How Bank Regulation May Affect You
by Ron Box, CPA.CITP
If you are responsible for ensuring an uninterrupted flow of capital to your business, you are probably experiencing the effect of many forces external to your organization. One factor that tends to happen in the background, but can be very important to your ability to obtain credit, is the regulatory environment that your bank operates within. You probably see firsthand the credit policy of your bank and how your business fits in to that policy, but how can the regulatory atmosphere affect you directly?
Financial Regulation in the United States
Financial institutions in the United States are subject to various forms of government regulation. The purpose of government's oversight role in banking is to ensure a strong and healthy banking system and a consistent flow of credit to the economy of the United States. Many of the regulations in force today stem from the efforts of the Franklin Roosevelt administrations to stabilize the economy during the great depression. Several agencies, including those from some state authorities, can have oversight responsibilities over a bank, depending on how the bank is chartered. Agencies of the federal government such as the Federal Reserve Bank, the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Office of Thrift Supervision (OTS) are a few of the primary organizations with regulatory authority over financial activity in the United States. In extreme cases, regulators can enforce a merger or sale of bank assets to other financial institutions if they believe that bank problems are systemic and irreparable.
The Financial Crisis of 2007
The years leading up to the credit crisis that began in 2007 saw an increasing spiral of demand, prices and credit for real estate in many markets. This type of cycle, with prices out of line with reasonable demand, is thought of as a "bubble" when viewed in retrospect. Subprime loans, credit issued to borrowers that had previously been thought of as bad risks, when packaged together, became securitized with the idea that a collection of such loans would offset the risk of the supposed small number that would default. Other derivatives, such as credit default swaps, were sold by a number of financial institutions in a manner that now appears excessive. These are a few of the activities faulted in the lead up to the financial crisis that began late in 2007. Alan Greenspan, former Chairman of the Federal Reserve Board of Governors, had a well documented preference for the free market system and a desire to allow markets to run their own course. Did this have any effect in persuading the regulators of our financial system to allow too much risk to creep in to the credit markets? The Associated Press recounts Mr. Greenspan's testimony before Congress on the credit crisis saying "The longtime Fed chief acknowledged under questioning that he had made a "mistake" in believing that banks in operating in their self-interest would be sufficient to protect their shareholders and the equity in their institutions. He went on to assign the blame on soaring mortgage foreclosures on overeager investors who did not properly take into account the threats that would be posed once home prices stopped surging upward. He said what had been "a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened." Committee members accused present and past federal regulators for not doing more to stop abusive practices or to go after wrongdoers. The cause of the financial crisis will be debated for many years, but many economists believe that an "easy credit" policy on the part of lenders had a significant impact on the events that ultimately created the Financial Crisis of 2007.
Where Were the Regulators?
A December 21, 2007 article in the New York Times asked, "So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded?" Many financial experts believe that tighter regulatory oversight of commercial and investment banks during the build up of the real estate bubble, securitization of subprime mortgages, sales of derivatives such as credit default swaps, and other issues faulted in the lead up to the credit crisis would have mitigated much of the problem. It is difficult to know the extent to which this statement may be true, but most regulatory agencies redoubled their efforts to ensure safe lending practices in the wake of the financial crisis. Some bankers, however, believe that the regulatory environment is now too aggressive. According to William Loving (on behalf of the Independent Community Bankers of America) in a June 8, 2010 statement (PDF) to the United States Senate Committee on Small Business and Entrepreneurship, "Bank regulators perform a critical function. But they must strike the appropriate balance between regulating safety and soundness and allowing the flow of properly underwritten credit. Many believe that the bank regulatory pendulum has swung too far in the direction of discouraging lending."
Why Do My Bank's Regulators Matter to Me?
Banks are expected to establish and maintain their own credit policies consistent with good lending practices. A business is evaluated based on many factors, but profitability, leverage and liquidity are a few of the most important issues that affect credit decisions. Financial covenants such as mandatory debt / equity ratios or debt service coverage ratios are usually included in commercial loan documents. Personal guarantees by business owners and board members are also general requirements. Consistently meeting these expectations is an important factor in determining credit approval. Regulators review the credit decisions made by your bank on a regular basis and make decisions regarding the correctness of those decisions. Your credit file could be reviewed by the bank regulators and they have the prerogative to agree or disagree. If the regulator disagrees, a strong suggestion is made to the bank regarding what is deemed to be a more appropriate approach. This recommendation could have the effect of downgrading your credit risk rating, which could reduce or eliminate your access to loans. In extreme cases, liquidation of collateral and removal of the credit from the bank's books could be recommended. Of course, these actions could be detrimental, even catastrophic, to your business.
What Steps Should You Take?
You should familiarize yourself with the charter of your bank and the regulators who determine the bank's level of compliance with best practices regarding capital, credit, and earnings ratios. Communicate honestly and frequently with your banker so that he or she can be an effective advocate for the most appropriate credit package for your business. The package will likely be reviewed by a bank underwriter, a credit officer, the bank's credit committee and ultimately the bank's regulators. It is difficult to overstate the effect that regulator decisions can have on this process. Many banks adjust their credit policy based on the expected determination from a regulator. Although you will probably not have an opportunity to talk directly with the regulator reviewing your credit, a well informed banker can anticipate and document any questions likely to be asked.
Critical decisions will be made regarding the ability of your business to obtain credit. Knowledge regarding how your credit will be evaluated, both by the bank and by their regulators, can allow you to anticipate potential problems. Ask your banker to explain the credit underwriting process for your loans, including a thorough explanation of the bank's regulatory position. Ensure that your access to credit is stable and that your banker has all of the information necessary to defend your credit rating.
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Ron Box, CPA.CITP, CFF, CISSP, is the chief financial officer and chief information officer for Joe Money Machinery, a Birmingham, AL.-based regional heavy construction distributor with operations in Georgia and Florida. Ron also serves as chair for the 2010 AICPA Top Technology Task Force and is a member of the AICPA Certified Information Technology Professional (CITP) Credential Committee.