251

The Meeting of the Advisory Committee on Community Banking

of the

Federal Deposit Insurance Corporation

Held in the Board Room

Federal Deposit Insurance Corporation Building

Washington, D.C.

Open to Public Observation

April 9, 2014 - 8:45A.M.

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

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

("FDIC") Board of Directors.

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

President and Chief Executive Officer ("CEO"), Bank of Charles Town, Charles Town, West

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

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

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

Mark Hesser, President, Pinnacle Bank, Lincoln, Nebraska; James Lundy, Chief Executive

Officer, Western Alliance Bank, Phoenix, Arizona; Joseph G. Pierce, President and CEO,

Farmers State Bank, Lagrange, Indiana; 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; Mark Stevenson, President & CEO

Capital Pacific Bank; 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 and Joseph G. Pierce, President and CEO, Farmers State Bank, Lagrange,

Indiana were absent from the meeting.

Members of the FDIC Board of Directors present at the meeting were: Martin J.

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

(Appointive).

Corporation staff who attended the meeting included: Willa M. Allen, Ruth R. Amberg,

Steven O. App, Lisa D. Arquette, Heather L. Basnett, Bobby R. Bean, Michael W. Briggs,

April 9, 2014
252

Richard A. Brown, Kitty Chaney, Navid K. Choudhury, Patricia A. Colohan, Carolyn D. Curran,

Patricia B. Devoti, Doreen R. Eberley, Bret D. Edwards, Diane Ellis, Patricia W. Farrell, Robert

E. Feldman, George E. French, Shannon N. Greco, William H. Henley, Jr., Martin D. Henning,

Shamara 1. Humbles, Kathy Kaiser, Sally J. Kearney, Van Y. Lee, Alan W. Levy, Linda Lorch,

Christopher Lucas, Peter A. Martino, Roberta K. McInerney, Jonathan N. Miller, Rae-Ann

Miller, Robert W. Mooney, Sumaya A. Muraywid, Thomas A. Murray, Christopher 1. Newbury,

Thomas E. Nixon, Richard Osterman, Bimal V. Patel, Mark E. Pearce, Sylvia H. Plunkett,

Stephen A. Quick, Jack Reidhill, Marlene M. Roberts, Claude A. Rollin, Barbara A. Ryan,

Martha Solt, Marc Steckel, Robert Storch, James C. Watkins, Cottrell 1. Webster, Mindy West,

Lauren A. Whitaker and Smith T. Williams.

William A. Rowe, Ill, Deputy to the Chief of Staff and Liaison to the FDIC, Office of the

Comptroller of the Currency ("OCC") and Elizabeth Ellis, Senior Advisor to the Director,

Consumer Financial Protection Bureau ("CFPB"), were also present at the meeting.

Chairman Gruenberg welcomed the Committee and gave an overview of the topics that

would be discussed during the day. The topics he reviewed were: technical assistance resources

that the FDIC is producing for community banks' use; current FDIC research projects and a

recent study on the impact of consolidation on community banking; current cyber security issues;

the role of the FDIC Ombudsman and the supervisory appeals process; customer due diligence

issues; a discussion of the qualified mortgage rules issued by the CFPB; and finally, a

supervisory policy update focused on a final rulemaking concerning the "Volcker Rule" and

recent actions by the Financial Accounting Standards Board ("FASB"). Chairman Gruenberg

also welcomed Mark Stevenson as a new member of the Committee.

Chairman Gruenberg introduced Chief of Staff Barbara Ryan, who moderated the day's

proceedings. Ms. Ryan in turn introduced Doreen Eberley, Director, Division of Risk

Management Supervision ("RMS") and Mark Pearce, Director, Division of Depositor and

Consumer Protection ("DCP") who led the panel titled, "Community Bank Initiative -

Supervisory Update." Ms. Eberley noted that there had been 75,000 views of FDIC-produced

technical assistance videos, including the Director's College videos. She said the Interest Rate

Risk ("IRR") video had been the most viewed one so far. Ms. Eberley gave an overview offour

of the safety and soundness technical assistance products released since the last Committee

meeting and discussed their contents. The four subjects she discussed were: appraisals and

evaluations; evaluation of municipal securities; Allowance for Loan and Lease Losses

("ALLL"); and Troubled Debt Restructuring ("TDR"). Ms. Eberley noted the FDIC's initiative

to provide technical assistance for rulemakings and said that guidance for complying with the

Volcker Rule had been issued. She then described the information packages the FDIC will be

sending to all FDIC-supervised institutions that describe the resources provided under the

Community Bank Initiative; the FDIC Ombudsman program; and the Supervisory Appeals

Review program. Ms. Eberley said the package also included a cover letter that encouraged

community banks to provide feedback to the FDIC and the ways they may do that.

Mr. Pearce then described the two technical assistance videos released since the last

Committee meeting that assist community banks in complying with consumer compliance

responsibilities. He described both a flood insurance video series and another related to fair

April 9, 2014
253

lending and fair lending risk. Mr. Pearce said that, at the beginning of every compliance exam,

the FDIC provides the bank with an information packet that describes the exam process and the

variety of ways the bank may communicate with FDIC personnel. Last, he noted that the FDIC

also uses teleconferences to provide technical assistance and that DCP conducted a

teleconference on mortgage rules which had more than 45,000 participants in 2013.

There was consensus that the technical assistance videos were very useful to community

banks. Member Seleski said the videos prompted more discussion than just reading materials

might; he said that his board watched videos as a group and then engaged bank management in a

discussion of the bank's decision-making in relation to the video's recommendations. Member

Saunders said that her bank made videos part of the directors' meetings; she suggested that a

video on the Home Mortgage Disclosure Act ("HMDA") would be helpful as a refresher for

banks that do not generate many residential mortgages. She said that directors also requested

assistance concerning their roles concerning credit. Member Saunders suggested that, from an

examination perspective, technical assistance would be useful on custom bench marking and that

the guidance could be shared with both examiners and bankers to encourage consistent

application.

Member Castillo said that his directors found the videos very beneficial and were

particularly curious about their roles concerning risk management. He said they were also

interested in guidance about their roles regarding the bank's audit committee and would prefer to

hear guidance from the FDIC than from other sources. Member Stevenson said he had not

previously known about the FDIC technical assistance available and was pleased to learn about

it. Member Blankenship applauded the FDIC's efforts and said she especially liked the videos'

"frequently asked questions" and "what if?" sections because they help viewers consider realworld situations. She suggested that a second FDIC notification to banks about the availability

of the technical assistance would be helpful, particularly ifit was directed to the bank's trainer or

compliance officer. Member Savarese commended the FDIC on the videos; she said that they

enable directors to understand their roles and responsibility much more quickly, and that they

encourage a consistency of expectations among bankers and examiners. She suggested that

guidance on the new mortgage rules would be useful. Mr. Pearce said that, as DCP had trained

its examiners concerning the new mortgage rules, DCP had considered how the examiner

training could be repurposed to be helpful to bankers.

Ms. Eberley said the FDIC was interested in learning how banks felt about the videos'

utility and what new or different subjects would be helpful. She said that RMS considered

adding questions at the end of the banker surveys that occur at the end of exams, but noted that

only about 33 percent of banks respond and that the information would be somewhat lagging.

Ms. Eberley said RMS had also considered conducting an industry survey that might also help

create awareness of the technical assistance available. Member Blankenship suggested that the

FDIC could promote awareness by including information about the technical assistance in trade

group newsletters, in publications from professional groups and universities, or by Tweeting

about it. Member Williams said that he thought the examination survey would be the best

approach since it had a relatively high response rate compared to other surveys. Member

Savarese suggested the FDIC consider using a micro-survey, a short one or two topic survey that

could occur every week or two; she noted that a periodic survey would allow the FDIC to be

April 9, 2014
254

aware and respond to emerging issues. Member Savarese also suggested that a pop-up survey

that occurred at the end of a YouTube video might work. For example, it might ask the viewer

to rate the video on a I to 5 scale. Member Savarese and Ms. Eberley also noted the possibility

of a Supervisory Insights Journal article on how bankers use the videos. Member Saunders

suggested that a paper survey could be included in the information packets that had been

described earlier.

Ms. Ryan then introduced Diane Ellis, Director of the Division ofInsurance and

Research ("DIR") and Richard Brown, Chief Economist, DIR, who spoke about community

banking research. Ms. Ellis said the FDIC was committed to developing a better understanding

of the structure and performance of community banks, their environment and the issues they

face, and that the research was a priority of Chairman Gruenberg. She said the FDIC released a

study on long-term trends in consolidation earlier that day and had updated a study describing

community bank performance and structural changes in late 2013. Ms. Ellis described two

current studies that were well underway: the first concerns minority depository institutions and

their structural changes and performance between 200 I and 20 I 2; the second study updates an

earlier FDIC study about trends in rural depopulation and the challenges for community banks in

those areas. Ms. Ellis said that three other studies were in early development. The first study

concerns de novo institutions, their early performance and viability. The second study, she said,

considers branch office trends, including what drove branch expansion before the financial crisis

and branch contraction after it. The third study in development looks at commercial real estate

("CRE") and construction and development lending by community banks.

