:•
 

The Meeting ofthe Advisory Committee on Community Banking
 

ofthe
 

Federal Deposit Insurance Corporation
 

Held in the Board Room
 

Federal DepositInsurance Corporation Building
 

Washington,D.C.
 

Open to Public Observation
 

Apri13,2013 — 8:31 A.M.
 

The meeting ofthe FDIC Advisory Committee on Community Banking("Committee")
 

was called to order by Martin J. Greenberg,Chairman,Federal Deposit Insurance Corporation
 

("FDIC")Board ofDirectors.
 

The members ofthe Committee present at the meeting were: Robert F.Baronner,Jr.,
 

President and ChiefExecutive Officer("CEO"),Bank ofCharles Town,Charles Town,West
 

Virginia; Cynthia L.Blankenship,Vice Chairman and ChiefOperating Officer,Bank ofthe
 

West,Grapevine,Texas; Leonel Castillo,President and CEO,American Bank ofCommerce,
 

Provo,Utah; Jane Haskin,President and CEO,First Bethany Bank &Trust,Bethany, Oklahoma;
 

Mark Hesser,President,Pinnacle Bank,Lincoln,Nebraska;James Lundy,CEO,Western
 

Alliance Bank,Phoenix,Arizona; Ann Marie Mehlum,CEO,SummitBank,Eugene,Oregon;
 

Kim D.Saunders,President,CEO and Director, Mechanics &Farmers Bank,Durham,North
 

Carolina; Dorothy A.Savarese,President and CEO,Cape Cod Five Cents Savings Bank,
 

Orleans,Massachusetts; David Seleski,President, CEO and Director, Stonegate Bank,Fort
 

Lauderdale,Florida; Alan Thian,President and CEO,Royal Business Bank,Los Angeles,
 

California; and Derek Williams,President and CEO,First Peoples Bank,Pine Mountain,
 

Georgia.
 

Carolyn"Betsy"Flynn,President and CEO,Community Financial Services Bank,
 

Benton,Kentucky; Walter E. Grady,President and CEO,Seaway Bank and Trust Company,
 

Chicago,Illinois; and Joseph G.Pierce,President and CEO,Farmers State Bank,Lagrange,
 

Indiana, were absentfrom the meeting.
 

Members ofthe FDIC Board ofDirectors present at the meeting were: Martin J.
 

Greenberg,Chairman,Thomas M.Hoenig,Vice Chairman,and Jeremiah O.Norton,Director
 

(Appointive).
 

Corporation staff who attended the meeting included: Ruth R.Amberg,Valerie J. Best,
 

Richard A.Brown,Kymberly K.Copa,Carolyn Curran,Christine M.Davis,Patricia B.Devoti,
 

Apri13,2013
 
190 

Dianne E.Dixon,Thomas J. Dujenski,Doreen R.Eberley,Bret D.Edwards,Diane Ellis, Robert
 

E.Feldman,George French,Andrew Gray,Shannon N.Greco,Marianne Hatheway,William H.
 

Henley,Jr., Alan W.Levy,Christopher Lucas,Roberta K.McInerney,Jonathan N.Miller,
 

Robert W.Mooney,Arthur J. Murton,Thomas E.Nixon,Richard Osterman,Tanya F. Otsuka,
 

Bimal V.Patel, Mark E.Pearce, Sylvia H.Plunkett,Paul Robin,Claude A.Rollin, Barbara A.
 

Ryan,Eric J. Spitler, Kristin A.Strong,and James C. Watkins,
 

William A.Rowe,III, Deputy to the ChiefofStaffand Liaison to the FDIC,Office ofthe
 

Comptroller ofthe Currency,was also present at the meeting.
 

Chairman Greenberg welcomed the Committee members and said that the FDIC greatly
 

valued its work and advice. He introduced the eight newest Committee members and gave an
 

overview ofthe day's discussion topics. Chairman Greenberg introduced ChiefofStaffBarbara
 

Ryan,who moderated the day's meeting.
 

Ms.Ryan introduced Arthur J. Murton,Director, Division ofInsurance and Research
 

("DIR")and Richard A.Brown,Acting Deputy Director and ChiefEconomist,DIR,who led the
 

discussion titled,"Follow-up on the FDIC's Community Bank Initiatives." Mr.Murton noted
 

the FDIC released the"FDIC Community Banking Study"in December 2012,after the last
 

Committee meeting,in which he and Mr.Brown gave the Committee a preview ofthe study's
 

findings. He discussed the purposes behind the study,adata-driven attempt to documentthe
 

trends in community banking over the previous 25 years. Mr. Murton also discussed the study's
 

general contents, which include: defining what a community bank is; documenting the changes
 

in their structure over 25 years; discussing their geographical distribution; comparing
 

performance differences between community and noncommunity banks,and among community
 

banks;reviewing capital formation trends; and summarizing the results ofinterviews conducted
 

with a group ofcommunity bankers on the topic ofregulatory compliance costs. Mr.Murton
 

said the FDIC was interested in the Committee'sfeedback on any ofthe study's topics.
 

Mr.Brown provided an overview ofthe study's findings(referring to a slide presentation
 

titled,"FDIC Community Banking Study"). Regarding the definition ofcommunity banks,he
 

said previous definitions had typically been associated with smaller institutions. He said thatthe
 

number ofsmaller institutions had declined during the study period of1984 through 2011,by
 

about 10,500 institutions. Mr.Brown noted thatthe decline in numbers did not mean the
 

extinction ofsmall institutions, however. The study found,he said,that small institutions
 

survived more often, and merged and failed less often than most other size groups. Mr.Brown
 

said the FDIC study did not rely solely on size, but also included other attributes commonly
 

associated with community banking,such as: afocus on lending and core deposit gathering,as
 

well as a limited geographic scope ofoperations.
 

After providing details about the definition, Mr.Brown observed that about95 percent of
 

banking organizations in 2010 were community banks,a percentage that had not changed greatly
 

over many years. Mr.Brown said an important result ofthe FDIC research definition was it
 

enabled some 330 organizations with total assets over $1 billion to be considered community
 

banks,thus distinguishing the study from previous studies that relied solely on size. Mr.Brown
 

Apri13,2013
 
191
 

said the FDIC had considered including information about local ownership ofthe bank,but noted
 

that data was not easily accessible.
 

Mr.Brown also discussed long-term industry consolidation trends. He said that while all
 

ofthe net consolidation since 1984 had occurred among banks with less than $100 million of
 

assets(and particularly among those with less than $25 million ofassets), one should not
 

automatically conclude that these institutions were less successful than those that started outin
 

one ofthe larger size groups. Regarding institutions with less than $100 million ofassets in
 

1984,Mr.Brown said 34 percent ofthem survived as charters into 2011(more than any other
 

size group),and that they failed less often than most other size groups, merged less often than all
 

other groups,and consolidated at about the same rate as others. He noted that over 2,500 ofthe
 

1984 small charters grew into larger size groups by the end ofthe study period.
 

Mr.Brown said about2,500 institutions failed in the study period. Mr.Brown said a big
 

driver ofconsolidation wasrelated to the relaxation ofgeographic restrictions on banking that
 

occurred in the late 1980s and 1990s. He said that after those deregulatory events there was a
 

wave ofmergers and intra-company consolidations within banking companies;he indicated
 

about 80 percent ofthe number ofinstitutions that exited the industry did so due to voluntary
 

mergers and consolidations. Mr.Brown said this relaxation ofgeographic restrictions on
 

banking was unlikely to be a driver ofconsolidation in the future. Mr.Brown said the FDIC
 

reviewed the question ofwhether that consolidation was related to economies ofscale, or that
 

banks needed to be a certain size threshold(such as $2billion or more)to achieve such
 

economies ofscale. He said the FDIC found that average costs among community bank
 

commercial real estate("CRE")lenders declined with asset size up to about $100 million, but
 

there was not much cost reduction above that level. Thus,he said,the results did not confirm
 

that economies ofscale were an important driver ofconsolidation among community banks.
 

Mr.Brown also noted that new bank chartering activity had been cyclical over the study
 

period,and thatthe FDIC anticipated new chartering would increase as the economy recovered.
 

Mr.Brown said geography was another important element in understanding community banking.
 

Community banks are widely distributed across the country,in metropolitan areas, micropolitan
 

areas(towns between 10,000 and 50,000 residents), and rural areas, he said, while
 

noncommunity banks are more focused on metropolitan counties. He noted that more than 85
 

percent ofthe U.S. population lives in metropolitan counties,that mostofthe gross domestic
 

product is generated in them,and thatthey have grown faster than rural counties,ofwhich some
 

50 percent experienced depopulation between 1980 and 2010. Thus,he said,a community bank
 

focus on rural and micropolitan areas was not a recipe for growth. Mr.Brown said that
 

community banks hold most ofthe deposits in rural and micropolitan counties, but have lost two-


thirds oftheir market share ofdeposits in metropolitan areas, as noncommunity banks amassed
 

an 86 percent share ofindustry assets.
 

Mr.Brown said the FDIC also compared earnings performance between community and
 

noncommunity banks. He said noncommunity banks had experienced a sizeable earnings
 

advantage in the 15 years before the recent financial crisis, which growth was driven largely by
 

noninterest income. Mr.Brown observed that while noncommunity banks have been better able
 

to generate income offthe balance sheet,community banks have had an advantage in provision
 

Apri13,2013
 
expenses and expense ratios, and earned more net interest income than noncommunity banks for
 

mostofthe study period. Mr.Brown also compared financial performance using the efficiency
 

ratio, or the ratio ofoverhead expenses to net operating revenue. Community banks' efficiency
 

ratio deteriorated in the study period while noncommunity banks improved theirs in the pre-crisis
 

years. Mr.Brown noted that net interest income was an importantfactor in the efficiency ratio
 

and said that the recent period oflow interest rates had a negative effect on community banks
 

that tend to rely on depositfunding. Mr.Brown said,ifone disaggregated the components ofthe
 

change in the community bank efficiency ratio, more than 70 percent ofthe cumulative
 

deterioration in the community bank ratio since 1998 could be explained by the decline in net
 

interest income alone.
 

Mr.Brown said the FDIC also compared the long-term earnings performance and failure
 

experience ofcommunity banks by five lending specialties(mortgage,consumer,CRE,
 

commercial and industrial, and agricultural)and diversified(no specialty). He said that the
 

highest performers in terms ofreturn on assets were agricultural specialists, diversified nonspecialists, and consumer specialists(which is currently a very uncommon specialty). The lower
 

performers were CREand multi-specialty banks. Mr.Brown observed that the percentage of
 

community banks specializing in CRElending had increased to 30 percent by 2006. He said that
 

the average earnings ofCRE specialists had been reduced by the crisis periods ofthe late-1980s
 

and the last five years. Mr.Brown further noted that CRE specialized banks had failed at twice
 

the rate ofthe average community bank during the study period as a whole. Mr.Brown said the
 

study looked at capital formation and whether community banks have access to external capital
 

sources. He said they found that retained earnings accounted for most community banks'
 

additions to capital. He said capital formation through retained earnings required both: healthy
 

earnings and an institution that does not grow faster than its market and its earnings. Mr.Brown
 

said only 19 percent ofcommunity banks had raised external capital frequently during the study
 

period. Usually,banks that raised capital from external sources were either troubled or preparing
 

for an acquisition, he said.
 

