BSA is Good for You- and Especially Good for your High Risk Customers!   

We hope that title got your attention!  It certainly got our attention when the comptroller of the currency Tim Curry  said it recently!  When Mr. Curry was speaking before the Association of Certified Anti-Money Laundering Specialists  convention earlier this year[1], he noted that when a financial institution has a strong  BSA program, its ability to service high risk clients increases.    

One of the many points that Mr.  Curry was making goes against  trends that we often see in banks,   when regulators increase the focus on a given area, the tendency is to cease the product line or service being offered.  One obvious example of this tendency was the response from many banks to the Qualified Mortgage rules.  These rules required the lenders who originate higher priced mortgages  to fully document the borrower’s ability to repay the loan before the loan was made.  The rule carved out a “Safe Harbor” for banks that did not make higher priced mortgages.  This exception,  the qualified mortgage (“QM”) exception, became the path of least resistance to many banks.  As of today there are still many banks that have decided to limit the non “QM” activity to zero.    In point of fact, a quick review of the requirements for documenting the ability to  repay,  reveals that these requirements are little more than best  practices for lending that have been established for many years. 

Mr. Curry pointed out that in many cases, banks suffer from similar over reaction in the BSA area.   Just because there is a great deal of attention paid to BSA, doesn’t mean that banks should immediately stop servicing high risk clients.   

Common Problems with BSA 

The biggest areas of concern for BSA be can be categorized into four major areas, according to Curry:

·         The culture of Compliance at the Bank;

·         The resources (or lack thereof) that are dedicated to BSA;

·         The strength of the information technology;

·         The quality of risk management

It is interesting to note that the very first item on this list is the compliance culture of the bank.  Regulators have made it clear that in 2014 and beyond, the area of compliance will directly impact the  “M” in a banks CAMEL ratings.   The expectation is that senior management including the Board of Directors will make compliance an issue that is fundamental to the ongoing operation of the Bank. 

The implications for the AML/BSA compliance program are clear; regulators expect that banks will spend the necessary resources to fully staff and administrate BSA/AML compliance.  Further, accountability for compliance rests at the highest levels of management at the bank. 

While all of this may seem ominous , it can actually result in a positive outcome.  The flip side of the coin is that when resources are properly allocated and the CMP is strong, there is absolutely no reason to turn large amounts of high risk business away.  This is not to say that a bank can use the excuse of  a strong BSA program to  add any and all high risk clients.  It does however, mean that with the proper screening and monitoring,  banks can offer their natural clients a full range of services.  So how does one get the Bsa Department in shape?  We have a few suggestions.  

Suggestions for Strengthening the BSA Program

 Make the BSA/OFAC  Risk Assessment Process More Dynamic

This is oftentimes a document that is often either overlooked or completed as a  “fill in the  blanks” document that captures general information about BSA risks.   It is also extremely rare that at the end of reviewing the  BSA assessment significant change is generated.  We recommend the risk assessment process should be dynamic.  Not only should all departments heads have input, but the conclusion from the document should be incorporated into the decisions for resource allocation to the BSA department.  In this manner, the risk assessment is tied directly to the resource allocation, the compliance culture and  strength of monitoring technology.  Discussions about the plan should be comprehensive and evidence that senior management and the Board have fully considered the risk associated with BSA and made decisions based on that risk.  The level and quality of training should also be tied directly to the risk assessment review process. 

Combine CIP/EDD with Business Development.  

In many banks, the business development department works at cross purposes with the BSA department.   While account officers do their best to obtain new clients by signing them up to as many new products as possible, the requirements of CIP can feel like they are in the way of the relationship.  Oftentimes, pertinent information about the client is not passed on to the compliance staff.  Many times, only the basic CIP data is obtained and the BSA staff is left to try to develop a risk profile using limited information.   However, it is often the case that it is the account officer that knows these customers best and can/should be able to fully describe what it is that they do.   We recommend that banks attempt to get the Bsa and business development units to work together to produce EDD that is based upon knowledge of the customer, knowledge of the industry and knowledge of the requirements of BSA. 

Develop Training that Meets the Specific Needs of Your Bank

Online training for staff is widely accepted and fine for a start.  However, we recommend that you augment this training with information that is specific to your client base.   For example, a bank that serves an area that has a great number of high tech firms can greatly enhance its BSA program by training staff the operations of these firms.  Is it likely that a high tech firm would have a large number of cash deposits?  Probably not!  On the other hand, such a firm would be likely to send wires to foreign countries.  If staff at the bank have been well informed, they can recognize a suspicious transaction even before software might have a chance to do so.  In addition a well-trained and well-informed staff can perform much more effective and complete  risk management.  

