Note: The following is an update of a blog that we originally posted in November of 2015. In light of recent implementation of the new Uniform Interagency Consumer Compliance rating system, we felt that this blog is once again timely.
Self-Policing- An excellent way to control your own destiny.
So, you are the compliance officer and while doing a routine check on disclosures, you notice a huge error that the Bank has been making for the last year. The beads of sweat form on your forehead as you realize that this mistake may impact several hundred customers. Real panic sets in as you start to wonder what to do about the regulators. To tell or not to tell, that is indeed the question.
Many of our clients struggle with the question of what to do when your internal processes discover a problem. We have always believed that the best policy is to inform the regulators of the problem. CFBP Bulletin 2013-06 discusses what it calls “responsible business conduct” and details the grounds for receiving consideration for getting enforcement relief from the CFPB. In this case, “consideration is somewhat vague and it depends on the nature and extent of the violation, but the message is clear. It is far better to self-police and self-report than it is to let the examination team discover a problem.
Why Disclose a Problem if the Regulators Didn’t Discover it?
It is easy to make the case that financial institutions should “let sleeping dogs lay”. After all, if your internal processes have found the issue, the thing is that you can correct it without the examiners ever knowing, move on and everybody is happy. Right? In fact, nothing could be further from the truth. There was a time when the relationship between regulators and the banks they regulate was collegial, but that is most certainly not the case any longer.
It is not enough that a bank discovers its own problems and addresses them. In the current environment, there is a premium placed on the idea that a bank has compliance and/or audit systems in place that are extensive enough to find problems, determine the root of the problems and make recommendations for change. An attitude that compliance is important must permeate the organization starting from the top. To impress the regulators that an organization is truly engaged in self-policing, there has to be evidence that senior management has taken the issue seriously and has taken steps to address whatever the concern might be. For example, suppose during a compliance review, the compliance team discovers that commercial lenders are not consistently given a proper ECOA notification. This finding is reported to the Compliance Committee along with a recommendation for training for commercial lending staff. The Compliance Committee accepts the recommendation and tells the Compliance Officer to schedule Reg. B training for commercial lenders. This seems like a reasonable response, right?
This does not rise to the level of self- policing that is discussed in the CFPB memo; a further step is necessary. What is the follow-up from senior management? Will senior management follow up to make sure that the classes have been attended by all commercial lending staff? Will there be consequences for those who do not attend the classes? The answers to these questions will greatly impact the determination of whether there is self-policing that is effective. Ultimately, the goal of a Bank should be to show that the effort at self-policing for compliance is robust and taken seriously at all levels of management. The more the regulators trust the self-policing effort, the more the risk profile of bank decreases and the less likely enforcement action will be imposed.
While at first blush self-reporting seems a lot like punching oneself in the face, this is not the case at all. The over-arching idea from the CFPB guidance is that the more the institution is willing to work with the regulatory agency, the more likely it is that there will be consideration for reduced enforcement action. Compliance failures will eventually be discovered and the more they are self-discovered and reported, the more trust the regulators have in the management of the bank in general and the effectiveness of the compliance program in particular. The key here is to report at the right time. Once the extent of the violation and the cause of it have been determined, the time to report is imminent. While it may seem that the best time to report is when the issue is resolved, this will generally not be the case. In point of fact, the regulators may want to be involved in the correction process. In any event, it is a bad idea to wait too long to report a problem. For example, don’t wait until discovery of the problem is imminent (e.g. the regulatory examination will start next week!).
When it is time to report a problem to the regulators, it is important to remember that you should give complete information, keeping in mind that you should know the extent and the root cause of the problem. It is also advisable to have a strategy for remediation in place at the time of reporting.
What will your bank do to correct the problem? Has there been research to determine the extent of the problem and how many potential customers have been affected? How did the Bank make sure that whatever the problem is has been stopped and won’t be repeated? What practices, policies and procedures have been changed as a result of the discovery of the problem? These are all questions that the regulators will consider when reviewing efforts at remediation. For instance, if it turns out that the problem has been improperly disclosing transfer taxes, an example of strong mediation would include:
A determination if the problem was systemic or with a particular staff member
A “look back” on loan files for the past 12 months
Reimbursement of all customers who qualify
Documentation of the steps that were taken to verify the problem and the reimbursements
Documentation of the changed policies and procedures to ensure that there is a clear understanding of the requirements of the regulation.
Disciplinary action (if appropriate for affected employees)
A plan for follow-up to ensure that the problem is not re-occurring
Despite the very best effort at self-reporting and mediation, there may still be an investigation by the regulators. If the regulators start to investigate an area that you have already disclosed, such an instance calls for cooperation not hunkering down. The more the bank is forthcoming with the information about its investigation, the more likely that the regulators will determine that there is nothing more for them to do.
The new regulatory ratings systems actually puts a premium on the ability of financial institutions to “self-police”. We will discuss the ways to get the most benefit from self-reporting in future blogs.
SAN FRANCISCO, CA (June 7, 2017) — Western Independent Bankers (WIB), the premier trade association for more than 22,000 members and 140 community banks, announced today that Virtual Compliance Management (VCM) has become a Premier Solution Provider of WIB to offer their compliance services to community banks across the Western states and U.S. Territories. Premier Solution Providers support products and services designed to address the unique challenges of community banks, contribute to the financial strength of the institution, and advance sustainability through education and innovation.
With a platform that includes audit services, data validation, compliance consulting, and an online resource portal, VCM delivers the tools necessary to navigate both internal and regulatory demands with confidence and success.
“The old approach to compliance in today’s competitive environment can actually increase your risk,” said James DeFrantz, Principal at VCM. “Our regulators are consultants, giving VCM a unique perspective which we use to enhance existing compliance programs. Our experience and relationship-based approach are what makes us unique.”
“We’re extremely happy to expand our relationship with WIB and its member banks,” said DeFrantz. “We understand the disproportionate and increasing cost of community bank compliance in relation to their bigger bank brethren. We can control compliance costs without increasing risk to help level the playing field. Compliance can actually be a competitive advantage, even opening up new revenue streams and increasing noninterest income.
