How the federal bank agencies have updated supervisory guidance

Dickie Heathcott, partner, Crowe Horwath LLP

Dickie Heathcott, partner, Crowe Horwath LLP

The federal financial institution regulators want to avoid a repeat of risky lending practices that contributed to the recent recession. New guidance sets higher standards for borrowers, including private equity firms and companies, seeking leveraged loans.

“This is a proactive move on the part of bank regulators to avoid some of the underwriting pitfalls that institutions encountered prior to the recessionary conditions we had going into 2007 and 2008,” says Dickie Heathcott, a partner at Crowe Horwath LLP.

Smart Business spoke to Heathcott about the guidance — which had a compliance date of May 21 — and what it means for borrowers and financial institutions.

What is the guidance, and do financial institutions have to adhere to its provisions?

Although a guidance isn’t necessarily a rule, it effectively becomes one in the field. Banks have to follow it because that’s what regulators are going to use when they examine the bank.

The guidance, issued by the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC), covers transactions with borrowers who have a degree of financial leverage that significantly exceeds industry norms.
It focuses on sound, levered lending activities, including:
•  Underwriting considerations.
•  Assessing and documenting enterprise value.
•  Risk management expectations for credits awaiting distribution.
• Stress-testing expectations.
• Pipeline portfolio management.
•  Risk management expectations for exposures held by the institution.
The guidance applies to all financial institutions supervised by the agencies, but significant impacts are not expected for community banks because few have substantial involvement in leveraged lending.

Are there certain industries where leveraged lending is of particular concern?

Construction and development lending is being looked at very closely because of what’s happened in recent years. This type of lending is generally considered commercial real estate lending.

The OCC and the Fed released a white paper in April with findings from the regulators’ study of bank performance in the context of the 2006 interagency guidance, “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.” That guidance established supervisory criteria for banks that exceeded 100 percent of capital in construction lending and 300 percent of capital in total commercial real estate lending.

According to the paper:
•  13 percent of banks that exceeded the 100 percent construction-lending criterion failed during the economic downturn from 2008 to 2011.
•  23 percent of banks that exceeded both the construction and commercial real estate criteria failed from 2008 to 2011, compared to 0.5 percent of banks that exceeded neither criteria.
•  An estimated 80 percent of losses in the FDIC fund from 2007 to 2011 were attributed to banks exceeding the 100 percent construction-lending criterion.

What does the guidance mean for businesses seeking loans?

Business owners can look for financial institutions to be very cautious in their underwriting. They will not have access to credit like they did in 2006, even though it seems that the economy has stabilized.

Regulators are being proactive; they can see that credit underwriting is loosening up. Quality deals are being priced so thin that financial institutions are looking at areas where they can make more profit, which, of course, brings additional risk.

From a financial institution standpoint, it’s becoming a very competitive environment again. That means pricing more thinly or a loosening of underwriting standards. Institutions may be willing to finance certain types of loans they would have pulled the reins in on completely three or four years ago. The guidance is about ensuring that to the extent institutions enter into leveraged financing again, they do so in a more prudent manner.

Dickie Heathcott is a partner at Crowe Horwath LLP. Reach him at (214) 777-5254 or [email protected]

Website: For more information on regulatory guidance for financial institutions, visit Crowe’s Regulatory Reform Competency Center.

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Bernanke says Fed’s easy policy benefits world economy

WASHINGTON, Mon Mar 25, 2013 — Federal Reserve Chairman Ben Bernanke on Monday defended the central bank’s aggressive easing of monetary policy, saying while it was aimed at bolstering the economic recovery, it was helping other countries as well.

The Fed’s asset-purchase programs, aimed at keeping long-term borrowing costs down and spurring investment, have been criticized overseas for their adverse impact on emerging market currencies.

But the Fed chief, fresh from a grilling from Congress on the potential domestic risks of his quantitative easing measures, countered the rhetoric about “currency wars,” though he did not use the term specifically.

In prepared remarks to a group of academics in London, Bernanke said the integrated nature of the global economy meant the whole world benefits from a sturdier outlook.

“Because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not ‘beggar-thy-neighbor’ but rather are positive-sum, ‘enrich-thy-neighbor’ actions,” he said.

In response to a deep financial crisis and recession, and subsequent weak recovery, the Fed not only lowered overnight interest rates to effectively zero but bought more than $2.5 trillion in mortgage and Treasury securities.