Richard Brown discussed the study, "Community Banks Remain Resilient Amid Industry

Consolidation." Noting that the Committee had discussed industry consolidation before, he said

that a focus on the reduction in the number of bank charters told only an incomplete and unduly

pessimistic story. Referring to a packet of charts with the same title, Mr. Brown observed that

consolidation in banking was not a new phenomenon, and that it had various components, each

of which has its own driving forces. He said there were two main forms of voluntary attrition in

banking charters: the first type was based on the voluntary merger of charters between different

banking companies; the second type occurred when there was consolidation within banking

companies. Mr. Brown said that a substantial amount of voluntary attrition occurred in the late

1980's and through the 1990's, due to the relaxation of geographic restrictions on banking, and

that the pace of voluntary attrition had slowed after 2001. He said that 2,500 charters had left the

industry involuntarily since 1985 through failure, but that the FDIC did not expect failures to

contribute substantially to consolidation in the next five years. Mr. Brown said that new

chartering activity is another driver that has been highly cyclical over time; new chartering has

declined sharply during and after the last three recessions and has always recovered after

conditions normalized. He said the period since 2008 had been a very slow period of charter

formation, but that it had probably reached the bottom for this economic cycle.

Mr. Brown discussed the effects of the trends on the size distribution of charters. He

noted that consolidation had a big effect on the smallest institutions, those with assets under $100

million, which had declined in number by 85 percent since 1985. Consolidation also affected the

distribution of the share of industry assets; institutions with over $10 billion in assets held 81

percent of assets at the end of 20 13 compared to 28 percent in 1985. Mr. Brown said it was

April 9, 2014
255

important to not overlook middle-sized institutions, those with assets between $100 million and

$10 billion. He said, after 28 years of consolidation, those middle-sized institutions had grown

in number and in the share of assets they held, thus indicating a sense of stability in center of the

size distribution of community banks. After discussing trends among small institutions, Mr.

Brown said it appeared that they evolved into somewhat larger institutions over time, not that

they were headed toward extinction.

Mr. Brown observed that the FDIC's definition of "community bank" was not solely

based on size, but also placed importance on a bank's traditional lending and deposit gathering as

well as limited geographic scope of operations. With that definition, he said that community

banks had remained stable amid a larger trend of industry consolidation. Community banks

made up 93 percent of insured institutions at the end of2013, compared to 87 percent in 1985.

Mr. Brown said that when community banks are acquired, they are usually acquired by other

community banks and the succeeding institutions usually remain community banks. Referring to

what he called a 'resilience chart,' he said that of community banks in operation at year-end

2003 with assets less than $100 million, some 94 percent still operated as community banks in

2013 or had been acquired by another community bank. Mr. Brown said that larger community

banks (those with assets over $1 billion) showed a higher rate of attrition and a lower propensity

to be acquired by other community banks. Mr. Brown said that, in summary, consolidation was

not a new trend and that it had not brought about the demise of the community banking model,

which has shown resilience amid larger changes in industry structure.

Member Stevenson said he appreciated the information concerning past trends but that

his primary concern was profitability going forward. He said that in the northwest U.S., there

was (at least) a positive correlation between size and profitability and that community banks with

a 6-7 percent return on equity may not be viable in the long run if shareholders demanded higher

returns. Mr. Brown noted that larger banks tended to be the first in and the first out of the

financial crisis while community banks were taking a longer time to work out of their real estate

exposures. He also said that the community bank operating environment, including interest

rates, had not been favorable, but that the operating environment seemed poised to improve as

the economy normalizes. Member Savarese said that two new factors in the community bank

operating environment might reduce the benefit of a retrospective analysis; one is the increased

cost of compliance burden; the second is the cost of technological changes. She queried if there

was any way those two factors could be factored into a retrospective analysis in order to predict

future performance. Mr. Brown noted earlier Committee discussions about the difficulty of

separating regulatory and non-regulatory expenses in the data the FDIC has available to it. He

suggested that it may be productive to think of regulatory costs in the broader context of total

expenses and how they are affected by economies of scale. Mr. Brown said the FDIC's 2012

economies of scale research could be updated to assist with both the regulatory cost and

technology cost issues. Member Williams observed that many community banks are closely and

locally held and may not demand as much return as other investors so that talk about the cost of

regulatory compliance may not translate into actual consolidation. He added that the market for

selling a community bank is weaker now than in the early 2000's and some community bankers

may believe that their franchises are worth more than the current market would pay; thus, fewer

consolidations may occur.

April 9, 2014
256

Member Blankenship asked if the FDIC had done any analysis on how truly voluntary

some voluntary consolidations were; she indicated that the decision of a bank to merge with a

CAMELS "3" rating might be considered less voluntary than a merger decision by a higherrated bank. Mr. Brown said it is difficult for an economist to make judgments about the strategic

considerations concerning mergers and consolidations and the FDIC had not pursued that

inquiry. He contrasted the situation with those off ailed banks where the FDIC has more data

available. Member Lundy suggested a methodology that the FDIC might use to address the

previous questions. He indicated that an important question was whether, in the future, the

community banking model was a viable way of deploying capital. He observed that regulators

make it difficult for capital to exit a bank such that a consolidation may be the only way to do it.

Member Thian asked about research on Minority Depository Institutions ("MDIs"),

including if they are smaller than other bank types, and if they are more vulnerable to increased

regulatory and technology costs. He said there are underserved and not-served communities that

may be better served by an MDI and inquired if the FDIC saw any trends regarding them. Mr.

Brown noted that an FDIC MDI study was underway. He added that the MDI structure has been

more volatile than community banks with institutions entering and leaving the MDI category.

Mr. Brown said that there had been some consolidation among MDIs since the financial crisis,

but he noted that the MDI program had proven to be robust and MDIs had grown in a lot of

metro areas. Regarding performance, he said that some MDIs underperform and have high

expense ratios but that, when their social impact is considered, they are phenomenally successful.

Ms. Ellis said that MDI successes are demonstrated in Call Report and HMDA data. She noted,

for example, that MDIs engage in more lending to low and moderate income borrowers, and

minority borrowers, than do traditional community banks generally.

Member Baronner said he thought that the larger banks that formerly acquired

community banks had left the market in the last six years and there has been a resulting drop in

consolidation. Member Castillo asked about the average size of community banks over thirty

years, if FDIC research provided insights about market share issues ofthe smallest community

banks, and if the research distinguished between urban and rural community banks, and what

business models they used. He said that the smallest community banks seemed to be losing the

market share battle and that shareholder expectations had changed substantially from what they

had been eight years ago. Mr. Brown said that community bank median asset size had grown

from about $40 million in 1985 to about $167 million in 2013, approximately the same as the

fourfold increase in the nominal size of the U.S. economy. He noted that the largest noncommunity banks had grown disproportionately in the same period, experiencing about a tenfold

increase. Mr. Brown said that community banks continued to have the largest market share in

rural and micropolitan counties, but they have lost market share in metropolitan areas, especially

those experiencing growth.

Member Savarese said she viewed the continued existence of smaller institutions to be

critical to the U.S. economy and recommended that a research goal be to help develop actionable

strategies to support their survival. She said that some small institutions saw the increasing costs

of technology and regulatory compliance and chose to merge or sell before their earnings

dropped too much. Such mergers of small institutions, she indicated, may not be good for the

semi-rural communities they serve or for minority or small-business lending. Member Savarese

April 9, 2014
257

I

suggested possible ways to support small institutions would be to allow them to share services or

mitigating the compliance expense for them. Member Seleski said his bank had made some

acquisitions where the sellers were motivated by board and management fatigue and/or a lack of

a management successor. He said that these subjective reasons for consolidation would be

difficult to capture absent individual interviews. Member Saunders suggested a useful research

subject would be to explore how much market share was going to non-bank competitors instead

of regulated banks. Another subject she suggested was to explore trends in the number of

banking offices and how the activities that occur in them are changing. Member Stevenson

suggested that any quantitative research done not be limited to a single point in time but be done

on an ongoing basis.

Ms. Eberley indicated that the FDIC could try to look deeper into voluntary mergers and

possible relationships between the merger decisions and the acquired institutions' pre-merger

CAMELS ratings and returns on earnings and assets. Mr. Brown said that the FDIC has data on

banking offices and would incorporate that information into a report coming out later in the year.

Member Castillo said he perceived community banks were moving away from consumer-related

loans, in part because of compliance costs, and asked if the Call Report data showed such a

migration. Mr. Brown said the 2012 community bank report did indicate community banks did

much less retail lending and migrated toward commercial lending, while non-community banks

began to dominate consumer lending and mortgage lending (although some community banks

maintained a successful niche in mortgage lending). He said the FDIC intended to continue

monitoring those trends. In response to a question from Member Lundy, Mr. Brown confirmed

that community banks make about one-half of small business loans, defined as commercial loans

below $1 million and agricultural loans below one-half million.