“If there is artistry in technology and confidence in service, then it’s compliance and risk where banks bear the steadfast promise of diligence,” said Michael Delucchi, President and CEO of Western Independent Bankers. “What the team at VCM delivers to our membership is a comprehensive approach to regulatory expectation that is grounded in practical experience and industry insight. With a methodology that includes direct consulting, speaking at WIB conferences, and engaging in our web-based education series, the relationship between WIB and VCM creates an extraordinary opportunity for member banks to explore compliance management solutions that are tailored to the particular needs of each organization.”
About Western Independent Bankers and WIB Service Corporation
For eighty years Western Independent Bankers (WIB) has been the premier networking and educational organization for community banks in the West. WIB informs, educates, and connects community banks with the resources and services to achieve the highest standards of personal and organizational performance. WIB Service Corporation was established in 1994 by the WIB Board of Directors as a wholly owned subsidiary of WIB. WIB Service Corporation conducts a strenuous selection process before putting the stamp of approval on an elite group of products and services that meet the highest industry standards and help WIB member banks to reduce costs, operate more efficiently, and compete more effectively. For more information, visit www.wib.org.
About Virtual Compliance Management
Virtual Compliance Management is a collective of former regulators, compliance officers, internal auditors, and trainers. The consulting firm provides flexible resources for financial institutions, including updating bank policies and procedures, training classes, audits, bank exam preparation, quality control reviews, fintech compliance consulting, and audit remediation. For more information, visit www.vcm4you.com
Senior Vice President Strategic Alliances/CTO
In the first two parts of this series we talked about the reason we have so many far-reaching regulations in compliance. The pattern these regulations follow is the same. Bad behavior by a number of financial institutions leads to a large public outcry which eventually results in regulations directed to addressing the bad behavior. The Truth in Lending Act, The Equal Credit Opportunity Act, and HMDA, all were implemented this way. Despite ongoing complaints from bankers about how burdensome these regulations might be, they are here to stay and are a part of doing business in financial services. However, by taking an optimist’s view of consumer regulations, one can find that there are many positives. These regulations add a level of stability to the banking industry and level the playing field for banks. Not only consumers but financial institutions have come to know what to expect when offering consumer products. Federally insured financial institutions have the same set of rules applied to them. Consumer compliance regulations are going to be a fact of life for financial institutions for the foreseeable future. However, all is not lost. Today there is a unique opportunity to reimagine the purpose of the compliance department. In fact, with the right change of focus, compliance can go from a cost center to a profit center.
Changes Have Come to the Banking Industry
In part two of this series we talked about the major factors that will drive change in the financial services industry in the very near future. Major forces are not only impacting the way financial institutions will do business in the future, they are directly impacting the meaning of compliance. Consider that the number of unbanked and underbanked people in the United States is at an all-time high. According to the FDIC there are more than 30 million people that fall into one of these two categories. Not only is the number of people striking, the composition of the group should give a moment’s pause to financial institutions doing strategic planning. The people in the unbanked and underbanked group include millennials, and people who simply have decided that it is better to stay outside of the banking system for assorted reasons.
Even though the unbanked and underbanked don’t have relationships with financial institutions, they DO have banking needs. Fintech companies have recognized the banking needs of this group and are developing the means to deliver. The smart phone is a gateway to banks even for persons that don’t want to have traditional accounts. Products such as Venmo and PayPal are the first generation of these companies. But in large part, these require a banking connection; today there are many ways to transfer money without a bank account. The second generation of Fintech’s allows customers to maintain a digital wallet1. The digital wallet allows the customer to maintain value (money) and store
the value on the smart phone. In other words, the new Fintech’s are making it more and more likely that the unbanked can stay unbanked and thrive.
Yet another hidden factor is the demand for the financial services provided by money service businesses (“MSB’s). MSB’s are companies that provide financial services including foreign currency exchange, check cashing and most important remittances. The constituency of MSB’s includes large populations of the unbanked and underbanked. During the period starting in 2010 through 2013, the Department of Justice along with the FDIC instituted Operation Chokepoint, which focused strict scrutiny on the administration of MSB’s. The result was that many financial institutions decided that they would no longer offer banking services to MSB’s. The need for banking services did not go away simply because Operation Chokepoint made it more difficult for MSB’s to get bank accounts. In many respects, Operation Chokepoint has created a significant opportunity for financial institutions who “step outside the box” and consider MSB’s as a source for non-interest income.
For many institutions, the ability to take advantage of the opportunities presented by underbanked, financial technology and MSB’s is severely limited. While each of these businesses present a reliable source of potential income, they all come with a level of risk. Compliance departments at financial institutions must be able to properly project the levels of risk and develop systems that will allow the institution to mitigate the risk.
Today’s compliance department tends to be misaligned with the strategic planning structure of financial institutions. Because compliance is viewed as a necessary (but unwanted) cost of doing business, the approach is often to get by with the minimum to meet the regulatory requirements. In extreme cases, some institutions simply calculate the costs of noncompliance into the operating budget.
Compliance programs are most often designed to be reactive. Compliance Officers make changes only when there is change in a regulation that impacts the institutions ability to keep the same products and services. For example, when the valuation rule was implemented, many compliance officers were tasked with figuring a way to document that the customer had received a copy of the appraisal or valuation used to establish collateral value. A more proactive approach might have been to partner with a Fintech company that could produce the required documentation electronically and efficiently, which will allow for significant cost savings.
The vast majority of compliance departments have limited resources and requests for budget increases are denied. Many Compliance Officers are forced to get by on their own grit and determination (in addition to lighting candles and praying). It is also common for a Compliance Officer to have several other duties including operations, security, BSA and IT to name a few. In the end, the best that a misaligned compliance depart can do is to try to keep its head above water.
Towards a More Proactive Compliance Department
Could you imagine the compliance department at your institution as a source of fee income, new clients and ongoing growth at your institution? Though it may sound farfetched, there is a possibility that this can be the case. There is a two-step process that must occur to get to this point.
First, recognizing the opportunities that exist; too many financial institutions write off MSB’s because they fear the compliance burden. However, the regulators have made it clear that with the right compliance program, there is absolutely nothing to fear from MSB’s. Making an investment into your compliance department that allows the necessary resources to properly monitor and administrate MSB’s will yield a positive return. In addition, by being able to offer banking to MSB’s your bank can access a group of potential clients that have given up on banking
Fintech companies have been developed to specifically meet the money movement needs of their customers. For many a fintech firm, there is a limited focus on compliance. One of the main things that vexes these companies is the need to get MSB licenses in each state in which they transact business. For many of` these firms a partnership with a Bank is a solution to this problem. Once again, by investing in your compliance department, the ability to engage in these partnerships can be realized.
