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TREASURY DEPARTMENT’S "NEW ERA OF ACCOUNTABILITY, TRANSPARENCY, MONITORING AND CONDITIONS" (Part 3 in a series)

COULD FINANCIAL STABILITY FUNDS HURT BANKS? DEFINITELY!

As discussed in a previous Alert, the Treasury Department recently announced a new Financial Stability Plan (FSP) intended to, among other things, strengthen financial institutions. See Alert dated February 18. A key component of the FSP is the Capital Assistance Program (CAP), which is designed to strengthen banks by providing to those eligible capital buffer assistance (or exceptional assistance) in the form of cumulative mandatorily convertible preferred stock and warrants for common stock. See Financial Stability Plan Fact Sheet [PDF], p.2 (Feb. 10, 2009)("FSP Fact Sheet").

Transparency, Accountability and Conditionality

An important aspect of the FSP is the imposition of new, higher standards for transparency, accountability and conditionality, the creation of which was fueled by public frustration and anger over the lack of accountability for the initial deployment of Troubled Asset Relief Program or TARP funds under the Emergency Economic Stabilization Act of 2008. See FSP Fact Sheet at 4. Key new standards, which were based on recommendations made by formal TARP oversight groups and the Congressional committees charged with oversight of the banking system and set forth in the Treasury’s FSP Fact Sheet, include:

• Showing how assistance from the FSP will expand lending

o A bank receiving exceptional assistance or capital buffer assistance will be required to show how every dollar of capital it receives is enabling it to preserve or generate new lending compared to what would have been possible without the assistance.
o Monthly reports also will be required showing (i) new loans, (ii) number of asset-backed and mortgage-backed securities purchased, (iii) a description of the lending environment in the bank’s market and (iv) what the bank’s lending would have been without the government support.

• Committing to mortgage foreclosure mitigation

o A bank receiving capital investments must commit to participate in mortgage foreclosure mitigation consistent with Treasury guidelines.

• Restricting dividends, stock repurchases and acquisitions

o A bank receiving exceptional assistance or generally available capital will be subject to certain dividend payment limitations.
o A bank receiving funding from the new CAP is restricted from repurchasing any privately-held shares, subject to Treasury approval.
o A bank receiving capital assistance may not pursue cash acquisitions of healthy firms until after repayment of the government assistance, except under certain circumstances.

• Limiting Executive Compensation

o A bank will be required to comply with senior executive compensation restrictions outlined in the Treasury’s February 4, 2009 guidance and in the American Recovery and Reinvestment Act of 2009.

See FSP Fact Sheet at 4-6, see also CAP Term Sheet, pp. 4, 6 available here [PDF]. ("CAP Term Sheet").

Although these standards are a response to legitimate public concerns, they will undermine the FSP’s goal of strengthening banks by negatively affecting many of the factors considered in evaluating the components of a bank’s CAMELS rating.

CAMELS Rating

The Federal Financial Institutions Examination Council’s (FFIEC) Uniform Financial Institutions Rating System, which commonly is referred to as the CAMELS rating system, is an internal rating system used by federal and state banking regulators to evaluate the soundness of financial institutions. See 61 Fed. Reg. 67021-22 (Dec. 19, 1996). The CAMELS rating system allows imposition of a uniform standard that is used to identify institutions that require special supervisory attention. Id. The CAMELS rating system was first adopted in November 1979 and updated effective January 1997. Id., see also FIL-105-96 (Dec. 26, 1996).

Under the CAMELS rating system, each financial institution receives a composite rating based on an evaluation and rating of certain components of the institution’s financial condition and operation. Id. at 67022. The components of a bank’s condition that are assessed under the CAMELS rating include (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity and (S) sensitivity to market risk. Id. at 67025. A qualitative analysis of the factors comprising a particular component and the component’s interrelationship with the other components are used to rate the component. Id. Some components may be given more weight than others depending upon the institution’s situation. Id. Generally, assignment of a composite rating may incorporate any factor that bears significantly on the overall condition and soundness of the financial institution. Id. The management component in particular often is given special consideration when assigning a composite rating because the ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating the institution’s overall risk. Id.

Components and Principal Factors

The FFIEC’s notice of the CAMELS rating system describes each component. Evaluation of the components is based upon, but not limited to, an assessment of certain principal evaluation factors. Id. at 67026. Because the components are interrelated, some of the evaluation factors may be considered under more than one component. Id.

Capital Adequacy

A financial institution is expected to maintain capital commensurate with the nature and extent of risks to the institution and the ability of management to identify, measure, monitor, and control these risks. The effect of credit, market, and other risks on the institution's financial condition should be considered when evaluating the adequacy of capital. The types and quantity of risk inherent in an institution's activities will determine the extent to which it may be necessary to maintain capital at levels above required regulatory minimums to properly reflect the potentially adverse consequences that these risks may have on the institution's capital. Id. at 67026. This component is rated based upon an assessment of certain evaluation factors including, among others, (i) the level and quality of capital and the overall financial condition of the institution, (ii) the nature, trend, and volume of problem assets, and the adequacy of allowances for loan and lease losses and other valuation reserves, (iii) the quality and strength of earnings, and the reasonableness of dividends and (iv) access to capital markets and other sources of capital. See id.

