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06.30.2016 | Legal Update

The Nutter Bank Report is a monthly publication of the firm's Banking and Financial Services Group.

Headlines
1. Agencies Publish Proposed Rule to Limit Incentive-Based Compensation Arrangements
2. Guidance on New Credit Loss Accounting Standard Issued by Federal Banking Agencies
3. Fed Provides Updated Guidance on Supervisory Expectations for Risk Management
4. CFPB Proposes New Rules for Payday, Vehicle Title, and High-Cost Installment Loans
5. Other Developments: New Cybersecurity Guidance and UDAP Amendments

1. Agencies Publish Proposed Rule to Limit Incentive-Based Compensation Arrangements

The federal banking agencies, together with the NCUA, the SEC and the FHFA, have published a proposed rule that would implement the incentive-based compensation restrictions for financial institutions under Section 956 of the Dodd–Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposal published on June 10 would establish new requirements for incentive-based compensation at certain covered financial institutions, including banks that offer incentive-based compensation and have average total consolidated assets of at least $1 billion. The proposed rule would not apply to institutions with less than $1 billion in total consolidated assets. The proposed rule would prohibit all covered institutions from establishing or maintaining incentive-based compensation arrangements that could lead to material financial loss to the covered financial institution or that encourage “inappropriate risks” by providing an executive officer, employee, director or principal shareholder of a covered institution with excessive compensation, fees or benefits. The proposed rule identifies three categories of covered institutions based on average total consolidated assets: Level 1, greater than or equal to $250 billion; Level 2, greater than or equal to $50 billion and less than $250 billion; and Level 3, greater than or equal to $1 billion and less than $50 billion. The proposed rule contains progressively more rigorous standards for Level 2 and Level 1 institutions. The proposal, if finalized, would become effective at the beginning of the first calendar quarter that begins 1½ years after a final rule is published in the Federal Register. The proposed rule would not apply to any incentive-based compensation plan with a performance period that begins before that compliance date. Comments on the proposed rule are due by July 22, 2016. Click here for a copy of the Federal Register notice.

    Nutter Notes: The proposed rule provides that an incentive-based compensation arrangement will be considered to encourage inappropriate risks that could lead to material financial loss to the covered institution unless the arrangement satisfies the following criteria: it appropriately balances risk and reward, it is compatible with effective risk management and controls, and it is supported by effective governance. The proposed rule specifically provides that an incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it includes financial and non-financial measures of performance, is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate, and is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. The proposed rule also contains requirements for the board of directors of a covered institution. Under the proposed rule, the board of directors of each covered institution (or a board committee) would be required to exercise oversight of the covered institution’s incentive-based compensation program and approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements. The proposed rule would also require the board of directors to approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.

2. Guidance on New Credit Loss Accounting Standard Issued by Federal Banking Agencies

The federal banking agencies have issued joint guidance on Accounting Standards Update (ASU) No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, recently adopted by the Financial Accounting Standards Board, which introduces the current expected credit losses methodology (“CECL”) for estimating allowances for credit losses. The guidance published on June 17, Joint Statement on the New Accounting Standard on Financial Instruments – Credit Losses, explains that the new accounting standard allows financial institutions, including banks, to leverage current internal credit risk systems as a framework for estimating expected credit losses. The new accounting standard applies to all banks and bank holding companies, regardless of asset size, according to the joint guidance. The joint guidance explains that CECL does not specify a single method for measuring expected credit losses. Banking organizations should develop credit loss estimation methods that are well documented, applied consistently over time, and faithfully estimate the collectability of financial assets by applying the principles in the new accounting standard, according to the joint guidance. The new accounting standard allows expected credit loss estimation approaches that build on existing credit risk management systems and processes, as well as existing methods for estimating credit losses. Click here for a copy of the joint guidance.

