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FDIC Chair Sheila Bair made a very interesting point in her speech to bankers in Orlando earlier this month when she noted that extensive consumer protection laws applied to the banking industry spawned the shadow banking sector. She noted that the buttoned-down practices of traditional banks allowed no room for questionable practices, so those questionable practices emerged outside the ranks of traditional banking.

“The regulatory reforms put in place after the last crisis actually helped push risk-taking outside of traditional banking and into the shadow banking system,” she said. “This created gaps between regulatory jurisdictions; weakened consumer protection; and led to the problems with subprime and nontraditional mortgages, and risky securitization structures.”

Bair then goes on to make the case that increased consumer protections should not be focused on the traditional banking sector, but on the shadow sector. Here is what she said:

But it’s time we leveled the playing field for all market players. We need strong rules that apply — and that are enforced — across the board for banks and nonbanks. And it is just as important to ensure that the burden of this regulation does not fall on the mainstream lenders who were not the cause of the problem.

The bankers welcomed this message. But I think it is worth considering whether this problem can ever be solved. When lawmakers passed tougher consumer protection laws and applied them to banks, they thought they were applying the law to all the relevant parties. They didn’t think they were leaving anyone out. Well, since the laws were passed, new industry sectors emerged to get around the laws. Is this cycle breakable? If new, broader laws are passed this time around, what is to stop the emergence of still more niche sectors?

It will be a daunting task to come up with an examination and enforcement regime for non-banks sufficient to match the level of supervision currently applied to banks. Keep in mind that the non-bank sector is much larger than the bank sector. My point is, even if you accomplish this herculean task, new kinds of businesses that skirt the rules are likely to emerge. It is a vicious cycle.

I am not saying government shouldn’t try to protect consumers, but I suspect there will always be weak spots. Universal oversight that prevents all companies from offering any products that could be deemed questionable simply seems impossible to me.

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.

Lots of talk about the need to resolve the too-big-to-fail problem in banking at the two big industry pow-wows earlier this month. It was THE topic at the ICBA convention in Orlando, and it was one of the top two industry challenges discussed at the ABA’s Government Relations Summit in Washington, D.C., March 17-18. The other big issue discussed at the ABA meeting was the need to stop reform legislation provisions that would create a new consumer financial protection agency or bureau. (More on that in future posts.) 

ABA brought in several top industry speakers, including a panel of Federal Reserve Bank presidents. Sandra Pianalto of the Cleveland Fed, Jeffrey Lacker of the Richmond Fed and Tom Hoenig of the Kansas City Fed all talked about the need to resolve too big to fail.

“Too big to fail is the central issue that reform needs to face,” Lacker said. He explained that ten years ago, 45 percent of the liabilities in the financial system were perceived to be guaranteed, either implicitly or explicitly, by the federal government. Today, he said, it is 58 percent. While the percentage has increased, the actual percentage of assets with an explicit guarantee has dropped to 22 percent today from 27 percent in 2000, he said.

“We know that too big to fail won’t go away without legislation that brings it under the rule of law,” Hoenig said. Too big to fail results in a “tremendous mis-allocation of resources,” he said. Furthermore, Hoenig explained that too-big-to-fail banks have a cost of funds advantage over community banks. Read Hoenig’s comments here.

While ICBA and ABA agree on the need to resolve too big to fail, they differ on whether the largest banks should be required to pre-fund a pool of money that regulators could use to unwind a systemically important financial institutions that gets into trouble. ICBA wants to see the largest banks put $50 billion into a fund in advance, while ABA argues that pre-paying such a fund only institutionalizes too big to fail. A banker put the question to Pianalto at the ABA summit.

“The issue of the fund, I don’t have a specific answer. The fund would come from those institutions that are too big to fail. The issue is open for discussion,” she said. “If you have an appropriate supervisory structure in place to begin with, then you won’t have to deal with that question.”

Millions of people who have little background on the financial crisis will read David Leonhardt’s article in the New York Times magazine, to be published in print on Sunday. For that reason alone it is worth reading, even though it will shed little light on the situation for those who have been following the banking and broader financial services industry over the last few years.

