Having the “Compliance Conversation” in the Face of Changing Expectations. 

One of the constants in the world of compliance is change.    This will be true again in 2016 when several new significant changes to regulations will be implemented.   For smaller institutions the regulatory changes won’t be as significant as for larger ones.  However, in addition to changes in regulations, there will also be changes in the areas of emphasis for the regulators.   For example, regulators will be looking at the financial intuitions usage of models as a tool and will expect that the governance around the usage of models will be well documented.  In addition, Bank Secrecy Act/Anti Money Laundering compliance programs will be scrutinized.  Changes such as these can significantly impact the outcome of examinations and audits. 

One of the other constants in compliance has been skepticism about consumer laws in general and the need for compliance regulations specifically.  It is often easy to feel the recalcitrance of the senior management at financial institutions to the very idea of compliance.  Even institutions with a good compliance record often tend to do exactly that which is required by the regulation for the sole purpose of staying in compliance with the letter and not the spirit of compliance.  Indeed, skepticism about the need for consumer regulations as well as the effectiveness of the regulations are conversations that can be heard at many an institution. 

The combination of changes in the consumer regulations and changes in the focus of these agencies presents both a challenge and an opportunity for compliance staff everywhere.  It is time to have “the talk” with senior management.    The point of the talk?  Enhancements in compliance can help your bank receive higher compliance ratings while improving the overall relationship with your primary regulator. 

The Compliance Conversation

While there are many ways to try to frame the case for why compliance should be a primary concern at a bank, there are several points that we have found that help convince a skeptic. 

Compliance regulations have been earned by the financial industry.  A quick review of the history of the most well-known consumer regulations will show that each of these laws was enacted to address bad behaviors of financial institutions.  For example, the Equal Credit Opportunity Act (ECOA) was passed to help open up credit markets to women and minorities who were being shut out of the credit market.  Moreover, the Fair lending laws, HMDA and the Community Reinvestment Act were all passed to assist in the task of enforcement of the ECOA.  In all of these cases, the impetus for the legislation was complaints from the public about the behavior of banks.  The fact is that these regulations were implemented to prevent financial institutions from hurting the public. 

Compliance will not go away.   Even though there have been changes to the primary regulations, there has been no credible movement towards doing away with them.   Banking is such an important part of our economy that it will always receive a great deal of attention from the public and therefore, legislative bodies.   The trend for all of the compliance regulations is that they continue to expand.  The need for a compliance program is as basic to banking as the need for deposit insurance.  In addition, since compliance is and will be, a fact of banking life, the prudent course is to embrace it.  

 

Compliance may not be a profit center, but a good compliance program reduces the opportunity costs of regulatory enforcement actions.  Many financial institutions tend to be reactive when it comes to compliance.  We understand that there is a cost benefit analysis that is done and often, the decision is made to “take our chances” and get by with a minimal amount of resources spent on compliance.   However, more often than not the cost benefit analysis does not take into account the cost of “getting caught”.  Findings from compliance examinations may require “look backs” into past transactions and reimbursement to customers who were harmed by a particular practice.  The costs for such action include costs of staff time (or temporary staff), reputational costs and the costs associated with correcting the offending practice.  A strong compliance management system will prevent these costs from being incurred from the outset and protect the Bank’s reputation; which at the end of the day is its most important asset. 

 

Compliance is directly impacted by the strategic plan. Far too often, compliance is not considered as banks put together their plans for growth and profitability.   Plans for new marketing campaigns or new products being offered go through the approval process without the input of the compliance team.  Unfortunately, without this consideration, banks add additional risk without being aware of how the additional risk can be mitigated.    When compliance is considered in the strategic plan, we find that the proper level of resources can be dedicated to all levels of management and internal controls. 

 

There is nothing about being in compliance that will get in the way of the bank making money and being successful.  Many times the compliance officer gets portrayed as the person who keeps saying no- No!” to new products, “No!” to new marketing” and “No!” to being profitable.  But the truth is that this characterization is both unfair and untrue.  The compliance staff at your banks wants the bank to make all the money that it possibly can while staying in compliance with the laws that apply.  The compliance team is not the enemy.  In fact, the compliance team is there to solve problems.  

 

Getting the Conversation to Address the Future. 

Today, we are seeing changes in the expectations that regulators have about responding to examination findings and the overall maintenance of the compliance management program.   There are three fronts that may seem unrelated at first, but when put together, they make  powerful arguments about how compliance can become a key component in your relationship with the regulators. 

