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Comptroller of the Currency John Dugan announced he will leave his office on August 14, completing his term. He had the job during a very interesting time in the history of the industry.

My guess is the OCC will become more important as a regulatory agency in the future. Although the Dodd-Frank bill preserves the dual banking system, I see the national charter going in a different direction than the state charters. Dodd-Frank makes a lot of distinctions between large banks and smaller banks, with nationally-chartered banks generally taking a tougher hit on new regs and costs.

Currently, there are 1,430 nationally-chartered banks and 5,247 banks with state charters. Dodd-Frank, with its emphasis on capital and its increased compliance obligation, will lead to consolidation. Where will most of the sales take place? Although the rules hit larger banks harder, smaller banks are less equipped to handle any increases in rules or costs. I am willing to bet more state-chartered bank owners sell than national bank owners. Proportionally, the number of national charters will grow compared to state charters. That’s just a guess.

It will also be interesting to see whether the proportion of national bank failures changes in relation to total bank failures. On March 19, Comptroller Dugan noted in a speech in Orlando that 33 of the 195 banks to fail since the start of the financial crisis in 2008 had national charters. That’s 17 percent, which aligns almost exactly with the percentage of national charters to total bank charters. As the provisions of Dodd-Frank become implemented, it will be interesting to see, albeit years from now, whether failures skew one way or the other, or whether they remain evening distributed among the charter types.

So whom ever President Obama selects as his next Comptroller will certainly have an interesting environment in which to work, although for reasons much different — we hope — than Dugan had.

One of the things I hear from bankers is that their regulators are encouraging them to hire a full-time information technology professional or — but in some cases, and — a full-time compliance officer. These are typically big-ticket employees, commanding salary and benefits that easily top $80,000 or $90,000 per year. So for a bank that needs to hire both, they are looking at a bottom-line hit of $150,000 to $200,000. Both are completely defensive hires; neither add a dime to the bottom line.

Two hundred thousand dollars is a lot of money. In Iowa, for example, excluding the 48 banks that lost money last year, there were 33 banks whose entire net income for 2009 was less than $200,000. (The state has 367 banks total.) Or in Wisconsin, where there are 281 banks, there were 29 banks with total 2009 earning of less than $200,000, not including 73 banks that lost money.

I have not doubt that the owners of these banks want to comply with the requests of regulators, but you can see the difficult situation that puts them in. They end up doing something that basically wipes out their income. In many cases, these bankers will decide to sell. These are the kinds of things that lead to accelerated industry consolidation. Now the Main Street shop owner has only one bank to approach for a loan rather than two. That business owner’s chances of obtaining credit for expansion or other needs just dropped substantially. This is the kind of thing the corrodes our economy.

I once heard someone say that they thought the government was doing a good thing by requiring banks to hire more IT and compliance professionals, saying it was a form of job creation. Well, in fact, it is just the opposite. These kinds of mandates ultimately will make it much more difficult to get a job, not just in banking but any in field.

When should a banker get a new appraisal on collateral? That question came up at the regulator panel hosted by the Minnesota Bankers Association earlier this month in Duluth. James LaPierre, the FDIC Director of the Kansas City Region offered guidance.

“The expectation is that you will have a current appraisal,” LaPierre said. “The most likely need for an appraisal less than annually is if the existing appraisal does not show what is happening in the project.”

LaPierre suggested an example of a condominium project in which the bank loaned the developer money based on a business plan to sell each of the condos. Mid-project, the developer decides to rent the condos. In that situation, “we would expect a new appraisal,” he said.  

“The more likely scenario is we will simply adjust the appraisal. If we see a project where the business plan says we are going to sell eight units a month for 10 months and the sales level is actually four units a month with the sales price $25,000 per unit less than anticipate, that will be an adjustment — assuming you are down to a collateral bases where the loan has become collateral dependent,” LaPierre said.

“If it is not collateral dependent and the borrowers continue to make payments, it is a much more difficult thing because the question becomes ‘does that borrower have both the capacity and the willingness to continue?’ We have seen cases where borrowers had significant other assets, but they get to the point where they realize that it is no longer a good economic decision for them to continue to pay, and if they are paying it is very difficult to look forward and say they are going to get to that point.”

Blake Paulson of the Office of the Comptroller of the Currency, had this to say: ”On appraisals, it is very important that you have done your analysis. And if it is a severe problem loan, I would expect every quarter that you have done you analysis of what that collateral is worth, given recent information. If the examiners see that you have done that analysis and it is reasonable, they are much more likely to accept that than if they open the loan file and there is no appraisal and it looks like the economics have changed. You are much better off doing the analysis yourself and let the examiners validate that, versus forcing the examiners to do their own analysis.”