Member Hesser said that the current low interest rate environment impacts consolidation

rates because, although bank owners are ready to sell, there is no alternative place to invest the

proceeds. He also said that he expected many community banks would have marginal

profitability in 2014 because of the continuing decline in the net interest margin, the increased

regulatory burden and the loss of non-interest income. Mr. Brown agreed that non-interest

income may decline because there was less mortgage refinancing occurring. Member Thian said

one reason smaller community banks were engaging in less retail banking is because regulators

respond to any mistake in compliance with an enforcement action against the bank. Member

Williams later said he believed that compliance regulators held banks to a perfection standard

that could not be reasonably met and was inconsistent with community bankers' work of

mitigating risk. He also expressed concern that that a perfection standard would migrate to

commercial lending.

Chairman Gruenberg said he thought the discussion had been very helpful and that

further work was needed to develop a better understanding of the dynamics of the consolidation

process. He said that the broad center of community banks, those from $100 million to $1

billion in assets, had remained stable in number, had retained their niche and remained

competitive over time, even as there was more consolidation among the smallest institutions.

Chairman Gruenberg indicated that closer review of the information did not confirm the notion

that community banks are disappearing in the U.S. Instead, it showed that they remain viable --

especially in terms of small business finance and servicing lower population areas, functions that

April 9, 2014
258

large institutions are not in a position to fill. Chairman Gruenberg said he did not think that the

FDIC held banks to a perfection standard, and should not, but that the subject was worthy of later

discussion.

The Committee stood in recess at 10:07 a.m. and reconvened at 10:21 a.m. that same day.

Ms. Ryan then introduced the FDIC staff for the "Cyber Security Update," Ms. Eberley,

Marlene Roberts, Senior Examination Specialist, RMS, and William Henley, Associate Director,

Technology, RMS. Ms. Eberley began by summarizing a variety of recent and ongoing

Information Technology ("IT") initiatives by the FDIC and the Federal Financial Institutions

Examination Council ("FFIEC"). She said that IT is a significant focus of the FDIC's bank

supervision program and that the FDIC's concerns range from banks' adoption and

implementation of new delivery channels to their readiness for cyber threats. She said that IT

guidance is developed through the FFIEC and the FDIC actively participates in the FFIEC's

Task Force on Supervision ("TFOS"), its IT subcommittee, and the Cyber Security and Critical

Structure Working Group. Ms. Eberley said these groups assess existing examination programs

and develop strategies to enhance IT oversight with the goals of ensuring the resilience of the

financial services sector, protecting customers, and promoting confidence in the financial system.

Ms. Eberley described four categories of FFIEC activities, the first being examination

methodology for technology service providers ("TSPs"). She said that a key goal regarding

TSPs was to share examination reports quickly and directly to TSP client institutions, a

recommendation that the Committee had previously made to the FDIC. The second focus area

was to identify and address gaps in examination policies on cybersecurity and critical

infrastructure resilience. The third area was communications. Ms. Eberley said one goal was to

ensure that TSP examination reports clearly articulate their findings (and responses) to client

institutions as well as the TSPs. The fourth category was cybersecurity. She said that the

FFIEC's Cybersecurity and Critical Infrastructure Working Group was working to promote

industry awareness about cyber threats, how banks can protect their systems and their customers,

and to enhance information sharing and coordination through public-private partnerships. Ms.

Eberley described guidance that the FFIEC groups had recently issued and said that the FFIEC

was developing a cybersecurity webinar designed for CEOs to help focus their management of

cybersecurity risk. She observed that cyber threats were different from natural disasters and said

the FDIC was encouraging focus on business continuity and recovery planning for cyber threats,

and described some of the issues that banks should consider.

Member Savarese thanked the FDIC for its fast response to the Committee's earlier

recommendation that TSP examination results be shared with all TSP client banks automatically

and quickly. She also thought that the CEO cyber threat video was a good idea for focusing busy

CEOs attention. Member Blankenship later said that the CEO focused video "hit the nail on the

head" because too many CEOs were not sufficiently aware of the threats to their institutions.

She said that a communication from the FDIC would help CEOs understand the seriousness of

the issue, and suggested that communications include some examples of how cyber issues can

threaten an institution.

April 9,2014
259

Member Savarese asked for additional information about how community banks can get

timely notification of impending cyber threats. Ms. Roberts began by describing the Financial

Services Information Sharing and Analysis Center ("FS-ISAC"), a membership organization

created by Presidential directive in 1999 to encourage critical infrastructure sectors to set up

information sharing and analysis centers to facilitate the flow of information to members in a

particular critical center. She said that the FS-ISAC's funding comes from member dues

(graduated from $850 to $50,000 depending on the amount of information made available). Ms.

Roberts explained that, whenever a member of the FS-ISAC detects cyber threat activity (such as

a distributed denial of service, or "DDoS,"attack), the FS-ISAC allows members to quickly

exchange information about how the attacks are being made and how to mitigate them. Ms.

Roberts said the FFIEC working group was exploring ways that community banks could get

similar levels of information and that one idea was to rely on TSPs to provide such information

to their clients. Member Savarese responded that she did not think it would be effective to rely

on TSPs to be intermediaries concerning cyber threats to community banks. She observed that

speed was of the essence conceming a cyber threat, so that the bank could take steps to harden

their systems. Member Savarese described various factors that would impede the fast flow of

information to potentially affected community banks, including: some TSPs are very large

corporations which are slow to communicate; community banks are not the largest clients of the

large TSPs; in addition, many community banks use vendors that are not TSPs to host their

websites that are subject to DDoS attacks; and, that some community banks maintain their own

systems rather than rely on TSPs, or rely on smaller TSP resellers. Member Savarese suggested

creating a network of Chief Information Officers to quickly distribute information.

Chairman Gruenberg inquired whether the FS-ISAC membership model was a potential

vehicle for community banks and the extent to which its membership costs were an obstacle. He

observed that bank regulators were making progress on dissemination of information among

larger institutions, but had not reached the same point for community banks, although the issue

was also highly relevant to them. Member Savarese said that the cyber threat issues were not on

the top of the minds of all community banks and that it would require some education efforts to

help them understand the issues. Member Haskin said many community banks do not realize

there is a preferred, single source of information. She observed that her bank uses a third party

(separate from its core processor) for firewall maintenance, and that the provider was a member

of the information sharing organizations, but that it was difficult to know if the correct players

actually get the key information.

Ms. Roberts said there were a variety of sources of information available concerning

various cyber threats and described them. One, she said, is U. S. Computer Emergency

Readiness Team ("US-CERT"), a portal through which the FBI distributes alert bulletins that

include, for example, in DDoS attacks, information about attacking IT address. Another FBI

project that is based in about 50 cities is called InfraGard, she said. Ms. Roberts said that the

FFIEC is working with internet service providers ("ISPs") to get classified internet protocol

("IP") addresses to the ISPs so that they can block the pipeline before it gets to the pipeline. She

said the FFIEC was also working with the Federal Communications Commission on a

Communications Security and Reliability Council to explore ways that ISPs can block attacking

IP addresses.

April 9, 2014
260

Ms. Eberley said that it was clear the FFIEC agencies needed to organize and publish the

information in a Financial Institution Letter ("FIL"). She referred to information sessions that

the agencies sponsored between 2002-2005 that encouraged public-private partnerships in local

communities that were focused on natural disasters and terrorist attacks. Ms. Eberley noted that

cyber-attacks were much faster, and that education was needed about them and the resources

available to respond to them, including their costs. Ms. Roberts said about 23 regional coalitions

had been created through the mid-2000s effort just mentioned and that they had successfully

brought the financial services sector together in those areas to respond to physical events. She

said it was important now for the regional coalitions to expand their scope to cyber issues and

that institutions know who to call and be able to exchange information quickly. Later, Ms.

Roberts also described the Department of Homeland Security's Private Sector Clearance

Program which would allow certain individuals to receive up to a "secret" level security

clearance so that they could receive cybersecurity briefings that included classified information.

Member Savarese observed that the ability for two-way communications was critical; that

the system needed to allow community banks to communicate that they were under attack (as

well as receive information from a central source). But, she noted, banks were sometimes

reluctant to share information about themselves that would create a competitive disadvantage for

them. Member Savarese also inquired about ways that the costs of receiving information could

be reduced for community banks, for example, through leveraging their mass buying power. Ms.

Eberley said that the FS-ISAC is meant to be a place where institutions could share information

on themselves and that the system contained confidentiality barriers so that the information that

is distributed to other members does not indicate who was attacked.

Member Savarese referred to the information security standards published by the

National Institute of Standards and Technology ("NIST") and said that she hoped those standards

would not become an additional layer of regulatory burden with which banks would have to

comply. Ms. Eberley said that the FDIC was reviewing the NIST standards to ensure that its

examination program does not have any gaps, but that there was no intention to examine banks

for compliance with the NIST framework. Member Lundy referred to a recent compliance

examination his bank had and said that the pre-examination conference call with DCP had been

very helpful in letting the bank understand the examiners' expectations and be prepared. He

suggested that a similar, collaborative pre-examination conference call, perhaps several months

before the IT exam, would be helpful. Member Saunders later suggested that anytime the FDIC

disseminates new examination training it would be a good time to distribute a webinar for banks

on the same subject so that banks could consider whether they are prepared for threats as well as

examinations. Members Hesser, Savarese, Ms. Roberts and Ms. Eberley also discussed certain

recent IT and cyber threat issues and the industry and agency responses to them.

