The Office of the Comptroller of the Currency’s National Risk Committee, which is tasked with monitoring the overall condition of the federal banking system and any emerging threats to the system’s safety and soundness, released its “Semiannual Risk Perspective for Fall 2016” on January 5. Using data from the first half of 2016, the publication identifies and discusses certain issues posing threats to the safety and soundness of banks – specifically national banks and federal savings associations but applicable to all financial institutions – and their compliance with applicable laws and regulations.
Four Key Risk Themes
Noting that the key issues facing banks are largely similar to those addressed in the Committee’s most recent edition, the report sets forth four “Key Risk Themes”, including:
- Strategic Risk
- Strategic risk remains high due to increased, and continually increasing, consideration and implementation by banks of changes to the traditional business model in an effort to meet, and even increase, target rates of return, particularly given the difficulties presented with low interest rates.
- Banks continue to explore new and improved financial products, services, and processes to meet the changing wants and needs of their consumers and businesses and in response to the entrance of new competitors (such as financial technology firms, sometimes referred to as “fintech” firms).
- Transactional activity – specifically, mergers and acquisitions – is expected to continue as value enhancement, economies of scale, market penetration, and cost efficiencies continue to be highly sought after by market participants.
- The continuation of low interest rates pressures net interest margins and has led banks to explore alternative options, such as extending asset duration, taking additional credit and liquidity risk, and direct investment in alternative and structured products, in an effort to generate greater returns.
- Underwriting Practices
- Underwriting practices and standards continue to ease with regard to credit products as banks attempt to increase loan volume, and in response to the added competition of other bank and non-bank lenders.
- New underwriting practices and standards continue to increase the level of risk by way of increased risk layering, policy exceptions, and loan-to-value ratios, and weaker covenant protection.
- As commercial real estate portfolios have grown over the past three years, the Committee notes its concerns regarding the quality of underwriting, concentration risk management, and weaknesses in stress testing.
- Weaknesses have been identified in some banks’ methodology of allowance for loan and lease losses, specifying lack of appropriate consideration of strong loan growth, increased concentrations of credit, and increased risk appetite as examples of weaknesses.
- Operational Risk
- The “interconnected financial services marketplace” is inherently subject to the risk of sophisticated cybersecurity threats.
- Domestic and foreign third-party relationships continue to increase, which presents risk management issues and, potentially, third-party concentration risk.
- The Wells Fargo scandal reflected a breakdown in the controls of that particular institution’s governance of sales practices and served as a reminder that, among other lessons, trust in the banking system, institutionally and as a whole, can be tarnished.
- Compliance Risk
- Operational efficiency through the increased use of technology has improved access and convenience; however, it has also created the potential for vulnerabilities which can be exploited by criminals, thus increasing the risk for violations of the Bank Secrecy Act and Anti-Money Laundering rules.
- The new and revised consumer protection rules under the Truth in Lending Act, the Real Estate Settlement Procedures Act, and the Military Lending Act (“MLA”) greatly increase compliance risk.
- The Committee afforded special attention to the new requirements under the MLA (under which compliance was required by October 3, 2016) which applied to lending to active duty military personnel and their dependents.
The Committee also discussed other risks that may develop into broader system-wide issues, including:
- The U.K.’s referendum to leave the European Union may require the reassessment of staffing and entity structure, among many other possible effects; and
- Unpredictability in energy prices have contributed to economic and credit quality impact in regions dependent on energy exploration and production.
- Federal banking regulators share similar viewpoints. While the OCC is tasked with the regulation of national banks and federal savings associations, all federal banking regulators (including, but not limited to, the Federal Deposit Insurance Corporation, the Federal Reserve Board, and the National Credit Union Administration) will take note of the guidance offered in the Perspective and will share these viewpoints.
- Risks highlighted in the Perspective will be the focus of examinations and reviews. Financial institutions of all types and sizes should expect to see focus in these risk areas in their examinations and in connection with any reviews.
- Risks are applicable beyond financial institutions. The OCC recently announced that fintech firms may apply for a national charter to become special purpose national banks and, as such, these firms should be cognizant of the risks set forth in the Perspective.
- Focus and prepare. The Wells Fargo scandal served as a reminder not only that trust in the banking system can waver, but also of why these risks should be subject to such scrutiny by financial institutions. In order to avoid a similar outcome, all financial institutions must intently focus on and actively prepare for these risks.
 Comptroller of the Currency Thomas Curry said that the OCC has “initiated a broader review to assess whether similar [sales] practices and weaknesses are occurring in other large and midsize banks.”