While the year is new, many of the issues facing bankers in 2005 will be the same as those in 2004. However, both bankers and regulators are hopeful that much of the uncertainty and many of the open issues will be resolved early in the year. I see ten major areas for continued attention, progress, and/or resolution in 2005:
Accounting, Auditing, and Internal Control
Accounting, auditing, and internal control issues will remain in the news, as FASB, the SEC, the PCAOB, and others bring closure to many open issues.
The first wave of Sarbanes-Oxley section 404 reporting—management’s report on internal control over financial reporting and the related auditor’s report on management’s assessment—will appear for accelerated filers in the first quarter 2005. Financial institutions will need to promptly address any identified internal control deficiencies to maintain both investor and supervisory confidence. To help financial institutions respond appropriately to the provisions of section 404 and to ensure consistent supervisory treatment of financial institutions across Federal Reserve districts, the Federal Reserve anticipates issuing supervisory guidance in early 2005. While we continue to hear about the unanticipated burden of section 404 compliance, it is important to remember that the provisions included in the Sarbanes-Oxley Act of 2002 were needed to reestablish and ensure investor confidence. However, the proper balance and application of Sarbanes-Oxley will remain an important policy issue. In the interim, the workload should ease with experience and more practical assessments by auditors.
FASB continues to consider EITF Issue 03-1, Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, and its impact on changes in fair value of debt securities due to changes in interest rates. The proposed recognition and measurement guidance has been deferred indefinitely; however, the disclosure provisions are currently effective.
FASB also continues to review the application of FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, on loan participations and how loan participations can meet FAS 140’s requirements for legal isolation and no continued control over transferred assets as conditions of sale treatment. The most significant issue to be resolved is the right of setoff in the event of a financial institution liquidation.
Some other issues that could affect financial institutions include the final FASB statement, FAS 123 (revised) on the valuation of stock options, which becomes effective for many public entities for reporting periods beginning after June 15, 2005 and for nonpublic entities for reporting periods beginning after December 15, 2005; SOP 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which is effective December 15, 2004; and the continued discussion about fair value accounting.
You can also anticipate expanded supervisory guidance in these and other areas. Bank management and financial institution auditors must be aware of the effects of these and other accounting and auditing issues to ensure that financial statements are prepared according to generally accepted accounting principles and accurately reflect the operations of the company. To fail to do so significantly increases reputational, operational, and legal risks.
In light of recent changes in legislation and regulation—including HMDA, Check 21, and the Bank Secrecy Act and anti-money laundering rules—compliance risk should remain near the center of management’s radar.
Both bank management and consumer activists are awaiting the release of the expanded HMDA data in the third quarter 2005. The data for 2004, which must be submitted in the March 2005 HMDA filings, will include disclosure of pricing data on higher cost loans, expansion of the number of non-depository institutions subject to reporting, and revisions to certain definitions to provide for more uniformity of reporting. These changes, which were approved in 2002, are discussed in more detail in the Third Quarter 2003 issue of Compliance Corner, and tools to aid in compliance appear in this issue of Compliance Corner.
Now that the October 28, 2004 effective date of Check 21 has passed, attention is turning from the operational aspects of implementing Check 21 to the compliance aspects of the Act, including the consumer awareness disclosure and the provisions for expedited recredit to consumer accounts. Consumer groups are also concerned about new disparities between the faster check clearing available through electronic means and the current funds availability rules in Regulation CC, Availability of Funds and Collection of Checks. On December 7, 2004, U.S. Representative Carolyn Maloney (D-N.Y.) introduced H.R. 5410, Consumer Checking Account Fairness Act, which is intended to address imbalances between the speed of funds collection under Check 21 and the slower pace of funds availability. While passage of the bill is not certain, the issue bears watching and banks should proactively assess their check clearing and funds availability processes.
Compliance risk encompasses more than just consumer compliance; it includes the failure to comply with all laws and regulations. As some bankers have already learned, failure to comply with the provisions of the Bank Secrecy Act and the anti-money laundering (BSA/AML) provisions of the USA PATRIOT Act might carry one of the heavier burdens—formal enforcement actions and significant civil money penalties. Banks doing business with money transfer companies, including so-called check cashers, have been under additional scrutiny, both to ensure that they are complying with BSA/AML laws and regulations and to ensure that they are not discriminating against check cashers to mitigate exposure in this area. The federal banking supervisory agencies plan to release BSA/AML examination guidance in 2005. These procedures, while ensuring that BSA/AML examinations conducted by the various federal banking supervisors are more consistent, will also be a valuable tool for financial institution self-assessment.
Interest Rate Risk
Short-term interest rates rose sharply in 2004 and early 2005, as the Federal Open Market Committee (FOMC) raised its target for the fed funds rate by 25 basis points six times between June 2004 and February 2005. However, during this period, middle-term rates rose only moderately and longer-term rates declined, resulting in a flatter yield curve. Accordingly, the most recent rises in short-term interest rates did not have the anticipated significant negative effect on portfolio valuations or mortgage volume. In fact, despite the rise in short-term interest rates, adjustable rate mortgages held a steady one-third share of application volume.
