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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2014

Divining the Regulations That Await

Don’t underestimate the relevance of big-bank requirements

Divining the Regulations That Await

In today’s regulatory environment, many nondepository mortgage companies are struggling to meet their regulatory obligations, and the significant time expended in doing so doesn’t often afford the opportunity to evaluate other regulatory requirements. That said, independent mortgage companies should still make time to be mindful of new requirements for large financial institutions, as those requirements often eventually become integrated in compliance requirements for nondepository entities.

The question thus arises: Which large-bank requirements might smaller institutions see in their future? One recently proposed set of guidelines from the Office of the Comptroller of the Currency (OCC) warrants close attention.

Independent mortgage companies that are wondering how closely they should follow the regulatory requirements of larger institutions only need to consider the Consumer Financial Protection Bureau’s (CFPB) central approach to its examination method. The CFPB is not simply evaluating whether or not institutions are complying with applicable statutes and regulations. Rather, the CFPB is evaluating the safety and soundness of institutions and how they are able to participate in the overall financial services sector.

This approach to examination is most similar to the historical approach of federal agencies like the OCC. By applying a bank-oriented approach to examination, the CFPB aims to comprehensively evaluate the overall financial services sector for compliance and limit the potential of a systemic failure. Because the CFPB has embraced the bank model of examination, it is only reasonable to look at bank compliance developments as a possible harbinger of future compliance requirements for nondepository entities.

Recently, the OCC proposed formal guidelines for the largest of its regulated banks that clarified its “heightened expectations” for those institutions. Even smaller mortgage companies should be aware, however, that certain elements of those requirements are instructive to all institutions regardless of whether they fall within the provisions of the proposed rules or beyond those provisions. Following the financial crisis, the OCC informally developed a series of heightened expectations that it suggested the largest banks embrace.

These heightened expectations are intended to strengthen the governance and risk-management practices of the largest depository institutions, as well as better enable the OCC to supervise those institutions. Let’s take a closer look at the expectations’ specifics and how they may eventually apply to even the smallest mortgage organizations.

The guidelines

The “heightened expectations” requirements — which, upon approval, will be set forth as formal guidelines — only apply to a small number of institutions. More specifically, the guidelines will apply to:

  1. Insured national banks, insured federal savings associations or insured federal branches of foreign banks that have total consolidated assets of $50 billion or more (fewer than 50 institutions fall within this category); and
  2. At the election of the OCC, institutions that have total consolidated assets of less than $50 billion but are either highly complex (because of the bank’s products and services, the bank’s risk profile and its scope of operations) or present a heightened risk as a result of their business activities.

In proposing its heightened expectations guidelines, the OCC hopes to achieve several goals that will serve to improve the safety of the financial system. Among others, the proposal will require entities to prepare a formal written plan that articulates their risk appetite. In essence, this written statement must define how a bank will approach its business activities and will identify the business sectors in which the bank may have the greatest risk.

The proposal requires active oversight of the bank’s compliance with safe and sound banking practices by the members of the institution’s board of directors. Under the proposal, the board of directors is actively tasked with ensuring that the bank has established and implemented an effective risk-governance framework that meets the minimum specifications set forth in the guidelines and is based on the written plan discussed previously.

The proposed guidelines also require a company’s board of directors to have active oversight of the bank’s risk-taking activities. General oversight is not enough; instead, the OCC expects that the bank’s board of directors will hold the company’s management accountable for its adherence to the accepted risk-governance framework.

In accordance with this expectation, the members of a bank’s board of directors must actively consider their management’s recommendations and its decisions by questioning, challenging and, if necessary, opposing any proposals that could lead to excessive risk-taking or pose a threat to the safety and soundness of the institution. As a measure aimed at enhancing the ability of the board of directors to actively police management, the proposed guidelines require each board of directors to have at least two independent members that are not part of the bank’s management or its parent company’s management.

Under the proposed guidelines, a bank’s chief executive officer is required to develop a written strategic plan that includes input from frontline units, independent risk management and internal audit. The board of directors, meanwhile, must evaluate and approve this plan, which should cover — at minimum — a three-year period. The strategic plan must do each of the following:

  1. Incorporate a comprehensive assessment of risks that currently impact the financial institution or could impact it during the period covered by the strategic plan;
  2. Specify an overall mission statement, including strategic objectives, and provide an explanation for how the bank will achieve its objectives;
  3. Summarize how the financial institution will update its risk-governance framework to account for changes in the bank’s risk profile projected under the strategic plan; and
  4. Be revised, updated and approved, as necessary.

The proposal suggests a demarcation between certain risk-minimization functions. For example, the guidelines call for an independent risk-management function, whereby a specific organizational unit — reporting to the company’s chief executive officer and its board of directors — would be responsible for identifying, measuring, monitoring and controlling aggregate risks. Under the guidelines, it’s essential that this risk-management function is independent from operational units.

Necessary changes

Although the express provisions of the OCC’s proposed guidelines do not apply to many institutions, the logic behind the agency’s proposal will likely extend far beyond its original reach. This necessitates even small mortgage banks to at least consider undergoing several significant, preemptive changes.

First, consider the fact that the OCC is requiring members of a bank’s board of directors to have a large degree of involvement in the bank’s activities. Although directors are typically involved in the oversight of their respective entities, the OCC now expects far greater involvement on the part of these company leaders. Directors are required to understand all aspects of their businesses’ operations and must, as needed, push back on management when operational personnel propose activities or operations that are not consistent with the strategic plan of the company.

It is important to understand that this heightened level of responsibility placed on board members suggests that appropriate training is necessary. Because the financial services sector is so complex, it may be difficult for truly independent directors to understand a bank’s activities sufficiently to render appropriate guidance. Consequently, when choosing independent directors, impacted institutions may wish to select individuals who have previously worked in the financial services sector so as to reduce the learning curve for those individuals.

Second, banks should focus on the fact that institutions are being asked to prepare written strategic plans and written risk assessments to guide the company’s business activities. These proposals, which require approval by an entity’s chief executive officer and the members of its board of directors, are intended to guide the company’s overall operations. The documents may also serve as a roadmap, however, highlighting potential areas of concern for regulators or, at minimum, areas where greater resources should be expended.

Finally, it’s important to note that the OCC seeks to reinforce independent compliance, internal audit and risk-management functions that are entirely separate from the operational units. Often, such separation helps these units function without fear of prejudice from the operational personnel. Because compliance and risk-management functions of a licensee have a natural tension with operational units, the OCC has concluded that it is essential to ensure appropriate independence is maintained between the various units.

•  •  •

Although the “heightened expectations” proposal by the OCC will not specifically capture a significant number of institutions, non-impacted institutions should be aware of the concepts and requirements in the proposal. Enhancing the degree of involvement and sophistication of an operating entity’s board of directors will ultimately improve its operations and overall direction. Mortgage companies would be well advised to anticipate that other regulatory agencies could follow suit over time and actively suggest that their board members have greater involvement in the operations of their institutions. Finally, enhancements to internal risk areas — e.g., internal audit, risk-management evaluation, etc. — can only serve to improve the compliance of the company. As a result, mortgage banks should carefully consider this and subsequent OCC proposals because they could include elements that may extend to nondepository institutions in the near future.  


 
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