1V1r. Brown said the FDIC was interested in measuring regulatory compliance costs but
 

noted that the Call Report does not distinguish between regulatory and non-regulatory costs. He
 

said the FDIC interviewed nine community bankers on the issue. Generally,the community
 

bankers reported they experienced a cumulative effect ofregulations over time that had required
 

them to hire additional staff, but all ofthem said they were unable to separate regulatory costs in
 

an accounting sense without incurring a significant expense.
 

In response to a question from Member Seleski aboutthe likelihood ofnew bank
 

charters, Mr.Murton noted they were a cyclical phenomenon and there will likely be more
 

demand for new charters as the economy improves. He noted that new charters raised a policy
 

question for the FDIC because some areas that saw higher bank failure activity were those that
 

had experienced greater new chartering earlier. Mr.Murton said a subject for future research
 

would be to compare the tradeoffcosts between allowing new capital to enter markets through
 

new charters and the cost to already established banks through higher deposit insurance
 

premiums caused by increased failure rates.
 

Apri13,2013
 
~~
 

Member Savarese asked ifthe FDIC had identified any secular(as contrasted with
 

cyclical)trends that warranted further research,such as the depopulation ofrural areas. Mr.
 

Brown responded that the shifts in community bank lending specialty lending groups,especially
 

the shift to CRElending, may warrantfurther research. He noted that the increase in banks
 

engaged in a CRElending specialty may be a trend for the community bank industry as a whole
 

and that, while such lending is important to the local economies where it occurs,it can also be
 

risky. Mr.Brown agreed with Mr.Murton that further research was warranted into the
 

appropriate balance between the social benefits ofincreased CRElending specialties as a source
 

ofcredit and a source ofeconomic growth in communities and the social costs ofincreased
 

failures due to balance sheet concentrations in this line ofbusiness.
 

Member Castillo asked ifthe FDIC anticipated a continuation ofthe consolidation of
 

smaller bank charters in metropolitan areas; he said he expected it would continue. Mr.Brown
 

agreed there would be more consolidation butthat the faster pace may not continue. He noted
 

that,in studying community banks,the FDIC had also studied noncommunity banks,and how
 

they had increased their share ofindustry assets(558 noncommunity charters held more than 80
 

percent ofassets at the end of2011,up from less than halfin 1984). Mr.Brown described how
 

the noncommunity banks had increased their asset share,including: acquiring(directly or
 

indirectly) more than 10,000 charters in the study period; changing locations to fast-growing
 

metropolitan areas; and shifting to fast-growing retail lines ofbusiness. He said it would be
 

interesting to see ifnoncommunity banks maintained a similar pace ofgrowth going forward,
 

and that the outcome would have implications for consolidation rates among community banks.
 

Member Hesser commented aboutthe FDIC study's limitation ofthe definition of
 

community banks to two or fewer large metropolitan areas; he said that he viewed his bank as a
 

community bank in model and management philosophy although it operated in four metropolitan
 

areas. He also indicated that he did notfavor looking for a definition ofa community bank as a
 

basis for imposing tiered regulatory requirements. Mr.Brown noted that the FDIC study
 

definition,like all study definitions, had to set an arbitrary line in its effort to capture community
 

bank qualities and that the definition was notintended to have any regulatory significance. He
 

also observed that many statutes and regulations already used size-based definitions.
 

Member Mehlum complimented the study,particularly its lending specialization
 

information, which she viewed as new,and the study's quantification ofother information. She
 

also shared her view that noncommunity banks experienced regulatory compliance cost
 

economies ofscale that community banks did not share. Member Mehlum said her view was
 

based on her observation thatthe percentage ofemployee time spent on regulatory compliance
 

had increased significantly from the mid-1980s to the present. In her estimation, about 3 percent
 

oftotal salaries(plus or minus2percent)was devoted to compliance in the earlier period,but
 

was about 30 percent today. She described how a 10-times larger bank in her market made a
 

similar review and estimated the percentage oftotal salaries devoted to compliance to be about
 

15 percent. Member Mehlum shared a chart illustrating her conclusions with other Committee
 

Members and FDIC staff(the chart is titled,"Salaries and Employee Benefits Expense to
 

Average Assets, 1985-2011"). In response to a question from Director Norton,Member Mehlum
 

said that her estimates were for all employee regulatory compliance time,without specific
 

distinction between the types ofregulations. Member Mehlum said thatthe regulatory burden
 

Apri13,2013
 
was heavy on community banks and getting heavier and that the subject deserved continued
 

regulatory agency attention. She observed that people entering the banking industry today see
 

the current regulatory burden asjust"part ofdoing business" whereas her longer perspective
 

allowed her to see the increase in regulatory burden. Mr.Brown thanked Member Mehlum for
 

her useful perspective and noted that people in the industry may be in a better position to
 

understand their cost structure than agency economists. Member Williams said that he thought
 

the 20 percent estimate ofemployee time devoted to regulatory compliance might be low. He
 

indicated that his employees were too busy dealing with compliance to calculate the time spent,
 

but added that the industry needed to improve its quantification ofregulatory compliance costs.
 

Member Seleski observed that comparisons between the 1980s and the present were difficult
 

because technology had made banks much more efficient. Heindicated thattechnological
 

efficiencies gained over time would tend to obscure the increased time spent on compliance.
 

Member Lundy said he thought the community banking study was excellent and timely
 

but indicated it may have paid insufficient attention to the impact ofincreased capital
 

requirements, which he viewed as a critical issue. He inquired ifincreased capital requirements
 

were put into the study's model retrospectively, whether the community bank model would be as
 

successful? Member Lundy observed that a9percent capital requirement compared to a6
 

percent one would require a bank to be 15 percent more efficient in order to provide the same
 

return to its investors. He also noted that community banks had not historically had easy access
 

to capital markets for capital formation. Member Lundy said he thoughtthat adding increased
 

capital requirements to the study's analytical elements would lead to more accurate conclusions
 

concerning community banks,which are an important part ofproviding financial services in non-


metropolitan locations. He added that atwo-tiered regulatory system might be needed.
 

Regarding capital requirements, Member Blankenship indicated that they should be based on a
 

risk-based model;she observed that modeling the risk ofa community bank and a"too big to
 

fail" bank were very different. She inquired whether the FDIC was going to explore those
 

differences further. Mr.Brown agreed that the business models ofthe two bank types were quite
 

different and discussed some ofthe differences. He said it makes sense to look at both types of
 

banks when considering competitive issues.
 

Member Raskin said she wasinterested in the increases in CRElending the study found.
 

She said that her small business lending experience in Oklahoma,which experienced oil booms
 

and busts, was it was better to rely on real estate that a small business owns rather than accounts
 

receivable, which is riskier. Member Raskin also inquired ifthe FDIC had seen any correlation
 

between the repeal ofthe Glass-Steagall Act and the divergence in business models between
 

community and noncommunity banks. She said her observation was that community banks
 

continued with their business model after repeal but noncommunity banks pursued a different
 

risk profile. Mr.Brown said the FDIC had noted similar correlations. He noted the study's
 

comparisons used weighted averages, and that the very largest institutions dominated the
 

noncommunity bank averages. Mr.Brown continued that the largest banks could generate a
 

large amount ofincome offtheir balance sheets(from such things as capital market activities,
 

servicing income and service charges on deposits). He said community bank non-interest
 

income was also somewhat diverse but raised much less in the area ofcapital markets. Mr.
 

Brown said the very largest banks ability to generate market-related revenue had been a
 

competitive advantage to them in the decade preceding the financial crisis.
 

April 3,2013
 
195
 

Member Savarese said that she had spoken to many community bankers and thought
 

there was a convergence ofseveral secular changes that mighttip community bankers toward
 

consolidation in the future. One change,she said, wasthe reinvention ofthe payments system
 

outside the regulated banking industry. She said this took away a traditional function that banks
 

provide on the liability side oftheir balance sheet. Member Savarese said that a second issue
 

wasthe difficulty ofadjusting to the new circumstances ofmortgage lending,including the new
 

Consumer Financial Protection Bureau("CFPB")rules. She noted that a significant amount of
 

mortgage lending was occurring outside ofregulated institutions altogether. Member Savarese
 

said many smaller institutions had indicated to her that they might have to exit mortgage lending
 

because ofthe pace ofregulatory change and onerous penalties ofnoncompliance. She also
 

noted another cost ofregulatory compliance wasthe cost ofconsultants,as well as the cost of
 

employees. In light ofthe convergence ofthese issues, Member Savarese inquired what
 

community banks'source ofrevenue would be in the future? She suggested that it might be
 

productive to inquire with community bankers how these issues impacted their business models
 

and future plans.
 

Member Mehlum observed that credit unions had increased their consumer lending
 

rapidly, at the expense ofbanks. She said that banks maybe moving into new lending specialties
 

because ofthat loss ofmarket share more than by strategic design. Mr.Brown said the FDIC
 

study had shown a significant drop in consumer lending specialists among community banks,
 

from aboutten percent to less than one percent in the study period. Member Castillo said
 

concern about compliance costs was causing community bankers to discuss withdrawing from
 

the consumer side ofthe business for funding their balance sheets. He said such a change could
 

have far reaching effects, particularly for the FDIC as the insurer ofdeposits.
 

Member Castillo asked ifFDIC bank examiners were obtaining any insights into what
 

smaller banks planned to do to address the higher costs ofregulation,and doing business
 

generally. Doreen Eberley,Director, Division ofRisk Management Supervision("RMS"),noted
 

that some institutions were relying on outside assistance,including trade associations and FDIC
 

technical assistance,in order to understand changes to the regulatory framework. To respond to
 

shrinking margins,she said some banks were reaching for yield. In addition, she said,the FDIC
 

was seeing institutions rely on third party providers to offer new products and services rather
 

than hiring new employees. Member Castillo agreed that most community bankers were using
 

mostofthe avenues that Ms.Eberley described. He expressed concern,however,whether all of
 

those "little steps" would be sufficient to provide a satisfactory return on investment for potential
 

community bank shareholders. Mr.Brown noted that interest rate margins had been tight and
 

there had not been much loan growth. Heindicated that, eventually,a period ofeconomic
 

growth,more lending opportunities and higher interest rates would improve conditions for
 

community banks.
 

Chairman Greenberg observed the economic environment had been very difficult since
 

2007 and that the financial crisis had been profound and wasfollowed by a severe recession. He
 

said there might be atendency to focus on the recent past and assume it was prologue,butthat
 

there was reason to think the economy was moving out ofthe very difficult environment and
 

there would be increased economic growth,demand for credit and an improved interest rate
 

April 3,2013
 
•;~
 

environment. Chairman Gruenberg said the community bank business model had been quite
 

resilient during this extraordinarily bad period. He indicated that community banks that followed
 

their traditional business model would benefit as the economic environmentimproves.
 