Asset Quality

The asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions. The ability of management to identify, measure, monitor, and control credit risk is also reflected here. The evaluation of asset quality should consider the adequacy of the allowance for loan and lease losses and weigh the exposure to counterparty, issuer, or borrower default under actual or implied contractual agreements. All other risks that may affect the value or marketability of an institution's assets, including, but not limited to, operating, market, reputation, strategic, or compliance risks, should also be considered.

Id. at 67026-27. This component is rated based upon an assessment of certain evaluation factors including, among others, (i) the adequacy of underwriting standards, soundness of credit administration practices, and appropriateness of risk identification practices (ii) the level, distribution, severity and trend of problem, classified, nonaccrual, restructured, delinquent, and nonperforming assets for both on- and off-balance sheet transactions, (iii) the adequacy of the allowance for loan and lease losses and other asset valuation reserves and (iv) the adequacy of loan and investment policies, procedures, and practices. See id.

Management

The capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution's activities and to ensure a financial institution's safe, sound, and efficient operation in compliance with applicable laws and regulations is reflected in this rating. Generally, directors need not be actively involved in day-to-day operations; however, they must provide clear guidance regarding acceptable risk exposure levels and ensure that appropriate policies, procedures, and practices have been established. Senior management is responsible for developing and implementing policies, procedures, and practices that translate the board's goals, objectives, and risk limits into prudent operating standards. Depending on the nature and scope of an institution's activities, management practices may need to address some or all of the following risks: credit, market, operating or transaction, reputation, strategic, compliance, legal, liquidity, and other risks. Sound management practices are demonstrated by: active oversight by the board of directors and management; competent personnel; adequate policies, processes, and controls taking into consideration the size and sophistication of the institution; maintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems. This rating should reflect the board's and management's ability as it applies to all aspects of banking operations as well as other financial service activities in which the institution is involved.

Id. at 67027. This component is rated based upon an assessment of certain evaluation factors including, among others, (i) the level and quality of oversight and support of all institution activities by the board of directors and management, (ii) the ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the initiation of new activities or products, (iii) the adequacy of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities and (iv) reasonableness of compensation policies and avoidance of self-dealing. See id.

Earnings

This rating reflects not only the quantity and trend of earnings, but also factors that may affect the sustainability or quality of earnings. The quantity as well as the quality of earnings can be affected by excessive or inadequately managed credit risk that may result in loan losses and require additions to the allowance for loan and lease losses, or by high levels of market risk that may unduly expose an institution's earnings to volatility in interest rates. The quality of earnings may also be diminished by undue reliance on extraordinary gains, nonrecurring events, or favorable tax effects. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, improperly executed or ill-advised business strategies, or poorly managed or uncontrolled exposure to other risks.

Id. at 67028. This component is rated based upon an assessment of certain evaluation factors including, among others, (i) the level of earnings, including trends and stability, (ii) the quality and sources of earnings and (iii) the adequacy of provisions to maintain the allowance for loan and lease losses and other valuation allowance accounts. See id.

Liquidity

In evaluating the adequacy of a financial institution's liquidity position, consideration should be given to the current level and prospective sources of liquidity compared to funding needs, as well as to the adequacy of funds management practices relative to the institution's size, complexity, and risk profile. In general, funds management practices should ensure that an institution is able to maintain a level of liquidity sufficient to meet its financial obligations in a timely manner and to fulfill the legitimate banking needs of its community. Practices should reflect the ability of the institution to manage unplanned changes in funding sources, as well as react to changes in market conditions that affect the ability to quickly liquidate assets with minimal loss. In addition, funds management practices should ensure that liquidity is not maintained at a high cost, or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions.

Id. at 67028. This component is rated based upon an assessment of certain evaluation factors including, among others, (i) the adequacy of liquidity sources compared to present and future needs and the ability of the institution to meet liquidity needs without adversely affecting its operations or condition, (ii) the availability of assets readily convertible to cash without undue loss and (iii) the capability of management to properly identify, measure, monitor, and control the institution's liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans. See id.

Sensitivity to Market Risk

The sensitivity to market risk component reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution's earnings or economic capital. When evaluating this component, consideration should be given to: management's ability to identify, measure, monitor, and control market risk; the institution's size; the nature and complexity of its activities; and the adequacy of its capital and earnings in relation to its level of market risk exposure.
For many institutions, the primary source of market risk arises from nontrading positions and their sensitivity to changes in interest rates. In some larger institutions, foreign operations can be a significant source of market risk. For some institutions, trading activities are a major source of market risk.