First, the regulators have determined that the overall effectiveness of the compliance programs should be a consideration of the CAMEL ratings.   The Comptroller of the Currency has published remarks that make it clear that he intends to evaluate the review of the compliance management program to directly impact the overall “M” rating within the CAMEL ratings.   The other prudent regulators are soon to follow.  The thought behind evaluating the compliance management program is that it is in fact the responsibility of management to maintain and operate a strong compliance program.  The failure to do so is a direct reflection of management’s abilities.  Compliance is now a regulatory foundation issue. 

 

Second, now more than ever, regulators are looking to financial institutions to risk assess their own compliance and when problems are noted, to come forward with the information.  The CFPB for example, published guidance in 2013 (Bulletin 2013-06) that directly challenged banks to be corporate citizens by self-policing and self-reporting.  It is clear that doing so will enhance both the reputation and the relationship with regulators.  The idea here is that by showing that you take compliance seriously and are willing to self-police, the need for regulatory oversight can be reduced.

 

Finally, the regulators have reiterated their desire to see financial institutions address the root causes of findings in examinations.   There have been recent attempts by the Federal Reserve and the CFPB to make distinctions between recommendations and findings.  The reason for these clarifications are so that banks can more fully address the highest areas of concern.  The regulators are emphasizing that they expect a financial institutions to address the heart of the reason that the finding occurred.  For example, in a case where a bank was improperly completing Good Faith Estimates in violation of RESPA, the response cannot simply be to tell the loan staff to knock it off!  In addition to correcting mistakes, there is either a training issue or perhaps staff are improperly assigned.  What is the reason for the improper disclosures?  That is what the regulators want addressed.   

The opportunity exists to enhance your relationship with your regulators through your compliance department.  By elevating the level of importance of compliance at your institution and using it as a topic, a relationship of trust and communication can be developed with your regulators. 



Does Your Internal Audit Scope Meet Regulatory Standards? 

A Two Part Series-Part TWO-Setting the Scope    

 

As we  noted in the first part of this series, the scope of the internal audit function at financial institutions has been an area of focus for  regulators.  In particular, regulators have focused on whether or not the scope of internal audits meets both regulatory standards and is appropriate in light of the overall risk profile of a financial institution.  It is the second of these two considerations that has most recently  caused findings and created concerns.    It is therefore, critical that the scope of audits reflect an understanding of the risks inherent at your financial institution.  

 

Using Risk Assessments Effectively  

The Federal Financial Institutions Examination Council (FFIEC”) issued a comprehensive policy statement on the audit process in 2003.  This statement is still the definitive regulatory guidance on the proper development and maintenance of the internal audit function for financial institutions.   The guidance states that risk assessments are a key component of internal audits.  A risk assessment is defined as follows:  

A control risk assessment (or risk assessment methodology) documents the internal auditor's understanding of the institution's significant business activities and their associated risks. These assessments typically analyze the risks inherent in a given business line, the mitigating control processes, and the resulting residual risk exposure of the institution. They should be updated regularly to reflect changes to the system of internal control or work processes, and to incorporate new lines of business.[1]

At smaller institutions, there generally is not a full time internal auditor on staff.  This does not obviate the need for comprehensive and timely risk assessments.  Unfortunately, the risk assessment process is often overlooked.   The risk assessment should consider the following:  

Past Examination and Audit Results-

It goes without saying that the past can be a  prelude to the future.   Prior findings are an immediate indication of lack of effectiveness of internal controls.  It is important that the root cause of the finding or recommendations from regulators is identified and addressed.  Internal audits should coordinate with the risk assessment to test the effectiveness of the remediation.   

Changes in Staff and Management

Change is inevitable and along with changes comes the possibility that additional training should be implemented or that the resources available to staff should also change.  For example, suppose the head of Note Operations is brand new.  This new manager will want to process loans using her/his own system.  Loan staff who may be used to past procedures may become confused.  Change generally increases the possibility of findings or mistakes.   Your risk assessment should take into account the risks associated with changes and how best to address them.  In addition, this is an area that should be covered by internal audit as it presents a risk.   

Changes in Products, Customers or Branches

It is also important that your risk assessment consider all  of the different aspects of changes that have occurred or will occur during the year.  Any new products or services, new vendors, and/or marketing campaigns that are designed to entice new types of customers are all changes that impact the overall risk profile of the institution.    The resources necessary to address these changes should also be a consideration for the internal audit.      

Changes in Regulations

Over the past few years, there have been a huge number of changes to regulations, guidance and directives from Federal and State agencies.  Many of these changes do not impact smaller institutions directly, but many do.  Moreover, there are often regulations that are finalized in one year that don’t become effective until the following year.   Part of your risk assessment process has to consider changes that will affect your institution.  The internal audit scope should also consider whether the institution is prepared to meet changing regulatory requirements.  