Chairman Greenberg noted that mostofthe community banks that failed in the recent
 

crisis had generally departed from their business model,and were high-flyers,trying to earn
 

money quickly while relying on volatile deposits. Member Mehlum remarked that the response
 

to the financial crisis rewarded the highest-fliers which had putthe global economy at risk, and
 

made them bigger and stronger. Chairman Greenberg agreed that community banks had not
 

been the cause ofthe crisis and said he hoped that community banks that followed their
 

traditional business model would be rewarded in an improving economic environment. Member
 

Williams agreed that the community banking model had been tested and shown to work. He
 

expressed concern,however,whether the model would continue to work under what he
 

described as the more restrictive regulatory environment resulting from the Dodd-Frank Wall
 

Street Reform and Consumer Protection Act("Dodd-Frank Act")and the CFPB.
 

AtChairman Gruenberg's request, Mr.Murton discussed areas ofresearch the FDIC may
 

pursue in the future. These included,he said, developing a better understanding ofowner-


occupied CRElending,how community banks fund their growth,and monitoring consolidation
 

trends. Mr.Murton said the FDIC would review its chartering policy and its implications,and
 

try to obtain better information about regulatory compliance costs,perhaps including some
 

additions to the Call Report. He said another area for further research wasthe impact of
 

technological change on community banking. Member Savarese suggested the FDIC could also
 

study two additional areas: multi-family housing and the overhang ofstudent debt. Later,
 

Member Savarese observed that a great deal ofeconomic activity occurs outside ofthe regulated
 

financial services industry and suggested that future FDIC studies try to consider that fact. Mr.
 

Brown noted the FDIC was also continuing to monitor the potential for a bubble in farmland
 

lending. In response to a question from Member Saunders, Mr. Murton said the FDIC would
 

study larger, noncommunity banks in order to understand community banks. He said the FDIC
 

would continue to explore whether the largest banks have advantages in regulatory compliance
 

due to economies ofscale. Member Saunders suggested that noncommunity banks could be
 

good early indicators ofanother financial crisis. He also observed that they typically drive the
 

community bank business model even ifthe community model is different.
 

MemberLundy inquired ifthe FDIC had considered how it should change its supervisory
 

approach in light ofthe 470 bank failures in the recent crisis, particularly regarding CRE
 

concentrations. Ms.Eberley said the FDIC had thought about it and referred to an FDIC Inspector
 

General reportthat discussed community banks that had been heavily concentrated in CRE and
 

either remained well-rated during the crisis or became troubled butimproved. She said that those
 

CRE concentrated banks had two characteristics that helped explain their good results. One
 

characteristic, she said, was that, whenthey exceeded concentration thresholds that mandated
 

heightened supervisory attention,the banks adhered to the regulatory guidance: they monitored
 

marketconditions,adjusted their internal concentration limits, and stress tested their portfolios. The
 

second characteristic wasthatthey heeded regulatory warnings and changed their practices when
 

examiners criticized their actions. Ms.Eberley said the FDIC would focus onthe heightened
 

Apri13,2013
 
supervisory expectations when circumstances warranted,and ensure banks were following the risk
 

management practices outlined in the guidance,particularly as risk is building.
 

Ms.Ryan introduced Sylvia H.Plunkett,Senior Deputy Director,Compliance and CRA
 

Exams and Enforcement,Division ofDepositor and Consumer Protection("DCP"),who,with RMS
 

Director Eberley,moderated the panel titled,"Next Steps: Outreach and Technical Assistance."
 

Ms.Eberley noted that the FDIC's Community Banking Initiative had a variety ofcomponents,
 

including outreach to bankers. The outreach efforts had identified four commonthemes ofbanker
 

interest: 1)streamlining the examination process,especially the pre-examination stage;2)
 

improving communications between the FDIC and banks,generally;3)expanding outreach and
 

technical assistance; and 4)helping banks understand and keep up with the rulemaking process.
 

The current panel's focus was outreach and technical assistance. Ms.Eberley and Ms.Plunkett
 

described six videos being released that day,and those to be released later inthe year,to provide
 

bank directors, officers and employees with useful information on areas ofsupervisory focus and
 

new rulemakings. Ms.Eberley said the videos would help new directors understand their
 

responsibilities and regulatory expectations. The six videos being released the day ofthe meeting
 

show anew bank director who learns about her responsibilities in thatrole and the FDIC
 

examination processes.
 

Ms.Plunkett continued,describing asecond set ofvideos to be released later in 2013. She
 

said these videos, also for directors, would be somewhatlonger than the first six and would address
 

six topics: interest rate risk("IRR"),third-party relationships,corporate governance,the
 

Community Reinvestment Act,informationtechnology("IT"),and the Bank Secrecy Act("BSA").
 

Ms.Plunkett also described athird set ofmore in-depth videos directed to the needs ofbank officers
 

and others who need to know better how to comply with various regulations. The first six topics in
 

this third set ofvideos would address:fair lending; appraisals and evaluations;IRR;troubled debt
 

restructuring("TDR")and allowance for loan and lease losses("ALLL");evaluation ofmunicipal
 

securities; and flood insurance. Ms.Plunkett said that afinal set ofvideos would focus on complex
 

regulations as they are proposed;the videos would describe the requirements and expectations of
 

the regulations for bankers so that they could be better prepared to commentaboutthem. Ms.
 

Plunkett said that,in addition to the videos,the FDIC would continue the Directors' College
 

programs in the regions,industry-wide teleconferences and in-person outreach. Ms.Eberley then
 

demonstrated how bankers could find various resources onthe FDIC website and the Committee
 

viewed one ofthe first set ofdirector videos.
 

Member Seleski said thatthe FDIC's communications had definitely improved over the
 

pastfive years,especially regarding supervisory expectations. Members Seleski and Lundy said
 

thattheir staffs had found an FDIC seminar on TDR's very useful. Ms.Eberley noted that the TDR
 

program had been developed in the San Francisco region and wasthe basis for other regions'
 

outreach and the TDRvideo. Member Thian also complimented the in-person outreach his bank
 

had received from the FDIC aboutits policies and procedures.
 

The Committee discussed various aspects ofenterprise risk management. Member
 

Savarese complimented the FDIC'srecent communications and outreach efforts, butsaid there was
 

alack ofclarity on FDIC expectations regarding enterprise risk management. The lack ofclarity,
 

she said,resulted in community banks engaging consultants, which had a negative effect onthe
 

Apri13,2013
 
• •,
 

banks'slim margins. Member Savarese suggested that FDIC outreach on enterprise risk
 

management would be timely and ofgreat interest. Ms.Eberley clarified that FDIC does not expect
 

community banks to purchase or adoptformal enterprise risk managementprograms. Ms.Eberley
 

and Member Savarese discussed the scope ofthe FDIC's expectations and whether they were
 

limited to the IT examination or were broader. Member Savarese indicated she thoughtthatthe
 

FDIC's expectations were notlimited to IT butthatthe FDIC was actually examining to whether the
 

institution has an overarching structure to manage risk. She suggested thatthe FDIC consider ifits
 

written guidance was up to date with its actual expectations.
 

Ms.Eberley said the FDIC examines under the framework ofthe Standards ofSafety and
 

Soundness,at 12 C.F.R.Part 364,which speaks to the FDIC's risk managementexpectations. She
 

said she appreciated the feedback and that,although the FDIC's expectations have notchanged,she
 

would make sure to further consider ifthe FDIC needed to make its expectations clearer. Member
 

Savarese clarified that she had not meantthe FDIC's expectations had changed butthat its
 

expectations as to methodology --including formality, governance processes,and documentation-­

had increased. In response to a questionfrom Chairman Greenberg,Member Savarese said that
 

"enterprise risk management"was aterm that FDIC examiners used and there was alack ofclarity
 

aboutits meaning. She said the FDIC's classification ofenterprise risk managementas an IT subexaminationissue maylead to the false premise that it is only an IT issue. Member Savarese
 

suggested the FDIC reassess its examination methodology so that institutions understand it is an
 

enterprise-wide governance and policy and procedure issue. Member Hesser said that,in the
 

Kansas City region,he had not heard FDIC examiners use the term "enterprise risk management"
 

although it had been discussed by consultants in previous years. Member Blankenship also
 

indicated the term was not used in the Texas area.
 

Member Castillo suggested that examinations could benefit ifthe FDIC ensured that there
 

was more philosophical consistency from one year's examination to the next. He noted that, while
 

all examiners appear fully qualified,they bring different backgrounds and expertise. As a result, he
 

said,a bank can have similar facts and processes in two examinations but be criticized in the second
 

one. He suggested that a bank that had an acceptable enterprise risk managementand wasin the
 

process ofamending it to respond to changed circumstances at the bank,should not be criticized.
 

Ms.Eberley noted the FDIC's safety and soundness standards are risk focused. The risk
 

managementpractices for audit systems,internal controls,monitoring ofgrowth,monitoring
 

concentrations,quality ofearnings,and ALLL need to be appropriate to the size and complexity of
 

the institution. She said the FDICfaced the challenge,in drafting guidance,between providing
 

sufficient clarity and being too prescriptive. Member Blankenship indicated she favored more
 

general guidelines because community banks have basic models which they customize to measure
 

the risks presented by the business niches they have chosen. Member Lundy said that his bank's
 

holding company was regulated bythe Federal Reserve and had adopted a relatively formal
 

enterprise risk management program,which he believed the Federal Reserve appreciated. He said
 

the FDIC examiners at his bank acknowledged the holding company's program was a good wayto
 

frame the overall risk approach,but were not prescriptive or focused onthe terminology used. Ms.
 

Eberley said that examiners should focus on a bank's risk management practices and should discuss
 

them in the examination report.
 

Apri13,2013
 
•• 

In response to a question from Member Baronner,Ms.Eberley said thatthe Directors'
 

College curriculums varied somewhat by regions to respond to more localized issues(such as
 

agricultural lending in the Midwest,IRR in the northeast,TDRsand ALLLin the Westand
 

Southeast). Member Baronner indicated that disengaged boards ofdirectors may have contributed
 

to many bank failures and inquired ifthe FDIC had considered testing board members against a
 

basic curriculum. Ms.Eberley said that bank board members'understanding oftheir
 

responsibilities was an importantissue. She said that the FDIC had learned that,in reviewing
 

applications for depositinsurance,it wasimportantto have afrank and lengthy discussion with the
 

organizing group so they would have a clear understanding oftheir responsibilities from the start.
 

Member Baronner complimented aDirectors' College program his bank had used in West Virginia
 

and indicated that webinars were acost-effective wayfor smaller banksto educate their directors.
 

Member Mehlum complimented the FDIC's coordination with trade associations and agreed that
 

telephone conferences and other FDIC outreach was a wayfor smaller banksto obtain some
 

economies ofscale.
 