Chairman Gruenberg said the panel had been very helpful. He noted that the issue of

how community banks could receive and respond to information about cyber threats was an issue

that deserved attention. Member Savarese said that community banks were excited that it was a

matter of regulator focus.

Ms. Ryan then introduced Cottrell Webster, FDIC Ombudsman, and Roberta McInerney,

Deputy General Counsel, Legal Division, who led the panel, "FDIC Ombudsman and

April 9, 2014
261

Supervisory Appeals Process." Mr. Webster gave the Committee an overview ofthe

Ombudsman's operations which are guided by three basic tenets: independence, neutrality and

confidentiality. Mr. Webster observed that the Ombudsman's office is independent of the FDIC

supervisory process; it advocates for a fair process and does not advocate for the FDIC or for

banks; and that all conversations with banks are strictly confidential unless the bank requests the

Ombudsman to identify the bank to help resolve an issue. Mr. Webster said the Ombudsman is

an informal resource and its role is determined in large part by what banks request. He said that

bankers usually prefer direct discussion of issues with examiners, and the Ombudsman

encourages direct communications between banks and examiners, but occasionally banks prefer

a confidential sounding board. Mr. Webster said that a question or issue can often be sufficiently

clarified by a conversation with the Ombudsman staff only; occasionally, Ombudsman staff

pursues an inquiry with FDIC staff. He said that his office receives questions by calls, letters,

faxes and through the FDIC website; he said that, if a banker wanted anonymity from the

Ombudsman's office itself, the Ombudsman's website provided that capability.

Mr. Webster described the roles of the regional Ombudsmen, including outreach to

bankers and to state banking departments. He also described reports the Ombudsman's office

makes to FDIC leadership so they can stay in tune with bankers' concerns, and reports it makes

to industry, which were developed at the request of bankers (and have about 14,000 subscribers).

Regarding the Supervisory Appeals Review Committee ("SARC") process, Mr. Webster said

that the Ombudsman's office has a strictly observer role, that it does not act as an advocate or

mediator. After the SARC issues a decision, he said that the Ombudsman's office follows-up

with the bank about its view of the process and reports to the SARC Chairman.

Ms. Mcinerney provided the Committee with an overview of the SARC history and

process. She noted that the SARC had been created, along with the Ombudsman's office, by the

Riegle Community Development and Regulatory Improvement Act of 1994, which required the

banking regulatory agencies to establish independent intra-agency appellate processes to review

material supervisory determinations ("MSDs"). Ms. Mcinerney observed that "independence" in

this context means that SARC members are independent of the persons who made the MSDs

under review. The FDIC SARC membership, she said, consists of FDIC Vice Chairman Hoenig

as SARC Chairman, and the deputies to FDIC Chairman Gruenberg and FDIC Director Norton.

The FDIC's (acting) General Counsel also serves as a non-voting member. Ms. Mcinerney

described the MSDs that couId be subject to SARC review and noted they included various

examination ratings (such as CAMELS, consumer compliance, IT, and Community

Reinvestment Act (("CRA")) ratings). She also described various determinations that are not

subject to SARC review, including decisions to: initiate informal enforcement actions such as

memoranda of understanding, initiate formal enforcement actions, require prompt corrective

action under Section 38 of the FDI Act, or to appoint a conservator or receiver for a bank.

Ms. Mcinerney summarized the process of SARC review. She noted that it began with a

written request for review, including a detailed description of the issues in dispute, to the

appropriate division director within 60 days of the MSD. In tum, the division director would

provide a written determination within 45 days. If the bank disagreed with the division director's

determination, it could appeal the decision to the SARC within 30 days. Ms. Mcinerney noted

that the SARC could review only matters that had first been presented to the division director

April 9, 2014

I
262

and that the SARC review was generally limited to the facts and circumstances as they existed at

the time of the MSD (thus, a bank's subsequent corrective actions could not be considered by the

SARC). Ms. Mcinerney said the SARC meets within 90 days of a bank's appeal and issues its

decision within 45 days after its meeting. She said that the SARC generally granted a bank's

request for oral presentation and found the presentations helpful in clarifying issues. The

SARC's review of an appeal is to determine if the MSD is consistent with the FDIC's policies,

procedures, and is reasonable overall, she said, and the SARC's decisions are made public (but

are redacted to avoid disclosing confidential information). Ms. Mcinerney noted that, in order to

promote independence, the Legal Division staff that advises the SARC is separated from the

Legal staff that advises the division whose determination is being appealed. She emphasized that

the FDIC took SARC matters seriously and any retaliation against a bank for exercising its

SARC rights was prohibited.

Member Stevenson said that his bank had a longstanding, positive and transparent

relationship with their supervisory office and thus had not needed to tum to the Ombudsman's

office. He said that he understood that part of the Ombudsman process was to gain mutual

understanding through informal conversations, but asked if there was a quantitative measure of

the Ombudsman process. Mr. Webster expressed his view that the Ombudsman process was

effective, and that, in many cases, the Ombudsman's sharing their knowledge of the exam

process with banks had significantly reduced the number of formal appeals to the SARC

(although the Ombudsman does not specifically track numbers of SARC cases). Ms. Mcinerney

agreed that many issues were resolved informally before they got to the level of the division

director or the SARC. She said the SARC had handled over 60 appeals since 1995 and that the

decisions were published, but not tracked as to the result. Member Stevenson said the growth or

contraction in the number of appeals might suggest whether bankers thought that the process was

worth pursuing. Member Williams said the volume of matters presented to the Ombudsman and

the SARC could be related to the regulatory environment. He said that the Atlanta regional

Ombudsman met with bankers during the most difficult days after the financial crisis, and

assisted their understanding of the FDIC's processes. Member Baronner agreed that such visits

were appreciated even if the bankers did not like what they were told. He encouraged the

Ombudsman's office to continue visits to the field.

Member Savarese said that there were such robust conversations with examiners in the

northeast region that many bankers did not feel a need to consult with the Ombudsman. Noting

that part of the Ombudsman's work was to help the FDIC engage in continuous improvement, a

hallmark of Chairman Gruenberg's tenure, she suggested that it would be helpful for the FDIC to

gather feedback on bankers' "grumbles" and not just moments of more intense disagreement. In

response to a question from Member Savarese about the Ombudsman's reporting structure, Mr.

Webster said that he reports to Chief of Staff and Chief Operating Officer Barbara Ryan

regularly and that Chairman Gruenberg also meets with regional Ombudsman staff regularly.

Ms. Ryan said that the FDIC greatly values the direct line of communication with the

Ombudsman's office for its view of issues and trends among bankers, but that the FDIC was

careful to respect the needs for confidentiality and independence of the Ombudsman function.

Member Savarese said that she thought that the Ombudsman's outreach was positive but that,

given the natural reluctance of people to provide negative feedback, it might be useful to harden

up the Ombudsman's independence and to communicate that hardening to bankers.

April 9, 2014
263

Member Castillo said that it would not occur to him to use the Ombudsman resources.

He indicated that the Ombudsman appeared to be an informal resource, something akin to a

therapy session for the banker. Member Castillo said that the process might be more effective if

it became a more formal resource that injected some accountability into the system, maybe not to

the point of being able to change an exam rating, but more formal than at present. He said that

the number of SARC cases, 60 in 20 years, struck him as a low number and that it might be

related to the perception of bankers and banking attorneys that the SARC process would be

unsatisfying to the banker. Member Castillo shared an experience that occurred in about the last

six years in which an examiner said that his bank should not be in business because it was too

small. He said that he would not want to report the examiner's statement just to feel better about

it, but in order to get an actual positive result from the FDIC, such as focused examiner training.

Mr. Webster said that he had heard of such comments, but that the ability to respond was limited

if bankers would not release the Ombudsman's confidentiality promise. He said that he was

certain that senior management at the divisions and at the FDIC as a whole would not want an

examiner making such a comment. Member Castillo said that he would be more willing to put

his name on a complaint if the process was more formal. Mr. Webster clarified his use of the

terms formal and informal. He said that the Ombudsman process is described as informal so that

bankers are not confused that the Ombudsman can change or interrupt the examination process,

but that, as a resource for a banker, the Ombudsman can be formal.

Member Stevenson inquired how the FDIC can control against retribution against a

banker who makes a complaint; he noted that retribution can be hidden and insidious. Mr.