Look for in-depth coverage of the regulatory panel in the July 15 edition of NorthWestern Financial Review magazine.

As an English major in college who needed a science credit, I took a course in meteorology. I remember the professor telling us that if you simply predict that the weather tomorrow will be the same as it is today, you will be correct about 70 percent of the time.

That statistic came to mind recently while I was listening to a panel of regulators discuss local conditions. The Minnesota Bankers Association hosted the regulators during a session of its annual convention two weeks ago in Duluth.

James LaPierre, the head of the FDIC’s Kansas City Region, commented on CAMELS ratings. He said if you want to predict what composite rating regulators will assign your bank after an examination, you should expect the rating to be the same as the one you had before.

“Across our region, from 1-rated banks to 5, by far the most likely rating if you were rated 1 last time, by far you are most likely to be rated 1 this time. And that is across all five rating bands. If you are examined again, your most likely rating is the same one you had last time,” LaPierre said.

However, if your rating changes, he said, in the current environment you are twice as likely to be downgraded as your are to be upgraded.

Ron Feldman, senior vice president at the Federal Reserve Bank of Minneapolis, also participated in the panel discussion. He noted that every quarter, the Fed runs a predictive model to calculate the likelihood of a CAMELS downgrade at each bank in its district. He said that for Minnesota banks in the first quarter, “It was the first time that I have seen a decrease in the likelihood of downgrades across each of the rating categories. The chance of being downgraded has gone down in virtually all of the categories.”

LaPierre reported that as of June 4, twenty-seven percent of the banks in the country have a CAMELS rating of 3, 4 or 5.

Kevin Murphy, the deputy commissioner of commerce for the state of Minnesota, who also participated in the panel discussion, indicated 200 of Minnesota’s 306 state chartered banks have a rating of 1 or 2.

We sent this post from Bank Lawyer’s Blog around yesterday with our weekly email. At every opportunity, we who care about the banking industry should ask the regulators, “What is your goal?”

I think it is amazing that in all the debate that went on in Congress about financial reform we never got a clear answer about what the goal of regulation should be. Maybe the goal by some people in power is a smaller industry. If so, why? We need to have this discussion, and it needs to happen in an open forum.

I think most regulators would tell you they want a safe and sound industry. But what does that mean? Does that mean no bank failures? I would argue that it does not mean that. No failures could mean the industry is not innovative enough. Remember, the most effective way to never fail is to never try. A certain amount of failure is symptomatic of a healthy industry.

It is easy to understand where some might assume the regulators want a smaller industry. Raising capital requirements is a way to weed out weaker institutions that are unable to raise new capital. But why would we want a smaller industry? From a macro level, we want a diverse system for credit allocation. We do not want a highly concentrated system, as exists in Europe and Canada. The more decentralized the system, the more opportunity there is for start-ups, entrepreneurs and non-traditional borrowers. More centralization just means less opportunity. Sure, it might be easier to supervise an industry with only 6,000 players, but it might not be better for people who need to borrow money.

I hope this is the kind of discussion that is going on at the highest levels of government. What kind of credit allocation system is best for the country? How can government, through Congress and the regulatory structure, encourage that kind of system? Is “number of institutions” an effective way to measure the industry’s size? What about non-regulated companies that allocate credit? How do they figure into the issue?

We need to define our goal. If we are not clear on our goal, then it really doesn’t matter what’s in the financial reform legislation, because if you don’t know where you are going, any road will take you there.

Commercial real estate, liquidity and capital are the main near-term problems facing community banks, said Federal Reserve Board Governor Daniel Tarullo in New York last week. Speaking April 8 at the New York Community Bankers Conference, Tarullo also called loan concentration and net interest margin major problems for community bankers in the longer term.

“Coping with CRE problems will not be easy. I expect these problems to be with us for some time to come,” he said. Solutions will require bankers to rethink credit administration practices, and force them to expand their loan work-out capability. He commented that the task is complicated by the large volume of properties on the market.

Saying that many banks have relied heavily on noncore funding sources, Tarullo said bankers will have to come up with new contingency funding plans to bolster their liquidity. “Additionally, capital planning will need to be strengthened across all institutions,” he said, noting that high capital cushions are likely to become the norm.

Although many banks will survive the challenges, Tarullo said the industry cannot expect to emerge unscathed. “These immediate financial challenges will, I am afraid, overwhelm quite a number of community banks this year,” he said.

Furthermore, Tarullo said, bankers will need to avoid high concentrations of any single loan type. A move toward loan portfolio diversification will prove difficult for some banks, and will likely lead to lower returns for nearly all banks.