The glaring omission in the article is the community bank sector. Leonhardt fails to provide an accurate picture of the credit allocation process in this country because he ignores 7,000 of the country’s 7,300 banks. He writes about how smart the Canadians are, but I don’t know that Canada is any source of innovation or entrepreneurial business activity the way the United States is. Community banks across the United States provide the majority of credit to our country’s small businesses, and this is where the jobs are. The strength of our country is its vast decentralized credit allocation system of thousands of community banks that are in position to fund small and medium size businesses which employee a majority of the country’s workforce.

You can’t have a very intelligent conversation about financial regulatory reform without acknowledging the diversity of players in our financial services system.

I am also struck by Leonhardt’s conclusion that a smaller financial services industry would be a good thing because this will free up the most intelligent members of the workforce to work for other, apparently more important, business sectors. He writes:

Highly leveraged financial firms became a dominant part of the economy. Their profits allowed the firms to recruit many of the country’s most sought-after employees – mathematicians, scientists, top college graduates and top former government officials. Yet many of those profits turned out to be ephemeral. So some of the best minds were devoted to devising ever-more-complex means of creating money out of thin air, the proceeds of which then drew in even more talent.

I think you could have a real discussion about whether these folks really have the best minds. I think Leonhardt gives way too much credit to the folks who came up with negative amortizing mortgages and securitization schemes that masked the quality of underlying assets. Many of the best minds I know belong to people who work in the community banking industry; it is a shame Leonhardt didn’t include them in his article.

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.

More from the Sheila Bair speech in Orlando:

“Job number one must be to level the playing field once and for all and to put an end to the doctrine of too big to fail,” she said to applause. “Too often in the past … we saw large, systemically important institutions exempted from the type of supervisory sanctions that community banks face very day.” Listening, I got the sense that this really ticks her off.

In “On the Brink,” Henry Paulson described some of the conversation surrounding the rescue of Citibank in November of 2008. In his entry for Saturday, Nov. 23, he writes:

No one seemed more frustrated than Sheila, who at first suggesting using the FDIC’s normal procedure for handling Citi … That morning she said she wasn’t sure that Citi’s failure would constitute a systemic risk. She felt that Citi had enough subordinated debt and preferred stock to absorb the losses. She spoke as if Citi were just another failing bank and not a world leader. “So” she said, “why not let them go through the receivership process?”

Paulson said the suggestion made his jaw drop; of course, they didn’t go that route.

A year and a half later, clearly, Bair still doesn’t like the idea that some banks get special treatment. “It is time to get serious about establishing a credible, pre-funded resolution authority for giant banks and non-bank financial institutions,” she said in Orlando. She said she likes the provisions in the House bill and the Senate proposal for dealing with too-big-to-fail institutions. “We would finally have a mechanism under which large, complex institutions could be closed if necessary without wreaking havoc on the rest of the financial system,” she said.

Last year, the FDIC changed statutory interest-rate restrictions for banks that are less than well capitalized. These banks are not allowed to pay interest rates more than 75 basis points higher than the local prevailing rate or the national average rate as reported on the FDIC web site. 

FDIC Chairman Sheila Bair, speaking to bankers at the ICBA convention last week, noted an interesting problem associated with the rule. She said that community banks located in areas where there are a substantial number of branches of nation-wide banks are put at a disadvantage because nation-wide banks can attract deposits with lower rates than community banks. The prevailing rate in these areas is thus lower than other areas, which prevents community banks from paying what they need to pay in order to attract deposits. The big banks remain attractive even with low rates because of their perceived safety as too big to fail.

“The largest banks enjoy lower average funding costs — and the differential appears to be rising,” Bair said in a speech to a packed ballroom at the Gaylord Palms Hotel. “In our judgment, this trend is driven at least in part by the market perception that some of these banks are too big to fail.

“It was never our intent for this regulation to disadvantage smaller banks.

“That is why, as of today [March 19], we have amended the Q&A document on our website to clarify that the FDIC will, as appropriate, drop multiple branches of the same banks from the calculation of locally prevailing deposit rates.”

Bair said the FDIC made the change after a concern was raised by members of the FDIC’s Community Bank Advisory Committee.

A three-judge panel for the U.S. Court of Appeals for the Seventh Circuit has over-ruled a Jan. 15, 2009 Tax Court ruling regarding the tax treatment of qualified tax-exempt obligations held by subchapter S banks. The ruling is good news for subchapter S banks. About a third of the banks across the country have subchapter S incorporation status. Read the decision here, issued March 17.