Monitoring systems in place

The information systems being employed to monitor the effectiveness of internal controls should be considered.  For many institutions, this system is comprised of word of mouth and the results of audits and examinations.  Information used by senior management and reported to the Board should be sufficient to allow credible challenges by the Board.[2]

Using the Risk assessment to Set Audit Scopes

Once a risk assessment is completed, the results should be directly tied to the internal audit schedule.   The FIIEC guidance points out the relationship between the internal audit plan and the risk assessment: 

 An internal audit plan is based on the control risk assessment and typically includes a summary of key internal controls within each significant business activity, the timing and frequency of planned internal audit work, and a resource budget.[3]

 

The risk assessment should prioritize the potential for findings, while the audit scope should be developed to test mitigation steps made to reduce findings.

The criticism that is often raised about outsourced audit is that the scope is incomplete.  This is often the case because outsourced vendors have developed their scope based upon best practices, and their experiences at various institutions.  While this is obviously a best practice for the audit vendor, the problem is that it doesn’t always fit the individual institution.   Information from a comprehensive risk assessment should be incorporated into the scope of an internal audit. 

In this manner, the auditor can best consider the areas of risk that are the highest priority at a particular institutions.  For example, when developing the scope for an independent audit of a BSA/AML program, the scope should include the most recent risk assessment.  Changes in the customer base, an increase in the overall risk profile of the bank or a change in personnel are all factors that should be included in the audit scope.  In addition, the auditor should consider whether current monitoring systems have the capability to properly monitor the additional level of risk.  Finally, the professional abilities of the BSA staff should be considered as they relate to additional risk.  

Ultimately, it is the responsibility of the Board to ensure that the internal audit is effectively testing the strength of internal controls.  

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[1] Interagency Policy Statement on the Internal Audit Function and its Outsourcing

[2] See for example, OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations

^[3] Interagency Policy Statement on the Internal Audit Function and its Outsourcing

Does Your Internal Audit Scope Meet Regulatory Standards? 

Part One:The Regulatory Standards 

One of the areas of focus for the regulators of financial institutions in the upcoming months will be the scope of the outsourced audits.   We have recently noted a number of clients that have been criticized for audit scopes that are either inadequate based upon risk, or are simply not comprehensive.   

It is well established that the safe and sound operation of a financial institution requires among other things, a well-established system of internal controls.  The regulatory agencies all have a similar definition of internal controls.  For example, the Office of the Comptroller of the Currency in the Management handbook as follows:

Internal control is the systems, policies, procedures, and processes effected by the board of directors, management, and other personnel to safeguard bank assets, limit or control risks, and achieve a bank’s objectives.[1]

Once a system of internal controls has been established by a Board of Directors, it is necessary to test the effectiveness of the controls and to make sure that bank personnel are adhering to the limits established.  This is the role of internal audit.   As the OCC handbook points out; 

 Internal audit provides an objective, independent review of bank activities, internal controls, and management information systems to help the board and management monitor and evaluate internal control adequacy and effectiveness.[2]

Regular, comprehensive auditing of the operations of a financial institution are a necessary part of a safe and sound operation.  All federally insured financial institutions are expected to maintain audit departments.   However, for smaller institutions that cost of employing a full time internal audit staff has proven to be prohibitive.    For most institutions with assets of less than $1 billion, the audit function have been at least partially outsourced.  

Outsourcing of the audit function is a well-established a practice.  The Federal Financial Institutions Examination Council (FFIEC”) recognized this when it issued a comprehensive policy statement on the process in 2003.   The guidance is called “Interagency Policy Statement on the Internal Audit Function and its Outsourcing”.  Since its release, there has been some additional guidance that has been issued that addresses outsourcing in more general terms[3] .  However, the guidance first issued in 2003 remains the seminal guide for outsourcing audit today.   

Standards for Outsourcing

The FFIEC guidance makes it clear that the responsibility for internal controls remains with the Board and senior management of the financial institution. 

Furthermore, the agencies want to ensure that these arrangements with outsourcing vendors do not leave directors and senior management with the erroneous impression that they have been relieved of their responsibility for maintaining an effective system of internal control and for overseeing the internal audit function.[4]

  The guidance is divided into four parts:

1.       The Internal Audit function

2.       Outsourcing Arrangements

3.       Independence of the public accountant

4.       Guidance for Regulators  

The Audit Function

The guidance notes that the audit function is the mean by which the Board can test whether or not internal controls are effective.  