Technology must be powerful  AND  Match  the Abilities and Skills of the BSA staff

We have had the experience more than once of meeting with a client who had purchased powerful  BSA/AML software, only to become frustrated and resort back to manual monitoring.  Oftentimes, the thinking of senior management was that the examiners have told the bank that they need software and the response has been to buy software, get the basic training that come with the software license and wait for miracles to happen.  Unfortunately the trainers from the software companies are focused on the operation of the software and not the meaning of the reports that are generated.  It is critically important that when considering upgrades that the upgrade are comprehensive.  Make sure that the BSA staff knows how to use the software in a manner that is most effective. 

At the end of the day, regulators are not advising banks to run away from high risk clients, but  instead to be ready,  willing and able to handle the risk.  So a strong BSA program is good for one and all!

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[1]  Remarks by  Thomas J. Curry  Comptroller of the Currency  Before the  Association of Certified Anti-Money Laundering Specialists  Hollywood, Florida  March 17, 2014

Why IS there a Regulation C? 

As anyone in compliance can attest to, there are Myriad consumer compliance regulations.  For bankers, these regulations are regarded as anything from a nuisance, to the very bane of the existence of banks.  However, in point of fact, there are no bank consumer regulations that were not earned by the misbehavior of banks in the past.  Like it or not these regulations exit to prevent bad behavior and/or to encourage certain practices.   We believe that one of the keys to strengthening a compliance program is to get your staff to understand why regulations exist and what it is the regulations are designed to accomplish.  To further this cause, we have determined that we will from time to time through the year; address these questions about various banking regulations.  We call this series “Why is there….” 

Introduction

As we have mentioned in the past in blogs, there are no consumer compliance regulations that were not  “well earned” by bad behavior in the financial industry.  The Home Mortgage Disclosure Act and its implementing regulation, Regulation C  are no different. 

This law came into being during a  time when a great deal of attention was being paid to the lending practices of financial institutions in urban areas.  In the late 1950’s and early 1960’s Congress conducted several  hearings on the lending practices of banks and financial institutions.  These hearings resulted in the passage of several pieces of legislation aimed directly at opening the credit market to women and minorities.  Among the legislation that passed during this period was the Fair Housing Act and  the Equal Credit Opportunity Act.  

The net effect of the these two powerful pieces of legislation was to help to open the credit application process for minorities and women.   However, unfortunately, just the opportunity to apply for credit Is not a guaranty of fair treatment or a positive outcome.  It soon became evident that financial institutions had taken a different approach to denying credit.  One of the most pervasive practices that caused concern was the practice of “red lining”.  This was a practice where a lender would  take a map of its  assessment area and would literally draw a red circle around certain areas  The areas that were circled were to receive no loans.  This was despite the fact that many people within the redlined areas were customers of the bank and kept their deposits in the bank’s branches. 

Economists noted that the practice of red lining caused “disinvestment “ in the red lined communities.   In other words, deposits were being taken in from the redlined area, but those same funds were being loan out in other areas.  Money was flowing from one community and then distributed elsewhere.  As a result,   Congress decided in 1975 that HMDA would be created. 

HMDA  1.0

The practices of redlining and disinvesting in communities was the first target of HMDA.  The initial idea was to get banks to disclose the total amounts of loans that they made in specific areas.   Congress theorized that redlining would be quickly unmasked as banks would have to show the places where the loans were made.  It would become evident that certain neighborhoods were getting no loans.    The problem here was that the Banks did not have to show individual loans; only the total amount of loans in a given census tract.  Financial institutions did not have to show the individual loans, and as a result, a few loans strategically placed could give the impression of strong community service when this was not that case at all.  For example, one  million dollar loan to a business in the census tract could give the impression that a bank was investing  this in the community.   Ultimately, HMDA proved to be ineffective in addressing redlining. 

HMDA 2.0

Starting in the late 1970’s the mortgage industry experienced significant change.  Banks and Savings & Loans that had dominated the market began to experience competition.  Finance companies, mortgage bankers and other financial institutions began to enter the market.  These lenders were aggressive and as a result many of the redlining and disinvestment practices that had been in place were simply overrun by the demand for more and more mortgages. 

However, this did not end the need for disclosure of lending information.   The experiences of women and minorities in getting mortgages was still less than satisfactory.  The focus of regulatory agencies changed from redlining to the lending practices of individual institutions.  By collecting information about the experience of borrowers at individual institutions, the regulatory agencies theorized that  valuable information could be gleaned about how people in protected classes were being treated.  

