Re-Imagining Compliance

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Re-Imagining Compliance- A Three-Part series

Part One – Compliance is here to Stay

Every culture has its own languages and code words.  Benign words in one culture can be offensive in another.  There was a time when something that was “Phat” was really desirable and cool while there are very few people who would like being called fat!  Compliance is one of those words that, depending on the culture, may illicit varying degrees of response.  In the culture of financial institutions, the word compliance has some negative associations.   Compliance is often considered an unnecessary and crippling cost of doing business.  Many of the rules and regulations that are part of the compliance world are confusing and elusive.  For many institutions, has been the dark cloud over attempts to provide new and different services and products.

Despite the many negative connotations that surround compliance in the financial services industry, there are many forces coming together to alter the financial services landscape.  These forces can greatly impact the overall view of compliance.  In fact, it is increasingly possible to view expenditures in compliance as an investment rather than a simple expense.   In this three-part blog, we ask that you reimagine your approach to compliance.

Why do we have Compliance Regulations?

Many a compliance professionals can tell you about how difficult it is to keep everybody up to date on the many regulations that apply to financial institutions.  However, if you ask why we even have an Equal Credit Opportunity Act or a Home Mortgage Disclosure Act (“HMDA”), it would difficult to get a consensus.   All of the compliance regulations share a very similar origin story.   There was bad or onerous behavior on the part of financial institutions, followed by a public outcry, legislative action to address the bad behavior and then eventually regulations.  The history of Regulation B provides a good example:

A Little History

The consumer credit market as we now know it grew up in the time period from World War II and the 1960’s.  It was during this time that the market for mortgages grew and developed and became the accepted means for acquiring property, financing businesses, developing wealth and upward mobility.  By the late 1960’s the consumer credit market was booming.

The Equal Credit Opportunity Act (“ECOA”) and regulation B are not nearly as old as you might think. In fact, the first attempt at regulating credit access was the Consumer Credit Protection Act of 1968.  This legislation was passed to protect consumer credit rights that up to that point been largely ignored.  The 1968 regulation was passed as the result of continuing growth in consumer credit and its effects on the economy.  For example, in the year before the regulation was passed, consumers were paying fees and interest that equaled the government’s payments on the national debt!  One of the goals of the Consumer Credit Protection Act was to protect consumer rights and to preserve the consumer credit industry.

The Civil Rights Movement was occurring at the same time as the passage of the CCPA and in 1968, the Fair Housing Act was passed by Congress.  The FHA was designed to assist communities that that had been excluded from credit markets obtain access to credit.  We will discuss the Fair Housing Act in more detail next month.

One of the things that the CCPA did was to empanel a commission of Congress called the National Commission on Consumer Finance.  This commission was directed to hold hearings about the structure and operation of the consumer credit industry.

Unintended Consequences

While performing the duties they were assigned, the members of the National Commission on Consumer Finance conducted several hearings about the credit approval process for consumer loans.  The stories and anecdotes from these hearings raised a tremendous public outcry about the behavior of banks and financial institutions that were in the business of granting credit.   One of the common themes of the testimonies given was that women and minorities were being left behind when it came to the growth of the consumer credit market.  Public pressure forced additional hearings on the consumer credit market, and the evidence showed that women in particular and minorities in general were being given unfair and unequal treatment by banks.

What was Going On? 

So what were banks doing that was a cause of concern?  There were several practices that had become normal and regular for banks when the applicant for consumer credit was a woman or a member of a racial minority group.

Women had more difficulty than men in obtaining or maintaining credit, more frequently were asked embarrassing questions when applying for credit, and more frequently were required to have cosigners or extra collateral.   When a divorced or single woman applied for credit she was immediately asked questions about her life choices, sexual habits, and various other personal information that was both irrelevant to the credit decision and not asked of men.

Racial minorities had difficulty even obtaining credit applications let alone credit approvals.  In cases, where members of minority groups attempted to get a loan applicant, there were either told that the bank was not making consumer loans, or that the area that the person lived was outside of the lending area of the bank.

For applicants that receive public assistance, child support of alimony, banks would not consider these as sources of income under the theory that they were temporary and might disappear.

Despite being subjected to embarrassing or incorrect information, in the cases where women and minorities persisted and completed a credit applications, banks would drag out the process for interminable time periods and would engage in strong efforts to discourage the applicant from going forward.