Webster agreed that it could be hard to pinpoint, but said that a bank identifying itself with its

complaint did something in itself. Ms. McInerney noted that the SARC guidelines specifically

prohibited retaliation and that it was not something division directors, or the FDIC, would

sanction. Member Saunders said she thought the Ombudsman's office was a great resource. She

said that she had heard stories of retaliation occurring and said that confidentiality was

important. Member Saunders suggested that the Ombudsman's office could gather feedback

more broadly so that any systemic issues of inappropriate comments or conduct could be

identified for appropriate FDIC response. Mr. Webster said the Ombudsman did do that and that

the divisions had provided focused training when a systemic issue was identified. Addressing

the issue of obtaining regulatory feedback, Member Savarese observed that banking trade

organizations gathered information about the exam process in an anonymized manner and shared

it with regulators. She noted that the FDIC post-examination surveys were conducted by the

examination divisions themselves and suggested that by making the surveys more confidential

and anonymous, bankers might feel freer to provide negative feedback. Member Savarese also

noted that the OCC had structured its Ombudsman to allow direct reporting to the Comptroller

and authority to intervene in some actions.

Chairman Gruenberg said that the Ombudsman reported directly to Chief of Staff and

Chief Operating Officer Ryan and that the three of them met regularly. He noted that Mr.

Webster, a former regional director, was a senior agency official who had access to senior

officials and so had the ability to intervene effectively where appropriate. Chairman Gruenberg

said that, if using the Ombudsman's office would improve post-examination survey results, the

FDIC was open to considering having those surveys come from sources other than the examining

April 9, 2014 I
264

divisions. Chairman Gruenberg said he viewed the Ombudsman as an important intermediary

who was not part of the examination operation and that he wanted the least hurdle possible for.

banks to make contact with the Ombudsman's office. He said the Ombudsman could provide a

valuable reality-check for a bank's concerns and was also well-positioned to intervene and

engage the decision-makers where warranted. Chairman Gruenberg indicated that he did not

view the number of formal SARC cases as an accurate barometer of the effectiveness of the

SARC process as a whole. He noted that a bank should have to rely on the formal and high-level

SARC appeal only if impasse was reached at lower levels. Chairman Gruenberg acknowledged

that there may not be a perfect solution to the issue of retaliation, but said that the FDIC was

committed to having a process that is as open and responsive as people can make it and had zero

tolerance for retaliation, which would harm the FDIC as an organization. He urged banks to

report misconduct for the benefit of the system and said he was confident that the FDIC's

executives would act to address any instances of retaliation. Chairman Gruenberg said the

example of an examiner's statement about Member Castillo's bank being too small to be in

business was inappropriate, a serious matter and a good example. He said that Member

Castillo's presence on the Committee demonstrated that he disagreed with the examiner's view.

Ms. Ryan then introduced the moderators for the fifth panel, "Developments in Customer

Due Diligence and Reporting Requirements," James Watkins, Senior Deputy Director, RMS, and

Lisa Arquette, Associate Director, RMS. Mr. Watkins spoke about a proposed rulemaking that

is expected from the Financial Crimes Enforcement Network ("FinCEN") concerning customer

due diligence ("CDD") requirements. He said that CDD is fundamental to the safety and

soundness of a bank's business model and was likely part of banks' underwriting and account

opening process. Mr. Watkins noted that CDD includes gathering a customer's identifying

information, deposit account expectations, the purpose of new loans and other accounts, the

customer's business projections, anticipated wire activity and other procedural and monitoring

steps. He said that CDD was a critical element of combatting all forms of illicit financial activity

consistent with banks' Bank Secrecy Act/Anti-Money Laundering ("BSA-AML") obligations.

Mr. Watkins reported that most banks have strong CDD programs; out of2300 BSAlAML

exams the FDIC conducted in 2013, only 22 programs had significant shortcomings requiring a

formal response.

Concerning the expected FinCEN proposed rule, Mr. Watkins said that three elements of

the rulemaking were already bank requirements and practices: I) identifying and verifying the

identity of customers; 2) understanding the nature and purpose of customer relationships; and 3)

conducting ongoing monitoring to maintain and update customer information and to identify and

report suspicious transactions. He said the rulemaking may also propose a new requirement- to

require banks to identify and verify the beneficial owners of legal entities. Mr. Watkins said that

the FDIC was not certain when FinCEN would publish its proposed rule but said that RMS

wanted to make banks aware so they could consider providing feedback to FinCEN. Mr.

Watkins noted that the FFIEC BSA/AML Manual also describes enhanced due diligence

expectations and practices for higher risk customers and makes reference to a list of steps a bank

might take in such a situation.

Ms. Arquette spoke about recent guidance concerning providing banking services to

marijuana businesses in states where marijuana sales are legal. By way of background, she said

April 9, 2014
265

that the Controlled Substances Act makes it illegal under federal law to manufacture, distribute

or dispense marijuana. She said that many states impose and enforce similar state laws but that

20 states make marijuana legal for medical purposes, and two have legalized recreational use.

Ms. Arquette said that in August, 2013 and February, 2014, the Department of Justice ("DOJ")

issued guidance to u.S. Attorneys concerning marijuana enforcement and set forth DOJ's

enforcement priorities. She said that the DOJ guidance made clear that DOJ expected that states

that authorized marijuana-related conduct would also implement clear, strong, and effective

regulatory and enforcement systems. Ms. Arquette also indicated that DOJ expected banks to

report and not offer services to marijuana businesses that operate outside such strong state

regulatory and enforcement regimes. Ms. Arquette said that, in February, 2014, FinCEN issued

guidance that described BSA expectations for banks seeking to provide financial services to

marijuana-related businesses which had two primary focuses. First, she said, the FinCEN

guidance emphasized that it is the financial institution's decision to open, close or refuse any

particular account or relationship. Ms. Arquette said the FinCEN guidance also provided

minimum due diligence procedures that banks should follow for marijuana-related businesses in

addition to considering the DOl's enforcement priorities as part of its CDD.

Ms. Arquette said the second focus of the FinCEN guidance was Suspicious Activity

Reports ("SARs"). She indicated that a bank's obligation to file a SAR is not affected by state

laws that legalize marijuana-related activity. Financial transactions involving a marijuanarelated business would involve funds derived from activity that violates federal law; therefore, a

bank is required to file a SAR. However, the FinCEN guidance identified two distinct categories

of SARs that a bank could file, including a "Marijuana Limited" SAR or a "Marijuana Priority"

SAR. Ms. Arquette explained that a Marijuana Limited SAR should be filed when the bank

reasonably believes that none of the DOJ enforcement priorities are implicated and described the

information that should be included in one. She said that a Marijuana Priority SAR should be

filed when a DOJ enforcement priority is implicated and she described its more detailed

reporting requirements. Ms. Arquette said that a bank should also file a specific SAR if it

terminated a relationship with a marijuana-related business. Ms. Arquette described various

BSN AML resources available to banks from the FDIC, including FDIC examination staff and

subject matter experts in regional and field offices, and a BSN AML training program on the

Director's Resource Center ofthe FDIC website.

Member Hesser, whose bank has decided not to open accounts for marijuana-related

businesses, said there was still a concern about how the FDIC would examine loans that had a

marijuana-relatedmarijuana-related business connection. What would occur, he asked, if aCRE

borrower rented space to a marijuana-related business? In that situation, Member Hesser said

there was a risk that the commercial property could be subject to civil forfeiture by federal law

enforcement causing the bank's interest in the collateral to be eliminated. He reported that banks

in such situations had taken a variety of approaches: some banks had informed the CRE

borrower that it was going to foreclose; others informed the CRE borrower that they would

foreclose if the borrower did not get the marijuana business out ofthe property; others had

informed the borrower that they would foreclose at the end of the loan. Member Hesser asked if

examiners would classify loans in such circumstances. Member Hesser said a second issue was

the regulatory/law enforcement burden put on banks. Not only did the bank have to "know its

customer," he said, but it would also have to evaluate the customer's activity for legality, which

April 9, 2014
266

raised large potential liability issues for the banle Mr. Watkins said that it was the bank's

decision to determine what customers to do business with, and the FDIC expected banks to have

good internal policies for risk assessment.

Member Lundy said that he had heard that DOl had recently wiped out a bank's lien in

Georgia. In response to Mr. Watkins' observation about relying on a bank's risk assessment

processes when it makes a loan, Member Lundy said that a CRE loan may have been within a

bank's policy when it was made but that state law may have changed afterward such that the

bank could no longer use a "violation of state law" clause to call the loan. Member Lundy said

that his institution had decided not to open accounts with marijuana-related businesses but that it

would feel aggrieved if an examiner took an aggressive view about money traceable to a

marijuana-related business flowing through the bank. Member Williams asked if such a loan as

earlier described would be classified based on a material weakness in the credit? Ms. Eberley

said that the FDIC had not developed guidance on the issue, but indicated that the banks

appeared to be on the right track, identifying the issue and considering whether it affected the

borrower's ability to pay. She said that examiners would likely evaluate the bank's evaluation

process although she indicated that classifying credits might require case-by-case determinations.