Finally, Tarullo commented on the shrinking net interest margin. “Despite all the emphasis on noninterest revenues in recent years, community banks have continued to rely heavily on spread income,” he said. He further noted that the “aggregate net intrest margin for banks with assets of $10 billion or less has tightened considerably.” Compressing by more than 70 basis points over the last 10 years, the net interest margin for those banks is now 3.63 percent. “As a result, it becomes more difficult for community banks to cover their overhead, pressuring their earnings and their ability to support capital needs fron internal sources,” Tarullo said.

The speech, in which Tarullo also discusses the Fed’s so-called “exit strategy,” can be read here.

In a speech last month to bankers gathered in Florida, Comptroller John Dugan said most of the bank failures in the last 18 months have been the result of:

• Excessive concentrations in commercial real estate lending, especially construction and development lending; and/or
• Excessive reliance on non-core funding, especially brokered deposits, to fund rapid growth, especially in CRE lending.

So you can bet there will be rules coming to reduce the banking industry’s commercial real estate lending and its access to non-core funding. Dugan listed the following things that we “know” about excessive commercial real estate lending:

• We know from experience from the late 1980s and the early 1990s, and from the current period, that a significant concentration in CRE lending leaves banks vulnerable to an economic downturn – and the higher the concentration, the more vulnerable the bank.
• We know that a robust economy will mask unsound underwriting for a period of time.
• We know that rapid loan growth, and particularly a rapid build up of CRE loans, is likely to overwhelm risk management controls.
• We know that there is a level of CRE concentration that even the most sophisticated control systems cannot protect from a serious economic downturn.
• We know that banks that build concentrations in CRE are more likely to rely on non-core and/or high interest funding.
• We know that banks, in response to market pressures, have increased their CRE concentrations significantly in recent years; CRE loans now account for well over one-third of the loan book on average at commercial banks, and for about half of loans at banks in the $500 million to $2 billion asset range.
• And we know that significant CRE concentrations in economic downturns can lead to an increase in problem banks, an increase in bank failures, loss of jobs, loss of incomes, loss to communities, loss to the deposit insurance fund, and higher costs for all banks, even those that do not have CRE concentrations.

Dugan said regulators should consider a variety of options for mitigating the risk posed by excessive commercial real estate lending, including increased capital requirements, a “more granular approach” to defining concentrations since not all CRE is the same, minimum underwriting standards, and more stringent requirements for loans funded chiefly with non-core money. He also said that new banks should be subject to even greater controls.

Dugan’s comments don’t bode well for many community banks, where real estate lending is a key source of business. Take away consumer credit, auto loans and ag loans, and what else is there besides loans secured by real estate? Sure, small business lending is important, but so many of those loans are secured by commercial real estate.

Here is what would really be helpful. Rather than solely tightening the rules on commercial real estate lending, why not work at the same time to eliminate the advantages that Farm Credit System lenders and credit unions have over traditional banks? The positive effect of leveling the competitive playing field would off-set some of the negative effect of limiting banks’ ability to make loans secured by real estate.

For as long as I have been covering this industry, bankers have told me that the OCC is really not interested in small banks. “They are focused on the big banks,” I have been told many times. OCC leadership obviously has heard this message and they clearly don’t like it. Many speeches delivered by the Comptroller begin with some clarification about all the community banks under OCC supervision.

“Despite my best efforts, I sometimes still confront the stereotype that the OCC is only concerned about big banks. Let me say again, emphatically, that that’s just not true,” Comptroller John Dugan told community bankers in a speech delivered March 19 in Orlando. He goes on to explain that two-thirds of OCC examiners are focused on community banks. He also noted that the agency reaches out to listen to community bankers through a variety of industry events and meetings. “My over-riding point here is that we at the OCC consider community bank supervision as core to our mission.”

Yet, I wonder whether Mr. Dugan really understands community banking. In the remainder of his speech, he talks about bank failures, emphasizing the disproportionate representation of community banks. “195 banks, nearly all of them community banks, have failed since the start of the crisis in 2008,” he says. Furthermore, he notes an “estimated cost to the deposit insurance fund exceeding $58 billion.”

Any community banker would find that observation a bit galling. Citi and BofA both failed on the OCC’s watch, but Treasury stepped in to prop them up so they were never closed. Had they failed, they would have wiped out the FDIC fund completely. I think it is pretty insensitive to talk to community bankers about the problems in community banking without acknowledging the far more severe problems in a sector of the industry where the OCC has much greater responsibility.

In the speech, Dugan noted four things that he believes regulators need in order to be effective: balanced judgment, to provide appropriate guidance, consistency and forthright engagement with bankers. The irony of his third item — consistency — is inescapable. There is nothing more inconsistent in bank regulation than regulators picking winners and losers. Too-big-to-fail pretty much tells community bankers they are a bunch of losers. Dugan is right to say that one of the most important things regulators can do is be consistent; to me, that means ending too big to fail. Not until this policy is ended will it make any sense to compare community banks with the rest of the industry.