    Nutter Notes: According to the joint guidance, the allowance for credit losses under CECL is a valuation account, measured as the difference between the financial assets’ amortized cost basis and the net amount expected to be collected on the financial assets (i.e., lifetime credit losses). The joint guidance explains that, to estimate expected credit losses under CECL, institutions will use a broader range of data than under existing U.S. Generally Accepted Accounting Principles (“GAAP”). The data includes information about past events, current conditions, and reasonable and supportable forecasts relevant to assessing the collectability of the cash flows of financial assets, according to the joint guidance. The joint guidance further explains that impairment measurement under existing U.S. GAAP is often considered complex because it encompasses a number of impairment models for different financial assets. The new accounting standard, in contrast, introduces a single measurement objective to be applied to all financial assets carried at amortized cost, including loans held for investment and held-to-maturity securities, according to the joint guidance. The joint guidance also explains that the new accounting standard updates the measurement of credit losses on available-for-sale debt securities. Under the new standard, institutions will record credit losses on available-for-sale debt securities through an allowance for credit losses rather than writing down individual securities for other-than-temporary impairment, according to the guidance.

3. Fed Provides Updated Guidance on Supervisory Expectations for Risk Management

The Federal Reserve has updated its supervisory guidance for assessing risk management at state member banks and bank holding companies with less than $50 billion in total consolidated assets. The core risk management principles outlined in the updated guidance, published as Supervision and Regulation Letter no. SR 16-11 on June 8, reflect updates to, and partially supersede, prior published guidance on the Federal Reserve’s evaluation of the adequacy of a banking organization’s risk management and internal controls. For example, while the Federal Reserve continues to expect that a banking organization’s risk management processes will evolve in sophistication as the institution grows and its business and operations become more complex, the updated guidance now includes a discussion of the Federal Reserve’s expectations for small community banking organizations (“CBOs”). According to the updated guidance, relatively basic risk management systems may be adequate for a CBO engaged solely in traditional banking activities and whose senior management is “actively involved in the details of day-to-day operations.” Examiners will also expect a parent company that centrally manages the operations and functions of its subsidiary bank(s) to have more comprehensive, detailed, and developed risk management systems than a parent company that delegates risk management to relatively autonomous subsidiaries, according to the updated guidance. Click here for a copy of the updated guidance.

    Nutter Notes: With respect to the assignment of supervisory ratings, the updated guidance does not change the risk management rating requirements and ratings definitions from Supervision and Regulation letter no. 95-51, November 14, 1995, which has been retained in the Federal Reserve’s Commercial Bank Examination Manual. When evaluating the risk management at a banking organization, Federal Reserve examiners will continue to place primary consideration on findings relating to the four key elements of a sound risk management system: board and senior management oversight; policies, procedures and limits; risk monitoring and management information systems; and internal controls. Consistent with the policy that risk management should be commensurate with an institution’s size and complexity, examiners will expect a smaller and less complex institution to require less frequent management and board reports to support risk monitoring activities, according to the updated guidance. Such reports for smaller CBOs, according to the updated guidance, may include daily or weekly balance sheets and income statements, a watch list for potentially troubled loans, a report on past due loans, an interest rate risk report and similar items. Similarly, the updated guidance provides that smaller CBOs whose size and complexity do not warrant a full scale internal audit function may rely on regular reviews of essential internal controls conducted by other personnel within the institution.