By reimagining the compliance department of your institution, the door can be opened to additional income, customers and sustainable growth.
In the popular HBO series “Game of Thrones” one phrase that is repeated often is “Winter is Coming”. While the true meaning of that phrase will only be known at the time the show reaches its climax, it serves as an ominous warning that change is afoot. The same thing can be said in the banking industry; significant change is coming that will impact the business model of financial institutions. This will be especially true for community and regional banks and credit unions. There are two forces that are bearing down on the financial services industry that are sure to bring about significant change. These changes will dramatically impact the role of compliance.
From One Direction- A Significant Market with Needs
The first force that will impact banking is the large number of unbanked and underbanked people in the united states. There are millions of potential customers who have either a limited relationship with financial institutions or no relationship at all as the FDIC showed inn their 2015 study of Unbanked and underbanked populations.
The FDIC has defined Unbanked and underbanked as follows:
“…… many households—referred to in this report as “unbanked”—do not have an account at an insured institution. Additional households have an account, but have also obtained financial services and products from non-bank, alternative financial services (AFS) providers in the prior 12 months. These households are referred to here as “underbanked.”
Per the Corporation for Enterprise Development, there are millions of unbanked and underbanked households across the country. For example, in 2010 the same organization estimated that 20% of the households in New Jersey are underbanked. The number of unbanked and underbanked people that live within the service areas of financial institutions presents both an opportunity and a level of risk. As the FDIC pointed out in there May 2016 study “Bank Efforts to serve underbanked and unbanked Communities” the whole banking community is better served when the level of trust and participation is increased.
Why are so Many Unbanked and Underbanked?
The FDIC asks similar of questions every year and the answers have been consistent. Here are the key observations:
The most commonly cited reason was “Do not have enough money to keep in an account.” An estimated 57.4 percent of unbanked households cited this as a reason and 37.8 percent cited it as the main reason.
Other commonly cited reasons were “Avoiding a bank gives more privacy,” “Don’t trust banks,” “Bank account fees are too high,” and “Bank account fees are unpredictable.
Perceptions of Banks’ Interest The 2015 survey included a new question asked of all households: “How interested are banks in serving households like yours?”
The survey results revealed pronounced differences across households.
Approximately 16 percent thought that banks were “not at all interested” in serving households like theirs, and the perceptions of the remaining 8 percent were unknown.
Unbanked households were substantially less likely than underbanked or fully banked households to perceive that banks were interested in serving households like theirs. More than half (55.8 percent) thought that banks were not at all interested, compared to roughly 17 percent of underbanked households and 12 percent of fully banked households.
Ultimately, there are well over 50 million households in America that currently either don’t have a relationship with a bank or have only a minimal one.
In many cases, misperceptions from the point of view of customers and financial institutions keep them apart. For far too long it has been an axiom that the costs of providing banking services for consumer accounts prevents an acceptable rate of return. However, through the development and use of new technologies, the costs associated with consumer accounts has significantly declined.
Many of the unbanked and underbanked turn to Money Service Businesses (“MSB’s”) to transaction business. Both the check cashing and money remittance industries handle billions of dollars on an annual basis for their customers. The fees available to financial institutions willing to provide bank accounts to MSB’s present a significant opportunity for income. Unfortunately, too many institutions still feel the sting of “operation chokepoint” a misguided attempt by regulators to drive MSB’s out of the financial services industry. Financial institutions willing to invest in the proper infrastructure to bank these customers have found the return to be worth the investment.
Without significant competition for the unbanked and underbanked households, financial needs are met by businesses that are predatory. Financial technology (“Fintech”) companies have set out to change the landscape and to fill the need of this massive pool of potential clients. So far, these efforts have yielded products such as digital wallets, person to person networks (such as PayPal and Venmo), fundraising sites and even remote bill paying. Most recently, there are a number of fintech companies venturing in to the consumer and business loan arena.
From Another Direction- Technology
Advances in technology have made it possible for customers to enjoy many of the services of a bank without actually having a banking relationship. Using a smart phone coupled with software programs, from financial technical companies, people can have access to money at ATM’s, pay bills, receive payroll and buy things, all without having a bank account.
The fact that many of the products that are being developed by fintech companies can be delivered to smartphones should not be lost on financial institutions. The unbanked and underbanked may not have accounts at financial institutions, but almost all of them have a smartphone. A large percentage of the people who fit into this category are millennials who have become accustomed to conducting business on their smart devices.
A growing number of institutions have recognized the potential benefits of working with fintech companies. In late 2016, the firm Manatt, Phelps & Phillips, LLP, conducted a survey of banks that have engaged in partnerships with fintech companies and the results are enlightening. There were four key takeaways that are useful to everyone in the banking and fintech sectors when approaching the challenges that come with collaboration:
Banks are on board with fintech. At 81%, the overwhelming majority of regional and community banks are currently collaborating with fintechs. In addition, 86% of regional and community bank respondents said that working with fintechs is “absolutely essential” or “very important” for their institution’s success.
Lower costs + a better brand = a win-win. For regional and community banks, enhanced mobile capabilities and lower capital and operating costs were highlighted as the benefits of collaborating with fintechs. Fintechs named market credibility and access to customers in regional markets as the main benefits to partnering with banks.
Data security remains a challenge. Both banks and fintech companies are highly sensitive to the ways in which data is shared and secured. This means extra attention must be paid to cybersecurity when the two sides collaborate—especially given the cultural mismatch that can exist between them. Despite the optimism among banks for collaboration, preparedness is a large concern. Almost half of regional and community bank respondents said they are just “somewhat prepared” or even “somewhat unprepared” for this kind of partnership.
Regulatory concerns remain paramount. For banks and fintech firms, structuring relationships that are regulatory compliant, including, if required, prior regulatory approval, is critical to ensuring success and the opportunity to change the way financial services are ultimately delivered.
As partnerships with Fintech firms become more commonplace, so does the need for compliance staff who are fully versed in this area. Compliance staff fully versed in both fintech and regulatory requirements have/will become key figures in an institutions’ ability to offer fintech products that are successful and compliant.