Chairman Greenberg noted that the Committee's earlier suggestions had been an impetus
 

for the FDIC developing online video technical assistance. He agreed that, by providing technical
 

assistance,the FDIC could help banks meettheir regulatory obligations and,perhaps,address
 

compliance cost issues,since it mightrelieve the need to hire consultants. Chairman Greenberg
 

invited further community banker input because he thoughtthe subject merited continuing FDIC
 

attention. Member Saunders said the FDIC'stechnical assistance had been excellentin the past and
 

complimented the current effort. For future training,she suggested modules on: mobile banking,
 

paymentsystems,deposit operations,and the use ofsocial media. Member Savarese said the
 

materials for bank directors were very helpful and inquired ifthere was a direct FDIC contact point
 

for directors who had questions. Ms.Eberley said that, although there wasno direct telephone line
 

for bank directors,the FDIC encouraged banker contacts and that bankers could uses various
 

methods,including a direct email address to her(direct~rrms ,fdic. ov),the regional office staffs,
 

the Ombudsman,and questions at outreach events. Member Baronner complimented the
 

Ombudsman program which had provided helpful explanations ofissues during the recent difficult
 

years. He suggested the FDIC consider having the Ombudsman make annual visits to banks as part
 

ofits outreach program. Member Blankenship suggested thatthe FDIC consider including
 

examples of"whatnotto do"in their training modules;she suggested such examples would be
 

interesting to bankers as well as instructive. Members Williams and Lundy agreed and discussed
 

benefits ofnegative examples. Ms.Eberley agreed that a"case study"can be helpful and thatthe
 

FDIC uses aform ofthem in teleconferences when examinations reveal that multiple banks are
 

heading downthe same path and raising acommonsupervisory issue. Chairman Greenberg said he
 

thoughtthe discussion had been very helpful.
 

The Committee stood in recess at 10:30 a.m. and reconvened at 10:51 a.m.that same day.
 

Ms.Ryan introduced the panel titled "Hot Topics in Supervision," which was moderated
 

by RMSDirector Eberley, Mark Pearce,Director,DCP,Thomas Dujenski,Regional Director,
 

Atlanta.Region,and Daniel Frye,Boston Area Director. Ms.Eberley noted that atthe previous
 

Committee meeting,Regional Directors gave an overview ofthe regions' risk managementand
 

consumer protection supervisory focuses. For this panel discussion,there would be more in-depth
 

focus on managing third-party risk and IRR. Mr.Pearce noted the Committee had requested
 

Apri13,2013
 
200 

examples ofwhatinstitutions should not do and said the first presentation would provide some of
 

that. Mr.Pearce said that,as the economy emerged from the financial crisis,community bankers
 

have reported weak loan demand and margin compression within the low interest rate environment.
 

In light ofthese circumstances,he said,some institutions were looking for opportunities to generate
 

earnings and revenue and some had considered partnerships with third parties who would offer
 

products to the bank's customers. The relationships, Mr.Pearce said,raised issues ofthird-party
 

risk, which Mr.Dujenski would speak aboutfurther.
 

Mr.Dujenski noted that banks enter into third-party relationships because they are
 

outsourcing certain operational functions or to offer products the banks do not originate. He
 

emphasized a bank board and managementneeds to have a robust program for managing the risks
 

that are presentin such situations,such as: strategic risk,reputational risk, credit risk, and the
 

possibility ofviolating applicable laws and regulations. While manyinstitutions do a goodjob of
 

managing the various risks, Mr.Dujenski said the FDIC had seen examples ofbanks that had not.
 

He discussed three examples. The first example Mr.Dujenski discussed involved a bank that
 

entered into relationships to process automated clearinghouse("ACH")transactions. He noted that
 

the small community bank started the relationship on a small scale but eventually had relationships
 

with 20third-party payment processors which covered over 10,000 merchantcustomers,such that
 

the bank was processing over 5 million transactions per month worth billions ofdollars. Mr.
 

Dujenski said the bank's processes and procedures failed to grow commensurate with the
 

relationship's growth. He noted that the institution did not have sufficient due diligence processes
 

in place for new merchants. It also did nothave: adequate training and expertise,internal controls,
 

or IT operations appropriate for the transaction volumes. For example,although the bank's policy
 

indicated they would review each new merchant,the bank,in fact, had only one employee
 

managing and supervising the huge numbers oftransactions. Mr.Dujenski said the lack ofproper
 

oversight resulted in: the bank dealing with high risk originators,including payday lenders;and for
 

illegal gambling operations, which resulted in a significant volume ofunauthorized transactions and
 

potentially fraudulenttransactions. Mr.Dujenski said the bank's failure to properly manage its
 

third-party relationship led it to violate the BSA,and to be involved in potentially unfair or
 

deceptive practices. He said the FDIC pursued an enforcement action to correct the deficiencies.
 

Mr.Dujenski discussed asecond example where a bank did not properly manage its third-
 party relationships involving prepaid cards. In this case,the bank wasinsufficiently aware ofthe
 

party it was dealing with or thatthe prepaid cards were used to facilitate payday lending. Mr.
 

Dujenski said thatthe cards also had overdraftfeatures where the overdraft amountallowed was
 

small and mostly consumed byfees. Mr.Dujenski said the bank did not engage in sufficient due
 

diligence or monitoring,and it had IT system deficiencies. He said the bank violated the BSA and
 

there were unfair or deceptive practices concerns because ofundisclosed fees associated with the
 

prepaid cards. The fact that the bank's name was onthe cards also raised reputation risk for the
 

bank. The third example Mr.Dujenski described involved a bank's offer ofidentity theft protection
 

to customers through a third party. This raised unfair or deceptive practices issues because the bank
 

failed to disclose that all the bank's customers received the identity theft protection without opting
 

in and paying afee;in addition,customers who paid the fee were led to believe they were receiving
 

various additional services when,in fact,they had to take additional steps to receive those services.
 

Apri13,2013
 
Mr.Dujenski noted thatthird-party risk was not new and discussed four guidance
 

documents on the subject. A2008 Financial Institution Letter("FIL"44-2008)provided broad-


based guidance. Later in 2008,the FDIC issued guidance on payment processor relationships in
 

FIL-127-2008. Mr.Dujenski said the sunulier 2011 SupeNvisoryInsightsjournal included an
 

excellent article discussing basic terms and supervisory expectations. The FDIC published afourth
 

guidance documentin 2012(FIL-3-2012)focused on payment processor relationships. Mr.
 

Dujenski discussed certain best practices that are further discussed in the guidance publications. He
 

said it is important,before entering into athird-party relationship,to perform athorough risk
 

assessmentofthe third parties; this would include checking for public complaints againstthe
 

entities and actions taken againstthem. Mr.Dujenski said that bank boards should be actively
 

engaged in the third-party decision-making and should approve the contracts the bank enters.
 

Regarding contracts,he said,they need to fully spell outthe parties' relationships and
 

responsibilities, including how the bank may exit the relationship. Further,Mr.Dujenski said banks
 

need to have good oversight and internal reviews ofthe third party programs.
 

Mr.Pearce noted that problematic third-party payment processors can migrate
 

geographically and maytarget smaller institutions that are particulaxly stressed and looking for fee
 

income opportunities. He said third-party relationships can raise both compliance and risk
 

managementrisks for a bank. Mr.Pearce said he thoughtthat,in the sphere ofcommunity banking,
 

the primary risk to consumers wasthe failure ofcommunity banks to effectively monitor third-party
 

relationships,either in front-end due diligence or ongoing monitoring. Mr.Pearce noted that
 

ongoing third-party monitoring wasimportant because,as illustrated bythe examplesjust discussed,
 

the third party can change the structure ofthe product offered,change the relationship, or change the
 

numbers ofentities with whom the bank is working. Each ofthese changes can have a significant
 

impactonthe bank's risk exposure.
 

Member Baronner inquired ifit wasafair assumption to believe that a mortgage lending
 

business was qualified ifit was allowed to sell to Fannie Mae and Freddie Mac. He referred to a
 

mortgage lending business that had actively marketed its services to community banks and later
 

wentout ofbusiness after fraud allegations were lodged against it. Mr.Dujenski said that banks
 

should engage in sufficient due diligence regarding any potential third-party provider to ensure that
 

they are comfortable with the provider's financial condition and reputation. He mentioned thatthe
 

FDIC guidance documents he had described provided alist ofitems to help with due diligence and
 

to mitigate risks. Mr.Pearce added that,in Member Baronner's example,the fact that afirm was a
 

Fannie Mae approved seller servicer would notbe sufficient due diligence in itself; a bank would
 

need to understand the business ofa particular broker. He added that brokers now need to be
 

licensed in the national mortgage loan originator system,which allows banksto track the history of
 

a broker,determine their experience and where they have worked. Mr.Pearce said the ultimate
 

judgmentis for the bank to make;his point wasthat banks need to take the third-party risk seriously
 

and mitigate it. Member Williams suggested that a bank may begin its third-party due diligence
 

with state and national trade associations,which perform due diligence on financial strength and
 

other matters; although not a replacementfor a bank's due diligence,it is a good place to start.
 

Member Savarese noted the Committee had earlier discussed core system providers. She
 

noted that there were so few ofthem and their power was so great in the marketplace,they were
 

able to impose long contracts with onerous terms on community banks. Sheindicated thatthe
 

Apri13,2013
 
'rte
 

substantial de-conversion penalties the core systems providers imposed inhibited banksfrom
 

changing providers and was worthy ofFDIC review. Member Savarese said that core systems
 

providers and mortgage providers also gave community banks regulatory risk because they do not
 

keep their systems compliant with regulatory changes.
 

In response to Mr.Pearce's inquiry, Member Blankenship said that she had noticed an
 

increasing level ofsolicitations from third-party vendors. She added that she thoughtthat social
 

media would play a big role in how community banks interacted with their customers and asked if
 

the FDIC had noticed any trends in that regard. Mr.Dujenski said the FDIC had seen a lot of
 

relationships evolve,particularly regarding social media. He said community banks were generally
 

conservative in choosing new parties to deal with and often communicated within their trade
 

associations to obtain information. Mr.Dujenski said that examiners ask to see a bank's processes
 

and procedures to confirm that they are considering the compliance,legal,reputational and other
 

risks in making their decisions. Mr.Pearce said the FDIC had worked with other Federal Financial
 

Institutions Examination Council agencies to develop guidance on the use ofsocial media. He said
 

the general theme wasthat the consumer protection and other requirements that apply to other
 

customer communication channels also apply in social media situations. Mr.Pearce added that
 

institutions should also consider the social media's additional risks,such as"phishing" problems.
 

He said the FDIC was aware that community banks were concerned aboutcompeting with larger
 

institutions ontechnology and that a separate afternoon panel would addressthose subjects.
 

The Committee then discussed IRR. Ms.Eberley observed that the FDIC had seen
 

institutions "go a little longer"on the duration ofassets in the current economic environment and
 

that the FDIC wanted to ensure that banks fully understood the implications oftheir IRR in a
 

rising interest rate environment and had viable risk mitigation strategies in place. Ms.Eberley
 

noted that Mr.Frye was a leading FDICIRR expert and was heading two groups developing IRR
 

training modules for the FDIC Director's College and alonger technical assistance video. Mr.
 