4. CFPB Proposes New Rules for Payday, Vehicle Title, and High-Cost Installment Loans

The CFPB has released proposed rules that would create new consumer protections for any loan with a term of 45 days or less, and for a loan with a term greater than 45 days if the annual percentage rate is greater than 36% and the loan is either repaid directly from the consumer’s account or income or it is secured by the consumer’s vehicle. Under the proposed rule, which was issued on June 2 under authority granted by the Dodd-Frank Act, the CFPB would consider it to be an abusive and unfair practice for a lender to make a loan covered by the rule without reasonably determining that the consumer has the ability to repay the loan. Specifically, the proposed rule would require that a lender must make a reasonable determination of the consumer’s ability to make the payments on the loan and be able to meet his or her other major financial obligations and basic living expenses without needing another extension of credit during the next 30 days. Under the proposal, a lender would be required to verify the consumer’s net income, debt obligations, and housing costs, forecast a reasonable amount of basic living expenses for the consumer, and project the consumer’s net income, debt obligations, and housing costs for a period of time based on the term of the loan. The proposed rule would also require a lender to make certain assumptions or presumptions when evaluating a consumer’s ability to repay a covered loan with a term greater than 45 days. For example, if a consumer seeks such a covered longer-term loan within 30 days of receiving a covered shorter-term loan, the lender may be required to presume that the consumer is not able to afford a new loan. Comments on the proposed rule are due by September 14, 2016. Click here for a copy of the proposed rule.

    Nutter Notes: The CFPB’s proposed rule would permit a lender to make covered loans without having to satisfy the ability-to-repay requirements under certain circumstances. For example, the proposed rule would permit a lender to make a covered loan with a term greater than 45 days without determining the consumer’s ability to repay if the loan meets criteria similar to NCUA’s Payday Alternative Loan (“PAL”) program criteria. Under this exemption, a covered loan would be required to have a principal amount of not less than $200 and not more than $1,000, fully amortizing payments, and a term of at least 46 days but not longer than six months. Such a loan could not have an interest rate that is more than the interest rate that is permitted for federal credit unions to charge under the PAL regulations or an application fee of more than $20. The proposed rule would also exempt from the ability-to-repay requirements certain covered loans that have fully amortizing payments and a term of at least 46 days but not longer than 24 months, provided such loans carry a modified total cost of credit of less than or equal to an annual rate of 36% percent. The proposed rule also would exclude certain types of consumer credit from the scope of the rule, including loans extended solely to finance the purchase of a car or other consumer good if that car or consumer good secures the loan, home mortgages and other loans secured by real property or a dwelling, credit cards, student loans, non-recourse pawn loans and overdraft protection products.

5. Other Developments: New Cybersecurity Guidance and UDAP Amendments

• FFIEC Issues Guidance on Cybersecurity of Interbank Messaging and Wholesale Payment Networks

The FFIEC has issued a statement advising banks to actively manage the risks associated with interbank messaging and wholesale payment networks. The guidance released on June 7 advises banks to conduct a risk assessment to determine whether effective risk-management practices and controls are in place, and consult their payment system provider’s guidance for specific security control recommendations.

    Nutter Notes: The FFIEC’s new guidance warns that recent cyberattacks have targeted interbank messaging and wholesale payment networks, resulting in large-dollar fraud at several foreign institutions. According to the FFIEC, the attacks have demonstrated a capability to compromise a financial institution’s wholesale payment origination environment and bypass information security controls, among other things. Click here for a copy of the new guidance.

• Massachusetts Division of Banks Amends UDAP Rules

The Division of Banks has amended its rules governing unfair and deceptive practices in consumer transactions (209 CMR 40.00), effective as of June 3. The amendments streamline the rules by providing that compliance with specified provisions of the regulations of the CFPB constitutes compliance with the Massachusetts rules.

    Nutter Notes: According to the Division, the amendments also allow for the incorporation of future federal changes while preserving certain Massachusetts differences that are statutorily required and deemed more advantageous to consumers. Click here for a copy of the amended UDAP rules.

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP. Chambers and Partners, the international law firm rating service, after interviewing our clients and our peers in the profession, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation. Visit the U.S. rankings at ChambersandPartners.com. The Nutter Bank Report is edited by Matthew D. Hanaghan. Assistance in the preparation of this issue was provided by Bridget L. Vellucci. The information in this publication is not legal advice. For further information, contact:

Kenneth F. Ehrlich
kehrlich@nutter.com
Tel: (617) 439-2989

Michael K. Krebs
mkrebs@nutter.com
Tel: (617) 439-2288

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.