HOW DID WE GET INTO THIS MESS?
The financial services industry is one of the most heavily regulated segments of our society. They're subjected to intense regulatory scrutiny to assure adherence to standards set forth for consumer protection. Details of regulatory compliance were discussed in the August 5, 2008 edition of GCFlash, available online.
Following the Great Depression, the Glass-Steagall Act of 1933 was enacted to regulate which markets an institution could serve, be it commercial banking, investment banking or insurance services. Their Charter made distinctions between offering loans, securities and deposits. It was felt that combining these interests could lead to conflicts of interest and fraud. It also created the Federal Deposit Insurance Corporation (FDIC). This was done to avoid another financial catastrophe comparable to what our great nation had just undergone.
But by the 1980s, people had already begun to forget its purpose. The banking industry began campaigning for its repeal.
The Depository Institution Deregulation and Monetary Control Act was passed in 1980, giving The Federal Reserve control over non-member banks. The Act allowed banks to merge, and permitted institutions to charge any interest rates they chose.
In 1982, the Garn-St. Germain Depository Institutions Act deregulated the Savings and Loan industry, which eventually became a contributing factor in the Savings and Loan crisis of the late 1980s. The bill was intended to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans. This Act was the advent of adjustable rate mortgages.
The result of these two Acts transformed the banking industry. Between the 1980s and 1990s, our country saw 7,402 bank mergers totaling $1.8 trillion in assets approved, despite U.S. antitrust laws.
This laid the groundwork for President Clinton's 1999 signing of the Gramm-Leach-Bliley Act which repealed the Glass-Steagall Act. With deregulation, the same bank that holds your deposits can use those assets to underwrite and trade mortgage-backed securities, collateralized debt obligations or other trade instruments. Enter the era of mega banks that we know now, those one-stop-shop institutions with the largest asset value. The ones deemed too large to fail.
Now that's a get-out-of-jail-free card for anybody sitting in the ivory tower of those institutions. Some of them, not all, felt they could do no wrong. They basked in the affluence of the times, paying little heed to the cyclical nature of any type of market. But basic rules of physics apply here as elsewhere: what goes up ultimately must come down.
And despite today's doom-and-gloom, another rule will also apply: the cream will always rise to the top.
The fallout from this debacle will hurt for a while. We will likely see the demise of some of those giants deemed too large to fail, but those that maintained responsible and prudent lending practices will prosper. Those few bad apples will fall from the tree, nourishing the good ones that remain. The news isn't all so bad...
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HOW CAN WE KNOW IF A BANK IS IN TROUBLE?
Late-night talk show hosts have been the beneficiary in these troubled economic times with a seemingly endless supply of jokes based on bank failures. They're probably the only group of people who find humor in any of this.
Yet the situation is not nearly as gloomy as you would be led to believe by listening to the nightly newscast. Financial institutions are subject to intense regulatory oversight that identifies any single bank that may be heading for trouble before they reach a crisis point. The agency will work closely to help the bank overcome temporary setbacks before seizing control of the rare few that are doomed to failure.
Various governmental agencies play a role in overseeing the operations of any financial institution. Each agency examines for compliance within its own area of jurisdiction.
Institutions are governed by their chartering authority, falling under the U.S. Department of the Treasury. The Office of the Comptroller of the Currency (OCC) regulates national banks. Banks are a chartered institution empowered to receive deposits, make loans and provide checking and savings account services for a profit. They're identified by the words "National" or "National Association" (N.A.) in the title of the bank. UPDATE: OFFICE DISSOLVED WITH DODD-FRANK ACT
Thrifts are federal banking institutions formed as a depository for primarily consumer savings. Savings and loan associations and savings banks are thrift institutions. These are regulated by the Office of Thrift Supervision (OTS). You'll recognize them by the words "Federal", "Federal Association" (FA or FSA), "Federal Savings and Loan" (FSL) or "Federal Savings Bank" (FSB) in their title. GCF Bank is chartered as a thrift, so we'll follow this route of audit responsibility for the remainder of this article.
Credit unions operate under the National Credit Union Administration (NCUA).
The OTS examines a financial institution every 12 to 18 months, based on your CAMELS rating. Those with lower ratings are reviewed more often. The CAMELS rating is a uniform rating system applied to every component of regulatory inspection to provide a complete picture of the institution's stability through adherence to compliance, ability to withstand turbulent economic cycles and management's effectiveness in implementing an effective compliance program.
The OTS provides the institution with the PERK (pre-examination response kit) approximately one month prior to the scheduled audit. This kit includes details of exactly what information will be requested by the auditors during the exam. The information varies by whichever function they're auditing at the time.
Federal laws to protect consumer interests apply to every aspect of the banking industry. Adherence to each must be proven at the OTS compliance exam. The institution must provide copies of all policies regarding laws enacted to protect consumer rights as well as samples of how they adhered to said policy. GCF Bank makes all policies available on their web site at www.gcfbank.com/policy.asp.
