Mercer Capital had the opportunity to attend the AICPA conference on banks and thrifts held September 10th to 12th in Washington, DC. Between sessions focusing on technical accounting issues, several presenters offered observations pointing to the direction of banking industry. We thought Mr. Rodgin Cohen offered the most trenchant observations regarding the state of the banking industry and the complex range of issues affecting it.

Mr. Cohen is the senior chairman of the law firm Sullivan & Cromwell based in New York. Many of the books written on the financial crisis reference Mr. Cohen’s role in providing legal counsel in a number of the failures, recapitalizations, and mergers that marked the height of the financial crisis. While Mr. Cohen’s practice focuses on the largest financial institutions, we believe his comments are instructive for all banks. In a speech lasting less than one hour, Mr. Cohen managed to complete that most difficult of tasks for a speaker or writer – communicating profoundly with an economy of words. At the risk of understating the subtlety of his comments, we provide the following synopsis of Mr. Cohen’s speech. Where noted, we also elaborate on Mr. Cohen’ comments, suggesting the impact of his large bank centric comments on community banks.

In Mr. Cohen’s forty year career advising financial institutions, the current period represents the most difficult regulatory environment for the following reasons:

  • Unpredictable and uncertain regulatory standards and guidance. That is to say, the difficulty facing banks is not that regulations are too tough but that banks do not know what the regulations are. This, in turn, unnecessarily frustrates planning for the future.
  • Disrupted channels of communication between regulators and the regulated. In short, neither group understands the issues facing the other, thereby hampering the ability to communicate.
  • The degree to which the industry’s future is subject to regulatory determination, as opposed to being within the industry’s ability to influence.

These themes are laced throughout the remainder of Mr. Cohen’s comments. To place the preceding themes in context, Mr. Cohen decomposes the current regulatory environment into four components: legislative, regulatory, supervisory, and enforcement.

With respect to legislation, Mr. Cohen accepts that Dodd/Frank represented the most significant thrust from a legislative standpoint. However, he also believes that most of the Dodd/Frank rules would have been implemented via regulation in the absence of Dodd/Frank, as they were sensible responses to shortcomings in the pre-crisis regulatory architecture. Importantly, Mr. Cohen would make exceptions for certain elements of Dodd/Frank that were more punitive in nature, such as the Durbin amendment affecting interchange income.

From a supervisory standpoint, Mr. Cohen notes tightening standards on capital, liquidity, and other matters while, at the same time, regulatory agencies have become more apt to intervene in banks’ decision making. In short, the current model has become one of regulation by supervision. Unlike proposed regulations, new or modified supervisory standards are not subject to a formal rulemaking process that provides interested parties an opportunity to comment.

To illustrate his perspective on the supervisory environment, Mr. Cohen uses the large bank stress testing process undertaken by the regulatory agencies as indicative of the centrality of regulators in creating the new banking regime – one that is quite apart from any legislative requirements. The stress test regime represents a novel set of capital requirements that is largely a mystery to the banks, as the Federal Reserve’s models are secret. Effectively, the regulators can create new capital requirements for banks simply by changing the (largely unknown) assumptions underlying or the inner workings of the stress test model. From the bank’s perspective, this exercise in uncertainty makes long-term planning nearly impossible.

Mr. Cohen notes that recent enforcement actions are damaging the reputation of the banking industry. Previously, actions by banks that would have merited informal sanctions have resulted in fines measuring in the billions and potentially more adverse CAMELS scores. Several intertwined issues relating to the enforcement environment exist:

  • The proliferation of regulations, coupled with the uncertainty of their implementation, has created a minefield for banks. In the midst of this uncertainty, regulators have a wide scope to subjectively interpret regulations, and the risk of committing a violation has increased exponentially.
  • Fines have increased dramatically. In this environment, Mr. Cohen noted that in determining fines the current practice seems to be adding another zero to the dollar amount of the most recent largest settlement of a similar nature. For example, Standard Chartered Bank’s recent settlement over alleged improper actions relating to transactions with Iranian entities was ten times the previous largest fine for similar actions.
  • Under regulations such as for anti-money laundering, banks have been essentially deputized by the federal government to identify and report violations of U.S. law. However, as the Standard Chartered matter demonstrates, regulators seem to be holding banks to an impossibly high standard of detecting each and every violation of regulations, a standard to which society does not hold traditional law enforcement agencies, as Mr. Cohen notes.
  • Regulators appear to be applying today’s interpretation of regulation to actions taken years ago, creating the risk that “industry standard” policies are open to attack.
  • Banks need to be aware of the risk that a disgruntled employee could approach regulators with information that casts the bank in a poor light. As a recent example, Mr. Cohen cited a former UBS employee, who after sharing information with the IRS about tax strategies sold by UBS collected in excess of $100 million as his payout (and despite spending several years in prison due to his actions).

    As another example, Mr. Cohen references Barclays’ settlement over LIBOR reporting. In this matter, Barclays reported its concerns regarding LIBOR fixings to its regulators. Barclays faced a dilemma as to how to proceed – report higher LIBOR fixings when weaker banks were reporting lower LIBOR fixings (thereby creating the risk of a run on Barclays) or report lower LIBOR fixings more in line with other banks. Ultimately, Barclays faced a severe penalty despite its efforts to bring the LIBOR matter to the attention of its regulators.1

    For many bankers, one of Mr. Cohen’s most surprising observations may have been his comment that the best and brightest individuals at the bank should be assigned to compliance activities, given the risk of compliance failures.

    From Mercer Capital’s vantage point, there may be a tendency in the community banking industry to view these enforcement matters as the province of the largest banks. Schadenfreude may be a natural response, but the risk exists that the large banks’ current $400 million fine for a previously accepted practice could be a community bank’s fine of $400 thousand next year for a similarly accepted practice.

It seems common today among commentators to accept that increased regulation will lead to greater consolidation activity. Mr. Cohen offered an alternative thesis, that enhanced regulation is a hindrance to consolidation activity. He supports the observation as follows:

  • A CAMELS score of 3 is the new normal (not a 2 as in the pre-crisis period), and banks with CAMELS scores of 3 generally are prevented from acquiring another institution. Further, a score of 3 or worse on a compliance examination generally has led to regulatory rejection of an acquirer’s transaction. Therefore, the number of potential buyers has decreased.
  • The largest banks are sidelined from participating in industry consolidation on account of capital surcharges and the like that affect their post-acquisition capital ratios.
  • Capital expectations regarding acquisitions are tightening in some respects and uncertain in other respects. For example, regulators have been reluctant to allow acquirers to restore any capital ratio dilution occurring at the acquisition date through retained earnings following the transaction.
  • Known or unknown compliance issues on the part of a target create a significant risk and one that is difficult to quantify. By acquiring a bank, the purchaser would be assuming the risk associated with any compliance lapses by the target.

    Certain of the preceding comments are more applicable to the larger banks. However, for community banks Mr. Cohen’s comments are instructive as to matters that acquirers should consider. First, capital levels are of the utmost importance to regulators. Second, compliance issues should not be overlooked in due diligence reviews.

This article represents Mercer Capital’s summary of Mr. Cohen’s comments. Any shortcomings in the description of Mr. Cohen’s views, in relation to his actual intent, are attributable to the author of this article.


1Mr. Cohen would distinguish between actions of traders, as captured in emails, that were unauthorized by management and actions that resulted from Barclays’ corporate policies and discussions with regulatory agencies. Mr. Cohen would agree that the former would require significant punishment.