Frye noted that banks had a growing appetite to accept additional IRR to stave offdeclining net
 

interest margins("NIM")and that banks needed to monitor and manage IRR,and to have IRR
 

mitigation and exit strategies in place,for the time when interest rates increase. Referring to a
 

handouttitled "Managing Interest Rate Risk," he noted that bank earnings had improved since
 

the onset ofthe financial crisis butremained well below pre-recession levels. He observed that
 

the earnings improvement had been largely the result oflower credit costs,lower loan loss
 

provisions, and a high volume ofmortgage sales,trends which are likely not sustainable.
 

Mr.Frye said thatthe prolonged low interest rate environment continued to drive down
 

NIM,which is the primary driver ofcommunity bank earnings(he said interest income
 

constitutes 80to 90 percent oftheir net operating revenue). He said that the environment had
 

been especially challenging to commercial banks but was also starting to affect savings banks,
 

which have longer term asset structures on their balance sheet(and were distinguished in the
 

charts ofhis presentation). (He noted there are about6,000 commercial and about 1,000 savings
 

banks in the United States presently.) As a result ofthe lowered NIM,Mr.Frye said that banks
 

had "reached for yield" and increased their long-term asset concentrations to record levels since
 

the recession. He noted that commercial banks had increased the percentage oftheir median
 

long-term earning assets(compared to total earning assets)from 14 percent in 2000to 27percent
 

Apri13,2013
 
203 

at the end of2012. Savings banks,which have traditionally had long-term concentrations,had
 

also increased their long-term concentrations(from 41.2 to 46.7 percent).
 

Mr.Frye then referred to a chart that illustrated community banks'increasing levels of
 

concentration in long-term assets,those that mature or reprice in over 5 years. The chart
 

distinguished among banks that had 30-40 percent long-term asset concentrations,those between
 

40-50 percent,and those over 50 percent. Mr.Frye said thatin 2012,more banks had
 

concentrations over 40 percent,than had 30 percent concentrations in 2004,the last time an
 

interest rate cycle had occurred where the Federal Reserve Board increased interest rates. The
 

significance ofthe increased long-term concentrations, he said, was that,in the last interest rate
 

cycle, banks that had over 50 percent long-term concentrations lost 47basis points from their
 

NIM. Mr.Frye said that banks with only 30 and 40 percent long-term concentrations also
 

experienced a significant decline in their margins. An additional source ofconcern in 2013,he
 

said, was that banks have much lower NIM than existed prior to the previous cycle. Mr.Frye
 

indicated there were also concerns on the liability side ofbanks' balance sheets. Referring to the
 

handout,he indicated that atremendous amountofmoney had flowed into banks' non-maturity
 

accounts during this period oflow interest rates and that a significant amountcould flow out
 

once interest rate differentials return. Mr.Frye said that this potential movement added another
 

dynamic for banks to manage when interest rates increase. Referring to a chart that compared
 

community bank long-term asset concentrations at year-end 2006,2008,2010 and 2012,Mr.
 

Frye said that one could see an increasing exposure to long-term assets across the U.S. now
 

(compared to a northeastern U.S.regionalization in 2006). He said that the increased long-term
 

asset concentrations across the country were a source ofconcern which encouraged examiner
 

focus on IRR.
 

Mr.Frye observed that IRR comes in a variety offorms,including option risk, basis risk,
 

re-pricing risk, and yield curve risk. It is important,he said,that bank directors and managers
 

identify and understand the various types ofrisk that are embedded in their balance sheets so
 

they can ensure systems are in place to respond to them. Mr.Frye said that examiners focus on
 

all aspects ofIRR,based on the complexity and size ofthe bank. He indicated that a bank's IRR
 

management process needs to meetfour criteria. First, a bank's board must establish risk limits
 

and risk mitigation policies and practices. Second,a bank's IRR process must be able to identify
 

and measure IRR. Third,he said, a bank's IRR managementprocess must monitor and reportin
 

atimely way whether the bank is conforming to the IRR limits established by the board. Fourth,
 

he said,there must be adequate internal controls and audit functions. Mr.Frye stressed that IRR
 

management was a continuous process that required along-term focus. The goal,he said, wasto
 

ensure 
banks have prudent levels ofIRR and to consider IRR mitigation and exit strategies for
 

when interest rates rise. In order to be prepared for the next increase in interest rates, NIr. Frye
 

said the FDIC was encouraging banks to take various prudent steps,including stress testing their
 

balance sheets. He said it was important for community banks to take a long perspective
 

regarding IRR so that they will have sufficient earnings to absorb losses in a future recession.
 

Mr.Frye indicated the various concerns he discussed helped motivate the FDIC to develop
 

IRR training resources for banks: some resources to respond to bank directors' need for general
 

understanding, while others provide more in-depth technical assistance for bank management.
 

Directors, he said, need to build a general IRR knowledge and understand their bank's IRR
 

Apri13,2013
 
r~~
 

profile. With that,they can perform their IRR managementresponsibilities, which include:
 

overseeing the establishment ofan IRR policy; establishing risk tolerances; establishing lines of
 

authority and responsibilities; monitoring the bank's IRR position; ensuring prudentIRR levels;
 

understanding the impact ofIRR mitigation strategies and ensuring the independent review of
 

the process. Mr.Frye suggested that the FDIC's training resources could be shown at a bank
 

board meeting where all the directors are gathered.
 

Mr.Frye discussed IRR measurement methods,noting that there are a variety of
 

measurement models and that a bank mustchoose a model appropriate to its ownIRR. He said
 

many banks are dependent on short-term models but need to consider longer term models iftheir
 

balance sheet has alonger term IRR exposure. Mr.Frye said that examiners will focus on
 

several aspects ofa bank's IRR modeling,including: interest rate changes; assumptions about
 

bank deposits; and prepayment estimates. He added that the FDIC's training resources will have
 

a similar focus. Mr.Frye also discussed the importance ofan independent review and validation
 

ofa bank's entire IRR process. He observed that the review process was comprehensive and
 

included the testing ofassumptions made in the IRR measurement model. He noted that an
 

incorrect assumption could have a significant impact on a bank's ability to navigate a changing
 

environment. Mr.Frye emphasized that community banks should explore the full range ofIRR
 

mitigation tools. These tools include: asset restructuring through sales and purchases; changing
 

the bank's product mix;pursuing strategic growth and other initiatives; and engaging in various
 

hedging strategies. Mr.Frye noted that successful hedging mitigation required a robust
 

understanding ofthe bank's embedded risks.
 

In concluding his prepared remarks,Mr.Frye said that community bank NIM would likely
 

continue to remain under pressure in the current interest rate environment. He indicated that
 

many banks would respond to NIM compression with increased holdings oflonger-term assets
 

while their liability structure shifted sharply to shorter-term and non-maturity deposits. Thus,
 

Mr.Frye said that it was importantfor banks to measure and monitor IRR,develop appropriate
 

risk limits, and consider reasonable mitigation and exit strategies before interest rates increased.
 

Member Baronner asked whether there were any empirical studies about prepayment
 

speeds on mortgage backed securities("MBS")or residential mortgage products in a very low
 

interest rate environment. Mr.Frye said there are published sources projecting dealer
 

prepayment speeds on existing MBS assuming various levels ofinterest rate shocks and that
 

those could be consulted. He added,however,that many community bank portfolios hold unique
 

mortgages tailored to their customers which may be less likely to refinance(compared to
 

conforming mortgages). Thus,a community bank would need to consider a qualitative factor
 

about its portfolio in addition to the public information on prepayment speeds. Member Hesser
 

suggested that the CFPB's new qualified mortgage rules would have the effect ofimposing 
more
 

IRR on banks because balloon mortgages will be discouraged. Mr.Frye agreed that some banks
 

had relied on balloon mortgages as an IRR managementtool and said thatthe FDIC was working
 

with the CFPB on the qualified mortgage rulemaking to provide some reliefon the matter. He
 

suggested that the new rules would continue to allow thatIRR management use,perhaps with
 

some new limitations. Member Hesser and Mr.Frye also discussed the issue ofthe cost of
 

funds to community banks in the future.
 

Apri13,2013
 
Member Savarese inquired whether the FDIC had seen any trends regarding community
 

banks using hedging and swaps to manage IRR. Mr.Frye said that, while hedging and swaps
 

were a viable tool, only a small percentage ofcommunity banks used them. He cautioned that a
 

bank mustfully understand its risk before using these tools. Member Seleski said that his bank
 

used derivatives or swaps on ten percent ofits loans to help manage IRR but noted that other
 

banks are making loans at fixed rates and holding them in their portfolio. He suggested that
 

those competing banks were perhaps taking on too muchIRR and,because ofcompetition,
 

driving other banks to be less prudent regarding IRR. Member Seleski inquired whether the
 

FDIC had a role in discouraging such excessive IRR. Mr.Frye said that the FDIC used a
 

forward-looking approach to supervision and that it relied primarily on moral suasion,to
 

encourage banks to consider their IRR and manage it. He agreed that there was a growing
 

willingness among banks to hold longer-term assets, but noted there were various resources to
 

assist in considering alternatives. Mr.Frye noted that banks faced hard decisions since managing
 

IRR could impose short term costs in an already difficult earnings environment.
 

Member Haskin inquired aboutthe treatment ofshort-term balloon real estate mortgages on
 

bank balance sheets under the proposed Basel III capital rules. She said it was difficult to
 

determine whether risk weights would be based on the amortization term or the note's balloon
 

maturity,and that the issue was a key point for community bank capital. Mr.Frye said that the
 

proposed rule was based on the maturity ofthe note,when it ballooned. However,he said that
 

the FDIC was concerned aboutthe proposed treatment's effect on community banking and had
 

received about2,500 comments aboutthe issue. He added that the regulatory agencies were
 

continuing to negotiate the terms ofthe final rule.
 

Member Lundy suggested that a useful area for data collection and research would be the
 

refinance or prepayment speed ofowner-occupied real estate mortgages. He said that his
 

experience was that actual loan duration was shorter than borrowers or bankers expected when
 

entering a loan contract because the market is so dynamic that borrowers find that they need to
 

sell, refinance,or expand sooner than they had expected. Shorter actual durations, Member
 

Lundy said, would support bankers accepting more blind extension risk. He said he had not seen
 

any good analysis ofthis duration question and suggested a research focus on commercial loans
 

for under $5 million. Mr.Frye agreed that the question was good but thought that it would be
 

difficult to draw conclusions since such commercial loans were unique in the ways they
 

discouraged prepayment. Member Lundy said that CRElending was so importantfor
 

community banks that it was worth building a modelfor gathering information now in order to
 

obtain useful conclusions 10 years from now. Member Mehlum said that her bank had used
 

swaps on CRE and other loans, and had done so in 2005-6;her bank appreciated that it had
 

mitigated its IRR but was frustrated that it had experienced a significant reduction in its NIM as
 

a result. Mr.Frye said he encouraged community banks to take along view and recognize that
 

there is atradeoffoflower earnings now in order to be in a better position when a normalized
 

interest environmentresumes. He observed that banks with higher long-term asset concentrations
 

will likely experience a reduced economic value in a more normal interest rate period.
 

