A Challenging Question

Last February, only days after Republic Bank and Trust Co. said it would challenge an order from the Federal Deposit Insurance Corp. to stop making tax refund anticipation loans, scores of examiners showed up unannounced. They descended not only on the Louisville, Ky., banking company, but on more than 100 tax preparers that offer Republic's product.

The way some characterize it, the scene had more in common with a shakedown by loan sharks than a surprise examination by federal regulators. In court documents, Republic said the examiners "attempted to harass and intimidate" those they encountered.

Over the past year, says Steve Trager, president and CEO of the $3 billion-asset Republic, hundreds of bankers across the country phoned to express support for his cause. In their minds, the battle with regulators wasn't just about a specific type of loan, but about the right for a bank to stick to its business plan.

"Every community bank in America can appreciate some of what we went through," Trager says. "We understand the need for firm regulation, but we also believe that reasonable minds can differ."

Or so the banking industry hopes, anyway. But these days, some industry insiders are starting to question whether bankers truly can differ with their regulators. Burned by accusations that they failed to curb excesses that led to the financial crisis, regulators are pouncing on banks with increasing ferocity. The question is whether the tightened grip is sometimes too extreme and, if so, how much latitude bankers have to get relief in those cases.

Congress is concerned enough that a recently introduced bill aims to give bankers more flexibility in the appeals process. After all, even in the best of times, disagreeing with regulators was not an easy thing to do. Republic, which ultimately settled with the FDIC in December and will stop offering the refund anticipation loans after this tax season, had been a rarity just for trying to fight.

Bankers generally say they are too fearful of retaliation to formally challenge those who have what amounts to almost absolute power over their businesses. They consider the unscheduled exam at Republic to be retribution and point to it as an example of exactly the kind of action that can be expected by banks audacious enough to take on regulators.

Though Republic had been the only banking company in the nation to offer refund anticipation loans, it is not alone in finding its longtime business plan suddenly unpalatable to regulators.

After spending several years going back and forth with the FDIC over its focus on small business loans, Main Street Bank in Kingwood, Texas, announced last year that it would give up its banking charter. Reinvented as a specialty finance company called Ascentium Capital, it now operates outside the purview of the FDIC.

"We never had any major issues, yet we were being treated as if we were about to fail," gripes Tom Depping, who was chairman at the former Main Street and holds that same title at Ascentium.

Depping says he held out little hope of getting the FDIC to reconsider its stance. So he decided to keep making the same loans, but not as a depository institution.

Engaged in another potentially instructive, multiyear battle is Frontier State Bank in Oklahoma City, which declined to comment for this story. Regulators say Frontier is too reliant on investments in securities, and the bank is challenging the FDIC in the U.S. Court of Appeals for the Tenth Circuit.

Sanford Brown, a partner at Bracewell & Giuliani LLP who has worked with both Frontier and Main Street and has followed the Republic fight, says the conflicts are united by a common theme.

"They all had legal business models that were approved at one point or another by the regulators and then they just changed their minds for whatever reason and tried to run those banks out of those businesses," Brown says.

Trager and Depping both say they respect the FDIC. But they also insist the power of regulators needs to be checked.

"The FDIC plays an important role in our industry," Trager says. "But I think everybody ought to be subject to some realistic form of challenge, including the FDIC. It creates a much healthier environment of accountability."

The FDIC declined several requests for an interview for this story.

Republic stands to lose about $25 million of profit as a result of its settlement. That is a hefty percentage of its overall profit. In the first nine months of 2011, the company earned $90 million.

Nonetheless, Trager says he feels satisfied with Republic's ability to air its dispute with the FDIC. But he says others might have a harder go of it.

"The ability to challenge is not always practical in most cases," Trager says.

Republic had the money to fight. It was considered a healthy institution that was otherwise largely above reproach. Most banks at odds with regulators wouldn't be so lucky.

But no matter the specifics of a dispute, the rule of thumb in the industry is that taking on a regulator is rarely, if ever, worth the effort. "It is not good to be at war with the FDIC. That is not a battle you want to fight in public," says Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University. "Regulatory power is 90 percent nuance, 10 percent legal. With that, they have so much power and so many ways that they can nail you."