“Winter” is definitely coming- will you be ready?
 Estimates from the 2015 survey indicate that 7.0 percent of households in the United States were unbanked in 2015. This proportion represents approximately 9.0 million households. An additional 19.9 percent of U.S. households (24.5 million) were underbanked, meaning that the household had a checking or savings account but also obtained financial products and services outside of the banking system.
 FDIC survey of unbanked and underbanked households
Every culture has its own languages and code words. Benign words in one culture can be offensive in another. There was a time when something that was “Phat” was really desirable and cool while there are very few people who would like being called fat! Compliance is one of those words that, depending on the culture, may illicit varying degrees of response. In the culture of financial institutions, the word compliance has some negative associations. Compliance is often considered an unnecessary and crippling cost of doing business. Many of the rules and regulations that are part of the compliance world are confusing and elusive. For many institutions, has been the dark cloud over attempts to provide new and different services and products.
Despite the many negative connotations that surround compliance in the financial services industry, there are many forces coming together to alter the financial services landscape. These forces can greatly impact the overall view of compliance. In fact, it is increasingly possible to view expenditures in compliance as an investment rather than a simple expense. In this three-part blog, we ask that you reimagine your approach to compliance.
Why do we have Compliance Regulations?
Many a compliance professionals can tell you about how difficult it is to keep everybody up to date on the many regulations that apply to financial institutions. However, if you ask why exactly do we even have an Equal Credit Opportunity Act or a Home Mortgage Disclosure Act (“HMDA”), it would difficult to get a consensus. All of the compliance regulations share a very similar origin story. There was bad or onerous behavior on the part of financial institutions, followed by a public outcry, legislative action to address the bad behavior and then eventually regulations. The history of Regulation B provides a good example:
A Little History
The consumer credit market as we now know it grew up in the time period from World War II and the 1960’s. It was during this time that the market for mortgages grew and developed and became the accepted means for acquiring property, financing businesses, developing wealth and upward mobility. By the late 1960’s the consumer credit market was booming.
The Equal Credit Opportunity Act (“ECOA”) and regulation B are not nearly as old as you might think. In fact, the first attempt at regulating credit access was the Consumer Credit Protection Act of 1968. This legislation was passed to protect consumer credit rights that up to that point been largely ignored. The 1968 regulation was passed as the result of continuing growth in consumer credit and its effects on the economy. For example, in the year before the regulation was passed, consumers were paying fees and interest that equaled the government’s payments on the national debt! One of the goals of the Consumer Credit Protection Act was to protect consumer rights and to preserve the consumer credit industry.
The Civil Rights Movement was occurring at the same time as the passage of the CCPA and in 1968, the Fair Housing Act was passed by Congress. The FHA was designed to assist communities that that had been excluded from credit markets obtain access to credit. We will discuss the Fair Housing Act in more detail next month.
One of the things that the CCPA did was to empanel a commission of Congress called the National Commission on Consumer Finance. This commission was directed to hold hearings about the structure and operation of the consumer credit industry.
While performing the duties they were assigned, the members of the National Commission on Consumer Finance conducted several hearings about the credit approval process for consumer loans. The stories and anecdotes from these hearings raised a tremendous public outcry about the behavior of banks and financial institutions that were in the business of granting credit. One of the common themes of the testimonies given was that women and minorities were being left behind when it came to the growth of the consumer credit market. Public pressure forced additional hearings on the consumer credit market, and the evidence showed that women in particular and minorities in general were being given unfair and unequal treatment by banks.
What was Going On?
So what were banks doing that was a cause of concern? There were several practices that had become normal and regular for banks when the applicant for consumer credit was a woman or a member of a racial minority group.
Women had more difficulty than men in obtaining or maintaining credit, more frequently were asked embarrassing questions when applying for credit, and more frequently were required to have cosigners or extra collateral. When a divorced or single woman applied for credit she was immediately asked questions about her life choices, sexual habits, and various other personal information that was both irrelevant to the credit decision and not asked of men.
Racial minorities had difficulty even obtaining credit applications let alone credit approvals. In cases, where members of minority groups attempted to get a loan applicant, there were either told that the bank was not making consumer loans, or that the area that the person lived was outside of the lending area of the bank.
For applicants that receive public assistance, child support of alimony, banks would not consider these as sources of income under the theory that they were temporary and might disappear.
Despite being subjected to embarrassing or incorrect information, in the cases where women and minorities persisted and completed a credit applications, banks would drag out the process for interminable time periods and would engage in strong efforts to discourage the applicant from going forward.
In many cases, when a person lived in a neighborhood that was predominately comprised of minorities, the borrower was told that the collateral did not have enough value without further explanation.
Though these stories created a great deal of interest, the CCPA was not amended until 1974 when the first Equal Credit Opportunity Act was passed. This Act prevented discrimination in credit based on sex and marital status.
Why are there a Regulation B and the ECOA?
The development of the consumer credit market brought with it a series of bad behaviors that directly and negatively impacted the ability of women and minorities to obtain credit. These behaviors included asking women to check with their husbands before getting a loan, denying a single woman credit, discouraging minorities from applying for credit and outright refusal to grant credit.
The law and regulation are designed to open credit to all who are worthy by limiting practices that unfairly exclude groups of people and by making sure that applicants are fairly informed of the reasons for a denial.
The regulations exist because there was bad behavior that was not being addressed by the industry alone. Many of the compliance regulations share the same origin story.
Compliance is not all Bad
Sometimes, we are caught up on focusing on the negative to the point that it is hard to see the overall impact of bank regulations. One of the positive effects of compliance regulations is they go a long way toward “leveling the playing field” among banks. RESPA (the Real Estate Settlement Procedures Act) provides a good example. The focus of this regulation is to get financial institutions to disclose the costs of getting a mortgage in the same format throughout the country. The real costs associated with a mortgage and any deals a bank has with third parties, the amount that is being charged for insurance taxes and professional reports that are being obtained all have to be listed in the same way for all potential lenders. In this manner, the borrower is supposed to be able to line up the offers and compare costs. This is ultimately good news for community banks. The public gets a chance to see what exactly your lending program is and how it compares to your competitors. The overall effect of this legislation is to make it harder for unscrupulous lending outfits to make outrageous claims about the costs of their mortgages. This begins to level the playing field for all banks. The public report requirements for the Community Reinvestment Act and the Home Mortgage Disclosure Act can result in positive information about your bank. A strong record of lending within the assessment area and focusing on reinvigoration of neighborhoods is a certainly a positive for the bank’s reputation. The overall effects of the regulations and should be viewed as a positive.
