OCC Worried About the Wrong Banks and the Wrong Risks

With all that has occurred at the large subprime mortgage banks, the mortgage backed securities underwriters, JPMorgan's "London Whale" trades, ING's money laundering indiscretions and now Barclays' LIBOR-rigging scandal, it seems strange that the Office of the Comptroller of the Currency now wants to scare the world about a variety of risks most specifically involving America's 6,500 community banks. 

In an effort to create transparency, the regulator offered "signs of doom" scenarios in its first semiannual Risk Review.  Interestingly this was presented in a conference call with market and industry observers and reporters, not bankers.

It was noted in this report prepared and presented by the OCC that in order to increase profits, banks are under increasing pressure to lower underwriting standards, offer new potentially dangerous products and ignore operating risk.  From what they said in the report and presentation I would surmise that these regulators have no real idea of the current circumstances in most small banks.

Any understanding and analysis beyond broad statistics would quickly establish that the managements and boards of community banks are universally struggling to continue serving their communities without ignoring the risks of their business.  They are under pressure from the negative social stigma created by the constant bank-bashing in the press and an onslaught of new regulations and demands from the regulators, not to mention a continually weakened economy.  Today even the best performing community banks are in full survival mode.

The OCC report notes that small banks are extending the duration of their investment portfolios, which creates a higher level of risk. I would note that the regulation and bank policies pertaining to the type, level and duration of bank investments are well established and documented. Additionally, primary and secondary liquidity requirements and analysis are clearly mandated. Banks are required to conduct a quarterly external analysis of the impact on earnings and capital from interest rate moves, both up and down. Even the assumptions behind this analysis must then be validated by another independent source. The individual bank boards review all these matters quarterly and the regulators review this information at least twice a year.

Also discussed in the OCC report is the extension of credit by small banks to new areas without possessing adequate skills or knowledge. Particularly noted by OCC officials were indirect auto loans, asset backed credits and loans financing oil and gas ventures. My recollection is that banking is a risk business and that these areas have all been part of bank lending and risk analysis for several decades. Evaluating these loan types is not rocket science and the elements are part of the standard credit process of most all banks.

The OCC report notes that these areas are riskier and could be a problem if they become concentrated at any bank.  I would note that the OCC recently issued guidance on controls and policies regarding any loan or investment concentration exceeding 25% of bank capital, which makes the report's point moot.

The report discusses the operating risks of banks as among the most noteworthy. The OCC cites the increased risk in utilizing third party providers and outsourcing functions to cut costs.  Such service sources have been part of community banking for decades. Data processing, internal and external auditing, credit review and many others forms of outsourcing permit small banks to effectively compete with their larger brethren, offering expanded capabilities, greater expertise and lower costs.  I have no idea what manifested this new high-priority concern.

Missing from the OCC's risk summary is any finger pointing to the size and concentration of the 19 largest banks that collectively control 85% of all banking assets and whose risks exceed anything noted in the report. Missing also is any mention of the real risks that large banks have taken on in asset securitizations, derivative creation, hedging strategies, trading positions and so many other little understood areas involving the financial markets. Counterparties, position exposures, conflicts with customer positions and the sheer volume of market activity and operating exposure go unmentioned. These are the areas that can bring about the next "Too Big to Fail" scenario – not a defaulted auto loan or mortgage or failed third party provider. 

Now is the time for the regulators to convey the importance and strength of the community banks and the role they play in supporting the needs so many local areas, and not to focus on the risks typically inherent in these small banks.  Recognizing such risks, community banks know their markets and have experience and skills in assessing local economies, environments and risks. Unfortunately community banks have been packaged in a "one size fits all" regulatory environment and remain under the black cloud still hanging over all banking. 

Keeping in mind the relative impact of systemic risks, if 1,000 community banks were to fail tomorrow the exposure would be a little less than one tenth the size of Bank of America.

Robert H. Smith, the former chairman and chief executive of Security Pacific Corp., is a founder and director of Commerce National Bank in Newport Beach, Calif.