and ultimately, its regulators.


Bob Morrison
Strategic Risk Associates