Protections not just for Customers
In some cases, consumer regulations provide protection not just for consumers but also for banks. The most recent qualifying mortgage and ability to repay rules present a good case. These rules are designed to require additional disclosures for borrowers that have loans with high interest rates. In addition to the disclosure requirements, the regulations establish a safe harbor for banks that make loans within the “qualifying mortgage” limits. This part of the regulation provides strong protection for banks. The ability to repay rules establish that when a bank makes a loan below the established loan to value and debt to income levels, then the bank will enjoy the presumption that the loan was made in good faith. This presumption is very valuable in that It can greatly reduce the litigation costs associated with mortgage loans. Moreover, if a bank makes only “qualifying mortgages’ the level of regulatory scrutiny will likely be lower than in the instance of banks that make high priced loans.
Compliance regulations will no doubt be a part of doing business in the financial industry for the foreseeable future. However, all is not Considering a strategy that embraces the regulatory structure as an overall positive will allow management to start to re-imagine compliance and consider greater investment. In our next blog, we will discuss the forces that are converging to make the return on investment in compliance strong.
For many financial institutions as January ends, the implementation phase of plans begins. As you put the finishing touches on your plans and give it one last look, among the critical things to consider should be your assessment of strategic risk. For the prudential regulators (the FDIC, the Federal Reserve, the OCC and the CFPB), strategic risk has become the preeminent issue, as indicated in public statements, guidance and planned supervisory focus documents. The main issue driving strategic risk is the convergence of unbanked/underbanked people, the growth of financial technology (” fintech”) firms and shrinking demand for traditional lending. And to paraphrase the comments of Comptroller of the Currency Thomas Curry, those who fail to innovate are doomed.
Strategic risk is generally defined as:
Strategic risk is a function of business decisions, the execution of those decisions, and resources deployed against strategies. It also includes responsiveness to changes in the internal and external operating environments.
The OCC’s Safety and Soundness Handbook- Corporate Guidance section discusses strategic risk as follows:
The board and senior management, collectively, are the key decision makers that drive the strategic direction of the bank and establish governance principles. The absence of appropriate governance in the bank’s decision-making process and implementation of decisions can have wide-ranging consequences. The consequences may include missed business opportunities, losses, failure to comply with laws and regulations resulting in civil money penalties (CMP), and unsafe or unsound bank operations that could lead to enforcement actions or inadequate capital.
More to the point, strategic risk today is the difference between being able to “think outside the box” and being mired in tradition. Banking as we know it is being disrupted by technology. There are many customers who have never had bank accounts and an equally large number of people who use banks on a limited basis. Many fintech firms have been founded specifically to offer products that meet the needs of these customers. Products such as online lending, stored value and bill payments are here to stay and they are changing the places customers look to fill their banking needs.
Both the FDIC and the OCC in their annual statements recognized the need to address strategic risk and will be looking at the institutions they regulate to determine the level of consideration of this risk. 
So, what does consideration of strategic risk look like? It means consideration of new types of products, customers and sources of income. It also means reimagining compliance.
Types of Products
Today a traditional financial institution offers a range of deposit products, consumer loans and commercial loans traditional loans. Tomorrows’ bank will offer digital wallets, stored value accounts, and financing that is tailored to the needs of customers. Loans with terms like $7,200 with a 7-month term which are not economically feasible, will be commonplace soon. Commercial loans will come with access to business management websites that offer consultation for the active entrepreneur, savings account will be attached to the digital profile of the customer. Banking will be done from the iPad or another digital device. Your institution can be part of this updated version of banking or continue to suffer declines as your current customer base grows old and disappears. Consider deciding which fintech companies will allow your bank to offer a full range of products that have not yet been offered. No need to reinvent the wheel, simply join forces
Types of Customers
The number of customers that are available for traditional commercial lending products is a finite pool and there is tremendous competition for these customers. However, for financial institutions that are willing to rethink the lending process there are entrepreneurs and small businesses that are seeking funding in nontraditional places. Fintech companies have developed alternative credit scoring that is highly accurate and predictive. Consider partnering with these firms to allow underwriting of nontraditional loan products.
The dreaded “MSB” word
In the early part of this decade we experienced the unfortunate effects of “operation chokepoint” a regulatory policy specifically aimed at subjecting MSB’s to strict scrutiny. Many financial institutions ceased offering accounts to these businesses. The law of unintended consequences was invoked as many of the people who used the MSB’s were left without financial services. Even today there are sizable communities of people are still hurt by the inability to get financial services. More importantly, financial institutions are missing the opportunity to develop fee income, expand their customer base and reshape the business plan.
MSB’s facilitate a huge flow of funds that flow throughout the world in one form or another and the more financial institutions are a part of that flow, the safer and more efficient it will be. MSB’s provide an extremely important service that will be filled one way or another- why not be part of it? 
Compliance as an investment
When considering overall strategic risk, an institution must balance risk levels with the systems in place to mitigate that risk. New products and different types of customers carry with them different levels and types of risk. Your system for risk management and compliance must be up to the task of administrating new challenges. The traditional planning process considers the compliance program only after the products and customers have been determined. A proactive approach to risk would consider expanding the resources and capabilities of the compliance department to an end; adding products and services that can breathe economic life into your institution.
When the ability to monitor, and administrate new products and customers is acquired by the compliance program, your financial institution can grow and expand. Now is the time to start thinking of compliance as an investment rather than an expense. This of course requires an investment in compliance, but the return is well worth it.
OCC Report Discusses Risks Facing National Banks and Federal Savings Associations
WASHINGTON — The Office of the Comptroller of the Currency (OCC) reported strategic, credit, operational, and compliance risks remain top concerns in its Semiannual Risk Perspective for Fall 2016, released today.
 Per the world bank High-income countries are the main source of remittances. The United States is by far the largest, with an estimated $ 56.3 billion in recorded outflows in 2014. Saudi Arabia ranks as the second largest, followed by the Russia, Switzerland, Germany, United Arab Emirates, and Kuwait. The six Gulf Cooperation Council countries accounted for $98 billion in outward remittance flows in 2014.