HMDA was amended after that as more than just banks were providing mortgage funding.   In the  late 1980s, HMDA was amended and the information that all lenders had to collect was enlarged to include  racial, ethnic, and gender information, as well as income for each applicant, and reflected both rejected and accepted applications for loans that did not close. ^[1]

HMDA 3.0

The mortgage industry continued to grow and change and as it did, the types of mortgages being offered also changed.  By the turn of the century, the questions wasn’t  about people in protected classes being denied credit.  Instead, it was more the type of credit being offered.  In the early part of the decade the number of adjustable rate mortgage ballooned,  Many of these products had “teaser rates” which were significantly below the actual rate that would be paid on the loan.  This decade saw “predatory lending” practices explode.  Predatory lending  is in essence,  the practice of  making loans with complicated  high rates and fees to unsophisticated borrowers.  The unsuspecting borrower believes that he/she is paying a low loan rate when in fact, at the time the loan re[prices, the rate is several times higher.  A huge number of these loans were included in the financial melt down of 2008. 

 

The third iteration of HMDA was then, the result of changed practices by mortgage lenders.  In early 2000 the issue was no longer discrimination in approvals or denials, but in pricing (predatory lending) .  HMDA was again amended to add the information about pricing and lien status.   In an effort to improve the quality of HMDA data, the revised regulation also tightened the definitions of different types of loans and required the collection of racial and ethnic monitoring information in telephone applications

So What do They Do With the information? 

When the information is collected by the regulators, it is actually used by many different agencies for various purposes.  Community advocacy groups use the information to bolster arguments about various issues they wish to emphasize.  The government uses the information for economic studies and as a basis for amending regulations and laws.  HMDA information has been at the heart of many studies about lending discrimination.  Many argue that the information collected by HMDA doesn’t tell the full story of whether or not a borrower suffered discrimination.  It does however, raise a threshold issue and it is often the case that HMDA is used to determine whether further study is indicated. 

The HMDA LAR is used to create the database  that is used by all of these agencies and for all of these studies.   This is why the examiners are so fussy about getting those entries correct!

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[1]

 The Home Mortgage Disclosure Act: Its History, Evolution, and Limitations†

By: Joseph M. Kolar and Jonathan D. Jerison

The Case for Complex Training

While the BSA/AML regulations are the only ones that directly mandate training courses annually, it is common knowledge that banks are expected to have and maintain compliance training programs. And in point of fact, every bank that we come across does have some sort of training program.  Most of these programs take the form on on-line training.  Online courses are for the most part accepted as the most cost efficient way to conduct training for staff.  We would like to suggest that in the case of training, cost efficiency may not ultimately be the most important consideration.

The compliance handbooks of all the regulatory agencies discuss the elements of a strong compliance program.  These elements include the following:

• Policies & procedures
• Internal controls
• Management reporting
• Training

Although the handbook does not specifically say it, the fact that training is listed as one of the “pillars” of the compliance program suggests that it is at least as important as the other pillars.  And yet, for reasons that are lost in tradition and some mystery, this area often is not treated as an important part of compliance.   

Most compliance programs at community banks consist of online training programs that allow participants the ability to take tests multiple times until the desired score is achieved.  In point of fact, we all know that the common strategy for the participants is to eschew reading the material, go straight to the test, take it, write down the answers to the questions that they got wrong and then retake the test with answer guide in hand. And while this process will help a bank ensure that everyone has received a passing grade on the training, it does little to increase staff knowledge of regulations. This is not meant to be an indictment of on line training programs at all.  We often recommend many of the online courses that are currently offered.  

Instead, we maintain that a complete compliance training program must have a great deal more.  Consider the nature of compliance regulations. Whether we like to admit it or not compliance regulations have a history of being earned!  For example, Regulation B (The Equal Credit Opportunity Act) was passed to address the fact that women and minorities were being denied equal access to credit.  And the Truth in Lending Act is the result of former banking practices that mislead borrowers about the real costs of the loans they were getting.   Consumer regulations have been designed to address areas that have been proven to cause consumer financial harm

Because consumer regulations are designed to either prevent certain behaviors, collect information on the results of bank practices or to provide complete information through disclosures, a great deal is left open for interpretation.  There are even times when regulations direct that staff must interpret information to the best of their ability (Government Monitoring Information in HMDA).  Often when a regulation is misunderstood, violations of regulation result.   We have come across clients who did not understand that Regulation B applies to ALL lending.  This misinterpretation has lead banks to assume that they did not have to meet the notification requirements of the regulation.  Moreover misunderstandings of the recent rules about QM and the ability to repay rules have lead many banks to arbitrarily decide to cease lending programs out of fear of the regulations will require^[1]

We have found that when management and staff alike are given the opportunity to hear a bit of the history of the regulation it makes a big difference in the overall level of compliance.  Knowing WHY a regulation was enacted goes a long way toward understanding what it is that the regulation is trying to accomplish.  Taking this idea one step further, giving staff information of what it is that the current regulation is trying to accomplish goes a long way toward obtaining positive participation in the compliance effort. 