A decade or more ago, community bankers would argue that they need their own regulator. They said that the existing regulators were focused on large banks, which had an entirely different business model. They said they wanted their own regulator, an agency that understood the economic dynamics of a small town, who understood agricultural banking, and an agency that understand what “character” means in a loan decision.

But the community bankers seemed to drop their call for a dedicated regulator. With so many other issues to resolve, the groups that advocate for community banks turned their attention to other, more pressing, issues.

But now, an advocate emerges who is calling for a community bank regulator. John Bowman, acting director of the Office of Thrift Supervision, said that Congress should terminate the existing scheme of regulatory agencies and start over. “Our proposal is simple: instead of four federal banking regulators, there should be two: one for community-based banks and thrifts and one for complex commercial banks.”

Speaking in Orlando 10 days ago, Bowman made the case for a dedicated regulatory agency that would focus solely on community banks.

Whether a community bank holds a state charter, a national charter or a federal thrift charter, that institution should not be supervised by the same agency that oversees complex commercial banks. The one-size-fits-all regulator, by necessity, will pay the greatest attention to the complex commercial banks, because they pose the greatest potential risks to the financial system. As a result, the community banks and thrifts that by far make up the largest number of institutions will receive “afterthought” supervision, rather than a regulatory approach tailored to their unique business model.

Bowman said he finds it “ironic” that none of the regulatory reform proposals being considered in Congress include a stand-alone agency for community banks.

You could argue that the FDIC serves as a regulator for community banks, but Bowman dismissed that idea, saying the agency has an inherent conflict of interest. Minimizing losses to the deposit insurance fund is a different mission than assuring the safety and soundness of banks, he said. Bowman also said the Federal Reserve should not be involved in the supervision of community banks, but instead should focus on monetary policy. He said the Fed could rely on other agencies for information about community banks.

I believe community bank supervision would best be managed by a new independent agency that would have the sole mission of supervising community banks and thrifts, supervising their holding companies and protecting consumers. For the first time, the health and welfare of this nation’s community banking sector and its consumers would be the top priority of a federal agency.

Read Bowman’s entire speech here.

Of course, the way things are going, OTS is likely to be merged out of existence. Such a pending fate likely emboldens Bowman to propose this radical idea. But it is unlikely anyone in Congress will pick up Bowman’s idea and run with it. And that’s too bad. It is really not a bad idea and at one time, most of the industry was advocating for something along these lines.

Politicians and pundits criticize bankers for making too few loans, for tightening credit too much. At the same time, most examiners are urging caution on lending. Few examiners are telling bankers to go out and make more loans. Most bankers say that when the examiners come into the bank, they are quick to criticize, even the loans that seem very sound.

The leaders of the regulatory agencies are aware of this dichotomy. FDIC Chair Sheila Bair and Comptroller John Dugan talked about this in Orlando last week. Bair referred to this join statement issued by the regulatory agencies and the Conference of State Bank Supervisors, which encourages banks to make loans to credit-worthy small business borrowers.

“The statement recognizes the importance of small businesses and the fact that some are experiencing difficulty in getting credit,” Bair said. “It clearly states that financial institutions that extend credit using prudent lending standards will not be subject to supervisory criticism. I know that there are concerns about examiners being overzealous in adversely classifying loans and applying capital requirements … What I want you to understand is that we hear your concerns. We are trying very hard to achieve a balanced approach to supervision during these challenging times.”

Dugan also acknowledged tension between advocates of increased lending and those focused on safety and soundness. “These hard times have produced a very difficult regulatory climate, for both community banks and their supervisors,” Dugan said. “A number of bankers and their trade associations … have complained that regulatory measures have been too stringent … At the same time, others have criticized regulators for being too lenient with troubled banks …”

Dugan said he has given his examiners a four-part message for dealing with this dilemma:

First, it is critical that examiners strive continually for professional judgment that is balanced.

Second, as significant issues arise, we can and should do more over time to provide appropriate guidance.

Third, in the expectations we communicate to banks and the actions we take, we need to be consistent.

Fourth, our examiners and their supervisors need to engage bankers forthrightly and address the specific concerns that [bankers] raise. Read the entire speech here.

It is difficult to argue with these four points, although the third point is a little hard to swallow. Certainly as long as too-big-to-fail is the official policy of the Treasury Department, action by regulators will not be consistent across the industry. Bair in her speech made a big deal out of the too-big-to-fail problem. Although Dugan mentioned too-big-to-fail in his speech, he did not go into depth about it.