There are many reasons financial intuitions suffer through periods of poor compliance performance. The causes for these problems are myriad. One of the key contributors to compliance woes is often overlooked. When resources in the compliance department are misaligned or inadequate, trouble is bound to follow. Inadequate resources result from not just a small compliance staff, but also instances of “over-compliance”. Misaligned staff occurs when your institution’s risk assessment fails to identify the highest risks or is not used as part of the compliance planning process.
Too few resources can result from many different sources including:
Training – Online training is a good first start for helping staff understand the basics of compliance. These courses are cost effective and provide good basic information about various topics in compliance. However, training that includes some in-person components tends to be more effective. In-person classes allow staff to review case studies, ask in-depth questions and gain a more complete understanding of the rationale for regulations. In addition, these types of classes significantly increase the retention for participants.
Software used for monitoring – Determine whether your software provider effectively helps you monitor compliance activities. Many compliance officers “take what they get” from their software providers and make do with the reports that get generated. Having a discussion with your vendor can result in significant changes. Software providers have significant resources including the ability to tailor the report you receive to meet specific needs. If the reports that are generated create more work than they resolve questions, now is good time to have a discussion with your software provider.
Compliance officer overburdened – Compliance has become a full-time occupation. In addition to constant reporting requirements there are nuances to the position that require the full focus and attention of the compliance officer. Despite these requirements, there are many compliance officers that serve in various capacities in addition to their compliance duties. When a compliance officer is overburdened, the compliance program suffers. Attention can only be addressed toward the pressing issues of the moment. Potential problems are left for consideration at the time they have become compliance violations.
Too Much Unnecessary information – In some cases, it is possible to engage in “over-compliance”, meaning developing data bases that are simply too large to effectively review and interpret. For example, some institutions make a habit of filing Suspicious Activity Reports on all clients that have even a whiff of questionable activity. Alternatively, some institutions include a large portion of their customer base as high risk customers. The sentiment for taking this course of action is understandable- a conservative approach to risk. However, the net result of taking such an approach is information overload. Massive amounts of data are presented to compliance staff rendering them unable to keep up and the process gets overwhelmed.
Compliance resources are limited in almost all institutions. This is also true in the regulatory agencies that supervise financial institutions. Therefore, the regulatory institutions take the risk based approach to supervision. The goal of the risk based approach is not to necessary catch every flaw in a compliance system. The idea is that the areas of greatest risk should receive the most attention. The same philosophy is at the heart of the compliance rating system announced by the FFIEC. The effectiveness of the compliance program will be reviewed and rated. Individual findings of low importance will still be addressed, but put into an overall context of risk. The point is that the areas with the highest risk should get the most attention.
At your institution, one of the ways to make your compliance program most effective is to concentrate on the highest levels of risk. You can do this be “letting go” in some cases and focusing on others. One of the areas that is illustrative is an institution with many Suspicious Activity Reports. For example, in this case the institution has $1 billion in assets that writes SARS on over 70 clients a month. The SAR process requires that each of these SAR reports has a follow-up at 90 days. The SAR reports describe activity that such as structuring and potential tax evasion. The compliance team at this institution has determined that all potential structuring activity will result in a SAR. The institution quickly finds out that the time that is taken by filing SARS and following up on them leaves little time to research the customer and to determine if there are business reasons for the activity that is viewed as suspicious. The number of SARs continues to grow while the amount of time that is spent on research of individual customers continues to shrink. Eventually SARs are filed late and compliance concerns are noted by the regulators.
In the above instance, a re-alignment of compliance resources would focus on getting to “know your customer”. By doing research on the customer and talking to them, the activity may not be suspicious at all. For example, one customer deposits cash in amounts between $8,000 and $9,300 every two days. This pattern may not be structuring at all if the customer is a small store that can prove the deposits are the actual cash receipts for the day. The compliance team could ask the customer to report cash sales weekly, match the results with the deposits and have a level of comfort that structuring was not taking place. Without a proper balance between KYC and SAR reporting, a compliance team can engage in a death spiral that included excessive SAR filing and inadequate research.
Compliance programs should look for the root cause of a concern and address that root cause rather than attempt to apply “bandages” when findings are noted. Training programs that help staff learn about the financial needs of the client base are also an effective means to aligned compliance resources. If your institution does not offer credit cards, then course information on these products could be reduced in exchange for information on current products.
Aligning Compliance to Risk
The compliance risk assessment is the best place to start the alignment of compliance risk to resources. Developing a comprehensive and effective compliance risk assessment will allow the institution to identify the greatest areas of risk and to direct resources to those areas.
As you prepare your annual audit schedule, a task that can often seem mundane, there are significant opportunities to take charge and “change the game”. The schedule is often set by focusing on the number of audits that must be completed within the year. The bulk of the planning attention goes to the task of scheduling the audits in a manner that is least disruptive. There is often little attention paid to the construction of the components of the audit scope. Consider building the scope of the audits around the results of your risk assessment and you can greatly enhance the effectiveness of the audit reports.
The Standard Menu
Outsourced internal audit firms design the scopes for the audits that they conduct based upon their knowledge of auditing, regulatory trends, best practices and the overall knowledge of their staff. This practice allows the firms to bring a wealth of experience and important information from outside of the financial institutions that they are reviewing. When your audit firm presents you the scope that they propose it is based upon completely external actors and considerations. This is not a criticism of the firm, it is a standard practice. However, setting of the scope for internal audits is really supposed to be a collaborative effort, and both the audit firm and your institution are best served by developing the scope for audits together, after all, who knows the strengths and weaknesses of your institution better than the management? To get the biggest bang for your buck, why not tie the audit scope into the results of your risk assessment?
The Risk Assessment and the Internal Audit
An effective risk assessment of your compliance program can be an excellent source document for various things including budgeting requests for additional resources and scoping of audits. Completing the assessment includes considering the inherent risk at your institution, the internal controls that have been established to address risk and a determination of the residual risk. The process is intended to be one of self-reflection and consideration of the areas of potential weakness. For those areas that have the potential to be a problem, the best practice is to make sure they are included in the scope of an audit. Audit firms are more than happy to work with the management of the institutions they are reviewing on developing a scope. One of the crucial goals of the audit is to uncover areas where there are weaknesses in internal controls. For example, in your risk assessment, you may have noted a large number or errors in disclosures for new accounts. This should be a focus for the internal auditors when the compliance audit is performed.
