Under pressure from lawmakers to cooperate, federal banking and securities regulators reached a deal Wednesday that should head off future disputes over excessive loan-loss reserves.

As part of the agreement, the Securities and Exchange Commission said it would not require a bank to restate earnings, even if it believes the institution has inflated reserves or failed to adequately document the size of the fund.

Instead, the agencies said they would work with banks to improve disclosure and documentation of loan-loss reserves. Banks also could be required to cut reserves in future years.

"This is a joint recognition that the best way to address any problem is to do it prospectively," said Kevin Bailey, deputy comptroller for core policy at the Office of the Comptroller of the Currency.

The SEC began cracking down on earnings management last fall. This included delaying SunTrust Banks Inc.’s acquisition of Crestar Financial Corp. until the company agreed to reduce loan-loss reserves by $100

million and restate earnings.

The SunTrust case outraged the industry, which charged that it was unfair for the SEC to punish a bank for holding excessive reserves at the same time banking regulators were urging them to bolster reserves.

Regulators issued a joint statement in November vowing to work more closely on loan-loss provisioning, but industry officials continued to complain about a lack of coordination.

The agreement, which was reached late Wednesday afternoon, also commits the SEC, OCC, Federal Reserve Board, Federal Deposit Insurance Corp., and Office of Thrift Supervision to establishing a joint working group on accounting issues. This group will issue guidelines on how banks should make "reasoned assessments of losses" in their portfolios and how they should document these expected losses, according to the agreement.

The new agreement, however, won rave reviews from industry officials and legislators. Rep. Marge Roukema, chairwoman of the House Banking Committee’s financial institutions subcommittee, was one of several lawmakers who had promised to introduce amendments to the financial reform bill to end the controversy over loan loss reserves. She dropped the amendment, however, after regulators announced the deal.

A group of insurers has moved the ball forward on the important issue of onshore securitization of catastrophic risk, which banks may soon be interested in as investments. But important hurdles remain to be negotiated.

The new instrument may also help banks hedge risk stemming from concentrations of loans that could be adversely affected by a hurricane or other natural disaster.

While approving a draft of a model act designed to allow insurance companies to securitize their risk within the United States, the NAIC Working Group on Securitization stalled on further efforts to bring the concept into reality.

The life insurance industry and other institutions are looking at investing in such arrangements as soon as property and casualty companies get state regulatory approval to do so.

The exposure draft of the model, approved last week at the NAIC’s spring meeting in Washington, D.C., calls for assets to be carried at fair value. It will also require fully active cells and funded dollar-for-dollar transactions within the protective cells, and will ban derivative-based deals–for now.

Jeffrey Alton, chief accountant for CNA Insurance Company, said that under the proposal, insurers will have to file a plan of operation with each insurance department. "It should be very clear to a regulator what exposures preside in those cells." Alton said he did not support the concept that the protected cell should have a separate risk based on a capital charge of 10% that stems from concerns of potential tax liabilities.

CNA has pushed the hardest for quick approval of the catastrophe model so it will be in place by the next hurricane season.

Questions continue to arise over whether the assets contained in the protective cells will be enough to sustain the liabilities. Mike McCarter, vice president of accounting for American International Group, isn’t worried. "These are high quality securities," he said.

The one-stop financial products shop may be the mantra for big banks, and if financial modernization legislation passes, it will be easier for banks to sell a range of new products. Bay View Capital, however, is taking the opposite path: specializing in niches and leaving tricky, thin-margined businesses to the behemoths.

The San Francisco-Bay-area-based Bay View made the conversion from thrift to bank official March 1 with the blessing of the Office of the Comptroller of the Currency, but really the change had begun in third quarter 1995. The principal shareholder at the then-$2.5-billion-asset thrift pushed for a change in management and got it, bringing in Ed Sondker and David Heaberlin, CEO and CFO, respectively.

They went to work boosting the thrift’s transaction accounts, which pay no interest and are thus a free source of funding, to the current 50% of total deposits from 15% when they started. They’re still not satisfied, and have a goal of 60% before the year-end.

The move into transaction accounts was prompted by difficulties faced by the thrift industry in California. Heaberlin said Bay View was confronting low yields on assets and high costs for deposits–a trend the Office of Thrift Supervision ranked as most severe in the 11th District. The thrift was trying hard to stay above water in the competitive mortgage loan market of California, and finding it tough sledding in a landscape littered with the likes of BankAmerica and North American Mortgage Corp. That prompted the new management to rework the lender’s strategy.

"We began on restructuring deposits products, focusing away from CDs and onto checking accounts and money markets and savings accounts. We’re not interested in single-source accounts. What we really focused on is relationship banking, moving away from hot money, high-cost-of-funds, which is how many thrifts do it," Heaberlin said. He said the bank has reduced its CD exposure by $800 million since the new management team came and grown transaction accounts to about $1 billion. The total asset size of the company has grown to $5.6 billion from $2.5 billion, mostly through acquisitions including the purchase of Bay-area EurekaBank in January 1998, which doubled the company’s size in total deposits. At year-end, the total deposit base weighed in at $3.3 billion and transaction accounts at $1.6 billion. That compares to $2 billion in deposits and $300 million in transaction accounts before the changes.