The Community Reinvestment Act ensures the locations and services provided by each bank meet the credit needs of their local area consistent with safe and sound operations. The quarterly evaluation is made public, with a full exam conducted about every two years.
The safety and soundness assessment is determined by examining the effectiveness of management, financial soundness, internal controls, liquidity and assets. Management must provide examples of their ability and willingness to effectively address weaknesses within their organization.
Are all employees properly trained in adhering to bank policy? Workshops are scheduled to cover new federal regulations or security concerns as they surface. The appropriate bank officer handling each area must create a presentation to teach all employees how to address such issues. Copies of the presentation along with handout materials and sign-in sheets must be provided to auditors upon request.
Financial records and statements must be produced during the examination. A sound institution will successfully balance their assets with their liabilities and net worth. Their ratio of deposits to loans must match to weather turbulent economic times. The banks currently in danger of failing missed this mark when they couldn't resist the ease of a quick dollar to be made in the subprime loan market.
In addition to those audits conducted by the OTS, a more financial/internal control oriented exam is required by an external auditor annually.
GCF Bank also hires outside firms to conduct internal audits. These audits primarily focus on technology and training compliance as well as internal control/procedures. They audit a few areas each quarter. The bank gets two week's notice of the reports/documentation requests to prepare for the audit.
A separate firm conducts an internal assessment of our commercial and national product line which includes the aircraft and RV markets.
GCF Bank's Compliance Officer also conducts regulatory compliance audits throughout the year. These other audits ensure that we remain compliant and earn a good rating. Satisfactory ratings are critical in that they affect the opening of new branches, mergers and fee assessments along with exam frequency. We have to pay for the OTS exam! Also, many regulations carry money penalties for non-compliance.
The risks of poor performance ratings are steep. Such institutions deemed unable or unwilling to reverse their programs find themselves on the FDIC's watch list. At present, 90 banks are in danger according to the FDIC. Analysts predict 100-200 of the nation's 8,494 insured institutions may fail over the next two years. Most of those currently in trouble will be saved by addressing issues raised during the intense audit process.
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FINANCIAL REFORM OR BUST?
One thing every American can agree upon is that financial reform is a necessity. Where they differ is on how to achieve true reform. Sounds a bit like the opening line in one of my healthcare articles a few short weeks ago. So maybe a more accurate opening would read "Here we go againâ€¦"
While healthcare legislation was crucial to our physical well-being, the financial crisis threatened both the economic and emotional welfare of our nation. Between the end of 2007 and the end of 2009, household net worth in the United States declined from $64 trillion to $54 trillion according to the Federal Reserve Flow of Funds Accounts. Millions of Americans have lost their jobs, their homes and their savings.
The objective is clear. Institutions had been deemed "too big to fail," therefore necessitating taxpayer bailout when those at the helm treasured that status above all else. This bill intends to end the concept of any institution being too big to fail.
Not all large banks fell into this category. Not all of those in leadership abused their privilege. But it only took a couple of rotten apples to decay the entire tree.
Consumers were exposed to harmful business practices, preying on those in vulnerable positions that couldn't properly assess the risk. Others had no option except to take that risk, despite what consequences it may bring.
Another key element is transparency. We've heard this term thrown at us each time a bill is debated. The public needs the opportunity to hear firsthand the rhetoric of each line item being discussed. They need to hear the pros and cons rather than blindly follow the opinion of their news source of choice. They have a right to know how their elected officials react in heated situations, and whether they voted n good conscience. The most popular option is not always in the best interest of the people, but it assures their vote in the next election. That is, unless the fallout from passing bad legislation occurs first.
In this case, transparency refers to public awareness about the true state of our economy. A debate about which, ironically, the details are expected to be ironed out behind closed doors.
A major stumbling block on bill passage is how to regulate derivatives. These can be quite complex. Derivatives are a product developed that permit investors to protect themselves by offsetting their risk or speculating on the future value of assets. They sit at the root of the real estate bust.
Financial reform is intended to assure there are no future bank bailouts. Yet one of the provisions in this bill calls for the creation of a $50 billion bailout fund to pay for "orderly liquidation" of large institutions in trouble going forward. Members of the financial industry will fund the program.
The bill, already approved by the House and now making its way through Senate, calls for yet another regulatory panel to oversee financial industry practices. This writer wonders if we would be in this position had the regulations already in place been uniformly enforced.
The legislation is being called the most sweeping overhaul of banking regulations since the Great Depression. It's only fitting that it should fall on the heels of our deepest economic plunge since that crisis. But it's easy to overreact in the wake of such disaster, and adds to the danger of passing poor legislation.
The Glass-Steagall Act was passed in 1933 to prevent the circumstances that led to the Great Depression. Read How Did We Get Into This Mess? in the February 24, 2009 edition of GCFlash for narrative on this Act.
Within 50 short years, the purpose of this Act was already being questioned. It was repealed. Those that replaced it shook up the banking industry. And eventually led to the crisis we're only just recovering from. Let's hope the lesson is better learned this time around.