Mr.Pearce said the FDIC had heard from many bankers about competitors reaching for
 

yield by extending maturities, which could create better short-term earnings opportunities but
 

also involved significant long-term risk. Mr.Frye added that it took some courage for bankers to
 

Apri13,2013
 
206 

stand up to their board and tell them they would take their earnings more slowly over a longer
 

period rather than pull them all forward to the present. He indicated banks that took such an
 

approach and maintained their underwriting standards would have less risk in afixture recession
 

and that margins would eventually recover.
 

Member Savarese inquired whether the FDIC shared its concerns about the extended low
 

interest rate environment with the Federal Reserve. Mr.Frye indicated that FDIC Chairman
 

Gruenberg served on the Financial Stability Oversight Council("FSOC")with members ofthe
 

Federal Reserve and thatthe topic was likely to be one ofthe FSOC's concerns. Chairman
 

Greenberg said that the extended low interest rate environment was one the Federal Reserve had
 

likely spent a lot oftime on. He suggested that Committee members could ask Federal Reserve
 

Governor Duke that question after her luncheon remarks. Vice Chairman Hoenig said the
 

question being asked is, when monetary policy is highly accommodative,how does one deal with
 

the misallocations that might be created by that broad macroeconomic stimulus? He asked ifone
 

can have supervisory authorities step in and stop banks from doing what all ofthe incentives are
 

driving them to do? He said history is replete with examples where it did not work,so it is a
 

difficult problem.
 

Mr.Pearce asked ifCommittee members had seen other issues or risks that warranted
 

further FDIC or industry attention. Member Savarese described an emerging risk thatinvolves a
 

closed loop debit card issued by a non-bank that uses the ACHsystem to access accounts in
 

financial institutions. She said that it wasjust beginning to be studied in Massachusetts but her
 

understanding wasthat,iffraud wasinvolved,banks would have to bear any loss. Ms.Eberley and
 

Mr.Pearce indicated thatthe FDIC had an interdivisional committee exploring the issue. Members
 

Lundy,Mehlum and Savarese discussed the issue of"patenttroll" attorneys claiming that software
 

used by core systems providers infringed on patents. They indicated that core systems providers
 

claimed the infringements were nottheir fault and were not very helpful in defending against the
 

claims. Member Lundy indicated that many banks settled the lawsuits because the cost of
 

defending them wasso high. Member Savarese noted that many banks that settled were bound by
 

confidentiality agreements which inhibited responding to the problem. Ms.Eberley said thatthe
 

FDIC had received many communications onthe subject which was being considered on an
 

interagency basis.
 

Member Savarese said that she believed that cybersecurity was a significant risk, greater
 

than IRR or credit risk to financial institutions, especially small ones. She indicated that institutions
 

were reluctant to discuss cybersecurity problems because such discussions imposed reputational
 

risk. Member Savarese also indicated thatthird-party core systems processors were reluctant to
 

provide adequate support. Member Haskin said there were manyinstances ofwire fraud in
 

Oklahoma caused by customers'failure to maintain adequate computer security. Outsiders gain
 

control ofcustomer computers and generate wire transfers, which often appear to be legitimate.
 

Member Haskin said banks were being encouraged to institute protective responses,such as
 

procedures to call back customers. Vice Chairman Hoenig agreed that the number offraudulent
 

wires was accelerating quickly. He said that banks'reputational risk concerns discouraged
 

reporting and inhibited asystemic response. Vice Chairman Hoenig also noted that it wasimportant
 

for banksto educate their customers aboutthe need for protective responses,such as callbacks to
 

confirm wire transfers. Member Savarese noted that some sophisticated frauds defeated callback
 

April 3,2013
 
programs by providing "spoofed"telephone numbers. She noted thatthe combined effect of
 

cybersecurity problems(including wire fraud,ACHfraud,and distributed denial-of-service attacks)
 

presented a significant challenge. Vice Chairman Hoenig said he thoughtthatthe banking industry
 

and regulators needed to do moreto educate the public about why security measures have to be put
 

in place and that Internet access cannot be quite as easy as the public may desire.
 

The Committee stood in recess at 12:21 p.m.and reconvened at 1:49 p.m.that same day.
 

Ms.Ryanthen introduced Jonathan Miller,Deputy Director,DCP,and George French,
 

Deputy Director,RMS,who moderated the paneltitled,"CurrentPolicy Issues." Mr.Miller spoke
 

aboutthe new mortgage lending rules and community banks. He noted thatthe mortgage marketis
 

quite differentthan five years ago and that, after the housing bubble burst, Congress passed the
 

Dodd-Frank Act. That Actrequires creditors to make a reasonable and good faith determination,
 

based on verified and documented information,thatthe consumer has a reasonable ability to repay a
 

loan according to its terms. Congress also established a presumption ofcompliance for a certain
 

category ofmortgages,called "qualified mortgages"("QM"). Mr.Miller said the Dodd-Frank Act
 

required the CFPB and other regulators to be mindful ofthe differences between community and
 

other banks when drafting regulations. He said the FDIC had developed a good understanding
 

aboutcommunity banksfrom its role as primary Federal regulator ofcommunity banks and through
 

its various outreach efforts,including the Committee. He said the CFPB had taken community bank
 

concerns seriously in developing its rules. Asa result, Mr.Miller said,the CFPB's mortgage rules
 

provide certain exceptions to requirements for community banks that minimize the burdens that are
 

imposed onthem and,in certain circumstances,reduce current burdens.
 

Referring to a handouttitled"New Mortgage Rules and Community Banks,"Mr.Miller
 

discussed certain definitions used in the CFPB regulations,including"community bank,""rural
 

community bank,""rural," and"underserved"(he noted the definitions were somewhatdifferent
 

than the FDIC research definitions). Mr.Miller said about one-third ofall banks meetthe definition
 

of"rural community bank," which definition includes: having $2billion in assets or less;
 

originating no morethan 500first-lien covered transactions in the previous year; holding mortgages
 

in portfolio; and(regarding"rural")making morethan 50 percent ofits first lien mortgages in rural
 

or underserved areas in the preceding year. Mr.Miller said that it would not be necessary for banks
 

to do research to determine ifthe counties in which they made mortgages metthe definition ofrural,
 

the CFPB would list all the counties that metthe definition(and would also list the counties that met
 

the definition ofunderserved).
 

Pursuantto the Dodd-Frank Act,ifa mortgage is a QMthere is apresumption that the
 

lender complied with its duty to make the ability to repay determination regarding the borrower.
 

Mr.Miller said that one way a QMis defined is by product characteristics,including: no negative
 

amortization;no interest-only loans;no balloons(with some exceptions for community banks);a
 

term ofno longer than 30 years; and no more than 3 percentin points and fees. In addition,QMs
 

must meet certain common-sense underwriting characteristics, including: reliance on fully
 

documented and verified income;the monthly payments ofadjustable rate mortgages("ARM")
 

mustbe calculated based on the m~imum costthat they could reach within 5 years; and,generally,
 

there must be a43 percent maximum debt-to-income ratio("DTI"). Mr.Miller said there were
 

important exceptions to the DTIrequirement. He said that,ifa mortgage is eligible for purchase by
 

Apri13,2013
 
rr
 

Fannie Mae or Freddie Mac,or is eligible for Federal Housing Authority or Veteran's
 

Administration insurance,then the DTIlimitation is notimposed. He said that another exception
 

wasthat certain balloon-paymentloans would be treated as QMsifthey are originated and held in
 

portfolio by small creditors operating predominantly in rural or underserved areas. Mr.Miller said
 

that akey and contentious issue had been whatlevel oflegal protections would be given to
 

originators ofQMs: a safe harbor or a rebuttable presumption. He said the CFPB rule made
 

distinctions based onthe cost ofthe loans originated. "Prime"QM —those with interest rates up to
 

150 basis points above the average prime offer rat would be given alegal safe harbor. Higher
 

priced(or subprime)mortgages —those with interest rates over 150 basis points above the average
 

prime offer rate- would receive arebuttable presumption that they had metthe CFPB's product and
 

underwriting standards. Mr.Miller noted thatthe rebuttable presumption gave originating banks
 

significant protection against lawsuits claiming the bank failed to meetits obligations to make
 

ability to pay determinations. Mr.Miller said the CFPB had also proposed arule that would give
 

community banks a safe harbor for all loans with an annual percentage rate up to 350 basis points
 

above the average prime offer rate. He said that,ifthat proposed rule is madefinal,then the new
 

regulatory standard would actually be better for community banks than the currentlaw.
 

Mr.Miller also discussed exceptionsto the CFPB's mortgage servicing rule. He said ifan
 

institution serviced 5,000 or fewer mortgage loans then it would be considered a small servicer and
 

the many provisions ofthe servicing rule would generally not apply to it. Mr.Miller indicated he
 

believed that the CFPB'sexception was based in part on distinctions the FDIC had made to it
 

between the problems caused by high volume-low margin servicers and the fewer problems
 

associated with the lower volume-higher touch servicer model employed by manycommunity
 

banks. Mr.Miller noted thatthe mortgage servicing rule, when it applied, was very process-
 oriented, establishing time periods in which certain actions mustbe done. He said the mortgage
 

servicing rule was another example ofwhere many community banks would not need to be
 

concerned aboutthe effects ofanew rule.
 

Mr.Miller also discussed the mortgage loan originator("MLO")rule which was designed
 

to ensure that loan officers and mortgage brokers do not have an incentive to place borrowers into
 

mortgages with higher costs than those they could otherwise qualify for. Mr.Miller described some
 

ofthe exceptions thatthe CFPB had included in its rule that would be helpful to community banks.
 

One ofthe exceptions,he said,wasto exclude bank executives or others who originate ten or fewer
 

mortgages in a year from the rule's limitation on compensation derived from mortgage profits.
 

Even for MLOs who originate morethan ten mortgages in a year, Mr.Miller noted thatthe CFPB
 

rule allows these MLOsto take part in a general profit-sharing bonus pool(outside ofa qualified
 

retirement plan)ifthe bonusthe MLOreceived constituted less than ten percent ofa person's total
 

compensation. Mr.Miller said thatthis was another example ofthe CFPB relaxing standards from
 

the currentlaw.
 

Referring to a chart titled,"Mortgage Rule Exemptions and Flexibility byBank-type,"Mr.
 

Miller described the waysin which the CFPB rules would provide rule exceptions to community
 

banks,rural and underserved community banks,and other banks. Mr.Miller said there was concern
 

among community banks thatthey would have to exit the mortgage lending business because ofthe
 

impactofthe new mortgage lending rules. He said he hoped community banks would conclude
 

that, given the various exceptions he described,they could continue in the mortgage lending
 

Apri13,2013
 
1'
 

business. Mr.Miller said that community banks would need to consider how they would be
 

affected by the new rules. He also said the FDIC and other regulators were working on compliance
 

guides for the industry,examination procedures,and training examiners to ensure they understand
 

the new rules and their exceptions.
 