With the Eureka acquisition, Bay View became the largest deposit franchise focusing on the Bay area exclusively. While that may seem a technical distinction, Heaberlin noted it has helped Bay View differentiate itself from massive neighboring competitors.

"It really puts us in a nice competitive position. With all the consolidation in California, people are always going to feel disenfranchised. It gives you marketing opportunities if people want to bank locally rather than with BankAmerica/NationsBank, Wells Fargo," he said.

In addition to boosting transaction accounts to a level Heaberlin calls "credible," the duo worked to get Bay View out of the mortgage origination business in short order.

"We began focusing on other areas we could originate assets without competitive barriers to bring home superior risk-adjusted yields to what we could get from traditional (methods)," he said. The company found success by acquiring auto and commercial business originators, he said.

"When you combine these new higher risk-adjusted yield assets with dramatically lower deposit costs now, that’s led to increase in profitability measured by net interest income. We started at 160 basis points, we’re up to 300," he said. He predicted that his company’s switch to a bank charter from a thrift would not be the last large charter conversion in the area, noting the difficulty in operating in the traditional mortgage market, which he described as "completely commoditized" and very tough to compete in "unless you’re a Wammu (Washington Mutual)."

Heaberlin said the management continues to look "aggressively" for acquisition opportunities, and the primary focus is on the asset-origination side.

The company has a securities subsidiary, MoneyCare, with between $700 and $800 million under management, that is a part of the depository group at the bank. Bay View has streamlined what was a multi-subsidiary corporate structure into one that consolidates all of its activities under the bank. The bank’s consumer lending group is called Bay View Acceptance Group, and the commercial side is called Bay View Commercial Finance Group. Heaberlin said although the company offers customers some insurance products through the securities firm, and is in the process of offering more, the bank is not going to rush into the insurance fray.

"We have the fourth largest metro area in the U.S., the highest percapita-income area–there’s so much to be accomplished. We’re trying to put the basics of commercial banking in place, so insurance is not as much of a priority. But we are interested in getting into that in the future."

The company announced just last week that its stock will move to the New York Stock Exchange from the Nasdaq, signaling what it hopes will be perceived as a move up in the banking world.

Financial consolidation and new technology spell a "bright" future for banks in the 21st century. The banks, however, also will face challenges– especially with the current version of financial modernization legislation as well as in building a brand, said former Comptroller of the Currency Eugene Ludwig.

He also warned that banks must stay in tune with regulation and legislation. "If H.R. 10 goes through in a form that gives banks an economic disadvantage, it could throw banks back eight years," he said. "You just can’t take the legislation for granted."

Ludwig explained, "Banking is going through a revolution, and you can’t overstate that revolution. In the next century (the banking industry) will be unrecognizable."

Three powerful forces will shape the banking industry in the next century–information technology, communication technology and globalization, he said.

Ludwig, who is now vice chairman of Bankers Trust, made his comments at the Bank Securities Association’s 12th Annual Convention in Palm Springs, Calif., last week.

Branding will be of the utmost importance in the 21st century because two types of customers will exist: "commodity and non-commodity," Ludwig said. Commodity shoppers will surf the World Wide Web and be well versed in every product.

But the non-commodity shopper–the dominant market player–will be the busy customer who wants one-stop shopping. "They will look for a trusted brand," Ludwig said.

Along with the challenge of branding comes the integration of products, Ludwig said. "We are not going to be living in a world where mutual funds, insurance or securities will mean anything" to the customer, he said. The product’s "functionality" and profit return will be key to the customer. The customer will be more concerned about an investment’s return than with the type of investment product, he said.

The current financial modernization legislation "boxes" everything into separate products, Ludwig said. But "hybrid products are the future."

If banking is about information technology, then how the customer interacts with that technology is also important, he said.

The shrinking globe and the changing tastes for new products will push banks to become even more technology savvy, Ludwig said. "Banking will become ever less physical and ever more technological."

Banking will be about "innovation and creativity and less about tradition," he continued. Banking has evolved very slowly until recently, he added, but "in the future, banking will be about speed and change."

And the future for small banks is also bright, Ludwig said. Small banks that are technologically savvy will be able to maintain a competitive edge over larger banks.

"If a small bank is technologically sophisticated it can sell its products all over the world," he said. Technology will become cheaper and third-party marketers will be able to provide these services for a cheaper price, he said.

The banking industry will not take on the expected "bar bell" form– with a huge disparity between small and large banks, Ludwig said. Rather, "Small institutions will be able to use technology to compete."

But just as increased opportunity for banks will abound in the new millennium, more risks will also surface. "In the 21st century it will be more volatile risk" due to the tremendous convergence of information and changes in connectivity, he said.

"The successful bank will take advantage of new opportunities, but maintain traditional integrity," Ludwig said. "The new world of banking is bright."

