By Debra CopeRodgin Cohen, senior chairman of Sullivan and Cromwell, has been described as the dean of banking M&A lawyers, the trauma surgeon of Wall Street, and a preeminent counselor to the financial services industry. Over more than 40 years, his financial services law practice has encompassed acquisitions, regulation, enforcement, securities law and corporate governance. He recently chatted with ABA Banking Journal Directors Briefing about the challenges currently facing banks of all sizes and their boards of directors.
__________Q How would you characterize the quality of interactions between banks and their regulators and supervisors? A The interactions are absolutely improving, and it is largely due to a change in the supervisory approach, which is less confrontational today than it was in the aftermath of the global financial crisis. It’s not that supervisors are using a light touch, but their attitude has changed to “supervision first,” not “enforcement first.” We are also seeing explicit regulatory recognition that boards cannot and should not perform a management role. There is certainly a change in tone. Q Rising supervisory expectations have been a fact of life for several years. What is your take on the challenges banks face as a result? A I have no quarrel with regulators increasing or changing expectations. The global financial crisis demonstrated the need for more robust regulation. Expectations should become more sophisticated as the world changes. But it is important for supervisors to recognize that compliance takes time, particularly if there is only limited transparency into what the expectations are.
If banks fall short, they should be given a chance to correct a problem before it becomes an enforcement action. Yet very often when a bank is put under, say, an anti-money laundering enforcement action, there will have been little or no criticism preceding it.
There are some positive signs, though. The Federal Reserve’s proposed supervisory rating scale for bank holding companies with more than $50 billion in assets in effect says, if you have a problem, we will give you a second chance to get it right. What the Fed has proposed is that, if you’re doing okay and not being criticized, then you should be given a chance to meet the new expectations before there is an enforcement action and a regulatory downgrade. This proposed guidance is for large banks, but as this mindset takes root, it’s likely to apply to regional and community banks as well.Q What is the biggest minefield right now in terms of enforcement actions?
A There are three: AML, consumer compliance and cybersecurity. In AML, where so many major enforcement actions occur, we see a combination of rising expectations plus a very complex legal and regulatory structure. In consumer compliance, we don’t have complete clarity as to the expectations or even the rules, and a number of banks get tripped up there. The biggest minefield of all is cybersecurity. In my opinion, the industry has actually done a very good job of preparing, but the problem is they are dealing with enormously malevolent forces. We haven’t seen many enforcement actions focused on cybersecurity, but I think we will see more. Q What will it take for banks to reap the benefits of the recently enacted financial reform bill?
A Some of the changes are self-executing, particularly topics such as the Volcker Rule, which made no sense to impose on banks that don’t engage in securities activities. Banks no longer have to put all the compliance mechanisms in place; the requirement has been stripped away.
But it’s not easy to remove some of the regulatory burdens that cause small banks to suffer because there are issues of scale. The cost of AML compliance at a community bank with $500 million in assets is considerably greater in relative terms than the cost to a $50 billion bank. The community bank is not paying only 1/100th of the $50 billion-asset bank’s costs; it’s paying more than that.
One challenge is that no single bank has the capacity to obtain comprehensive information about not only thousands or even millions of its own customers, but also all the other people whose transactions are transmitted through that bank. Regulators really need to encourage banks, particularly smaller and midsize ones, to utilize utility-type functions to deal with these regulatory requirements. Pooling and sharing information would have the double advantage of reducing smaller banks’ burdens and making compliance more effective.
The utility approach wouldn’t have to be limited to AML. If you had 100 banks doing vendor management through a single source instead of banks doing it one by one, you could improve efficiency and outcomes.Q What is the M&A outlook for community and regional banks?
A It’s a mixed picture. There are forces that encourage combinations, including the better regulatory and supervisory tone. There’s a greater regulatory willingness to entertain applications. There are also non-regulatory forces, including the fact that technology is making scale so much more important, and not just in the traditional sense of back office and controls, but in marketing and delivery of services. A feature of all bank deals is substantial synergies, and those synergies are worth 10 percent to 12 percent more now under the tax bill.
But there are also two factors that are discouraging transactions. We are seeing buyers with lower price-to-earnings ratios than their targets, and that can make the math difficult to work. We’ve also seen a negative market reaction this year to the two deals that were valued at more than $2.5 billion. We’re still trying to understand why the market has had that reaction. But the fact is that if you’re a seller that would command a 20 percent premium, but you are seeing buyers’ stocks fall and erase much of that premium after a deal is announced, you’re going to think twice.
I am hopeful that a more considered evaluation will upgrade the market reaction, particularly when you consider the success of such transactions as KeyCorp-First Niagara and Huntington-First Merit.Q What do you see as the most urgent issues right now for bank boards of directors?
A Cybersecurity needs to be front of mind, because it is the existential threat to any bank. Additionally, boards of almost any bank that is publicly traded should be attuned to the possibility of shareholder activism. It may happen relatively rarely, but there is a degree of randomness about where it occurs. A board should be able to deal with activism based on its own judgment rather than being forced to capitulate. If you’re not prepared, an institution that has been performing service to its community can all of a sudden be forced into a sales mode, and that risk deserves the board’s attention.
Crisis management, especially as it relates to gender diversity and sexual harassment, is another key issue to which the board should pay attention. A board needs to plan for both how to recognize discrimination and how to respond forcefully. If you have a 20-person senior executive suite and there’s only one woman, that’s an issue. I do take heart in the fact that an increasing number of banks have women in the role of general counsel. They could be a force for change.Q How do you see smaller and midsize banks fitting into the banking ecosystem?
A We have around 5,600 banks today, and nobody knows what the right number will ultimately be. But we definitely need our community banks. Communities and borrowers benefit from their local banks, and not just in terms of convenience and banking facilities. Banks are critical to the communities they serve, providing not only loans but also leadership and support. Communities really, really hurt when they lose their banks.