A quick example; one of our clients was having a very difficult time with compliance with HMDA.  The Bank had suffered repeat violations in this area and the regulators of this bank were threatening enforcement action if improvement was not made immediately.  After we completed our compliance assessment, we noted that one of the biggest problems was being caused by the inaccurate and incomplete information being collected by loan officers.  Upon interviewing the officers we found that there was a general lack of understanding of what HMDA was and why collection of the data is so important.  No one could understand why the regulators were being so strict about the information.  By the way, all of these officers had received passing grades on the Banks online training course. 

We developed a HMDA training course for the lending department.  In the course we spent at least a third of the time describing the history of the regulation and the process that the data undergoes when it is submitted by the bank.  We explained that this data is critical to the studies that are performed by the Federal Reserve and therefore the data has to be as accurate as possible.  By helping the staff see that they were part of something much bigger and that their accuracy really did make a difference we were able to get their “buy in”.  Reporting errors dropped dramatically and the need to pursue enforcement action was extinguished. 

By helping to ensure that staff members understand the specifics of compliance regulations, you can greatly enhance the effectiveness of the program.  Staff who understand what it is that the regulation is trying to can feel empowered.  Whether or not staff members agree with the regulation, understanding it is key.  With the basic understanding of the regulation as a tool, the number of misinterpretations and resulting errors are greatly reduced. 

We suggest that courses on consumer regulations at least annually include information about the history and the legislative intent of the regulation.   Optimally, staff will be given the opportunity to work through case studies during the training session as we have also found that these are very helpful in increasing understanding of the regulation.  

By either taking the time to develop training classes internally or by obtaining classes from an outside vendor, getting comprehensive material for staff is well worth the investment. 

 

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[1] A careful review of the ability to repay rules will reveal to the reader that these rules are recognizable “best practices” for consumer lending.

Credible Challenge, Risk Management and Compliance

 For several years now, regulators have talked about enterprise wide risk management (“ERM”).  Often times however, when you ask someone to describe, it becomes a “shaggy dog” story with many different component parts but no main theme.  The truth is that there has not been much clear guidance in this area.  

In recent months there have been some developments that have come together to shed some light on what ERM might mean for community banks.  First there has been the OCC pronouncement about the expectations for ERM in very large banks.   Next the concept of clear credible challenge by the Board to the senior management of banks has been espoused by all of the regulatory agencies.  Finally , regulators have made it clear that in the future, compliance management will be considered a part of the “M” rating in a banks CAMEL rating for safety and soundness. 

The OCC released guidance for very large banks on what is expected for a credible risk management structure.  For very large banks this means that there has to be:

·       Department heads and  line business holders must track and manage the individual risk in their business units

·       There must be an independent risk manager whose role it is to  monitor and control risk throughout the organization

·       Independent audits must be performed to test the risk monitoring system

The main thrust of this guidance is that there has to be an entity (ultimately the Board) that serves to set the level of risk that is acceptable at a financial institution.  Further the risk managers should be independent of the risk takers.  At the end of the day, the expectation is that the Board will control the level of risk at the Bank and must push back against the business lines that naturally want to increase risk for profits. 

Along those same lines, the idea that the Board must present credible challenge to the senior management at the bank is a concept that is becoming widely impressed by the regulators.  The concept here is not simply that the Board members question each and every decision of management.  Instead the idea is that the Board must undertake a process that allows them to get comprehensive information about the banks performance in real time.  It also means that the Board must then take this information and use it to challenge the strategic plans and projections of management.  Much like the biblical saying that “iron sharpens iron” the idea here is that the Board must increasingly ensure that management has thought through the idea and has answers for credible challenges to those plans.   Again most of the pronouncements in this area are directed at large banks, but that no means says that community banks should a different route. Board members should be cognizant of the fact that the regulators are expecting a strong commitment to directing the bank. 

The third factor that comes into play is the ascendance of compliance as an issue for bank management.  In past years, the truth is that compliance often took a back seat to safety and soundness.  After all, the thought went, no banks fails because of compliance problems.  However, recently regulators have come to realize that compliance management is s indeed a reflection of overall management.  The ability of banks to direct the compliance management program has to be a part of the “M” component of the CAMEL ratings.  In point of fact the Comptroller of the Currency in remarks made in late 2013 said as much.   In his December 2013 comments to the Consumer Federation of America, Mr. Tim Curry, the Comptroller of the Currency pointed out that consumer compliance is a management issue:

In reality, there is no neat dividing line between consumer compliance and safety and soundness issues. If an institution has a compliance issue, they are certain to have underlying risk management issues.  Consumer protection is inextricably linked to safety and soundness. ^[1]

The fact of the matter is that at the very base of the financial crisis that this country recently experienced is consumer lending gone horribly wrong.   Compliance is going to be a major focus for the regulators in the near future.  The areas of compliance are also expanding.  The area in simply the alphabet soup regulations that we know so well, vendor management, debt collections practices, the effects of practices at a bank are all topic that cme under the rubric of compliance.