An area that is often overlooked in audits is a discussion of the root causes for findings. For every violation or a problem noted during an examination or audit, there is a reason the violation occurred. Ineffective training, incomplete written procedures, poor communication or incompetence are all possible causes of a finding. Getting feedback from the auditors on the root cause of a problem allows the remediation to be most effective. One of the main reasons for repeat findings is ineffective remediation.
Future or Strategic Risks
The environment for banking is going through significant change as fintech companies have begun to make inroads into the financial markets. Financial institutions should consider whether their current systems, business plans and infrastructure is well positioned to meet the annual goals. External audit firms can be a very good source of information for industry trends and ideas. Building a consideration of both future and strategic risks into the scope of the audit can yield significant benefits.
Self-Policing and the New Compliance Ratings
One of the main reasons to expand the scope of your audits is to take advantage of the new compliance ratings systems that take effect in March of 2017. The new ratings will consider the Board and management oversight, strength of the compliance program as well as the potential for consumer harm. These new ratings will put an increased premium on an institutions ability to self-police potential violations. The ability of a financial institution to identify problems, determine the root cause and to remediate the problem will have a large impact of the overall rating of the institution. By setting the scope of your audits to help self -police, your institution can take full advantage of the new ratings system.
2017 is here! Now is the time for new resolutions, renewed plans for success and… if you’re in compliance, now is the time for new compliance risk assessments. As we have discussed in previous blogs, the risk assessment is often discussed and sometimes reviled as a meaningless regulatory requirement. When attempting to prepare a risk assessment, a frequent question is presented; what are the essential items in my risk assessment? Per regulatory guidance produced by the Federal Reserve:
“Principles of sound management should apply to the entire spectrum of risks facing an institution including, but not limited to, credit, market, liquidity, operational, compliance, and legal risk.”
This guidance applies to general principals of risk assessment preparation. The compliance risk assessment is something of a different animal because questions of market risk, credit risk and liquidity risk are relatively minor concerns when considering risks in compliance. The focus instead should be on compliance, transactional, strategic, financial and reputational risks associated with compliance activity.
Think of the risk assessment as a matrix – not the type where you get to choose a red pill or a blue pill, just a square with several blocks. There is a formula that you can use to complete an effective risk assessment. The basic formula is INHERENT RISK (minus) INTERNAL CONTROLS (equals) MITIGATED RISK.
Inherent risk is the risk associated with the products, customers and overall compliance structure at your bank.
An inherent risk is a risk category that really relates broadly to the activities and operations of a company without considering necessarily the company. For example, unsecured lending is inherently more risky than secured lending. If I were auditing an institution that was primarily involved in unsecured lending, then I would have a higher assessment of inherent risk in that organization than, let’s say, secured lending. And that’s a fairly simple example, but that type of a risk assessment is done for each critical business component1
When considering the level of inherent risk at your institution, consider all the products that you offer and the worst-case scenarios lurking in the background. For example, supposed you are considering the inherent risk associated with consumer lending. The inherent risk might look something like this:
Consumer Loans- Inherent Risk/Type of Risk Comment
Compliance Risk -The risk associated with the regulatory requirements for making consumer loans, e.g. disclosures, accurate calculations, etc.
Transactional Risks- The risks associated with the systems in place that are being used to support offering the product. Can your core support the loan types being offered?
Reputation Risks-The risk that the products will result in consumer complaints, UDAAP violations or potential fair lending concerns.
Strategic Risk -Are your products really meeting the credit needs of the community you serve?
The point of this part of the exercise should be to determine the level of risks that are part of offering the products at all. This level of risk doesn’t consider anything of your compliance program.
One you have identified the risks inherent in the products you offer, the customers you serve and the overall current compliance program, the next step is to review the steps your institution has taken to address them. This is where your policies, procedures, training and independent audits come in. There is really an opportunity to self-reflect and simultaneously project your aspirations during this part of the risk assessment. It is one thing to note you have policies and procedures in place. It is a far different consideration to determine how effective they are. Are the policies and procedures written and updated on an annual basis? How much of the policies and procedures are internally developed and how much have been “borrowed” from other institutions? (Note: This is not to imply that borrowing is a bad thing, if the information truly reflects the situation at your institution). The risk assessment should contain an analysis of the current state of the internal controls. What would excellent controls look like and what would it take for the compliance department to get there? These considerations should be included.
Your overall assessment of how well the internal controls at your institution address the possibility of problems is the mitigated risk. For the risk assessment to be a most effective tool, it is necessary for this process to truly consider potential proems with internal controls. Written policies and procedures, for example, can be comprehensive and up to the minute accurate, but totally ineffective if staff don’t use them. Training is an area often taken for granted. The online training that most institutions offer is a great start for training. However, for a full in-depth understanding, additional training that includes case-studies is a best practice.
For the banking industry in general regulators have put strategic risk at the forefront. For example, its semiannual risk perspective for spring 2016, the OCC noted that strategic risk is a concern:
“Banks are several years into the risk accumulation phase of the economic cycle. The banking environment continues to evolve, with growing competition among banks, nonbanks, and financial technology firms. Banks are increasingly offering innovative products and services, enabling them to better meet the needs of their customers. While doing so may heighten strategic risk if banks do not use sound risk management practices that align with their overall business strategies, failure to innovate to meet evolving needs or financial services may place a bank at a competitive disadvantage.”2
As the risk assessment process is completed this year, it is important to consider whether your institution is keeping up with trends in technology and innovation. The financial industry is being disrupted in a way that will significantly impact the relationship between customers and institutions. Without the right technology and business plan, it will be easy to be left behind. Make sure that your risk assessment considers strategic risk.
James DeFrantz is the Principal of Virtual Compliance Management Services LLC. He can be reached directly at JDeFrantz@VCM4you.com
 William Lewis, Price Waterhouse Coopers Comptroller of Currency Administrator of National Banks Audit Roundtable, Part 1 Risk Assessment and Internal Controls .