Accordingly, directors and senior management should have reasonable assurance that the system of internal control prevents or detects significant inaccurate, incomplete, or unauthorized transactions; deficiencies in the safeguarding of assets; unreliable financial reporting (which includes regulatory reporting); and deviations from laws, regulations, and the institution's policies. [5]

The function of internal audit, then is ultimately to inform the Board, of weaknesses in internal controls and the possibility of regulatory violations.    There is a great deal of discussion in this section about the reporting structure for the audit function.  Ultimately, the critical point from this section is that whatever reporting structure is developed, the auditor must have the ability to report directly to the audit committee. 

We note that in many smaller institutions, the results of audits are read out to business line managers and the final reports are delivered directly to the Board or to the audit committee of the Board.  This process often does not allow the auditor in charge to communicate directly with the audit committee.  A comprehensive scope should include a comment on the effectiveness of management to carry out their assigned duties. The guidance is specific that in small institutions, the person responsible for testing internal controls should report findings directly to the audit committee.   As a best practice, a member of the audit committee should attend the exit meeting and allow the auditor to comment on any concerns that he/she feels should be directly communicated to the Board.  

Outsourcing Arrangements

The guidance notes that even in the event that the audit function is completely outsourced, it is still the responsibility of the Board and management to ensure that internal controls are effective.    The outsourced agreement should take into account both the current and anticipated business risks of the financial institution.  

 

The guidance details the minimum requirements for an outsourcing agreement, including the limitation that outside auditors must not make management decisions and can only act in the capacity of informing the Board.  Once again, the idea that the outside auditor should communicate directly with a representative of the Board is emphasized.   

One of the areas of criticism that we are currently seeing is that the internal audit plans do not adequately consider factors that should be part of the risk assessment.  Changes in staff, new regulatory requirements, software limitations, overall training and experience of management are all factors that should be considered when developing the internal audit plan.   As a best practice, the scope of the audits to be performed by the outsourced auditor should reflect the fact that the Board has considered these factors and included them. 

Independence of the Public Accountant

For many financial institutions, the temptation is to use the same accounting firm that prepares financial statements to perform internal audits.  This issue presents itself most often with institutions that are over $500 million in assets, because there is a requirement for an independent audit on financial statements by a public accounting firm.  Generally, the guidance limits the ability of public accounting firms to also be the outsourced audit firm.   

For smaller institutions, there is no prohibition to use public accounting firms, however, the practice is strongly discouraged.   In large part, the reason for this is that the firm that prepares the financial statement must be completely independent.  The data that is used to prepare financial statements has to be independently verified.  When the accounting firm performs both of these functions, the appearance is that independence is lacking.  In other words, the firm that is preparing the financial statements of a bank may be auditing its own work. 

 There are several independent firms that specialize in auditing for financial institutions.  These firms tend to provide cost effective and comprehensive alternatives to the public accounting firms.   

 

Guidance for Regulators

The guidance specifies the goal of the examiners review of the internal audit.  The examiners are directed to ensure that the audit scope reflects the risk assessment of the institution and the Board has directed the auditor to consider the areas that are the highest risk.  The examiners are also directed to review the work papers of the auditor to ensure that they support the findings and conclusions in the audit report.   Examiners will also review how findings are communicated to the Board and management.  There is an expectation that responses to findings are tracked and monitored.  

We have recently noted that the regulators are criticizing Boards for not receiving information about the overall effectiveness of the senior managers that they have employed.   Examiners have often been critical when the audit report does not specifically draw a conclusion about the training, effectiveness and capabilities of the senior management in charge of the business line being audited.  As we noted, it is a best practice to allow an outlet for the auditor to communicate a conclusion about senior management in the audit process.

 

In part two, we will discuss best practices for developing the audit scope

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[1]   Comptroller’s Handbook-Internal Control 2001  page 1

[2] Ibid  Page 1

[3] See for example, Supervision and Regulation (SR) letter 13-19/CA letter 13-21, "Guidance on Managing Outsourcing Risk."

[4] Interagency Policy Statement on the Internal Audit Function and its Outsourcing

[5] Ibid

Self- Policing- An excellent way to control your own destiny!

So you are the compliance officer and while doing a routine check on disclosures, you notice a huge error that the Bank has been making for the last year.  The beads of sweat form on your forehead as you realize that this mistake may impact several hundred customers.   Real panic sets in as you start to wonder what to do about the regulators.  To tell or not to tell, that is indeed the question! 