Putting together the ideas of enterprise wide risk management, credit challenge theory and compliance management as a safety and soundness issue.  We come to a “brave new world” for compliance.  When the strategic plan is being put together for example, it will soon be the expectation that the question “how are we meetng the credit needs of our community” is asked regularly.  When a Chief Credit Officer tells the Board that it is not economically feasible to offer home mortgages, it will be expected that a member of the Board will challenge the officer to “prove it”! 

There are currently many mantras that have been held to be true for some time without challenge.  For example, community often say that they have limited accesses to community development opportunities because they get eaten up by the big banks.  Now is a good time to find out if that is really true.  When was the last time you actually reviewed the community development opportunities in your assessment area.  This is not to say that there are vast opportunities out there that remain untapped.  It IS to say that now is the time to prove it with statistics and research!  

What’s a community Bank to do?

It is clear that the regulators don’t expect community banks to hire a full time risk officer.  Frankly it might be easy to say these directives only apply to large banks, stick ones head in the proverbial sand and hope that nothing will happen.  On the other hand, it is also clear that the regulators are expecting that a senior management position, preferable one that is not in the risk taking function to monitor and administrate the risk portfolio of the bank.  Now is the time to face the inevitable realty of risk management.  

So how does a community banks start the risk management process under his new regime.  Well, you start with putting your Board reports on turbo charge!   Report to the board have to step outside the box.  In addition to the operating results of the last reporting period, the reports should include changes to regulations and how these regulations might impact the bank.  For example, many community banks felt hat the rules on qualified mortgages represented a whole new world of regulatory concerns and immediately decided to make only qualifying mortgages.  However, if the specifics of these regulations had been presented to Boards with the opportunity to discuss them, many would have noticed that the regulations basically state best practices for making loan.  There was very little to fear and the in some cases, an opportunity to increase market share.   Going forward regulators will expect that these sort of regulations receive robust discussion at the Board level. 

We also suggest that Board reports include information on technological changes and they impact the bank.  Mobile banking and RDC present opportunities to grow the client base.  Of course, both of these products come with the possibility of increased risk.  The expectation that the decision to use (or not to use) these products will come after the considered decision of the Board.  

One of the areas that often goes overlooked by banks is the changing demographics of the assessment area that they serve.  In the recent past the failure to note the changing face of the neighborhood lead a client to make a product decision that lead to a fair lending investigation.  The bank simply decided that the minimum disposable income for HELOCs would by $50,000.  However, because had not done research on its assessment area in some time, they were unaware that this decision cut out whole neighborhoods that surrounded the headquarters of the bank.   In our opinion, change presents opportunity, so a changing environment has to be one of the considerations of a strategic plan. 

In the end, now is the time to enhance your risk management program, the level of Board participation in the process and to include compliance as one of the pillar considerations that your bank makes as it plans for the future.

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[1] Comments by Comptroller Tim Curry before the CFA Financial Services Conference  December 2013

EDD- The Place Where Marketing and BSA Come Together

EDD- The Place Where Marketing and BSA Come Together

Enhanced Due Diligence (EDD) and Customer Due Diligence (CDD) are two areas of close focus of the regulators.  The need to enhance EDD is one of the top citations that we see at the conclusion of BSA examinations.  We see criticism over the trend to have accounts subject to EDD that have numerous Suspicious Activity Reports and continued High Risk monitoring that seem endless.  These accounts often have specific trends of activity that makes them seem unusual or suspicious and it is this activity that draws the attention and scrutiny the BSA department.  

There are several concerns that the regulators have raised about these “evergreen” high risk accounts.  There is of course, the question of when a pattern of activity that repeats itself in a regular intervals becomes something less than suspicious.  There is also the question of whether the financial institution should keep the account if the account holder is regularly engaged in suspicious activity.  On the other hand if the pattern of the customer is truly not criminal and is part of a regular and legitimate business, then important BSA resources are being expended unnecessarily on these accounts. 

We note that in many of these cases, additional information on the customer would be of great assistance to the BSA department. The ability to know about the customers’ business and why it works the way it does can completely change the characterization of activity. 

A quick example, on of our clients had a customer who was on the high risk lit because several SAR’s had been filed for structuring.  The customer had a habit of depositing around $9,000 every two days.  Of course this appeared to be structuring.  However, once we looked into a little further, we found that the customers’ business insurance required that the customer could only have a certain amount of cash on hand.  The $9,000 deposits were necessary to meet the insurance requirements! 