Bankers freely express sympathy for the challenges regulators face in striking a balance between imposing necessary restraint and allowing latitude.

But concern about whether examiners are being too tough-and curbing lending that could help the economy-is growing.

"Banks have to feel free to lend to creditworthy borrowers and need to make those judgments on their own," says Rep. Shelley Moore Capito, a West Virginia Republican who serves on the House Financial Services Committee. "They can't make those judgments if they are in an ambiguous situation with the regulators. It has a paralyzing effect and just feeds into this uncertainty."

Capito says it is an "enormous red flag" that bankers are concerned about retaliation if they appeal regulatory edicts, and she recently introduced legislation that would among other things give banks a choice in their appeals route.

Under existing rules, banks can file an appeal with an ombudsman at the agency that conducted the exam, or in the case of the FDIC, with an administrative law judge. Capito's proposal would establish an ombudsman's office at the Federal Financial Institutions Examination Council, the interagency group that establishes uniform standards for exams. Banks could appeal examination findings to this new office, with the hope of getting a more objective hearing outside of the agency that conducted the exam. An additional appeal to an independent administrative law judge also would be possible.

Regulators are expected to oppose adding a new appeals route, because it effectively allows the FFIEC to override rulings by the other agencies. Industry representatives, however, argue that the existing process is flawed and change is needed.

For Republic, which had offered refund anticipation loans since the late 1990s, the regulatory nudging to curb this type of lending had been getting increasingly forceful for several years.

Consumer advocates say the loans target the financially illiterate. Over time, their concerns gained the ear of regulators.

Meanwhile, the Internal Revenue Service's processing time shrunk. Refunds that once took months to process are now done in days.

Rather than ban refund anticipation loans officially through rulemaking, regulators managed to strong-arm every other lender out of the business.

For instance, the Office of the Comptroller of the Currency banned Pacific Capital Bancorp in Santa Barbara, Calif., from making such loans, which were its most profitable business. The company was struggling to survive because of a rash of problem assets related to commercial real estate and was not in a position to argue.

"This is pretty widespread activism on the part of the regulator," says Bracewell's Brown, a former OCC lawyer. "They have a history of attacking products that they don't think are consumer friendly. They've been pretty aggressive about it, but I am not sure why they've never done a notice of proposed rulemaking."

The FDIC's opportunity to get Republic out of the business came in August 2010 when the IRS said it would no longer divulge debt, such as student loans or child support, owed against tax refunds. Without that, the FDIC argued, the product was too risky, especially since Republic drastically inflates its balance sheet during tax time. (Republic, which normally has about $3 billion of assets, made $1 billion in refund anticipation loans in the first quarter of 2011, for instance.)

Republic countered that the debt indicator, while a useful tool, was not its sole way of determining creditworthiness. But the company overhauled its procedures and built in other safeguards. It also capped the loans at $1,500 for the 2011 tax season, compared with its average loan of $3,700 the previous year.

Unmoved by the changes, the FDIC insisted the loans were unsafe and unsound and wanted Republic to agree to a consent order that said as much.

Trager declined to do so and defended the loans in interviews with the press.

Then, on Feb. 15 last year, the FDIC sent its examiners, with subpoenas in hand, to Jackson Hewitt Tax Service and Liberty Tax Service offices across the country to examine the way the providers sold the refund anticipation loans.

That impromptu examination led to the lawsuit Republic filed against the FDIC in the U.S. District Court for the Western District of Kentucky, claiming that the regulator was bullying the company for not consenting. Republic also asked the court to compel the FDIC to play by the rules and set policy only through rulemaking, and not through supervision.

By May, the FDIC had upped the ante, with a supersized notice of charges following the nationwide visit. The notice included a $2 million civil penalty. The FDIC claimed that Republic's servicers had violated laws including the Truth in Lending Act because they only disclosed the flat fee for the loans, which comes out to $61.22, not the annual percentage rate, which is 124 percent.

As part of the settlement, Republic withdrew its lawsuit and the civil penalty was reduced to $900,000.

Though opponents of refund anticiaption loans might view Republic's capitulation as progress, others are not so sure.