Fed to hold lenders’ feet to the fire on mortgages

NEW YORK, Mon Dec 3, 2012 — Frustrated Federal Reserve policymakers on Monday sought an explanation from mortgage lenders as to why the benefits of lower interest rates were not filtering to home buyers as quickly as in the past even as investors benefited.

At an all-day New York Fed workshop, officials from Fannie Mae, Freddie Mac, Wells Fargo & Co. and other big lenders will be asked why there is a growing disconnect between the rates Americans pay on home loans, and the yields on mortgage-backed securities.

The question has puzzled central bank policymakers who worry the situation is undercutting their efforts to stimulate the country’s slow economic recovery from recession.

Since September, when the Fed targeted the U.S. mortgage market with its latest round of large-scale bond purchases, the closely watched spread between the interest rates homeowners pay and what investors reap on mortgage-backed securities has widened to record levels.

The Fed’s purchase of $40 billion per month in agency MBS has made a big splash in the secondary market. Yet in the primary market, the drop in the mortgage rates that home buyers can get from lenders has not been as pronounced as the central bank wanted, lagging historical trend.

This clog in the passage between the primary and secondary markets undermines an important reason for the Fed’s monetary stimulus: kick-starting a housing sector that was at the heart of the 2007-2009 financial crisis, and that has only just begun to show some life.

“There is clearly something that is manifesting as a form of constraint,” Jeremy Stein, a Fed governor, said when asked about mortgage lending at a Boston conference on Friday.

Fed’s Williams: Policies have aided growth without undue fallout

IRVINE, Calif., Tue Nov 6, 2012 – The U.S. Federal Reserve’s unconventional monetary policies have lowered borrowing costs and boosted growth without creating unwanted inflation, a top Fed official said on Monday, predicting the Fed’s latest round of asset-buying will exceed $600 billion.

The Fed will want to see sustained jobs gains and a consistent drop in the unemployment rate before it stops buying assets, making it likely the purchases will continue until “well into next year,” John Williams, president of the San Francisco Federal Reserve Bank, told reporters after a lecture at the University of California, Irvine.

The U.S. central bank’s prior round of quantitative easing totaled $600 billion; its first one was about $1.7 trillion.

The Fed began its third round of quantitative easing, known as QE3, in September, beginning with $40 billion a month in mortgage-backed securities and promising to continue or expand the purchases if the labor market does not improve substantially.

Although asset-buying and other non-traditional monetary policies pose potential risks, “the available evidence suggests they have been effective in stimulating growth without creating an undesirable rise in inflation,” Williams said at the lecture. “We are not seeing signs of rising inflation on the horizon.”

Fed names banks that tapped discount window in Q3 2010

WASHINGTON, Fri Sep 28, 2012 – The Federal Reserve on Friday named the banks that borrowed at its discount window during the third quarter of 2010, but the period showed very low levels of activity and none of the biggest Wall Street firms had turned to the facility for help.

Some of the decline in discount window borrowing may have reflected banks steering clear because they knew their actions would be disclosed, albeit with a two-year lag, once the Dodd-Frank financial reform law was passed.

However, Fed officials said it was impossible to know how much this may have been a factor in driving down discount window business, as opposed to what extent the lower level of borrowing just a reflection of market conditions at the time.

The data showed that Gorham Savings Bank of Gorham, Maine, and Commerce Bank of Kansas City, Mo., took the largest discount window primary credit loans. Gorham’s largest loan was $70 million during the period and Commerce’s was $60 million.

The data covers a wide range of Fed activities, including discount window borrowing and foreign exchange transactions, from July 22, 2010, which was the day after the passage of Dodd-Frank, until Sept. 30, 2010.

The discount window is a Fed lending facility that banks can access in times of stress and became essential to maintain functioning markets during the 2008 financial crisis.

The Fed document release was the first mandated by the 2010 Dodd-Frank financial reforms, but it also followed previous discount window disclosures forced on it by U.S. courts after several media organizations fought a stiff legal battle.

Fed’s Evans: ‘essential’ to do as much as we can now for economy

HAMMOND, Ind., Wed Sep 26, 2012 – Chicago Federal Reserve Bank President Charles Evans on Tuesday reiterated his support for the U.S. central bank’s bold new push to lower borrowing costs and boost the so far “disappointing” recovery, and said the Fed should do even more.