It would be easy to look at this situation and blame the BSA staff for not having done enough research.  However, we noted that one of the things that held back the effectiveness of the BSA staff was lack of intimate knowledge of the customers.  And the best source of that knowledge was the account managers who actually worked with the clients.   Our conclusion has been that this is the place where BSA compliance and cross marketing come together.  

The core of any good BSA program is the system’s ability to know its customers thoroughly.  And in point of fact, the core of a strong marketing program is the same.   To effectively cross sell to customers, the expert sales person is able to know the needs of his customer and anticipate how the bank will best be able to meet those needs.  The goals of both the BSA department and business development is essentially the same-KNOW YOUR CUSTOMER

So Why Can’t We Be Friends?

 

Too often, because neither department fully understands what the other is trying to accomplish, natural partners become adversaries.  The BSA Department is seen as a group of people who don’t seem to understand that the bank is a for profit business.  “We can’t ask these people questions that will make them mad” say the operations and marketing staff.  On the other hand, the marketing department can be seen as the “Bain of the existence” of the BSA department.  Incomplete information leads to additional work and monitoring that might be avoided. 

The truth is that with a little work, these two departments can enhance BSA compliance while expanding market share.   As an account officer discovers that he has a client that needs to add RDC to his product base, it is important to let the BSA department know that business has been growing and transactions are now going to change.  Despite the way transactions are changing the actual line of business is still the same and not really a matter for concern.  By the same token, maybe  the customer mentions that he has been approached about a new line of business that sounds good, but is unfamiliar (bitcoin anyone?).  A quick check with the BSA Department can help the account officer steer the client clear of harmful sometimes illegal business lines.  

We recommend a program that cross trains these two departments in particular.  When one is aware of t what the other is doing the results are tremendous.  For example, at one of our clients, a customer had decided to open his own business and run it out his home.  The business did better than expected and soon the customer was conducting a large number of transaction son his personal account.  These transactions drew the attention of the BSA staff, SARs were filed and within months, the account was being considered for closure.  Fortunately in this case, the BSA Officer and the Account Officer talked about the customer.  When they did it became obvious that a business account and several other potential business products were in order.  Not only was the account NOT closed, but he bank was able to sell the customer a business analysis account, a revolving line of credit and a business credit card account.  

Share a Little –

 

The account opening process and the account updating process provide excellent opportunities for information.  Once that information is obtained, when it is shared a great deal of positive things can happen.  The more you know about your client, the more you can keep the bank safe and your customer happy! 

Why IS there a Truth in Lending Act (aka) Regulation Z? 

As anyone in compliance can attest to, there are Myriad consumer compliance regulations.  For bankers, these regulations are regarded as anything from a nuisance, to the very bane of the existence of banks.  However, in point of fact, there are no bank consumer regulations that were not earned by the misbehavior of banks in the past.  Like it or not these regulations exit to prevent bad behavior and/or to encourage certain practices.   We believe that one of the keys to strengthening a compliance program is to get your staff to understand why regulations exist and what it is the regulations are designed to accomplish.  To further this cause, we have determined that we will from time to time through the year; address these questions about various banking regulations.  We call this series “Why is there….” 

For any lender that has made a consumer purpose loan in the past 30 years, the Truth in Lending Act aka, Regulation Z has been a major factor.  The main part of any consumer lending audit or examination is compliance with the Omni present Reg. Z.   And just as you might know that the regulation exists, you also know that if mistakes are made, they can be costly.  If examiners find that a loan or groups of loans has not been properly documented and the consumers not properly informed, various painful enforcement actions may occur.  These can range from reimbursements to the customer, a look back at the entire loan portfolio and even the possibility of civil money penalties.   It is clear that Reg. Z is a powerful regulation.   But why does it exist?  What is it the regulators are trying to get banks to do? 

We believe that the more you know, the more you comply! 

What was Happening?

Starting in the late 1950’s the United State saw a tremendous growth in the amount of credit.  In fact, 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 all with acquiring the American Dream.   As time passed more and more stories of consumers being misled about the cost of borrower by terms “easy payments”, “low monthly charges” or “take three years to pay”.   The borrowers found out that every 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 pretty 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]

So from the very start the idea behind the Truth in Lending Act is to force lenders to list the cost of borrower in a common format.  Consumer should be able to take their Regulation Z disclosures and be able to shop from one financial institution to the next and compare prices. 

For the next several years, the Federal Reserve and the courts began to shape what the Truth in Lending law would eventually come to represent.  After a series of court decisions and interpretive rulings by the regulators, the law began to grow in importance.   The basic history of the regulation is this: 

The Truth in Lending Act (TILA), 15 USC 1601 et seq., was enacted on May 29, 1968, as title I of the Consumer Credit Protection Act (Pub. L. 90-321). The TILA, implemented by Regulation Z (12 CFR 226), became effective July 1, 1969.