Jerome and Doris Vainisi, owners of the First Forest Park Corp., in Forest Park, Ill., were the petitioners. The holding company owns First Park National Bank and Trust Co., in Forest Park. The bank owned qualified tax exempt obligations that generated more than $600,000 in income in 2003 and 2004. When computing their interest expense deduction for their federal income tax returns for those years, the bank did not take a TEFRA disallowance because it had obtained subchapter S status more than three years earlier. The IRS cried foul, saying the bank should have taken a disallowance.

Prior to the IRS determination and its Tax Court ruling, it was widely believed that subchapter S banks did not need to take a disallowance if they had been a sub S bank for three years or more. The Tax Court Judge, Maurice Foley, ruled that since the provision in the tax code regarding the TEFRA disallowance does not make reference to S corporations or S subsidiaries, they need to take the disallowance.

The Vainisis appealed the Tax Court ruling and now the Appeals Court has overturned the decision to the previous, generally-held interpretation of the tax code. In the Appeals Court case, argued Feb. 23 in Chicago, the U.S. government argued that Congress did not intend for bank holding company subsidiaries with sub S status to enjoy this tax advantage.

“We cannot rewrite statutes and regulations merely because we think they imperfectly express congressional intent or wise social policy,” circuit judges Richard Posner, Diane Sykes and William Bauer write in their ruling.

“Of course, unless abrogated, the privilege conferred by section 1363(b)(4) will perpetuate a competitive advantage enjoyed by S or QSub banks that have never been C corporations or that converted from C to S earlier rather than later. Later converters — not to mention all existing C corporation banks — may be gnashing their teeth in fury at the additional interest deduction that many of their S or QSub bank competitors can take. But the difference in treatment, and whatever consequences flow from it, are built into section 1363(b)(4),” the judges write.

“The regulation was promulgated a decade ago and the Treasury Department has thus had ample time in which to decide whether the favored treatment of S and QSub banks is a bad idea. The Internal Revenue Service thinks it is a bad idea, the Tax Court thinks it a bad idea, but the institutions authorized to correct the favored treatment of these banks — Congress by statute, and the Treasury Department, as Congress’s delegate, by regulation — have thus far left it intact. True, the Treasury has proposed to subject all subchapter S banks, no matter now long they have enjoyed that status, to section 291… But the proposal has been in limbo for years … Unless and until such a regulation is adopted or the statute amended, the distinction stands, and exempts the Vainisis from section 291. The judgment of the Tax Court is therefore reversed.”

The Minnesota Department of Commerce closed the State Bank of Aurora a couple of hours ago. It was one of seven banks closed today, bringing the total number of banks closed this year to 37.

The Northern State Bank of Ashland, Wis., is picking up the deposits and nearly all the assets of the failed bank, which had $28 million in assets at year-end. The FDIC provides the details here. State Bank of Aurora was the 11th Minnesota bank to fail since the bank in Staples was closed in May of 2008. If you are interested in following the failed bank situation across the country, you might appreciate this graphic.

Meanwhile, FDIC Chairman Sheila Bair was in Orlando today speaking at the ICBA convention. She spoke about the need to resolve too-big-to-fail, noting that the largest banks in the country have a distinct cost-of-funds advantage over community banks (a point we have made repeatedly at NorthWestern Financial Review). Among other things, she also said her staff is considering the implications of extending the Transaction Account Guarantee program, which is set to expire June 30. She said she expects the FDIC to make a decision soon. You can read her comments here.

Lots of break-out sessions yesterday at the ICBA convention here in Orlando, (where the weather wasn’t much better than it was back in Minneapolis). Philip K. Smith is president of Gerrish McCreary Smith, Consultants and Attorneys. In one session, he told a room full of CEOs “Ten things community banks should know to be successful.” He said they are:

Understand the regulatory environment;

Have a renewed vision of strategic planning;

Overcome the fear of new capital;

Get back to basics;

Redefine success;

Embrace change;

Create a better board;

Seize acquisition opportunities;

Get in the right structure;

Be a community bank.

Watch for an upcoming edition of NorthWestern Financial Review magazine where these concepts will be described in detail.

Today’s session at the convention features the first general session, where Comptroller Dugan, and FDIC Chair Bair are scheduled to speak. Also on the agenda is ICBA’s Cam Fine and the author, Jim Collins.