Member Lundy said that banks would like guidance on whether to file a SAR on a CRE

borrower who had a tenant with a marijuana-related business. Ms. Arquette said that if the CRE

borrower's repayment capacity related to the loan involves tenants, and one of them was a

marijuana-related business, the bank would be obligated to file a SAR (every 90 days if there

was no changes in circumstances). Ms. Arquette added that banks were not expected to be part

of law enforcement, they need only file the report in the FinCEN database and law enforcement

would evaluate the SARs.

Member Blankenship expressed concern that banks might lose their collateral position if

they get caught off guard on a CRE property that has been seized by federal law enforcement.

Ms. Arquette said that a bank's CDD should be expanded when they have a higher risk customer.

Member Blankenship observed that marijuana-related businesses might turn to money service

businesses if banks would not open accounts for them and indicated that banks might risk

liability if they had account relationships with those money service businesses. Member

Savarese questioned whether a bank would be obligated to file a SAR on the executive director

of a not-for-profit medical marijuana dispensary if the dispensary was the director's primary

income source; she noted the bank might learn about the source of income after an account

relationship had begun. Member Savarese inquired if regulators would have difficulty if banks

had customers who were breaking federal law. Mr. Watkins acknowledged that there were risks

for banks, but that regulatory guidance indicated that banks should do their own risk assessment

and have a good understanding of their customers. He added that it was not unusual for a bank

to file a SAR, that thousands are filed on a regular basis. Mr. Watkins said the FDIC appreciated

the feedback on this emerging new topic.

Member Haskin said that the potential FinCEN rule requiring a bank to identitY all the

beneficial owners of a bank account would impose a big burden on community banks with

relatively few employees to accomplish the added work. She said her bank had many Limited

Liability Corporation ("LLC") accounts, and while it appeared reasonable for the bank to know

the LLC's active members, it would be burdensome to identify all the minority owners (who

April 9, 2014
267

might also find the requirement intrusive). Member Haskin also noted that a community bank

could not afford the fine for a BSAlAML violation and so would hire additional staff to comply

with the rule. Ms. Arquette encouraged community bankers who shared that view to provide

feedback to FinCEN after the proposal is made. In response to a question from Member

Stevenson, Ms. Arquette said the FDIC was aware of banks that opened accounts for marijuanarelated businesses and had filed SARs regarding them.

The Committee stood in recess at 12:22 p.m. and reconvened at I:31 p.m. that same day.

For the sixth panel, "Qualified and Nonqualified Mortgage Discussion," Ms. Ryan

introduced Mr. Eberley, Mr. Pearce, Jonathan Miller, Deputy Director, DCP, and Rae-Ann

Miller, Associate Director, RMS. Mr. Pearce noted that the Committee had previously discussed

the CFPB Ability to Repay/Qualified Mortgage rule ("ATR/QM") as the rule was developed.

Under the ATR/QM Rule, creditors must consider a consumer's ability to repay a loan according

to its terms for all closed-end residential mortgages. Mr. Pearce said that the ATR/QM rule had

some elements focused on community banks. First, Mr. Pearce noted that some community

banks (those with under $2 billion in assets, and which make fewer than 500 mortgage loans that

they then then hold in portfolio) can make QMs that have debt to income ratios above 43 percent

and have an Annual Percentage Rate of up to 350 basis points above the average prime offer rate.

Also of interest to community banks, he said that mortgages with balloon payments can also be

designated as a QM. Mr. Pearce said some banks had questioned how their business decisions in

response to the ATR/QM rule might interact with fair lending and the CRA evaluations. He said

that the regulatory agencies had issued guidance on the subject and that Mr. Miller and Ms.

Miller would further discuss the issue.

Mr. Miller said that one banker concern had been whether banks would experience fair

lending criticism if they decided to make only QM loans. He said that the CFPB and the banking

agencies issued a press release in October 2013 that clarified that if a bank chose to do only QM

lending, such a decision by itself would not run afoul of fair lending laws. Mr. Miller said that

fair lending decisions were fact-specific and that his statement should not be viewed as a general

safe harbor. He likened the QM situation to banks that chose not to participate in Federal

Housing Administration lending or in secondary market lending. Mr. Miller said that most FDIC

supervised institutions were portfolio lenders and that such business decisions alone did not

result in fair lending or CRA violations.

Ms. Miller provided the Committee with a risk management perspective. She said that

bankers had expressed concern that they would receive safety and soundness criticism if they

chose to make non-QM loans; for example, non-QM loans might be automatically classified or

there would be an inclination to finding legal risk for non-QM loans. Ms. Miller said that the

banking agencies issued a December 2013 statement that indicated that institutions may originate

both QM and non-QM loans based on their business strategy and risk appetite and that

residential mortgage loans will not be criticized solely because they are QM or non-QM. She

explained that the FDIC would continue to expect institutions to underwrite residential

mortgages prudently, addressing key risk areas such as loan terms, borrower classification

standards, loan to value limits, and documentation requirements regardless of whether the loans

were QM or non-QM.

April 9, 2014
268

Ms. Miller said the FDIC examination manual focuses on lending and underwriting in

general and emphasizes the importance of having a sound lending policy, sound underwriting,

risk review systems, watch systems, and appropriate ALLL. She said the examination manual

also states that ATR is the most important element of underwriting, regardless of the type of

loan. Ms. Miller said that a bank's real estate policy needs to ensure that loans are granted with a

reasonable probability that the debtor will be willing and able to meet the loan's payment terms.

She noted that all the banking agencies required banks to adopt and maintain appropriate policies

for real estate loans and discussed what those policies should entail. Ms. Miller said that banks

are expected to monitor market conditions and adjust policies appropriately. She said that the

FDIC had issued guidelines to help banks develop their policies and that the guidelines address

matters such as loan portfolio management, loan administration, loan to value, and underwriting.

She also provided additional specifics about underwriting. Ms. Miller said there was also

guidance, commonly called the retail credit policy, which addresses the classification and

modification of mortgages and other consumer loans. She said the retail credit policy indicates

that classifications are generally based on a combination of delinquency status of the loan and

collateral value, not on the loan's QM or non-QM status. Ms. Miller said that the agency's

policies concerning residential mortgage lending was widely discussed within the agency

because it was important that FDIC examiners understood the policies.

Mr. Pearce observed that a recent American Banker article discussed a survey indicating

that, as a result of the QM rule, about one-third of banks had made no changes in their lending

plans, about one-third decided to make only QM loans, another third decided to make some nonQM loans, and about one to two percent had ceased mortgage lending. He said the survey was

generally consistent with what the FDIC had heard in outreach events and invited the Committee

to discuss their observations. Member Williams said that his bank was aiming to make primarily

QM loans but that there would be times it would make non-QM loans in order to meet its

community's credit needs. Member Savarese said the her bank would aim to do QM lending

plus carefully defined types of non-QM lending, for example, making loans to asset-heavy

clients although the debt to income ratio would go above 43 percent. She said that her bank

thought that non-QM lending presented banks with a significant litigation risk if a non-QM loan

became delinquent. Member Williams said that many retirees had substantial assets that would

not generally show as regular income in calculating a debt-to-income ratio and asked if the FDIC

had discussed how to address that issue. Mr. Miller said that a borrower's assets was one of the

eight underwriting factors identified by the CFPB that could be considered in making an ATR

decision. Member Williams said that banks' concem was whether such a loan would be defined

as QM or not. Member Savarese agreed and reported that there was a disconnect between the

CFPB's eight factors and 16 pages of detailed guidance in Appendix Q to the rule. Mr. Pearce

and Mr. Miller said that the FDIC would look into the question further.

Member Williams said that it would be very helpful to have definitive guidance on how

assets might be considered from a QM definition standpoint (and not just from a safety and

soundness standpoint). Mr. Miller said the key point to recall was that in making an ATR

decision, the lender has made a good faith estimate to establish the borrower's ability to repay

the loan. He said that most banks' normal underwriting would document their consideration of

the eight ATR factors; he reported that a CFPB study indicated that over 90 percent of all loans

originated in 2013 met QM standards. He also noted that the 43 percent debt to income ratio did

April 9, 2014
269

not apply to small lenders (as earlier defined) and it did not apply to loans eligible to be sold to

Fannie Mae or Freddie Mac.

Member Haskin said that in Oklahoma about 35 percent of bank respondents surveyed

indicated that they no longer made mortgage loans, and that among those who did make

mortgage loans, 78 percent were offering only QM loans. She said that many rural bankers who

had a volume of only 5-10 loans per year decided that it was not worth the effort required to

revamp their systems to comply with the ATRlQM rule; this meant that there were many rural

communities that lost many mortgage loan originators. Member Blankenship said that Texas had

similar results and that, in many rural areas, there were no alternative mortgage lenders servicing

the market. She said her bank had a branch in a location where the demographics made it hard to

make a QM loan and that making a non-QM loan involved taking a substantial litigation risk.

Mr. Miller agreed that uncertainty about litigation made lenders more thoughtful about their

decisions. He noted that rural banks had more flexibility in lending terms and still obtain a QM

determination; he also noted that the CFPB was giving further consideration to its definition of

rural. Mr. Pearce said that the Committee's feedback was valuable because the FDIC was

concerned about the issue of mortgage loan availability in rural communities. He said that there

had been a lot of change in the mortgage lending rules recently and the FDIC was hoping to

clarify as many issues as possible so that community banks choose to offer mortgage lending.