The TILA was first amended in 1970 to prohibit unsolicited credit cards. Additional major amendments to the TILA and Regulation Z were made by the Fair Credit Billing Act of 1974, the Consumer Leasing Act of 1976, the Truth in Lending Simplification and Reform Act of 1980, the Fair Credit and Charge Card Disclosure Act of 1988, the Home Equity Loan Consumer Protection Act of 1988.

Regulation Z also was amended to implement section 1204 of the Competitive Equality Banking Act of 1987, and in 1988, to include adjustable rate mortgage loan disclosure requirements. All consumer leasing provisions were deleted from Regulation Z in 1981 and transferred to Regulation M (12 CFR 213).

The Home Ownership and Equity Protection Act of 1994 amended TILA. The law imposed new disclosure requirements and substantive limitations on certain closed-end mortgage loans bearing rates or fees above a certain percentage or amount. The law also included new disclosure requirements to assist consumers in comparing the costs and other material considerations involved in a reverse mortgage transaction and authorized the Federal Reserve Board to prohibit specific acts and practices in connection with mortgage transactions. Regulation Z was amended to implement these legislative changes to TILA.

 The TILA amendments of 1995 dealt primarily with tolerances for real estate secured

credit. Regulation Z was amended on September 14, 1996 to incorporate changes to the TILA. Specifically, the revisions limit lenders' liability for disclosure errors in real estate secured loans consummated after September 30, 1995. The Economic Growth and Regulatory Paperwork Reduction Act of 1996 further amended TILA. The amendments were made to simplify and improve disclosures related to credit transactions[3]

 

Changing Times Makes Changing Law

 

A quick comparison of these changes to the regulation with economic events in the United States will tell a story of bank and financial institutions practices that avoided the general intent of the regulation in one way of another.   The growth and development of the credit card market prompted the changes in Reg. Z that have to do with open end credit and the growth of adjustable rate mortgages because the additional changes to mortgage disclosures.  

The goal of Regulation Z has always been a desire to tell the borrower the highest amount she may possibly pay for borrowing money from an institution.   Regulation Z does not tell a borrower how much they may charge or even how they may structure consumer deals.  However, it does require that you disclose what you are charging to the customer in a clear and understandable manner. 

 One of the most notable changes to the regulation is the right of rescission.  This portion of the regulation was written to stop a particularly nasty practice: 

 

TILA's legislative history indicates that Congress included rescission to provide a cooling off period to borrowers who obtained credit secured by a lien against their primary residence. Congress heard a parade of horror stories from consumers about unscrupulous home improvement contractors who pressured them into financing expensive renovation projects (like aluminum siding) but failed to disclose that the loan was secured by a lien on the consumer's dwelling. Consumers who defaulted on the financing lost their homes. Rescission is designed to protect consumers from making an impulsive decision by disclosing the lien and providing a three-day cooling off period after the loan closing. With the salesperson gone, the consumer can reconsider whether he wants to place his home at risk.[4]

 

The point here that as lending practices change, the disclosure requirement may change, but the goal of the regulation remains the same.  

 

Why are They Doing This to Us?  

 

At the end of the day, the goal of the Truth in Lending Act is to make it possible for a borrower to compare the cost of borrowing between one lender and the other AND the cost of borrowing versus the cost of buying the same item for cash.   In other words, the borrower should be able to tell how much the bank is costing her to borrower money to buy the car.  Unfortunately, the way in which this cost is defined causes headaches!

According to Reg. Z the finance charge should include all of the costs that the lender is creating vis a vis a cash transaction: 

 

The finance charge is the cost of consumer credit as a dollar amount. It includes any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit. It does not include any charge of a type payable in a comparable cash transaction.

For many of our clients this language leaves as many questions as it does answers but the basic thrust of it is that things like taxes and official documents are costs that anyone would have when they buy a card or a house.  Anything else is generally going to be a finance charge. 

 

Recent Changes and the Future

 In 2011, the rule making authority for Regulation Z was transferred to the Consumer Financial Protection Bureau.   Since that time we have seen some updates to the regulation including the ability to repay rules, treatment of higher-priced mortgages and appraisal and escrow rules for these high priced mortgages.   Again these changes are a directly reflection of lending practices.  As loan terms evolve and change, the regulation will also evolve. 