“This was the time to act,” Evans said in remarks prepared for delivery to the Lakeshore Chamber of Commerce Business Expo in the industrial Chicago suburb of Hammond, Ind. “With the problems we face and the potential dangers lying ahead, it is essential to do as much as we can now to bolster the resiliency and vibrancy of the economy.”

Evans’ prepared remarks were the same he gave on Sept 18, less than a week after the Fed decided to embark on a third round of asset buying and said it would not let up until the outlook for the labor market had improved substantially.

The central bank also said it would keep short-term interest rates near zero until at least mid-2015, even after policymakers expect it to show signs of strength.

To boost the impact of its actions, the Fed should explicitly say that it will be just as tolerant of inflation running slightly above its 2-percent goal as it is about inflation running slightly below, Evans said.

U.S. core inflation has run below 2 percent since 2008. Unemployment, at 8.1 percent, is well above the 5.5 percent to 6 percent that many economists believe is normal for the economy in the long run.

“We should not be resistant to policies that could move the unemployment rate closer its longer-run level, but run the risk of inflation running only a few tenths above our 2 percent goal,” he said. “Such accommodative polices could further improve the employment picture, even beyond our recent highly beneficial actions.”

Fed’s Lockhart says mind not made up on easing

ATLANTA, Tue Aug 21, 2012 – Atlanta Federal Reserve Bank President Dennis Lockhart said on Tuesday he had not yet made up his mind on whether further monetary easing is warranted.

“It’s a cost-benefit calculation to consider more monetary stimulus and someone like me has to do his best to really carefully weigh the costs and benefits,” Lockhart told reporters after a speech. “I’m not finished with (that) processs.”

Chance of Fed printing more money rises to 60 percent: Reuters poll

NEW YORK, Fri Aug 17, 2012 –  Chances that the Federal Reserve will launch a third round of money printing have risen slightly over the past month to 60 percent, according to a Reuters poll that also showed economists lowering economic growth expectations for this year and next.

Most forecasters have turned more pessimistic on the economy, despite recent, modestly better news on retail sales, payrolls and the battered housing market. The trimmed quarterly growth forecasts for a third straight month.

The latest findings are based on a survey of 17 of the Wall Street primary dealers who deal directly with the Fed, as well as an additional 44 economists in the monthly Reuters Poll.

It was the first time this wide sample of economists put the probability of more quantitative easing, or QE3, at greater than 50 percent, with one economist saying there was a 95 percent chance the Fed will act.

The latest consensus was for $500 billion in additional government bond purchases, on top of the $2.3 trillion the Fed has already bought. The highest forecast was for $750 billion.

The majority of economists polled thought the Fed’s next policy meeting in September was the most likely time for any announcement on QE3.

Fed’s Williams sees big costs to boosting inflation

DANA POINT, Calif., Fri May 4, 2012 – Boosting inflation purposefully to prod people into spending more would hurt the economy much more than it would help, San Francisco Federal Reserve Bank President John Williams said on Friday.

The positive effects of such an effort “would be modest,” Williams said after a speech to the California Bankers Association. “The potential costs would be quite significant.”

Nobel-Prize winning economist Paul Krugman has advocated pushing inflation up in order to boost the recovery.

The Fed targets a 2 percent annual rate of inflation.

Rate hikes a distant prospect for more upbeat Federal Reserve

WASHINGTON,| Wed Apr 25, 2012 – The Federal Reserve may appear slightly more upbeat on the economy on Wednesday, though investors should not mistake this cautious optimism for any desire to raise interest rates soon.

Instead, central bank officials will probably reiterate their expectations that official borrowing costs will remain near zero until at least late 2014, and leave open the option to ease policy further if the economy worsens.

“The meeting tomorrow is unlikely to provide any new clues to the Fed’s next actions, rather leaving open the possibility of new measures depending on the economic outlook,” said Richard Gilhooly, a bond market strategist at TD Securities.

Investors wishing for clues to the prospect of a further easing of monetary policy from the central bank may be disappointed, leaving the stock market vulnerable to some selling. Analysts will be keen for any hints of action following the end of the Fed’s Operation Twist, its latest effort aimed at keeping down long-term rates.