 OCC Semiannual Risk Perspective From the National Risk Committee Spring 2016
For those of you who have experienced a BSA examination or audit, you know one of the first things you are asked for is your BSA/OFAC risk assessment. It has also likely been your experience to find a risk assessment deemed complete and not in need of some sort of enhancement is something of a “unicorn”. In most cases, examinations and audits include a comment discussing the need to expand the risk assessment and to include more detail. The detail required for a complete risk assessment is elusive at best. Often, the right information for the risk assessment fits the famous Supreme Court definition of pornography- “you know it when you see it”.
The FFIEC BSA manual is not exactly helpful when it comes to developing risk assessments. The manual directs every financial institution should develop a BSA/AML and an OFAC risk assessment. Unfortunately, the form the risk assessment should take or the minimum information required are left as open questions for the financial institution. Thus, many financial institutions end up with a very basic document which has been developed to meet a regulatory requirement, but without much other meaning or use.
As financial institutions continue to change and the number of financial products and type of institutions offering banking services grows, the risk assessment can be something entirely different. Taking the approach that the risk assessment can be used to formulate both the annual budget request and the strategic plan, can change the whole process.
The FFIEC BSA examination manual specifically mentions risk assessments in the following section:
“The same risk management principles that the bank uses in traditional operational areas should be applied to assessing and managing BSA/AML risk. A well-developed risk assessment assists in identifying the bank’s BSA/AML risk profile. Understanding the risk profile enables the bank to apply appropriate risk management processes to the BSA/AML compliance program to mitigate risk. This risk assessment process enables management to better identify and mitigate gaps in the bank’s controls. The risk assessment should provide a comprehensive analysis of the BSA/AML risks in a concise and organized presentation, and should be shared and communicated with all business lines across the bank, board of directors, management, and appropriate staff; as such, it is a sound practice that the risk assessment be reduced to writing” 1
This preamble has several important ideas in it. The expectation is, management of an institution can identify:
Who its customers are: including the predominant nature of the customer base- are you a consumer institution or a commercial at your core? Who are the customers you primarily serve?
What is going on in your service area? Is it a high crime area or a high drug trafficking area, both or neither? The expectation is you will know the types of things, both good and bad going on around you. For example, if you live in an area where real estate is extremely high cost, there might be several “bad guys” buying property for cash as a means of laundering money. The point is you need to know what is going on around you
Where are the outlier customers? Do you know which types of customers who require being watched more than others? There are some customers who, by the nature of what they do, require more observation and analysis than others. The question is, have you identified these high-risk customers?
How well are you set up to monitor the risks at your institution? Do you have systems in place are up to the task to discover “bad things” going? Does the software you use really help the monitoring process? This analysis should consider whether the staff you have truly understand the business models your customers are using. For example, if your customer base includes Money Service Businesses, do you have staff in place who know how money services business work and what to look for? The best software in the world is ineffective if the people reading the output are not familiar with what normal activity at an MSB.
Ties to the strategic plan: Does the BSA program have the resources to match changes in products or services planned for the institution? For example, if the institution plans to increase the number of accounts offered to money services business, does the BSA department have an increase in staff included in its budget?
Effective Risk Management
The information and conclusions developed in the risk assessment should be used for planning the year for the BSA/AML compliance program. The areas with the greatest areas of risk should also be the same areas with the greatest dedicated resources. Independent audits and reviews should be directed to areas of greatest risk. For example, if there are many electronic banking customers at the institutions while almost no MSB’s, then the audit scope should presumably focus on the electronic banking area and give MSB’s a limited review. In addition, training should focus on the BSA/AML risks associated with electronic banking, etc.
Rethinking the Risk Assessment process
Continued development of new products and processes in finance and technology (“fintech”) and BSA/AML have opened the possibility of a vast array of potential new products for financial institutions. Products such as digital wallets and stored value on smartphones have opened new markets for people who have been traditionally unbanked and underbanked. Financial institutions which are forward thinking should consider the possibility some of these new products have the potential to enhance income.
The ability to safely and effectively offer new products depends heavily on the ability of the compliance department to fully handle the regulatory requirements of the products. When preparing the risk assessment, consider the resources necessary to offer new and (money making products).
There are no absolute prohibitions against banking high risk clients
Per the FFIEC BSA Examination manual higher risk accounts are defined as:
“Certain products and services offered by banks may pose a higher risk of money laundering or terrorist financing depending on the nature of the specific product or service offered. Such products and services may facilitate a higher degree of anonymity, or involve the handling of high volumes of currency or currency equivalents” 2
The Manual goes on to detail several other factors which should be considered when monitoring high risk accounts. We note the manual does not conclude high risk accounts should be avoided.
The BSA/AML examination manual (“exam manual”) establishes the standard for providing banking services to clients who may have a high risk of potential money laundering. Financial institutions are expected to:
Conduct a risk assessment on each of these clients,
Consider the risks presented
Consider the strengthening of internal controls to mitigate risk
Determine whether the account(s) can be properly monitored and administrated;
Determine if the risk presented fits within the risk tolerance established by the Board of Directors.
Once these steps are followed to open the account, for high risk customers, there is also an expectation there will be ongoing monitoring of the account for potential suspicious activity or account abuse. The exam manual is also clear; once a procedure is in place to determine and properly mitigate and manage risks, there is no prohibition against having high risk customers. The risk assessment section of the exam manual notes the following:
“The existence of BSA/AML risk within the aggregate risk profile should not be criticized as long as the bank’s BSA/AML compliance program adequately identifies, measures, monitors, and controls this risk as part of a deliberate risk strategy.”3
Once an account has been determined to be high risk, and an efficient monitoring plan has been developed, there can be various levels of what high risk can mean. When a customer’s activity is consistent with the parameters which have been established and have not varied for some time, then account can technically be high risk but not in practice. For example, Money Services Businesses are considered “high-risk” because they fit the definition from the FFIEC manual. However, a financial institution can establish who the customers of the MSB are and what they do. A baseline for remittance activity, check cashing and deposits and wire activity can be established. If the MSB’s activity meets the established baseline, the account remains “high risk” only in the technical meaning of the word. Knowing what the customers’ business line is and understanding what the customer is doing as they continue without much variation reduces the overall risk.
For a more complete discussion of the effective use of the BSA/AML risk assessment, please contact us at www.vcm4you.com.