With the prospect of a downturn in the economy getting ever so closer, the time is right for executive management teams and boards of directors of financial institutions to review and reassess how they are going to prepare for and respond to regulatory examination criticisms, whether that be in the form of matters requiring attention, board resolutions, memorandums of understanding, or cease and desist orders. While the list below is by no means exhaustive, it should serve as a helpful guide for banks in continuing a productive relationship with their regulatory partners.
A. Prepare, Prepare, Prepare
Most financial institutions know (or should know) their stress points prior to a regulatory exam. Maybe it is an overconcentration in a particular area of the loan portfolio, failure to have an adequate executive succession plan in place or inadequate internal resources to address operational integration following a recent acquisition. You should always assume that these concerns will also be identified by your regulators during an exam. Accordingly, management must be forthright with their boards of directors and speak honestly so there is no “surprise” element during the course of the exam or in that first exit interview. Similarly, those key areas of discussion should be memorialized in board minutes. Certainly, the best path is always to rectify concerns prior to an exam; unfortunately, that is not always possible or necessarily desirable depending on a bank’s risk profile. Not having a management succession plan in place is a very different criticism from having a higher than average concentration in your construction loan portfolio when your team has a full understanding of the associated risks of such concentration and has implemented underwriting procedures to mitigate that risk. To the extent management can demonstrate to the regulators that they have prepared for these anticipated examination criticisms, have actively engaged on the issues with the board and are prepared to address the criticisms, regulators will generally approach such concerns with a “softer” touch when preparing their exam findings.
B. Board Engagement
Regulators need to see an actively engaged board of directors with respect to all material examination findings. Regulators raise a “red flag” internally when a board is far too deferential to its management team. The ultimate responsibility for the safety and soundness of a financial institution rests with the board. The board must constructively and actively engage with management and the regulatory examiners on all key examination findings. Board members may want to have one or two principal spokespersons—perhaps the chair of the board or the head of the audit committee, to the extent regulators are focused on a particular financial aspect of a bank’s condition—but all board members must understand the issues at hand, actively speak with the regulators and be prepared to be leaders within the organization to address examination findings. If a board does not seem engaged, regulators will be very comfortable (and quick) in downgrading management in an examination.
C. Negotiating the Findings During the Exam and in the Exit Interview
Being prepared and having an actively engaged management team and board can be an effective tool to negotiating an examination finding during the course of an exam or in an exit interview. In particular, board-level engagement and commitment can lead to a proposal for a set of board resolutions rather than the harsher memorandum of understanding. Examiners will make a preliminary determination about a recommended finding and come into an exit interview with their talking points and anticipated resolution protocol. Even so, examiners can be convinced that management and the board have taken a subject so seriously that the solutions can be effectively addressed with continued board and management commitment through board resolutions or just a matter requiring attention. In particular, an institution’s demonstrated past history of effectively addressing exam criticisms, whether or not regulators previously identified the same area of concern in a prior exam, and an institution’s commitment to devote the time and resources necessary for resolution are all factors that can mitigate the level of anticipated penalty. Continue to constructively engage with your regulators prior to the delivery of the final exam report, as regulators have more flexibility prior to their commitment on the final examination text.
D. Negotiating the Penalty
Not every effort to negotiate an exam criticism will be successful, and banks have received, and will continue to receive, board resolutions, memorandums of understanding, and cease and desist orders. Typically, the proposed text of an enforcement action will be presented to management and the board for signature by all board members. Receipt of the enforcement action should not, however, be the last opportunity to engage with your regulators. The terms and language of an enforcement action can be negotiated, with the extent of the negotiation typically revolving around timing to meet various requirements and focusing the language specifically on the exam criticism (rather than overarching responsibilities to correct every conceivable violation possible). In the context of the negotiation, management and the board should be very clear with the regulators that they understand the severity of the issue warranting the criticism and are deeply focused and engaged on an expedited resolution.
Management should also engage with their regulators between mandatory reporting cycles to apprise them of the ongoing progress they are making (and potential challenges they are facing). In particular, prior to the next exam, management should be actively engaged and prepared to demonstrate complete resolution so there is no further criticism or, far worse, an escalation of the criticism to the next level (i.e., from a memorandum of understanding to a cease and desist order). Working with outside advisors in areas of need can help facilitate an effective resolution process. However, both management and the board must acknowledge and accept that the responsibility for the safety and soundness of the institution rests with management and the board, not an outside consultant or advisor.
E. Disagreement With the Conclusions
It is not uncommon for management and the board to disagree with regulatory findings. Boards will often weigh their level of disagreement with the recommended regulatory course of action. Needless to say, any disagreement should always be conveyed respectfully and thoughtfully. Regulators know you are not always going to agree with them on their findings, but they also remember how institutions behave both in good times and stressful times. If you need to formally appeal a regulatory finding, work closely with your advisors and your regional supervisory director, take advantage of the regulatory ombudsman that agencies have to resolve disputes, and familiarize yourself with the appeal process. The manner of conduct and approach to the appeal process (although infrequent) may not affect the ultimate resolution, but it can have a bearing on future examinations if the appeal is conducted with thorough preparation, in good faith and with zealous, yet respectful, advocacy. If you are not successful in the appeals process, resolve the issue of concern and move on. You will see that regulator again in the next exam cycle, and you want to start with a clean slate. Finally, don’t let your next exam be the first time you again engage with the regulatory agency. Pick up the phone every quarter—let your case manager and regional director know what is going on with the bank and, most of all, continue to be engaged with the regulatory team. Behind every regulatory agency (and every bank) are people with institutional memories.