Mr. Pearce noted that FDIC examiners were often a source of information for community

bankers and that the FDIC was working to ensure its examiners were fully informed about the

issues.

Member Blankenship said that community banks wanted to continue to offer mortgages

but wanted to quantify their litigation risk if possible. Mr. Pearce said he appreciated the desire,

but said there was not much the FDIC could offer about quantifying litigation risk. Member

Savarese said that an effect ofthe litigation risk uncertainty was that bankers were cutting back

on their mortgage lending and there had been a reduction in the availability of credit. She asked

if the FDIC had seen any impact on mortgage lending volume. Mr. Miller said that, because

mortgage lending was subject to so many economic factors, it was very difficult to determine the

effect of the legal changes alone. He said he thought another driving force on mortgage lending

was the unhappiness of investors who had purchased mortgage backed securities with warranties

that did not protect them as expected.

Member Lundy said that his bank had decided not to engage in mortgage lending for

reasons other than the ATRlQM rule. He said that bankers had perceived a difference between

FDIC and OCC evaluation of mortgage loans (especially jumbo loans); if the loan to value ratio

became too high, FDIC examiners wanted the bank to downgrade the loan even though it was

current/non-delinquent while OCC examiners were not requiring the same downgrades for large

banks. Ms. Miller said that the FDIC's policy was not to classifY performing loans based solely

on a drop in collateral value; she said the FDIC had done outreach and issued guidance on the

subject.

Chairman Gruenberg said it was worth remembering that there had been significant

problems in mortgage markets from 2005-2007 relating to mortgages that were made without

determinations about borrowers' ability to pay. He noted that there had been no requirements

April 9, 2014
270

that lenders determine a borrower's ability to pay and the QM rule was designed to set

reasonable standards to apply to the mortgage market. Chairman Gruenberg indicated that the

financial crisis crimped access to mortgage credit and the economy had spent five years

recovering from those problems so it was important that a real balance be struck.

Ms. Ryan introduced the panelists for the "Supervisory Policy Update," George French,

Deputy Director, RMS, Bobby Bean, Associate Director, RMS, and Robert Storch, Chief

Accountant, RMS. Mr. French said the panel would discuss IRR, Volcker Rule implementation,

and recent developments from the FASB. He began by noting that IRR was a current

supervisory focus. Mr. French discussed trends from mid-2008 to mid-20 13, observing that the

period was one of very weak loan demand and noting that the total loans on the balance sheets of

all insured institutions had actually shrunk during the period. In the same period, he said, banks'

securities portfolios grew at an annualized rate of about eight percent per year so that, by mid2013, investment portfolios had grown in relative significance as a part of banks' balance sheets.

Mr. French said that the quarterly annualized yield on the investment portfolio had reduced from

about 5 percent to about 2.2 percent in that period while, maturities were increasing significantly

(so that by the end ofthat period the average community bank had about 56 percent of its

securities and assets with maturities over five years). He said that community banks now have a

significant volume oflow coupon, long maturity securities that would experience significant

price depreciation in an increasing interest rate environment. Mr. French added that municipal

bonds make up a large percentage of the securities so that there is additional potential for

depreciation if there are marketplace concerns about municipal credit quality. Regarding the

liability side of the balance sheet, Mr. French said that there had been an influx of deposits over

the period and that a significant amount of those deposits might runoff faster than historical

experience if interest rates rise.

Mr. French said that the examination process was indicating that, among institutions that

have high levels ofIRR exposure, many are not managing the risks well by: I) not having

adequate risk limits in place; 2) operating outside of risk limits that have been established; 3) not

considering alternative deposit runoff scenarios; and 4) not having mitigation strategies in place.

After noting that the FDIC and other banking agencies provided a variety of resources on IRR,

he said that banks should be focused on the issue and invited comment.

Member Hesser said he thought that Mr. French's observations were correct; his bank

looked at potential acquisitions frequently and often found what Mr. French had described. He

said that his bank walked away from banks because of the securities portfolios more often than

their loan portfolios. Member Hesser said that a typical bank for sale today has a loan-to-deposit

ratio of about 50 percent and had taken all the bond gains they could in the last two years to

increase their earnings. He indicated that such banks would soon be struggling for earnings. In

response to Mr. French's inquiry if bankers are starting to strategize for interest rate increases,

Member Hesser said that bankers worry about today. Member Blankenship said that her bank

was fortunate to have good loan demand, but indicated that many banks are in a difficult position

due to pressure on their net interest margins. She said that, as long as interest rates stay low and

banks lose fee income, there will be more pressure on banks.

April 9,2014
271

Mr. French said that the FDIC had seen some loan demand reemerging in parts of the

country and said that about 60 percent of institutions were growing their loan portfolios to some

extent. Member Blankenship said that loan growth would tend to mitigate the risk somewhat

because it would reduce the need to buy long-term securities to generate income. She said that

most bankers are cognizant of the dilemma but many just do not see a way out. Mr. French said

that mitigation strategies described in the technical assistance videos and the guidance include

having enough capital to absorb potential losses from securities depreciation, and reducing their

exposure to IRR by balance sheet adjustments, sales, and purchases of different duration assets.

He asked what actions bankers were considering. Member Blankenship responded that the

options were limited, it was typically a choice between loans and securities, and if there was no

loan demand there was not much that could be done. Member Stevenson said that his bank had

configured all of its assets and liabilities to be of short duration so that the bank did not have

much exposure in either direction. He said the challenge was just the pure margin and that a

steepening of the yield curve would be beneficial to his bank.

Mr. Bean spoke about the Volcker Rule (final rule approved by the five signatory

agencies on December 10, 2013) which, he said, had two primary elements: I) generally

prohibiting banking entities from engaging in short-term proprietary trading for their own

account; and 2) generally prohibiting them from owning, sponsoring, or having certain

relationships with hedge funds or private equity funds, referred to in the final rule as "covered

funds." Mr. Bean said that only the very largest domestic and foreign banking organizations

(about 15) had proprietary trading desks and regulators perceived that most of them were now

closed. He said there was a concern that proprietary trading might migrate to market making and

underwriting activities that are not prohibited, but that few banking organizations outside the 15

largest engaged in market making. He said that most community banks did not engage in

proprietary trading. Concerning "covered funds," Mr. Bean said that the Volcker Rule

prohibited ownership by a banking entity in a hedge fund or private equity fund unless the

institution was a sponsor of it (and, if so, the ownership is limited to three percent and that

ownership interest must be deducted from capital). He explained how the definition of 'covered

funds' was structured to prevent a general evasion ofthe rule while allowing the origination of

loan securitizations (which are specifically allowed under the section 619 of the Dodd-Frank Act

which authorized the issuance of the final rule). Specifically, he said, all securitizations were

included in the definition of' covered funds,' but that securitizations backed solely by loans were

then excepted from that definition. Thus, he said, a variety of securitizations he named fall

outside of the "covered funds" definition (including: residential mortgage-backed securities;

commercial mortgage-back securities; certain asset-backed commercial paper programs; and

credit! auto /trust and credit card securitizations).

Mr. Bean said that the regulators worked to scale the Volcker Rule's compliance burden

appropriately. Community banks that engage in no covered activities would have zero

compliance requirements. Institutions that have less than $10 billion in total consolidated assets,

he said, would be allowed to tailor their compliance programs to their specific covered activities;

for example, such a bank could state that it would limit its securitization investments or

sponsorship to those not covered by the Volcker Rule, and that could constitute its compliance

program. Mr. Bean said that larger institutions would be required to implement more complex

compliance programs. While the final rule would become effective April I, 2014, Mr. Bean said

April 9, 2014
272

that it was important to note that the Federal Reserve Board issued an extension of the

conformance period until July 21,2015.

Mr. Bean said that on January 14, 2014, the banking regulatory agencies issued an

interim final rule concerning collateralized debt obligations backed by trust preferred securities

("ImPS CDOs") that grandfathered those securities from the prohibitionslrestrictions on

investments by banking entities in covered funds under the final rule. He said that the agencies'

decision was consistent with the "Collins Amendment" of the Dodd-Frank Act (section 171 of

the Dodd-Frank Act), and observed that no new ImPS would be issued and that the management

of those already issued was such that the IruPS generally could not be used to circumvent the

intent of the Volcker Rule.

Mr. Bean then discussed Collateralized Loan Obligations ("CLOs"), distinguishing

between those issued before and after 2009. CLOs issued before 2009 often allowed for the

inclusion of a variety of financial instruments other than loans, thus making them and a 'covered

fund' prohibited by the Volcker Rule. CLOs issued after 2009 generally limited non-loan

content to about ten percent of the underlying assets. He said that about half of post-2009 CLOs

invested in nothing but loans and are not 'covered funds.' Mr. Bean said that large banks,

particularly very large banks, had concerns about CLOs under the final rule, and in April, 2014,

the Federal Reserve Board issued a Statement indicating its intent to extend the conformance

period for certain CLOs until July 21, 2017. Mr. Bean explained that many CLOs will be paid

off by the end ofthe conformance periods, in part because they are very interest rate sensitive

and have call features that would allow issuers to respond to interest rate increases. He said that

it was estimated that about 25 percent of pre- Volcker Rule CLOs would still be outstanding as of

July 21,2015, and that the large institutions that held them would be able to restructure that

amount ofCLOs prior to July 21, 2017.