Many of our clients struggle with the question of what to do when your internal processes discover a problem.  We have always believed that the best policy is to inform the regulators of the problem.    CFBP Bulletin 2013-06 discusses what it calls “responsible business conduct” and details the grounds for receiving consideration for getting enforcement relief from the CFPB.  In this case, “consideration is somewhat vague and it depends on the nature and extent of the violation, but the message is clear.  It is far better to self-police and self-report than it is to let the examination team discover a problem.     

Why Disclose a Problem if the Regulators Didn’t Discover it?  

It is easy to make the case that financial institutions should “let sleeping dogs lay”.  After all, if your internal processes have found the issue, the thing is that you can correct it without the examiners ever knowing, move on and everybody is happy.  Right?  In fact, nothing could be further from the truth.   There was a time when the relationship between regulators and the banks they regulate was collegial, but that is most certainly not the case any longer.   Part of the process of rehabilitating the image of banks is to ensure that they are being well regulated and that misbehavior in the area of compliance is being addressed. 

Self- Policing

It is not enough that a bank discovers its own problems and addresses them.  In the current environment, there is a premium placed on the idea that a bank has compliance and/or audit systems in place that are extensive enough to find problems, determine the root of the problems and make recommendations for change.  An attitude that compliance is important must permeate the organization starting from the top.  To impress the regulators that an organization is truly engaged in self-policing, there has to be evidence that senior management has taken the issue seriously and has taken steps to address whatever the concern might be.  For example, suppose during a compliance review, the compliance team discovers that commercial lenders are not consistently given a proper ECOA notification.  This finding is reported to the Compliance Committee along with a recommendation for training for commercial lending staff.   The Compliance Committee accepts the recommendation and tells the Compliance Officer to schedule Reg. B training for commercial lenders.  This seems like a reasonable response, right?  

This does not rise to the level of self- policing that is discussed in the CFPB memo; a further step is necessary.  What is the follow-up from senior management?   Will senior management follow up to make sure that the classes have been attended by all commercial lending staff?  Will there be consequences for those who do not attend the classes?  The answers to these questions will greatly impact the determination of whether there is self-policing that is effective.   Ultimately, the goal of a Bank should be to show that the effort at self-policing for compliance is robust and taken seriously at all levels of management.  The more the regulators trust the self-policing effort, the more the risk profile of bank decreases and the less likely enforcement action will be imposed. 

Self-Reporting

While at first blush self-reporting seems a lot like punching oneself in the face, this is not the case at all.   The over-arching idea from the CFPB guidance is that the more the institution is willing to work with the regulatory agency, the more likely it is that there will be consideration for reduced enforcement action.  Compliance failures will eventually be discovered and the more they are self-discovered and reported, the more trust the regulators have in the management of the bank in general and the effectiveness of the compliance program in particular.   The key here is to report at the right time.  Once the extent of the violation and the cause of it have been determined, the time to report is imminent.  While it may seem that the best time to report is when the issue is resolved, this will generally not be the case.  In point of fact, the regulators may want to be involved in the correction process.  In any event, you don’t want to wait until it seems that discovery of the problem was imminent (e.g. the regulatory examination will start next week!).

It is important to remember here that the reporting should be complete and as early as possible, keeping in mind that you should know the extent and the root cause of the problem.  It is also advisable to have a strategy for remediation in place at the time of reporting. 

Remediation

What will your bank do to correct the problem?  Has there been research to determine the extent of the problem and how many potential customers have been affected?      How did the Bank make sure that whatever the problem is has been stopped and won’t be repeated?  What practices, policies and procedures have been changed as a result of the discovery of the problem?  These are all questions that the regulators will consider when reviewing efforts at remediation.  For instance, if it turns out that the problem has been improperly disclosing transfer taxes, an example of strong mediation would include:

·       A determination if the problem was systemic or with a particular staff member

·       A “look back” on loan files for the past 12 months

·       Reimbursement of all customers who qualify

·       Documentation of the steps that were taken to verify the problem and the eimbursements

·       Documentation of the changed policies and procedures to ensure that there is a clear understanding of the requirements of the regulation.

·       Disciplinary action (if appropriate for affected employees)

·       A plan for follow-up to ensure that the problem is not re-occurring

Cooperation

Despite the very best effort at self-reporting and mediation, there may still be an investigation by the regulators.  If the regulators start to investigate an area that you have already disclosed, such an instance calls for cooperation not hunkering down.  The more the bank is forthcoming with the information about its investigation, the more likely that the regulators will determine that there is nothing more for them to do. 

At the end of the day, it is always better to self-detect, report and remediate.  In doing so you go a long way toward controlling your destiny and reducing punishment!