What the Deloitte Crackdown Means for Banks

The New York crackdown on Deloitte's financial-consulting business will send waves through its bank customers, competitors and federal regulators.

On Tuesday, New York's Department of Financial Services became the first state agency to take action against a bank consultant, fining Deloitte Financial Advisory Services $10 million in connection with its anti-money-laundering advisory work for Standard Chartered in 2004 and 2005. The regulator also banned Deloitte from working for New York-chartered banks for one year.

The department's actions mark a new approach for the government in attempting to rein in consultants, who have faced mounting scrutiny in the past year over their nebulous and expensive roles as brokers between their bank clients and regulators who rely on them to help banks fix compliance problems. The sanctions against Deloitte may also signal that Benjamin Lawsky, the department's superintendent, intends to go after big banks by proxy.

"For banks that are regulated by the superintendent's office, the concern should be that compliance is being taken much more seriously than in the past," says Ross S. Delston, a former assistant general counsel at the Federal Deposit Insurance Corp., who consults with banks mostly on anti-money-laundering issues.

The strategy is more precisely targeted than the $340 million fine the department imposed on Standard Chartered last year, which penalized many shareholders who "bought long after the violations in question," says John Coffee, a Columbia University law professor.

"Dealing with the banks' gatekeepers is a much more effective strategy," Coffee says.

Deloitte and the banks that employ it will likely weather the crisis; the one-year ban affects a relatively small segment of the firm's business. But New York's action raises several questions about the long-term impact on banks, consultants and regulators in general:

How does New York's crackdown affect banks that regularly use consulting firms?

A relatively small — but heavy-hitting — number of banks would be directly barred from using Deloitte's consulting services for the next year. The DFS supervises fewer than 100 state-chartered banks, but among the largest are Goldman Sachs (GS) and Bank of New York Mellon (BNY). It also supervises the New York units of foreign banks (and more than 4,000 other financial institutions, including credit unions and insurance companies.)

More significant is the precedent Lawsky has set. It could be "very disruptive" for banks if other states, following New York's lead, ban consultants from operating and issue their own sets of regulations, says Francine McKenna, an accounting watchdog and journalist who has contributed to American Banker's BankThink columns.

"Banks will have to have a contingency plan if suddenly a very significant consultant stops working," she says.

Even though the New York sanctions on Deloitte would only apply to state-chartered banks, they could have a spillover effect in terms of industry-wide reputational risk. Some consultants expect to see big national banks — especially those already under regulatory scrutiny — also rethinking their use of the firm.

"It would be up to the national banks about whether they wish to use a company under sanction" by New York state, "particularly if [they] had ongoing matters with the New York state supervisor elsewhere in its company," says Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc.

"My instinct is that this will be a year or so in which prospective consulting arrangements for proxy supervision will be very carefully drawn," she adds.

How does this affect Deloitte and its bank consulting business?

The direct financial impact on the company will probably be limited, but the damage it does to Deloitte's reputation could be significant.

The one-year ban on consulting for state-chartered banks applies to Deloitte Financial Advisory Services, which is the smallest of the parent company's four units. It does not apply to Deloitte Consulting or any other divisions of the auditor. The ban could also be shortened to six months; the agreement allows for an early termination of the ban if Deloitte puts in place the state's new rules for financial consultants.

How does this affect other consultants?

Bank consultants have come under increasing scrutiny from lawmakers and regulators, who have paid particular attention to their participation in the aborted and expensive independent foreclosure review process.

Delston and other consultants say they expect New York's action against Deloitte to intensify that scrutiny — but they also see a potential silver lining for their industry.

"There has never been an explicit code of conduct for consultants who advise banks, and so in one sense [Lawsky is] setting a best practice," Delston says. "In a perverse way this helps consultants, it makes explicit something that many consultants are already doing but haven't had a clear basis for doing."

The DFS will require all consultants working in the state to follow new rules designed to ensure consultants' independence and make them easier to monitor. Consultants will have to disclose to the regulator all work they've done with the financial institution for the past year, to certify that the final report to regulators is their own work, to maintain records of all recommendations that don't get included in the final report, and to maintain regular contact with the agency. Consultants will also have to develop policies on complying with confidentiality rules.

The order "may make firms start to think twice about certain engagements if they think there is a liability," says Nicholas Ketcha Jr., executive managing director at the consulting firm FinPro, and a former head of supervision of the Federal Deposit Insurance Corp.

Petrou also sees a potential upside for consultants trying to improve their much-battered reputations, arguing that Lawsky's new set of standards could "give that work the credibility that it increasingly has to have."

"Clarity and best practices will help to allay fears," she says. "A more transparent business model that works for the consulting industry as well as for supervisors might actually be a good thing."

Will federal regulators crack down on consultants, too?

There's no sign that federal banking regulators will immediately follow New York's lead. The New York DFS said it hopes its new rules could be a "template" for reforms at other regulatory agencies. But none of the national regulators that have jurisdiction over banks — the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp. — would comment on whether they plan to beef up their consulting guidelines following New York's example, or whether they coordinated with Lawsky's office.

But McKenna predicts that other state-level regulators may be "emboldened" by events in New York. "Other states could decide they want to ban firms, and the process could become very disorganized," she says.

Delston also predicts more actions by New York state and some follow-on actions by other regulators:

"It's possible that they'll look at the set of best practices in the order and say, 'Gee, that's pretty reasonable stuff and maybe we should be doing it as well,'" he says.

— Joe Adler and Jeff Horwitz contributed to this article.