Mr. Bean said that the Volcker Rule regulatory agencies had established an interagency

working group to ensure its consistent application across agencies. He said that the agencies

would issue a "Frequently Asked Questions" document that would probably focus on issues

faced by the very largest banks which have the earliest compliance responsibilities. Mr. Bean

said that the agencies would also issue additional information for all banks, including community

banks. Until then, he said that banks were welcome to send questions to the FDIC (at

capitalmarkets@fdic.gov) for general or individual guidance. Member Savarese said that the

industry was grateful for the extension of the conformance period, which would allow for the

development and evaluation of alternative compliance approaches under the final rule.

Mr. Storch first spoke about the recent history of the FASB' s proposals concerning

classifYing and measuring financial assets and public response to them. He noted that, in May

2010, the FASB proposed that substantially all financial assets would be reported on the balance

sheet at fair value and that the banking agencies and the banking industry had registered their

opposition to that proposal. In response, Mr. Storch said, in February 2013, the FASB proposed

that it would require financial assets to be classified based first on an asset's cash flow

characteristics and second on the business model to be used to manage the asset. After

providing more detail about these tests and the resulting measurements, he discussed banking

regulatory agency criticisms of the February 2013 proposal. Mr. Storch said that in December

April 9, 2014
273

2013 and January 2014, the FASB determined that it would not further pursue the two

classification criteria in its February 2013 proposal and asked its staff to consider whether any

targeted improvements could be made to the current U.S. accounting standards for classifying

and measuring loans and securities. He said that the FASB staff subsequently reported that they

had not identified any significant targeted improvements. Since the effect of making no changes

to the current standards would be to continue to rely on the "legal form" models of classification,

Mr. Storch indicated the FASB asked its staff to consider whether there was a need to better

distinguish between instruments that would be deemed loans for accounting purposes and those

that would be deemed securities. Mr. Storch said that the FASB staffwas currently pursuing that

request.

Mr. Storch said that the FASB Board's decisions should be viewed favorably by banks

generally because these decisions responded to banking agency and other public comments about

the complexity and compliance costs of the FASB's proposal, especially where the proposed

changes essentially achieved the same accounting outcome as the current standards. He said that

whatever final standard the FASB adopts would not likely have a material effect on banks'

current classification and measurement policies.

Mr. Storch then discussed the current state of the FASB's December 2012 proposal

concerning the accounting for credit losses, which would replace the existing incurred loss model

with a Current Expected Credit Loss ("CECL") model. He said that the proposed change to the

CECL model was intended to address criticisms that the present model resulted in loan loss

allowances that are too little and too late. The change to CECL would also broaden the range of

information that should be considered when estimating credit losses, he said, by bringing

reasonable and supportable forecasts into the assessment of the collectability of loans (something

that, from a credit risk management standpoint, the FDIC hoped bank management already did).

Mr. Storch said the FASB received a lot of criticism for the CECL proposal because it

was viewed as front-loading the recognition of credit loss expense. As a result, in December

2013 the FASB considered whether to pursue an alternative model. He said that the FASB

decided that it would continue with the CECL model, but would try to refine it and make it more

understandable and operational for financial statement preparers. Mr. Storch provided additional

detail about subsequent FASB decisions on expected credit loss accounting and reporting. He

said that the banking regulatory agencies had emphasized to the FASB that it needs to make clear

that it is not imposing a requirement for banks to use a complicated and expensive model to

comply with the new standard, an issue particularly important for community banks. Mr. Storch

said the FASB had also agreed that it would include implementation guidance describing factors

that an entity should consider when adjusting historical loss experience for current conditions

and reasonable and supportable forecasts, and when an entity should revert to its historical

average loss experience.

Mr. Storch reported that the FASB decided, for the time being, not to include formal

nonaccrual guidance within generally accepted accounting principles ("GAAP"), which means

for banks that the existing nonaccrual rules in the Call Report instructions will remain in place

(and there would be no potential conflicts between a GAAP standard and bank regulatory

reporting standards). Finally, he said, the FASB had decided it remained important to identify

April 9, 2014
274

which loans are TDRs and disclose information about TDRs. Mr. Storch said that the FASB

anticipates that it will issue a final standard on credit losses by the end of2014, but it would

likely not take effect before 2017 and might provide different effective dates for public and

private companies.

Member Seleski asked if regulators expected that there would be a regulatory standard

for determining prepayment speed when determining loss factors and cash flows, or whether

banks would be expected to make determinations for their individual market. He inquired how

banks would obtain such data and whether it would be historical or market data. Mr. Storch said

that regulators would expect the bank to make the determination based on management's

experience, current conditions, and forecasts of prepayment speeds. He noted that prepayment

speeds could change from period to period. Mr. Storch said that a bank would need to document

how it reached its conclusion and what objective evidence it considered. He said that guidance

to examiners should make it clear that they should accept a bank's prepayment assumptions as

long as they have a reasonable basis, and that different banks with different circumstances could

have different assumptions.

Member Williams expressed concern about how much the ALLL would need to increase

when banks have to transition to CECL and about the cost of modeling, especially for a small

bank, to comply with CECL. Mr. Storch said that the general opinion was that, once a bank has

cleared the transition hurdle, it would have a higher ALLL, but that the fluctuation in the level of

the ALLL from period-to-period under the CECL model would be similar to what occurs under

the current model. He added that it is unknown what economic conditions, loan loss allowance

levels, and the composition of banks' loan portfolios would be in 2017 or 2018 when the CECL

standard becomes effective. Mr. Storch said that the Office of the Comptroller of the Currency

had estimated most banks may experience a 30-50 percent increase in their ALLL levels, but

some banks would see larger increases and others would see smaller increases. He noted that a

bank with a very short term loan portfolio may not experience any ALLL change except for the

incremental effect on the allowance from having to consider forecasts. Regarding the effect of

CECL on regulatory capital, Mr. Storch said the regulatory agencies could consider whether

transition rules might be appropriate. With regard to the cost of modeling, he said the FASB had

indicated it would try to develop, as part of its implementation guidance, an example of how a

community bank could apply the CECL model. Mr. Storch said the banking agencies have been

conveying the message that they would not impose a requirement that a community bank obtain

an expensive model. He said that a good starting point for a bank could be to build up

information about its own lifetime loan loss experience. Mr. Storch said the banking agencies

also realize that the CECL model will give them a large task to accomplish, including

communicating the changes to financial institutions, retraining examiners, and updating

examination and guidance materials. Member Williams said that banks would appreciate agency

guidance early so that they could begin preparations.

Member Haskin observed that the loan loss model was reworked after every crisis but

said that the current change was unlikely to be a cure-all because predictions about the future are

so subjective. She said she was concerned that the effect of the change to CECL, including the

need to predict the future, would be to take capital out of the system that could otherwise be used

for loans. Mr. Storch said that many people interpreted the term "reasonable and supportable

April 9, 2014
275

forecast" in the FASB' s proposal to be about two to three years in the future, after which banks

would revert to their long-term historical loss experience. He indicated that banks would not be

expected to make predictions five to ten years out.

Member Haskin inquired how balloon loans would be treated under CECL. Mr. Storch

said that, while CECL expected banks to estimate prepayments, they were not allowed to

consider anticipated extensions and renewals. Thus, he said, a bank would be estimating cash

flows as of the balloon payment date (unless the bank has a troubled borrower and expects to

undertake a TDR when the balloon payment is due at maturity). Mr. Storch said that the banking

agencies would encourage the FASB to provide guidance on how to apply the CECL proposal to

a balloon payment loan. He said that if the FASB does not provide guidance, the banking

agencies would need to so that examiners would understand the agencies' expectations in this

situation.

Chairman Gruenberg said the meeting had been very productive. He thanked the

Committee members for their valuable contributions and said that he and the FDIC staff had a

substantial "to-do" list as a result of the meeting.

There being no further business, the meeting was adjourned at 3:08 p.m.

~

Robert E. Feldman

Executive Secretary

Federal Deposit Insurance Corporation

And Committee Management Officer

FDIC Advisory Committee on Community Banking

April 9, 2014
Minutes

of the

Meeting ofthe FDIC Advisory Committee on Community Banking

of the

Federal Deposit Insurance Corporation

Held in the Board Room

Federal Deposit Insurance Corporation Building

Washington, D. C.

Open to Public Observation

April 9, 2014 - 8:45 A. M.

I hereby certify that, to the best of my knowledge, the attached minutes are accurate and

complete.

~JMartin J. Gruenberg

Chairman

Board of Directors

Federal Deposit Insurance Corporation