In many cases, when a person lived in a neighborhood that was predominately comprised of minorities, the borrower was told that the collateral did not have enough value without further explanation.

 

 

The ECOA

Though these stories created a great deal of interest, the CCPA was not amended until 1974 when the first Equal Credit Opportunity Act was passed.  This Act prevented discrimination in credit based on sex and marital status.

Why are there a Regulation B and the ECOA?

The development of the consumer credit market brought with it a series of bad behaviors that directly and negatively impacted the ability of women and minorities to obtain credit.   These behaviors included asking women to check with their husbands before getting a loan, denying a single woman credit, discouraging minorities from applying for credit and outright refusal to grant credit.

The law and regulation are designed to open credit to all who are worthy by limiting practices that unfairly exclude groups of people and by making sure that applicants are fairly informed of the reasons for a denial.

The regulations exist because there was bad behavior that was not being addressed by the industry alone.  Many of the compliance regulations share the same origin story.

Compliance is not all Bad

Sometimes, we are caught up on focusing on the negative to the point that it is hard to see the overall impact of bank regulations.   One of the positive effects of compliance regulations is they go a long way toward “leveling the playing field” among banks.   RESPA (the Real Estate Settlement Procedures Act) provides a good example.  The focus of this regulation is to get financial institutions to disclose the costs of getting a mortgage in the same format throughout the country.   The real costs associated with a mortgage and any deals a bank has with third parties, the amount that is being charged for insurance taxes and professional reports that are being obtained all have to be listed in the same way for all potential lenders.  In this manner, the borrower is supposed to be able to line up the offers and compare costs.  This is ultimately good news for community banks.  The public gets a chance to see what exactly your lending program is and how it compares to your competitors.  The overall effect of this legislation is to make it harder for unscrupulous lending outfits to make outrageous claims about the costs of their mortgages.   This begins to level the playing field for all banks.  The public report requirements for the Community Reinvestment Act and the Home Mortgage Disclosure Act can result in positive information about your bank.    A strong record of lending within the assessment area and focusing on reinvigoration of neighborhoods is a certainly a positive for the bank’s reputation.  The overall effects of the regulations and should be viewed as a positive.

Protections not just for Customers

In some cases, consumer regulations provide protection not just for consumers but also for banks.  The most recent qualifying mortgage and ability to repay rules present a good case.  These rules are designed to require additional disclosures for borrowers that have loans with high interest rates.   In addition to the disclosure requirements, the regulations establish a safe harbor for banks that make loans within the “qualifying mortgage” limits.  This part of the regulation provides strong protection for banks.  The ability to repay rules establish that when a bank makes a loan below the established loan to value and debt to income levels, then the bank will enjoy the presumption that the loan was made in good faith.  This presumption is very valuable in that It can greatly reduce the litigation costs associated with mortgage loans.  Moreover, if a bank makes only “qualifying mortgages’ the level of regulatory scrutiny will likely be lower than in the instance of banks that make high priced loans.

Compliance regulations will no doubt be a part of doing business in the financial industry for the foreseeable future.   However, all is not Considering a strategy that embraces the regulatory structure as an overall positive will allow management to start to re-imagine compliance and consider greater investment.   In our next blog, we will discuss the forces that are converging to make the return on investment in compliance strong.

Strategic Risk- a top Consideration in 2017

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For many financial institutions as January ends, the implementation phase of plans begins.  As you put the finishing touches on your plans and give it one last look, among the critical things to consider should be your assessment of strategic risk.  For the prudential regulators (the FDIC, the Federal Reserve, the OCC and the CFPB), strategic risk has become the preeminent issue, as indicated in public statements, guidance and planned supervisory focus documents.  The main issue driving strategic risk is the convergence of unbanked/underbanked people, the growth of financial technology (” fintech”) firms and shrinking demand for traditional lending.  And to paraphrase the comments of Comptroller of the Currency Thomas Curry, those who fail to innovate are doomed.

