Changing the Way We Think About Compliance       

Compliance, Compliance, COMPLIANCE!   Sometimes just saying the word can evoke a dramatic response from financial institution management.    Even though there has long been talk of a separate set of regulations for community banks, no such changes are in the offing.  For now and the immediate future, community banks and small financial institutions will face increasing expectations in the area of compliance.    Moreover, the costs of compliance can be prohibitive.  This is especially true if your bank has experienced compliance problems in the past.

Despite the gloom and doom and through all of the curses there are actually reasons to support compliance regulations.    Wait, what did you say?     

History as a Guide

A quick review of the history of some of the most far-reaching consumer regulations yields a familiar pattern.  In each case, banks and financial institutions engaged in unfair or unreasonable practices.  Eventually, a public outcry was raised and legislation was passed in response.   The history of the Truth in Lending Act   (Regulation Z) provides a good example.  

Starting in the late 1950’s the United States saw a tremendous growth in the amount of credit.  In fact, in a study the US House of Representatives estimated that the amount of credit in the United States from the end of World War II to the end of 1968 grew from $5.6 billion to $96 billion.   [1]

The growth in credit was fueled by consumer credit and in particular, a growing middle class that created a huge demand for housing, cars and various other products that went with acquiring the American Dream.   As time passed more and more stories of consumers being misled about by use of terms like “easy payments”, “low monthly charges” or “take three years to pay”.   The borrowers found out that even though they thought they were paying an interest rate of 1.25 %; with add-ons, fees and interest payments that were calculated using deceptive formulas, the rate was actually as much as three times what they thought.  

Congress began to investigate the growing level of consumer debt and eventually in 1968; the Truth in Lending Act was first passed.  Congress was clear about what they were trying to do: 

“The Congress finds that economic stabilization would be enhanced and the competition among the various financial institutions and other firms engaged in the extension of consumer credit would be strengthened by the informed use of credit.  The informed use of credit results from an awareness of the cost thereof by consumers. It is the purpose of this subchapter to assure a meaningful disclosure of credit terms so that the consumer will be able to compare more readily the various credit terms available to him and avoid the uninformed use of credit, and to protect the consumer against inaccurate and unfair credit billing and credit card practices.” [2]

The regulations that have been implemented as part of the Dodd Frank Act have a similar history.  The most recent financial meltdown was caused in part by the lack of oversight and by financial products that far outpaced the reach of the regulations.  Dodd Frank is the most recent legislative response to the public outcry about the behavior of banks and financial institutions. 

Of course, it is also clear that the behavior that caused the most recent meltdown was not being practiced at community banks.  It is unfortunate that the whole industry is often painted with a broad brush.  However, the fact is that the public does not make much of a distinction between large banks and community banks.  The reputation of the industry suffered mightily during the meltdown.  The good news is that the regulations have helped to restore the confidence of the public in that financial system.   Therefore, while regulations may be bothersome, they do support the industry. 

Overall Effects

Sometimes, we focus on the negative to the point that it is hard to see the overall positive impacts of regulations.   One of the positive effects of compliance regulations is that is goes a long way toward “leveling the playing field” among financial institutions.   RESPA (the Real Estate Settlement Procedures Act) provides a good example.  The focus of this regulation is to get financial institutions to disclose the costs of getting a mortgage in the same format throughout the country.   The real costs associated with a mortgage, the arrangements that a bank has with third parties and the amount that is being charged for insurance taxes and professional reports that are being obtained all have to be listed in the same way for all potential lenders.  In this manner, the borrower is supposed to be able to line up the offers and compare costs.  This is ultimately good news for community banks.  The public gets a chance to see what exactly your lending program is and how it compares to your competitors.  The overall effect of this legislation is to make it harder for unscrupulous lending outfits to make outrageous claims about the costs of their mortgages.   This begins to level the playing field for all banks. 

There are other regulations that can help the reputation of your institution.  For example, the public reporting requirements for the Community Reinvestment Act and the Home Mortgage Disclosure Act can result in positive information about your bank.    A strong record of lending within the assessment area and focusing on reinvigoration of neighborhoods is a certainly a positive for an institution’s reputation. 

Protections not just for Customers

In some cases, consumer regulations provide protection not just for consumers but also for banks.  The most recent qualifying mortgage and ability to repay rules present a good case.  These rules are designed to require additional disclosures for borrowers that have loans with high interest rates.   In addition to the disclosure requirements, the regulations establish a safe harbor for banks that make loans within the “qualifying mortgage” limits.  This part of the regulation actually provides a strong protection for banks.  The ability to repay rules establish that when a bank makes a loan that is below the established  loan to value and debt to income levels, then  the bank will enjoy the presumption that the loan was made in good faith.  This presumption is very valuable in that it can greatly reduce the litigation costs associated with mortgage loans.  Moreover, as long as a bank makes only “qualifying mortgages’ the level of regulatory scrutiny  will likely be lower than in the instance of banks that make high priced loans. [3]

The next time you hear a conversation about how bad consumer regulations are, we suggest that you take a step back.  Consider that the regulations are generally well earned, that they provide stability and can tend to level the playing field for community banks.  Also, please consider the idea that in at least some cases, these regulations provide protections for banks.  You may not turn out to be a consumer zealot, but we think you will give compliance regulations a different, more accepting look. 

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[1]  Griffith L. Garwood, A Look at the Truth in Lending - Five Years after, 14 Santa Clara Lawyer 491 (1974). 

[2]  See Preamble to 15 U.S.C. 1601 (1970)

[3] Of course, a strong case can be made for the origination of non-qualified loans.   This case will be presented in subsequent blogs