Member Williams indicated he thoughtthe CFPB definition of"rural" wastoo restricted.
 

He noted that many,clearly rural parts ofGeorgia would notbe considered rural under the CFPB
 

definition because they were located in counties that bordered metropolitan statistical areas.
 

MemberBlankenship later agreed that the CFPB definition ofrural wastoo restrictive. A request
 

fora"show ofhands"indicated that none ofthe Committee members'banks would meetthe CFPB
 

definition ofrural. Mr.Miller noted that the CFPB definition ofrural was broader than an earlier
 

Federal Reserve Board definition and suggested that interested bankers share their concerns about
 

the definition with the CFPB. Member Hesser observed that, underthe CFPB definition ofrural,it
 

would be possible for two banksto operate in the same town,with one meeting the "rural"
 

definition while the other one did not. He expressed the opinion that consumer confusion could
 

occur because the "rural"bank would be allowed to offer different terms than the non-rural bank.
 

Member Williams said he thoughtthat there had been a problem with subprime loans in
 

the mortgage market and the CFPB response was generally good. He said that balloon mortgage
 

loans from community banks had not been asource ofthe problem;rather,they were a good
 

product which worked wellfor many years. Member Williams said small,community banks were
 

frustrated that the CFPB rules would make such balloon mortgages more difficult to make. He also
 

expressed concern aboutthe rules' effect on the renewal of"in-house"non-conforming loans. He
 

said he thought it would be difficult for borrowers to meetthe 43 percentDTIstandard and that a
 

different standard should apply for such renewals.
 

Member Savarese inquired how the CFPB mortgage rules,particularly the 43 percentDTI
 

maximum,would impactthe ability ofcommunity banks to lend responsibly to persons with low
 

and moderate income. She said that her bank,working with the Massachusetts housing finance
 

agency,made loans that would not meetthe 43 percent DTIrequirement,but had other features,
 

including mortgage insurance in the case ofjob loss, which protected against loss. Mr.Miller said
 

the FDIC had given significant thoughtto low- and moderate- income lending. He observed that
 

minorities and low- and moderate- income borrowers had been disproportionately hurt by earlier
 

aggressive lending practices. Mr.Miller said that a goal ofthe new rules wasto minimize the
 

number ofloans that fail because they were not properly underwritten. In response to Member
 

Savarese's particular question,Mr.Miller said he thoughtthat,first,the CFPB proposals would give
 

additional leewayto state housing finance agencies. He said he would check on the matter and
 

respond to her after the meeting. Second,he said that while many state housing finance agencies
 

engage in creative programs,no program is sufficient to meetthe markets' needs for access to
 

credit. Mr.Miller said that the market and its loan products, as a whole,needed to be safe for low-
 and moderate- income borrowers,and that wasthe goal ofthe CFPB rules.
 

Mr.French then spoke about new regulations required bythe Dodd-Frank Actconcerning
 

permissible investments. He said thatthe new regulation required banks to base their investment
 

decisions on their due diligence understanding ofthe security being purchased and notrely on its
 

credit rating. Mr.French said the FDIC's expectations for a bank's due diligence would depend on
 

April 3,2013
 
~~
 

the size,complexity,and risk ofits investment portfolio. He observed that the new rule represented
 

a learning curve for both bankers and examiners and that the FDIC would work with them to clarify
 

expectations. He said the FDIC would produce atechnical assistance video on due diligence for
 

municipal securities. Mr.French also noted that the FDIC does not expect every bank to engage in
 

extensive stress testing. He said the FDIC's stress testing expectations can befound in existing
 

guidance and deal with commercial real estate loans over certain thresholds,subprime loans,and
 

interest rate shocks. Generally,Mr.French said,the FDIC expects banksto understand their risk
 

exposures,to measure those risks, and to control the risks appropriately. In mostcase,he said, a
 

community bank would not need to engage a consultant or buy an expensive stress testing model.
 

Mr.French then spoke about a proposal by the Financial Accounting Standards Board
 

("FASB")that would change how credit losses are recognized and measured for certain financial
 

assets(principally loans)in the allowance for loan and lease losses("ALLL"). He noted the
 

proposal would change the modelfor setting aside loan loss reserves,from an incurred loss modelto
 

an expected loss approach. Mr.French noted thatthe incurred loss model depended on an event
 

thattriggered the recognition ofcreditlosses onthe financial statements while the expected loss
 

approach would call for banks to maintain an allowance equal to the present value offuture cash
 

flows that are notexpected to be collected. He said the FASB proposal represented afundamental
 

change in practice and warranted community bankers' attention. N1r. French said the banking
 

regulatory agencies had supported moving toward the expected loss modelofreserving for the
 

ALLL and that the FDIC would likely send acommentletter to the FASB on the proposal.
 

In response to a question from Member Castillo, Mr.French and Robert Storch, Chief
 

Accountant,RMS,spoke abouthow banks mightreserve for expected losses. Mr.Storch noted that
 

FASB had recognized that there was not a single method that should be used by all institutions;
 

rather,it recognized that there maybe different methods used,even within a single bank. The
 

objective,he said, wasto estimate whatcash flows the bank does not expectto collect and to use
 

that as the ALLL estimate. Mr.French said that banks should gather data on their historical charge-


offexperience for varioustypes ofloans,then engage in vintage analysis to determine when losses
 

tend to occur over time,and then make ajudgmental adjustmentto the reserve based onthe
 

portfolio's quality. Mr.Storch added that a bank should look atthe loss experience onthe particular
 

types ofloans in its portfolio over the lives ofthese loans(rather than limiting the analysis to
 

annualized loss experience). For example,he said,for retail loans offive or more years that are
 

amortizing,particularly ifthey are collateralized,losses tend to increase in years two,three,and
 

four,butthen decrease over time as they amortize. Mr.Storch said a bank may compare the
 

average age ofthe loans in its portfolio against such aloss curve. He added that banks would also
 

need to factor forward-looking information into their analysis. For example,he said,ifthere were
 

consensus indicators ofadverse economic conditions onthe near-term horizon,a bank might
 

determine its expected losses over that period would be higher than its long-term average. Mr.
 

Storch noted that community banks may not currently have data abouttheir life-of-the-loan loss
 

experience and regulators should help address thatissue, as well as setting expectations for
 

institutions.
 

Member Castillo observed that the FASB proposal would increase the number of
 

subjectivejudgmentsthat a bank would have to make in setting its ALLL and that would increase
 

the opportunities for misunderstandings. He noted thatthe FDIC and bankers had devoted
 

April 3,2013
 
211
 

considerable effort to developing a common understanding aboutthe accounting standards for
 

troubled debtrestructurings, but a substantial amountofsubjectivity remained. Mr.Storch agreed
 

thatthe ALLL was probably the mostjudgmental area ofaccounting for community bankstoday
 

and that thejudgmental nature would increase ifthe FASB's proposal is adopted. Mr.Storch said
 

the new approach would also challenge bank examiners who would be reviewing a bank's
 

documentation ofits ALLL decision-making and whether the bank'sjudgments are reasonable. He
 

said all ofthe banking regulators would need to putforth a concerted effortto send a consistent
 

message to banks and examiners. He noted that community banks'local accounting firms may not
 

have developed sufficienttechnical expertise in estimating expected losses.
 

Member Williams said his experience wasthat he could make a more reliable forward-


looking projection about aspecific credit than for an entire portfolio. He also indicated he saw
 

some amountofduplication in the forward-looking aspect ofthe FASB's proposal and the
 

impairment analyses he is already doing. Member Williams also remarked that making forward-


looking predictions could become speculative in nature. Mr.Storch noted that there was a limit on
 

how far one could look forward and have the forecast remain reliable enoughfor accounting
 

purposes. He noted that the FASB's proposal specifically indicates that banks' expected loss
 

estimates should not be worst-case scenarios. Rather,he indicated the focus was onthe lifetime loss
 

experience for particular types ofloans,adjusted for the effect on collectability ofreasonable and
 

supportable forecasts aboutfuture conditions. Mr.Storch emphasized that it wasimportantfor
 

banksto documenttheirjudgments so that bank examiners could use the documentation as a basis
 

for a dialogue with the bank aboutits allowance methodologies. In response to a question from
 

Member Saunders,Mr.Storch said the FASB's proposal,ifadopted,would replace five different
 

models ofimpairment measurementthat currently apply to differenttypes offinancial assets. In
 

response to another question from Member Saunders,Mr.Storch said that,under the FASB's
 

proposed approach,real estate collateral and guarantor protection for loans would continue to be
 

considered in the analysis ofexpected credit losses.
 

Member Saunders inquired aboutthe rationale underlying the FASB's proposal. Mr.
 

Storch said the proposal was meantto address criticisms thatthe currentimpairment model delays
 

the recognition ofcredit losses onloans and securities because ofthe trigger requirementthat aloss
 

be incurred before an allowance can be established. He observed thatthere were many signals in
 

the 2007-2008 time period that substantial risk existed in loan portfolios, butthe increase in risk
 

could not be reserved for because the accounting standards did not allow the consideration offuture
 

events. Mr.Storch said the consideration offorward-looking information under the FASB's
 

proposal would permitthe ALLLto be increased as risk built up in the loan portfolio. Thus,
 

because ALLLlevels would be higher when economic conditions begin to worsen,banks would not
 

experience as big a hitto their ean~ings as they experienced five ago under the current accounting
 

standards.
 

Member Lundy inquired ifthe FDIC had information aboutthe historical weighted loss
 

rates on all community banks' productcategories. Mr.Storch said the FDIC wastrying to
 

determine ifit could look at annualized loss rates in order to estimate lifetime loss rates. He said
 

that such an estimate would help community banks begin complying with the new standard, which
 

would not be effective before 2015,ifadopted. Member Saunders noted that community banks had
 

sustained lower loss rates than the rest ofthe industry and suggested thatthe FASB proposal might
 

April 3,2013
 
212
 

not achieve the objective Mr.Storch had discussed. Mr.Storch indicated he thoughtthatthe FASB
 

proposal would result in some additional loan loss reserves for community banks because the
 

current standards do not allow the consideration offorward-looking information. He said that most
 

bankers at arecent program in which he had participated estimated thattheir ALLLs would increase
 

about25to 50percentifthe FASB's proposal was adopted. Mr.Storch noted thatthe change in the
 

level ofthe allowance would vary bythe type oflending banks did. He said banks thatfocused on
 

short-term lending would probably have lifetime losses not much greater than their annualized
 

losses. However,banks that were longer-term lenders may experience a greater impact under the
 

FASB's proposal. Mr.Storch said the FDIC and the FASB were continuing to gather information
 

aboutthe impactofthe proposal. Herecommended that community bankers provide commentsto
 

the FASB aboutthose aspects ofthe proposal relevant to their institutions.
 