Id. at 67029. This component is rated based upon an assessment of certain evaluation factors including, among others, the ability of management to identify, measure, monitor, and control exposure to market risk given the institution’s size, complexity, and risk profile. See id.

Negative Effect of FSP’s New Standards on CAMELS Ratings

The imposition of higher standards for transparency, accountability and conditionality most certainly will undermine the FSP’s goal of strengthening banks by negatively affecting many of the principal evaluation factors in the CAMELS ratings. Consider for example the following negative impacts of each of the FSP’s new standards on principal factors that will be considered in assessing the CAMELS rating components.

Using assistance from the FSP to expand lending

Depending on the creditworthiness of borrowers demanding loans, requiring a bank to use FSP funds to make loans that it otherwise would not have the resources to make, will skew the bank’s loan portfolio toward higher risk borrowers. Because higher risk borrowers are less likely to make required payments, making loans to such borrowers will increase the volume of delinquencies and problem assets, raise questions regarding the soundness of credit administration practices and increase the percentage of problem or delinquent and nonperforming assets, thereby negatively affecting factors considered in determining the "capital adequacy" and "asset quality" components.

Committing to mortgage foreclosure mitigation

The Treasury’s March 4 "Home Affordable Modification Program Guidelines" require, among other things, that lenders reduce payments on mortgages to not greater than 38% front-end debt-to-income ratio. See Home Affordable Modification Program Guidelines at 1 (March 4, 2009) available here [PDF] ("HAMP Guidelines"). Also, for borrowers in the foreclosure process, the HAMP Guidelines indicate that any foreclosure action will be temporarily suspended during the trial period, or while borrowers are considered for alternative foreclosure prevention options. Id. at 3. Requiring a bank to adhere to these and other foreclosure mitigation requirements will diminish the return on the bank’s mortgage loan portfolio. More specifically, foreclosure suspension, however temporary, will increase the risk of default and raise the number of borrower delinquencies, which will require higher
loan loss reserves and ultimately higher capital needs, thereby negatively affecting factors considered in determining the "capital adequacy" and "asset quality" components. Additionally, placing limits on an institution’s ability to manage defaults and recoveries as it deems necessary (such as by requiring any type of moratorium on foreclosures, even if only temporarily) restricts management’s ability to implement sound risk management programs and may be viewed as creating unsafe or unsound practices, thereby negatively affecting factors considered in determining the "management" component. Also, earnings clearly will decline as a result of the required payment reduction ratios set forth in the HAMP Guidelines, thereby negatively affecting factors considered in determining the "earnings" and "liquidity" components and ultimately negatively impacting stock prices and the bank’s ability to raise capital. Finally, management has lost control of market risk when it cannot fully and freely realize on its assets, thereby negatively affecting factors considered in determining the "sensitivity to market risk" and "management" components.

Restricting dividends

Requiring a bank to restrict payment of dividends to common shareholders will significantly impair the bank’s ability to raise capital by lowering the return on the bank’s stock and thus lowering the stock’s price and market value. This restricts the bank’s ability to raise Tier I capital, thereby negatively affecting factors considered in determining the "capital adequacy" component.

Limiting Executive Compensation

Bank senior executives may face civil penalties of $5,000 per day for certain violations of law to as much as $1 million per day for certain knowing violations of law. In light of the risks to executives in undertaking any position in the banking industry, requiring a bank to significantly restrict the compensation of these executives will vastly increase the difficulty of obtaining and retaining qualified individuals, thereby negatively affecting factors considered in determining the "management" component.

Regulatory Capital Status

As stated above, the capital provided under the CAP will be cumulative mandatorily convertible preferred stock. See Application Guidelines for Capital Assistance Program at 2 available here [PDF]. This capital is designated as Tier 1 for holding companies (a slight of hand by the regulators but patently obvious to the market place). See CAP Term Sheet at 3. Presumably, the capital issued under the CAP will not be considered Tier 1 capital for institutions other than holding companies, thus creating greater capital needs for the non-favored. Because this type of capital is more like debt, adding it to a bank’s capital, whether designated Tier 1 or not, will reduce the quality of a bank’s capital, thereby negatively affecting factors considered in determining the "capital adequacy" component.

Conclusion

Many banks have expressed concerns over participating in TARP, with particular concern over public perception (with many worried that participation will be viewed by the public as a sign of weakness in their institution) and over government intrusion in banking operations. Government intrusion is of course a continuing concern, but one with which the banking industry constantly lives. But, the negative affect on the factors that go into determining the CAMELS ratings should be of significantly greater concern to banks than "public perception." One has to wonder why the federal government is imposing harmful policies on a banking system that it is committed to keeping financially sound. When the government implements policies that without a doubt will adversely affect factors considered in determining a bank’s CAMELS rating components, the banks (and the investing public and depositors) need to take a hard look at the downsides versus the benefits.

  • Darrell Dreher and Margaret Stolar