 The focus of these rules is to ensure that customer of financial institutions know exactly what it is that they are getting into.  The best rule to follow is when in doubt, disclosure and make sure you disclose the worst case scenario

---

[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] http://www.federalreserve.gov/boarddocs/caletters/2008/0805/08-05_attachment1.pdf

[4] Philadelphia Federal  Reserve The Right of Recession: Overview and Recent Developments Compliance Corner 2007

To Tweet or Not to Tweet

The fact is that innovation is one of the greatest traits of the US economy.  The more we innovate, the more things grow and change.  The same is true in the banking industry where technology has produced dramatic change in the industry.   Mobile and RDC are two of the up and coming and spreading technologies.   As these technological advances continue, the relationship between banks and their customers has also changed.  Many banks are reducing the number of physical branches that they maintain and instead serve their customers virtually through the internet.   In addition, to keep up with the changing environment financial institutions have begun to explore the use of social media as a means of achieving growth.  And just as you might have expected, the regulatory agencies that monitor banks have considered the risks that the growing use of social media presents.   Recently, the FFIEC published proposed guidelines for the use of social media by the financial institutions that they regulate.    This proposed guidance establishes the fact that social media is an area that examiners will review in the coming years.    

Social Media as a Tool for Growth

Social media sites such as Facebook, Twitter and LinkedIn have been all the rage for some time.   Not only young people but the parents of young people use these networks extensively.       The fact is that millions of people around world stay connected and get the bulk of their information from these sites.   There is no question then that social media represents the opportunity for banks to connect with a much larger market than the ones that traditional advertising reach.  Taken a step further, sites such as Facebook and Twitter give financial institutions yet another means to reach out to communities that may have been under banked or altogether overlooked in the past. 

A cleverly designed Facebook page or a well-placed twitter campaign can produce impressive results for advertisers that include these sites as part of the marketing plan.   Banks can benefit from the potential to reach customers that had heretofore been unreachable.   On the other hand, potential customers can ask questions on the internet that they may be embarrassed to ask in person.   In addition, they can review information from a bank at their own pace and without the pressure of a bank employee looking at them.  

Used the proper way, it is clear that including social media in the overall strategic and marketing plans can create opportunities for growth at financial institutions. 

Social Media as a Risk Consideration

Along with the potential for growth, the use of social media presents the possibility of adding a great deal more risk to financial institutions portfolio.  The FFIEC proposed guidance is designed to focus on this risk and the steps that financial instructions should take to manage this risk.   The guidance mentions three types of risk to consider:

·         Compliance Risk

·         Reputational Risk

·         Operational Risk

Compliance risk generally derives form the possibility that social media is designed d to become a form of formal advertising.   When financial institutions advertise that are several regulations that apply.  Included in these are the Truth in Lending and Truth in Savings Acts.  Both of these regulations act in similar fashion and require a great deal of disclosure when “triggering terms” are used.  The guidance points out that in the event that social media is used as advertising, there should be systems I place to make sure that all required disclosures are being made.   Moreover, social media is an outlet for customer complaints and if a financial institution is going to use social media there has to be a mechanism to monitor and quickly respond to official complaints. 

Reputational risk comes from the need to manage and maintain social media sites.  The fact is that information moves swiftly on the internet and it is very easy for a site that is not constantly monitored to become obsolete overnight.   The guidance here is that when a financial institution commits to using a social media site, the commitment has to be full-fledged.  There must be a system for limited the numbers of people who can make changes to the social media and this pole have to be tasked with constant monitoring of the site.   Websites are viewed by the public as the internet manifestation of the financial institution and the material on the website must properly reflect the mission and overview of the Board. 

Operational risk is described by the guidance as the possibility that the use of social media will increase the possibility of internet attacks on the bank.  Social media sites must be administered with the full complement of security procedures to ensure that privacy of financial information is maintained at all times.  

The Guidance

The good news is that the guidance mirrors the structure of the several other pronouncements form the FFIEC.  The steps that should be taken by an institution include policies and procedures, reporting to the Board and internal controls to prevent security breaches and compliance concerns.   If a financial institution chooses to use social media, then the policies, procedures, reporting and testing should be documented. 

Though this is proposed guidance today, the fact of the matter is that the guidance will soon become official and examiners will be directed to review this rea as part of the compliance and safety and soundness examinations.  Now is the time to embrace the change and develop strategies for use of social media. 

Hot Spots

Based upon our reading of the guidance and the overall emphasis with financial institutions regulators, it is clear that the “hot spots” for social media usage will be:

·         Advertising- ensuring that any social media used as advertising has proper disclosures

·         Privacy- ensuring that customer information is properly protected

·         Complaints- Developing a system to ensure that complaints on social media are monitored

·         Discouragement – Ensuring that social media sites don’t  lend themselves to discouragement of potential customers from classes

Even though the guidance is proposed at the time of this writing it is clear that social media will be an issue for financial institutions in the near future and examiners will include this area in the scope going forward.