Ms.Ryanthen introduced Luke Brown,Associate Director,DCP,and William Henley,Jr.,
 

Associate Director,RMS,who moderated the paneltitled,"Mobile Banking Issues." Mr.Brown
 

remarked aboutthe widespread use ofsmartphones and noted thatthey will be a key driver of
 

growth in mobile payments and banking. He discussed a variety ofstatistics about mobile banking.
 

Mr.Brown said astudy indicated that29percent ofsmartphone owners used their phone to check
 

bank account balances or engage in online banking in 2012,upfrom 18 percentin 2011. Another
 

study found,he said,53 percent ofunderbanked mobile phone users own atleast 1 smartphone,
 

which is similar to the 51 percent ofall consumers. Mr.Brown said that 17percent ofunderbanked
 

consumers planned to use mobile banking in the next year,about double the rate ofconsumers
 

overall. Mr.Brown said 37 percent ofcommunity banks offered mobile technology in 2012,more
 

than double the numberin 2010. He also observed that community banks had identified mobile
 

banking as their mostimportantIT-related project next year.
 

From the FDIC perspective, Mr.Brown noted that, while mobile technology provides
 

consumer convenience and access to financial services in real time,the FDIC was also considering
 

how it mightimprove access ofunderbanked persons to mainstream financial institutions. He noted
 

that the FDIC Advisory Committee on EconomicInclusion had chartered asubcommittee on
 

mobile financial services to look at how mobile technology might be used to facilitate economic
 

inclusion, which is a continuing priority for Chairman Greenberg and the FDIC. Mr.Brown said
 

the FDIC was considering how mobile technology could be used as a conduitfor underbanked
 

persons obtaining full relationships with traditional banks. The FDIC wasinquiring into how
 

consumers use mobile technology,whattheir preferences are regarding it, and whattheir financial
 

education needs were. Mr.Brown noted that it wasimportantto remember that consumer
 

protection laws that apply to other business channels also apply to mobile technology;he said
 

consumers need to be reassured that protections are in place in the mobile world and thattheir
 

personal information is protected. He said the FDIC monitors mobile technology developments in
 

the evolving marketplace and was hopeful thatthe technologies can be used to increase the range of
 

consumers who have access to financial services from atraditional bank.
 

Mr.Henley observed that 97percent ofbanks use the Internet as a banking delivery
 

channel while 37percent ofcommunity banks use mobile as a delivery channel;thus,a saturation
 

point had been reached with the Internet butthat mobile delivery provided an opportunity for
 

expansion. He noted that community banks are considering introducing mobile banking both
 

because competitors offered it and because consumers requested it for its convenience in making
 

Apri13,2013
 
213 

transactions. Mr.Henley reviewed various sources ofFDIC published guidance that were available
 

and said the FDIC was interested in hearing whether(and what)additional guidance would be
 

helpful. He said that it is importantfor banksto identify risks associated with any emerging
 

technology and to mitigate those risks.
 

Member Mehlum said that her bank had launched mobile banking,limited to seeing
 

account balances and making transfers among them(withoutthe ability to make deposits). She
 

likened her bank's mobile banking approach to how it conducted online banking and inquired if
 

there were any additional safety and soundness aspects to mobile banking that should be added to
 

the bank's existing ones regarding online banking. Mr.Henley observed that mobile banking was a
 

delivery channel,as the Internet was,and that both delivery channels presented a wide range of
 

possible functions that banks could choose to offer their customers. Herecommended that a bank's
 

risk program identify whatfunctions it offered in mobile banking and whatcorresponding
 

protections have been built into the system. Member Baronner inquired whatadditional steps a
 

bank should take ifit added the function ofallowing a customer to photograph a check to make a
 

deposit("consumer remote deposit capture"). Mr.Henley indicated that examiners would expect
 

the bank to articulate an understanding ofthe risks introduced bythis additional function and the
 

protections the bank has taken to ensure customer data.is notcompromised. He referred to a
 

Supervisory Insightsjournal he had discussed for a more complete review.
 

Mr.Broom noted that interagency guidance was being prepared concerning social media
 

use. He said institutions had been reluctantto use social mediato interact with customers because
 

they were unsure which supervisory issues they should be concerned with,and that banks were
 

interested in a uniform discussion ofwhatothers were doing. Mr.Brown said the guidance would
 

notimpose new requirements,but would provide a discussion ofissues arising in the changing
 

environmentthat could be helpful,especially to smaller institutions that may not have the resources
 

to consider the matter independently. In response to a question from Member Haskin,Mr.Brown
 

said the guidance would remind institutions how the compliance regulations apply to social media,
 

withoutimposing new requirements. Member Hesser said it would be helpful to provide banks with
 

any agency guidance being given to examiners on mobile deposit capture,such as per item deposit
 

limits, daily deposit limits or similar information. Mr.Henley agreed and indicated that the
 

instructions to examination staffwasthe same as whatis contained in the public guidance
 

documentsthat he had previously described to the Committee. He said that,ifthe FDIC or other
 

agencies provided an update it would not add new requirements but would gather them into a single,
 

comprehensive document. In response to a questionfrom Member Lundy,Mr.Henley said he was
 

not aware ofany significantfraud incidents involving mobile payments mechanisms. He said that
 

consumers appeared to approach mobile banking with an amount ofcaution,using mobile banking
 

primarily for inquiries and simple payments.
 

Member Haskin said she thoughtthe banking industry was on the verge ofatechnology
 

revolution that would transform how business is done within five years. She said thattechnology
 

might be the reason that banks consolidate in the future. Member Haskin said that her bank,which
 

had previously outsourced to multiple differentthird parties, had to consolidate all its outsourcing
 

under its core processor in order to begin mobile banking,so that systems integrated properly. She
 

said one ofher greatest frustrations wasthatthe core processor did not provide new mobile products
 

quickly enough for her bank to keep up with its competitors. She noted,for example,thattwo
 

Apri13,2013
 
nearby competitors offered remote deposit capture for retail customers which she could offer only
 

commercially. Member Haskin said that aFederal program was offering smartphones to low- and
 

moderate-income individuals in Oklahoma atlow costthus increasing how widely available they
 

were. She said that ATMshad been the greatest new technology in banking for many years and that
 

mobile technology was a similar(or greater)change. She said that banks that embrace mobile
 

technology would likely become more efficient; she noted that her bank added four mobile
 

technology products and its computing costs remained relatively the same. Member Haskin noted
 

that her bank had saved money on postage by using e-statements, which she thought were secure.
 

Member Haskin said mobile banking deserved further study and careful thought. She
 

noted that mobile technology products were expensive decisions,especially for community banks.
 

She said thatFDIC guidance on directions to pursue and strategic planning would be helpful to
 

banksthat were struggling with whattechnology to purchase. Mr.Henley said the December 2012
 

SupervisoryInsightsjournal article touched on issues such as mobile technology functionality and
 

security, and the classes ofdevices that are available. Although the article was note~austive,he
 

said,it provided footnotes that could be pursued for further research. Member Haskin said FDIC
 

input onthe security ofthe smartphone platform would be helpful; her opinion wasthat it was more
 

secure than most bankers believed and such information would help bankers guide their decisions.
 

Member Saunders said that mobile banking technology would likely change the branch banking
 

model since foottraffic into branches would probably decrease and banks will need to consider how
 

to keep customers. She said that it would be helpful ifthe FDIC could share information about what
 

developments it is seeing across the industry. Member Haskin observed that community banks
 

were losing marketshare in payment systems to start-up companies which are notregulated. She
 

expressed concern that consumers had been lulled by the safety ofthe paymentsystem within
 

regulated banks,and hoped that consumer losses would not occur because ofa breakdown ofsuch a
 

non-regulated company. Mr.Brown agreed thatthe safety ofpaymentsystems wasan important
 

issue and said thatthe FDIC was consulting with other agencies about it.
 

Mr.Brown invited membersto discuss what mobile banking features they offered or were
 

considering. Member Blankenship said that her bank offered similar banking capabilities on mobile
 

devices as online. She said that security was her bank's primary issue,including a concern about
 

the effect ofa huge fraud. Member Blankenship said her generation maybeless comfortable with
 

new technological advances than others and was concerned that vendors may"tell us what we want
 

to hear"to make bankers comfortable. Member Haskin observed that manyhigher-end customers
 

have adopted mobile banking technologies because they like the convenience and can afford the
 

technologies. She said it may be a mistake to think that only younger customers are interested in
 

mobile banking.
 

Mr.Henley invited feedback on the supervision oflarge third-party services with respectto
 

mobile banking issues. Member Savarese said that she thoughtthe topic wasimportant and that
 

Committee members would have information to share butthat there may be alack oftime in the
 

current meeting. Chairman Greenberg said the topic had ongoing importance and could be puton
 

the agendafor the next meeting after FDIC staffhad given more thoughtto the issues and how to
 

frame them for discussion.
 

Apri13,2013
 
--

215 

In parting,Chairman Greenberg asked ifconditions for community banking had improved.
 

Member Seleski said that conditions were better butthatthe issue ofmargin compression extending
 

into 2015-16 was a concern. Hethoughtthat larger banks,with robust non-interest income,were in
 

abetter position to face along-term low-interest environmentthan manycommunity banks.
 

Member Mehlum said that the economy was better and that communicating and working with the
 

FDIC had improved. She said that she was concerned aboutthe community banking model and the
 

growth ofgiant banks that control the industry. Member Williams said that,in Georgia,there was
 

still concern aboutthe effects ofloss share agreements and whatwould happen when they ended.
 

He said thatthese concerns were having a negative impacton real estate values even though,
 

theoretically,the negative effects were not supposed to occur. Member Saunders said that overall
 

conditions were improving and there was an uptick in loan demand,butthat unemployment
 

remained very high for African-Americans,and low- and moderate- income people in underserved
 

markets. She said there was concern aboutthose sectors and how they would receive financial
 

services. Member Saunders also expressed concern about minority-owned depository institutions
 

and community developmentfinancial institutions and their business modelsin light ofnew
 

regulations,including new capital rules.
 

Chairman Greenberg thanked the Committee for their input.
 

There being no further business,the meeting was adjourned at 3:16 p.m.
 

RobertE.Feldman
 

Executive Secretary
 

Federal Deposit Insurance Corporation
 

And Committee Management Officer
 

FDIC Advisory Committee on Community Banking
 

Apri13,2013
 
Minutes
 

ofthe
 

Meeting ofthe FDIC Advisory Committee on Community Banking
 

ofthe
 

Federal DepositInsurance Corporation
 

Held in the Board Room
 

Federal DepositInsurance Corporation Building
 

Washington,D.C.
 

Open to Public Observation
 

Apri13,2013 — 8:31 A.M..
 

I hereby certify that,to the best ofmyknowledge,the attached minutes are accurate and
 

complete.
 

Martin J. Gruenbe
 

Chairman
 

Board ofDirectors
 

Federal DepositInsurance Corporation