Banks are on the verge of new curbs on their exposure to correspondents, including concentrations of 5% of funding and 25% of credit. Though the percentages are issued as guidance, the four bank regulators state that examiners will probe institutions that exceed them or fail to conduct extensive, independent analyses before entering transactions with other institutions.
The guidance, contained in a new Financial Institution Letter regarding "Correspondent Concentration," would formalize the need for examiner scrutiny of any funding exposure of 5% or more of an institution's liabilities and any credit exposure of more than 25% of Tier 1 capital, whether to individual borrowers, interrelated groups of borrowers or a single repayment source.
"Banks know how to evaluate banks better than anybody," says Ron Paul, CEO of Eagle Bank of Bethesda, Md. ($1.5 billion). "Sometimes the pendulum swings too far." Eagle already conducts extensive analyses and an "overall scrub-down" at least quarterly of correspondents' non-performing assets, capital position and performance trends, he says. "It's second nature to bankers. The guidelines sound like overkill."
The regulators acknowledge in the letter that exposures are part of the business life of any bank, including the need to concentrate funds for clearing activities. But they offer a list of potential problem credit and funding exposures that could catch banks off guard, including "due from" bank accounts (CDs, demand deposits); Fed funds sold as principal; over- and under-collateralized portions of reverse repos; current positive fair value on derivatives contracts; unrealized gains on unsettled securities transactions; direct or indirect loans, including participations and syndications; and trust preferred securities, subordinated debt and stock purchases of the correspondent, its holding company or any affiliated entity.
Even so, there already is an existing regulation: Reg F (Limits on Interbank Liabilities), points out Daryl Wilton, senior VP at Cornerstone Bank ($812 million) in York, Neb. Under the reg, "We have not been tracking [concentrations] to the extent that they are looking at it in the proposed information," he allows. "But we have been looking at it [proactively] in an informal matter for the safety for our bank."
Wilton attributes the heightened concern to excessive participation by banks in CDOs. "Leverage certainly is the secret to making money in a bank, but you have to be awake when you go in," he says. Cornerstone completed a regularly scheduled exam in June, and examiners focused much more attention than usual on loan purchases.
Why the Funding Limit Could be Trouble Down the Road
In addition, the guidelines are a further attempt by U.S. regulators to harmonize U.S. and international banking rules, says Diane Reynolds, a senior director at Algorithmics, a Toronto-based enterprise risk-management firm owned by Fitch Group. At least on the credit side, the guidelines are similar to what already exist in Europe.
One potential difference, however, is the 5% funding limit, Reynolds says. While on its face, such a cap sounds reasonable, especially with excess liquidity now in the market, she says a 5% cap could become an issue. "Trying to find 20 sources of funding could be a significant constraint for some banks," she says.
The regulators acknowledge that they are treading new ground by proposing a funding exposure cap as low as 5%, but note that they have encountered instances - especially with credit sensitive funds - where this "posed an elevated risk" to the recipient. "The primary risk of a funding concentration is that an institution will have to replace those advances on short notice," the regulators state.
In the Federal Register notice, the regulators offer a hypothetical example of well-capitalized banks that withdraw funds from a well-capitalized correspondent bank at the same time, depleting its capital base and leading to multiple failures. The same thing might happen if the correspondent had sold a significant portion of the banks' Fed funds to an institution that fails. "Although these interbank exposures may comply with regulations governing individual relationships, collectively they pose significant correspondent concentration risks," the regulators state.
Credit Concentration Rules Unneeded, Analysts Contend
Regulators are simply being cautious. With almost 100 bank failures this year - many due to violations of the banks' credit exposure policies and board inattention - regulators are very sensitive to all risk exposure, says Tom Lyons, president/CEO of BankFive ($710 million), a mutual in Fall River, Mass. "Concentration is something we think about and measure all the time. We are well within the regulator's guidelines," he says, especially regarding correspondents' asset quality. "Like anything in life, diversification is a good thing."
A credit concentration could emerge, for example, if a bank maintains large balances with a correspondent to facilitate account clearing activities, the regulators explain. Or a correspondent could abruptly limit the availability of liquid funding sources as part of its own program to limit credit exposure.