Within days of the settlement, JTH Holding, the owner of the Liberty Tax chain, disclosed in its initial public offering documents that it would continue to provide such loans to consumers. JTH said it had found a replacement for Republic-a new partner that it did not name, but that it specified is not a bank.

It is a development that, some might argue, validates Trager's oft-repeated argument that there is consumer demand for the product.

The situation at Republic raises questions about the ability of banks to set their course in the current environment of increasing regulatory power.

The natural tension between the pursuit of profit and the role of regulation has always existed, but it has been magnified by the fallout from the financial crisis, causing bankers to worry over how to preserve what they see as a right to free enterprise.

TCF Financial famously sued the Federal Reserve in October 2010, challenging the constitutionality of the Durbin amendment to the Dodd-Frank Act-which imposed limits on debit interchange fees. The unprecedented legal battle was prompted by what TCF saw as violations of due process and equal protection. Bill Cooper, TCF's chairman and CEO, compared the government's capping of interchange fees to telling Burger King it could charge no more for a hamburger than the cost of the meat and the bun.

In his letter to stockholders last year, Cooper wrote that the level of government oversight in the banking industry "is unlike any I have seen in my career. However, I can say with certainty that banks, including TCF, will find ways to continue to address these issues going forward."

But TCF withdrew its lawsuit in June, after an appellate judge denied the company's motion to delay implementation of the Durbin amendment, and after the Fed proposed interchange fee cuts that, while significant, were less harsh than many in the industry had feared.

Like the change of heart over lending products and business practices previously deemed acceptable, the Durbin amendment represents a redrawing of the lines between fair and foul territory that leaves bankers feeling as though their playing field is shrinking.

Kevin Jacques, the Boynton D. Murch Chair in Finance at Baldwin-Wallace College in Berea, Ohio, says an inherent conflict has emerged from the regulatory agencies since the crisis. "At the highest level, there is a general philosophy that believes the management of a bank knows better than the regulators," says Jacques, who served as an economist for the Treasury Department for more than a decade. "We view banks as private enterprises that make their choices based on the best interest of their shareholders and their customers."

But the crisis made regulators more cognizant of their past mistakes, and more attuned to their consumer protection responsibilities. "What has happened is that they've been so beaten up over not doing a good enough job of protecting consumers that they are reacting and maybe overreacting," Jacques says.

Of course, banking is a highly regulated industry because of the ramifications its woes have on the rest of the economy.

But Kenneth E. Scott, a business and law professor at Stanford University, says he understands why the crackdown after the financial crisis might leave bankers feeling hemmed in. "Obviously, when you have highly discretionary power, it is subject to abuse," Scott says. "The range of enforcement authority is substantially enlarged and that narrows the activities that banks can do. They are not going to be able to perform certain functions that they would have in the past and those things might have genuine consumer value."

In the case of Main Street Bank, Depping says the FDIC in 2008 began to take issue with the company's almost exclusive focus on small-business lending, a business plan that had been in place since 2004.

Though the product at issue is different-and though many people are eager to see banks lend more to small businesses-Main Street's scenario is a lot like Republic's.

"Our business plan was always OK with the regulators, until it wasn't," Depping says. "Here I am, two years later, and none of the problems they were convinced about have manifested. There are no problems other than the giant provisions they made me book."

His bank reported a loss for 2009, but was profitable in 2010 and in the first half of 2011.

In 2009, however, the bank stipulated to a consent order from the FDIC. "When we received our consent order, we had a Texas ratio of 3.4 percent. The average for everyone else that received one that month was 92.05 percent." (A ratio of more than 100 percent is considered a red flag for potential failure.)

Depping says he tired of fighting with the FDIC over his business plan and did not have faith that the appeals process would offer relief. The bank sold its three branches and its deposits to Green Bank in October and surrendered its bank charter. It also secured a line of credit with a money center bank and is now starting its next iteration as a specialty finance company.

Depping says Capito's bill sounds like a godsend for bankers who want to challenge regulators.

"Right now, they are the judge, jury and prosecutor," he says. "You just can't win."

Robert Barba covers community banking for American Banker.