a number of its processes and controls in underwriting, closing and servicing loans. Operational efficiencies in mortgage production can mean the difference between becoming a market leader or a follower. SifiBank management pressed hard to place itself as one of the top three mortgage originators in the country before the crisis and to do so meant finding ways to reduce the operational burdens of the loan manufacturing process.
Streamlining bank processes included allowing some loan production staff to bundle closing documents together and sign off with little review of what was being signed. Loan programs allowed many borrowers to avoid having to produce documents verifying their income and employment. Servicing staff was further reduced because, after all, mortgage defaults were expected to remain low. Automation was accelerated in both underwriting and collateral valuation where possible, thus reducing the number of underwriters and property appraisals in the process.
To no one’s surprise, fraud, both internal and external was rampant in these programs and surfaced once loan defaults began rising during the crisis. Counterparties and investors in securities created by SifiBank sued the company for billions of dollars of repurchases based on claims that the loans violated the terms of the contract relating to fraud and misrepresentation. Loan documents went missing during this period and once the deluge of defaults hit the bank, it did not have sufficient servicing resources to handle the caseload. Many borrowers were erroneously foreclosed on as a result, which caught the attention of the media, regulators and litigators. SifiBank faced billions of dollars of legal damages and settlements as state attorneys general and the U.S. Justice Department lodged suits against the bank.
The government’s decision to intervene and prop SifiBank up at the beginning of the financial crisis was very difficult. On the one hand, the government realized that there was a reasonable likelihood that not intervening could lead to SifiBank’s insolvency. If the third-largest U.S. bank were to fail, it would send shock waves through an already weak financial sector potentially resulting in a cascade of bank failures and precipitating an economic depression. But in saving SifiBank, the government risked not only the ire of the U.S. taxpayer but also created a perverse incentive that if a bank was perceived as too-big-to-fail, it could continue to engage in risky behavior knowing that eventually the company would be bailed out.
The government financing for Sifibank came with several strings attached. The government insisted that the CEO and chairman must be replaced as well as several key members of the executive team and board of directors. The bank was also forced into an agreement in which the U.S. Treasury would receive a large number of warrants, effectively allowing the government to exercise options to buy its stock in SifiBank at a favorable price that it held as part of the agreement. The government would also have greater involvement over key decisions for a period of time until the bank was able to repay its obligation to the government. These events ushered in an unprecedented amount of scrutiny for SifiBank and while the morale of company employees took a massive hit, over time it allowed the bank to remake its tarnished image to the public, investors and employees by reinvigorating the principles that had led the company to greatness in its early years.
Within several months of the ouster of the CEO and chairman, the board hired a new CEO, who had formerly been the enterprise CRO of a major competitor and had 20-plus years of banking experience running commercial bank businesses. With this background SifiBank was well on its way to becoming an industry leader in risk management. On the day the new CEO took office he called for the separation of the combined position of CEO and chairman in order to reduce potential conflicts of interest. He further went on to describe his vision for the bank, which was to be built upon a foundation of strong risk management that would allow the bank to operate prudently in all economic environments while positioning itself to grow its businesses profitably and creating significant value for shareholders, customers and employees. SifiBank was to become a risk-centric organization and one that would be admired by its peers and customers over time. But even with that vision, the bank faced regulatory headwinds that posed a number of challenges for the new management team.
BANK REGULATORY LANDSCAPE
Unlike many other industries, the banking sector is heavily regulated by a patchwork of federal and state regulatory authorities. The larger the institution, the greater the regulatory scrutiny that occurs, and this has only heightened since the financial crisis. As a national bank, SifiBank’s primary regulator for safety and soundness of its operation is the OCC. In this capacity, the OCC maintains regular contact with the bank, in fact deploying 75 examiners headed by an examiner-in-charge (EIC). This team actually works onsite at SifiBank and has regular access to management, reports and other information, allowing the examination team to stay abreast of ongoing developments at the bank.
The OCC has a responsibility to ensure the bank operates in a safe and sound fashion and to carry out these responsibilities the OCC conducts periodic standard and as needed targeted examinations. SifiBank receives a 1–5 (best to worst performance) rating each year by the OCC referred to as a CAMELS rating, which comprises an assessment of the bank’s capital adequacy (C), asset quality (A), management quality (M), earnings (E), liquidity (L), and sensitivity to market risk (S). The OCC has an array of punitive actions that it can take to ensure the bank complies with regulatory standards and policies. The examination process is critically important to SifiBank as the OCC’s findings on a particular exam could lead to severe monetary penalties as well as cease and desist orders that could limit the bank’s ability to operate in certain ways. The OCC appears at SifiBank’s board meetings and provides a summary of their findings and any management required actions (MRAs) they demand from the management team following a major exam.
Since SifiBank has a bank holding company structure it is also overseen from that standpoint by the Federal Reserve Board (FRB). As a BHC, SifiBank is subject to a variety of regulations imposed by the FRB, which will also conduct periodic examinations. After the crisis, one of the more significant requirements imposed on SifiBank was compliance with regular stress tests on its capital, a program known as the Comprehensive Capital Analysis and Review (CCAR). The process requires Sifibank to provide detailed data and analysis on its various positions under a set of FRB established stress scenarios. The FRB conducts this on bank holding companies with assets of $50 billion and greater, although it has added an additional 12 financial institutions to this list of 18 BHCs. This is just one of many regulations imposed by the FRB on SifiBank. In addition, SifiBank enjoys access to the Fed discount window, which provides backup low-cost, short-term funding to the bank.
Another important regulator for SifiBank is the Federal Deposit Insurance Corporation (FDIC) that is charged with overseeing the federally insured deposit insurance fund and resolving institutional failures in addition to its examination of state chartered banking institutions. The FDIC sets deposit insurance premiums for the banking system based on a variety of factors including bank ratings and size, among others. As a result, deposit premiums have a risk-based component to incent the right behavior from institutions. Since the financial crisis the FDIC has an increasing oversight of banks due to changes in legislation known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA).
Following the financial crisis, Congress and the Administration came together to pass the most comprehensive legislation to affect the banking industry since the Great Depression: the DFA. The Act touches virtually every aspect of banking and even sets out guidance for regulating nonbank SIFIs. Among key provisions of the Act are regulations regarding derivatives trading such as over-the-counter (OTC) transactions, which includes CDS; securities that experienced significant losses during the crisis; a ban on proprietary trading by banks also known as the Volcker Rule; creation of a new Consumer Financial Protection Bureau (CFPB) and associated regulations on the mortgage industry; establishment of the Financial Stability Oversight Council (FSOC) and its analytics agency, the Office of Financial Research (OFR) charged with overseeing the buildup of systemic risk across the entire financial sector; and establishes an orderly liquidation facility for banks, requiring them to create their own “living wills” for how they would liquidate their operations under an insolvency, among other reasons.
The DFA also put the largest financial institutions – that is, those most likely to be too-big-to-fail – under a new set of regulations known as SIFI designation criteria that expose those firms to heightened supervision