Strategic risk is generally defined as:

Strategic risk is a function of business decisions, the execution of those decisions, and resources deployed against strategies. It also includes responsiveness to changes in the internal and external operating environments.[1]

The OCC’s Safety and Soundness Handbook- Corporate Guidance section discusses strategic risk as follows:

The board and senior management, collectively, are the key decision makers that drive the strategic direction of the bank and establish governance principles. The absence of appropriate governance in the bank’s decision-making process and implementation of decisions can have wide-ranging consequences. The consequences may include missed business opportunities, losses, failure to comply with laws and regulations resulting in civil money penalties (CMP), and unsafe or unsound bank operations that could lead to enforcement actions or inadequate capital.[2]

More to the point, strategic risk today is the difference between being able to “think outside the box” and being mired in tradition.   Banking as we know it is being disrupted by technology.  There are many customers who have never had bank accounts and an equally large number of people who use banks on a limited basis.  Many fintech firms  have been founded specifically to offer products that meet the needs of these customers.  Products such as online lending, stored value and bill payments are here to stay and they are changing the places customers look to fill their banking needs.

Both the FDIC and the OCC in their annual statements recognized the need to address strategic risk and will be looking at the institutions they regulate to determine the level of consideration of this risk.  [3]

 

 

So, what does consideration of strategic risk look like?  It means consideration of new types of products, customers and sources of income.  It also means reimagining compliance.

Types of Products

Today a traditional financial institution offers a range of deposit products, consumer loans and commercial loans traditional loans.  Tomorrows’ bank will offer digital wallets, stored value accounts, and financing that is tailored to the needs of customers.  Loans with terms like $7,200 with a 7-month term which are not economically feasible, will be commonplace soon.  Commercial loans will come with access to business management websites that offer consultation for the active entrepreneur, savings account will be attached to the digital profile of the customer.  Banking will be done from the iPad or another digital device.   Your institution can be part of this updated version of banking or continue to suffer declines as your current customer base grows old and disappears.   Consider deciding which fintech companies will allow your bank to offer a full range of products that have not yet been offered.  No need to reinvent the wheel, simply join forces

Types of Customers

The number of customers that are available for traditional commercial lending products is a finite pool and there is tremendous competition for these customers.  However, for financial institutions that are willing to rethink the lending process there are entrepreneurs and small businesses that are seeking funding in nontraditional places.  Fintech companies have developed alternative credit scoring that is highly accurate and predictive.  Consider partnering with these firms to allow underwriting of nontraditional loan products.

The dreaded “MSB” word

In the early part of this decade we experienced the unfortunate effects of “operation chokepoint” a regulatory policy specifically aimed at subjecting MSB’s to strict scrutiny.  Many financial institutions ceased offering accounts to these businesses. The law of unintended consequences was invoked as many of the people who used the MSB’s were left without financial services.  Even today there are sizable communities of people are still hurt by the inability to get financial services.  More importantly, financial institutions are missing the opportunity to develop fee income, expand their customer base and reshape the business plan.

MSB’s facilitate a huge flow of funds that flow throughout the world in one form or another and the more financial institutions are a part of that flow, the safer and more efficient it will be.  MSB’s provide an extremely important service that will be filled one way or another- why not be part of it? [4]  

Compliance as an investment

When considering overall strategic risk, an institution must balance risk levels with the systems in place to mitigate that risk.  New products and different types of customers carry with them different levels and types of risk.  Your system for risk management and compliance must be up to the task of administrating new challenges.   The traditional planning process considers the compliance program only after the products and customers have been determined.  A proactive approach to risk would consider expanding the resources and capabilities of the compliance department to an end; adding products and services that can breathe economic life into your institution.

When the ability to monitor, and administrate new products and customers is acquired by the compliance program, your financial institution can grow and expand.  Now is the time to start thinking of compliance as an investment rather than an expense.   This of course requires an investment in compliance, but the return is well worth it.

 

For a more complete discussion or reimagining compliance as an investment please contact us at ***www.VCM4you.com***

[1]Businessdirectory.com

[2] OCC Comptrollers Handbook-Safety & Soundness- Corporate Risk management

[3] OCC Report Discusses Risks Facing National Banks and Federal Savings Associations

WASHINGTON — The Office of the Comptroller of the Currency (OCC) reported strategic, credit, operational, and compliance risks remain top concerns in its Semiannual Risk Perspective for Fall 2016, released today.

 

[4] Per the world bank High-income countries are the main source of remittances. The United States is by far the largest, with an estimated $ 56.3 billion in recorded outflows in 2014. Saudi Arabia ranks as the second largest, followed by the Russia, Switzerland, Germany, United Arab Emirates, and Kuwait. The six Gulf Cooperation Council countries accounted for $98 billion in outward remittance flows in 2014.