"Correspondent concentrations represent a lack of diversification ... that management should consider when formulating strategic plans and internal risk limits," the regulators urge. They want management to understand how "significant economic events or abrupt deterioration in a correspondent's risk profile" could affect your institution.
But concentration risk ultimately is a question of how the deals are structured and especially whether there is recourse on the loans, says Mike Moebs, an economist at Moebs Services, an independent economic research firm in Lake Bluff, Ill. He cites two bank clients, one that specializes in funding buyouts of independent insurance brokers and another that specializes in loans to churches. In each case, other banks lend to his clients exclusively on recourse. His clients' viewpoint: "If we screw up, we'll take it back," Moebs says.
This brings him to another point: The proposed guidelines - like much that is coming out of Washington, D.C. - is overkill, attempting to impose rules on a market that instead needs standardization and transparency in underwriting loans and debt, Moebs says. "The two of them [regulation and standardization] are very much intertwined," he explains. "What would have happened with Bear Stearns, Lehman, Fannie, Freddie, if we had done securitization on a recourse/non-recourse basis? It would be a whole different ballgame because the ratings agencies and the marketplace would have been able to rate them properly. These complex CDOs would have been put on a non-recourse basis with high prices. It would have been a much less liquid market."
Reynolds agrees that correspondent concentration usually is not a problem but that this can change quickly in a time of crisis. "Examiners are looking at everything right now," she adds. "There are a lot of rules coming out, and they each hold water in and of themselves. What's debatable is the detail. Is 5% the right number or is there another number?"
Jonathan York, VP of Technology and Development at Ambit ERisk, a New York risk management firm, advocates a "portfolio credit risk model" in a paper he wrote for the Risk Management Association. The model is the equivalent of using credit scoring to calculate reserves - pegging capital costs against concentration risk and establishing soft sub-portfolio exposure limits and hard overall limits, based on the bank's strategic plan. Such a system "allows the bank to take an enterprise perspective on all sorts of risk/reward trade-offs," York notes.
"Broad-brush limits are bad for business because they restrict bank expansion in growth sectors where there may be no real economic reason for restraint," offers York. "This is particularly unfortunate for mid-sized re¬gional and smaller banks that lack the enormous risk diversification benefits of the large banks."
The guidelines are open to public comment this month. Regulators especially want to know if some types of advances or commitments should be excluded, the types of factors and limits that should be considered in any assessment of a correspondent, and the timing and types of contingency plans to consider.
To Calculate Exposures under the New Guidance, Banks Must:
- Implement procedures to identify exposures with stand-alone institutions and their affiliates. To start, regulators expect banks to have written investment, lending and funding policies & procedures, including exposure limits. The limits would comprise all assets advanced or committed to another organization.
- Specify what information, ratios or trends have been reviewed. Banks are supposed to calculate gross credit exposures as well as net exposures secured by net proceeds from marketable collateral. Example: $10 million in Fed funds sold to a correspondent with $3 million secured by Treasury notes represents a $10 million gross exposure, but a $7 million net exposure due to the pledged collateral.
- Set concentration limits, including ranges of tolerance for each monitored factor. The new guidance goes further than Reg F, pressing banks to include documentation requirements for such reviews in its policies and set triggers for reporting to the board or a committee when risks need to be assessed and addressed. Reg F requires quarterly monitoring of capital when there is significant exposure to a correspondent. But the new guidance suggests at least quarterly reviews of a broader array of all correspondents' financial data and more specifically spells out the metrics, such as enforcement actions, credit rating downgrades, rising amounts of OREO and large increases in non-accrual/past due loans.
- Develop plans for managing risks when concentrations exceed those ranges both with individual institutions and collectively with affiliates. Examiners have been told to review during exams your correspondent concentrations, related policies & procedures and contingency plans. Among the actions recommended by regulators: Reduce the volume of uncollateralized/uninsured funds, transfer excess funds to other institutions, require the correspondent to serve as agent rather than principal for Fed funds sold, and establish limits on asset and liability purchases from and investments in correspondents. But do not rely on temporary deposit insurance programs to mitigate concentration risk.
- Conduct the independent analysis before entering a credit or funding transaction with another institution. Regulators are particularly focused on ensuring that transactions are arm's length and avoid potential conflicts of interest.