Nevertheless, due to heightened competition, loan pricing is not keeping pace with existing funding costs, resulting in declining margins for some banks. Organizations with a high proportion of earning assets in securities and those that have funded expansion through borrowing will likely experience margin challenges. In addition, the increasing volume of options across the balance sheet has made it more important for banks to measure interest rate risk from an economic value perspective.
Bank management should still resist the temptation to chase yields, whether through portfolio extension, which provides even less benefit with a flatter yield curve, or through greater credit risk; should focus on long-term performance and sustainability; and should remain vigilant about interest rate risk management practices.
Curtailing expense growth will be a focal point in 2005. Bankers will continue to evaluate branching strategies, which traditionally come with significant overhead costs, as they assess the dynamics of old and new distribution channels. The ultimate goal, in addition to providing stellar customer service, is to avoid negative operating leverage, where expense growth exceeds revenue growth.
The pressure to increase profits as margins compress has resulted in some institutions lending longer and funding those loans with short-maturity deposits. While creating interest rate risk, this also increases liquidity risk. Accordingly, bankers should sharpen their focus on liquidity. This might entail building a diversified and reliable base of lower cost funding and restructuring the balance sheet to minimize asset/liability mismatches.
Achieving satisfactory loan growth is one of the top challenges for commercial banks. Increased competition from alternative sources of credit—such as credit unions, captive lending subsidiaries of nonbanks, finance companies, securities companies, and nationwide institutions—coupled with increased competition from peer banks, could, if not managed appropriately, lead to unprofitable or unsustainable pricing and term concessions and declining portfolio quality. Furthermore, the volume of refinancing activity in 2004, by both consumers and many investment grade companies, might place significant pressure on loan volume in 2005. In this environment, lenders should make sure that lending standards remain sound and that loans are priced for the long-term to fully account for risks.
Further exacerbating the competitive challenges are the challenges of attracting and retaining experienced commercial lenders. As many attendees at a recent Bankers’ Forum remarked, it is increasingly difficult for community banks to attract mid-level lenders, those who have credit analysis experience but are not demanding top wages. Inexperienced lenders, without the benefit of lending through a full economic cycle, might not recognize what to a more experienced lender would be a marginal loan or might, again through inexperience, overlook operational safeguards.
Finally, the economic cycle has not been revoked. It is possible that we have reached or are near the peak in asset quality as part of the normal credit cycle, and bankers may need to begin to take higher loan loss provisions as loans season and deteriorate and to account for continued portfolio growth.
Because of these challenges, banks are increasingly under pressure to have a portfolio-wide set of early warning indicators. In 2005 and beyond, regulators will be looking for objective leading indicators of credit risk in addition to traditional lagging indicators to gain better assurance about management’s ability to effectively manage credit risk.
Banks will continue to expand consumer lending efforts in 2005 in search of the best growth opportunities. Home equity products are often cited as areas of emphasis. Bankers should ensure risk management efforts in consumer finance keep pace with rapid growth. Lenders with significant high loan-to-value activity in low score buckets should actively monitor risk exposures. Other areas of consumer risk include overall consumer debt levels, regulatory risk, phishing, and low savings rates.
Mergers and Acquisition
Earnings growth is likely to slow as short-term rates rise and the yield curve flattens. Banks already lean from cost cutting may look to mergers and acquisitions to provide the next profit surge. As this activity picks up, executives should focus intently on the top-line revenue synergies, customer defections, and problems stemming from existing service arrangements.
Although we have seen some recent evidence of divestitures related to one-stop-shopping business models, corporate governance related to diversified banking organizations remains key. For acquisitions outside of core banking activities, banks should make sure that business models fit into the banking compliance model to mitigate reputational and legal risk.
The flood of recent fines, criminal investigations, and prosecutions related to fraud is raising questions about the ability of banking as an industry to be a frontline defense against financial impropriety. In response, financial institutions are adding to their internal compliance staffs, educating consumers about identify theft, and investing in software to identify suspicious transactions. Continued vigilance against fraud, whether internal or external, should be a standard operating procedure, not only in 2005 but well beyond.
Finally, in 2005, we will see continued progress toward the implementation of the Basel II capital framework. In January 2005, the U.S. banking agencies conducted the Quantitative Impact Study 4 (QIS-4).1 The purpose of this study is to solicit information to help the banking agencies better understand the likely effect of the proposed international capital standards on the minimum regulatory capital requirements of large U.S. banking organizations. Feedback from this survey will guide the agencies in adopting and implementing such standards in the United States.
Also in January, regulators released interagency standards on the qualification process for Basel II implementation.2 As part of this process, banking agencies expect that implementation plans, along with evidence of budgeted resources to meet requirements, would be approved by the institution’s board of directors and that institutions would make formal notification to the primary regulator of intent to comply with the framework.
More relevant for many Third District banks, however, could be
possible proposed changes to the original Basel capital standards
for banks that will not use Basel II. Of course, any changes to
the original framework for small and regional banks would be subject
to a public comment period, and regulators would carefully consider
the burden of implementing changes against the benefits of clearer
or more streamlined capital calculations.
While managing all of these risks, banking executives must also
pay attention to operational capabilities, their institution’s
ability to execute strategies, and talent shortages. This will
require carefully balancing short-term and long-term performance
objectives. Banking organizations that instill a longer-term mindset
into their culture will be successful at managing current opportunities
while laying the foundation for long-term growth.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.