Executive Summary (Download the full report)
2013 was marked by continued uncertainty for bank executives and their boards. Bank leaders struggled to ready their institutions for implementation of the new rules amid lingering questions about whether impending regulations would even apply – and if or when they would actually materialize.
Implementation of the long-awaited "Volcker Rule"
Among the most anxiously anticipated sections of the Dodd-Frank Act was the long-awaited Volcker Rule, which prevents banking entities from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments on their own account. It also prohibits banks from having an “ownership interest” in a “covered fund” such as hedge funds and private equity funds.
For additional information about the accounting implications of covered funds, read our recent publication, “Volcker Rule: Potential accounting implications of the requirement to divest of “ownership interests.”
In what can be seen as a nod to the difficulty banks face in implementing the requirements, regulators have given them until July 21, 2015 to comply with the final rule. Boards and senior management will spend much of the coming year examining their compliance controls and ensuring that they are adequately prepared for full implementation, but the Volker Rule also requires immediate action for many institutions.
"Although the Volcker Rule was only recently finalized, many banks have been preparing for the rule to take effect for over two years," comments Jack Katz, Financial Services Global Leader. These firms have shed their proprietary trading desks, refocusing on banking activities such as direct lending (primarily commercial and industrial loans) and evaluating investments in funds and other entities.
3 strategic imperatives for banks
Despite continued regulatory challenges and a sluggish economic environment, most institutions witnessed improvement in their financial conditions over the course of 2013. Bank earnings rose to new heights — reaching record levels. Net operating income has risen year-over-year every quarter since the recession (with the exception of Q3 2013), credit quality improved while loan balances have grown, and we experienced a continued decrease in the number of institutions that failed or were deemed problematic, according to the FDIC’s Q3 Quarterly Banking Profile.
How will banks keep the momentum going? We outline three areas to focus on. Download the full report (PDF) for action items on how your bank can minimize risk and maximize returns in 2014.
Priority #1: Increasing capital
“Capital drives so much right now from the regulators’ perspective. Excluding statutory requirements, capital is the regulators’ be-all and end-all,” says Nichole Jordan, Banking & Securities Industry Leader.
According to Grant Thornton’s 2013 Bank Board & Executive Survey, most bank directors think their capital levels are adequate, though regulators might beg to differ. While 71% of respondents indicated that their banks’ capital levels are satisfactory, and they have no plans to raise capital over the next year, 42% indicated a longer-term need to raise capital to support either growth or to comply with Basel III. Of those that do plan to raise capital, half plan to do so through a private offering to existing shareholders, while 47% plan a secondary offering on the public market.
At a minimum, banks will need to integrate into their capital planning and strategic planning processes an analysis of where they stand relative to Basel III requirements and make plans to address any capital needs.
Priority #2: Managing credit quality
The wave of residential refinancing receded considerably in 2013, and the continued low-rate environment has compressed the net interest margin for most institutions. As a result, bank executives are turning to new, expanded or modified product offerings and service lines to improve performance. The regulators’ concern is that many banks — particularly smaller community banks — may not have performed the upfront risk analysis required in their zeal to address net interest margin compression. Moreover, as rates rise and competition for loans increases, banks must be diligent in maintaining their underwriting standards.
“Regulators fear that banks competing to win customers by matching rates may be so doing without regard for risk profiling,” says Graham Dyer, senior manager in Grant Thornton’s National Professional Standards Group. “If and when future loan losses surface, will banks have been compensated for the risk they assumed?”
“The bank’s board should ensure that a full cross-section of its committees, including its risk committee, enterprise-risk-management committee and audit committee, as applicable, are involved in making sure the organization has all its risks covered,” says Katz.
Katz also suggests that banks look closely at the skills of their boards and management teams, and consider whether they need additional board or management expertise given their growth strategies and the complexity of the industry.
Priority #3: Managing interest rate risk
Throughout 2013, interest rates remained at or near historic lows, compressing net interest margins and creating fierce competition among banks for higher yielding assets. Many banks are now turning to aggressive interest-rate strategies, such as extending asset or loan maturities or increasing holdings of riskier investments. Yet with these types of strategies come growing exposures to rising interest rates. And given the Federal Reserve Bank’s commitment to taper and eventually eliminate the quantitative easing program, interest rates are likely to increase.
The OCC is focused on interest rate risk as a top operating risk facing banks right now, especially given that many banks have underwritten higher-yield or longer-term loans to earn more in interest. When interest rates increase, “banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion," cautions the OCC.
Jordan remarks, “Regulators have been saying for a while that long-term rates will go up. Their concern is that, because banks have not worried about this for six years, they may not have the people, policies and systems in place to manage it.”
Regulators will be confirming that banks have taken the appropriate steps to monitor and manage their risk related to fluctuating rates, and will want to see that banks are focused on this area of vulnerability. Stress tests are a useful tool to provide insight into a bank’s exposure to risk, while at the same time, assessing how well capitalized the institution is.
The Dodd-Frank reform process will continue to unfold throughout the 2014. At the same time, Basel III will usher in a host of additional changes and regulatory priorities.
“Banks shouldn’t lose sight of the big picture in the sea of compliance requirements,” says Jordan. “They need to stay rigorously focused on the fundamentals that underpin their financial stability: capital, credit risk and interest rate risk. Those institutions that do so will be poised to compete — and win — upon full implementation of the new rules and going forward.”