A few investment banks are in the running to be the first to apply to have a new limited purpose broker/dealer that will use the Value At Risk (VAR) method through the entire entity. The innovation would reduce commercial banks’ capital charges for derivatives transactions they enter into with the broker/dealer, as well as increase the flexibility of the derivatives activities of their own broker/dealers.

Although VAR has been used in the past by bankers, it has not been used by the securities industry as a capital adequacy measure. Sources at Morgan Stanley said that the bank will be applying to the Securities and Exchange Commission for this new limited purpose broker/dealer entity, known as "B/D lite," which would deal only in over-the-counter derivatives. "This would only apply to a fairly small piece of the overall inventory. It won’t be the case for regulatory capital purposes for the whole… It’s just a better measure of market risk. That’s why the SEC is interested in implementing this initiative," said a source at Morgan Stanley.

The new entity’s ability to engage in derivatives transactions would be better than the traditional broker/dealer because it would have different capital requirements, usually less stringent, depending on how the deals are booked. Currently, derivative activities are handled through offshore entities. This is because the deals are too capital-intensive for a broker/dealer’s U.S. office.

"This allows U.S. investment banks to bring activity back into the U.S., which should attract certain investors unable to deal with offshore counterparties. If U.S. bank regulators adopt a recent amendment to the BIS (Bank for International Settlements) Capital Accord, the B/D lite counterparty will also be a more favorable counterparty. For banks not subject to marketrisk guidelines, the counterparty rating will be reduced to 20%, which will be a further incentive for these companies," said Chris Maher, a partner in Ernst & Young’s risk management practice.

The use of VAR is an anticipated innovation because it significantly lowers the capital burden. Currently, a broker/dealer’s securities capital charges are a flat percentage of the nominal amount (of the contract). Now bankers will be able to model that risk and come up with value at risk which in general will be lower.

If a regional bank wanted to do an OTC derivative with a broker/dealer, the counterparty risk weighting is currently 100%. With the new broker/dealer entity, it would drop to 20%, because it would be considered a regulated entity.

The Morgan Stanley source said the SEC views the new entity as a way to test out new initiatives in a regulatory capital context. "It’s a significant change and it could pave the way toward further changes in the overall way broker/dealers have to determine what their regulatory capital is."

Goldman Sachs is also rumored to be one of the first expected to apply, but it declined to comment. The SEC has not yet received any applications.

Long-awaited guidance from the Securities and Exchange Commission on materiality, which sources expect out in the next week, may not impact bankers in the short term, but it could increase their auditing costs in the long term.

The forthcoming guidance is expected to discuss qualitative things like important ratios or subtotals in the financial statements, and the net interest margin rather than just net income. The guidance reflects the SEC’s increased scrutiny on what it calls earnings management, which bankers will have to consider going ahead. A celebrated example of the SEC’s concerns are what it identified as excessive loan-loss reserves, ones that the bank regulators saw instead as prudent. That issue has the attention of a newlyformed joint working group of the SEC and banking regulators (see story, p. 2).

"The SEC believes some companies are using the cover of materiality to record improper entries," said Robert Herz, a partner at PriceWaterhouseCoopers and the chair of the American Institute of Certified Public Accountants’ SEC Regulations Committee, and formerly an SEC advisor. Many bankers said they do not have a problem with the SEC’s disapproval on that score, having heard warnings in SEC officials’ speeches for a long time.

But they do wonder if the issue will become a problem for the auditors because the implication behind the forthcoming guidance is the SEC’s guidance dips to a lower materiality threshold than the auditing firms have in their own internal policies.

"The problem is they have to do more work," one banker said. He said the issue has made auditors so nervous that over time it will drive up the cost and work level required to complete a bank’s annual audit. The idea of the materiality guidance in the first place is to reduce the work and cost of the audit. For example, if revenue and expense are both overstated by $5 million, the net is not overstated at all because the two offset each other. The auditors might choose to say it is not material because the net income is not misstated. But bankers fear that the SEC may call it a misstatement because the revenue was misstated.

"It’s not absolute assurance; it’s fair presentation. The implication there is (that) it’s reasonable and you can rely on it," said Roger Dean, controller at Fifth Third.

Tom Ray, director of audits and attest standards at the American Institute of Certified Public Accountants, agreed that the new guidance could have an effect on the audit, but said he did not expect it would force auditors to go looking for items that are smaller and less material than they do now. Rather, he said, the guidance should help auditors and bank management to evaluate the matters that the audit tests identify.

Dean said that he believed the SEC has gotten overly concerned about sensitivity of markets to trends and high (price-to-earnings) ratios. While the idea of making sure investors know what is material to the business is admirable, he said, the SEC is painting the picture of abuses with too broad a brush. Because the question of what is material can be argued to be in the eye of the beholder, and the audience he and most bankers deal with–analysts– will not easily be swayed by the kind of alterations the guidance might prevent, it could be less than useful.

"The analyst community we deal with usually looks at us over time and at long-term performance, and (it looks for) good long-term management. So I don’t have any motivation to paint some rosy picture of one item in my financials because you can’t sustain it and that’s not what my audience is worried about. The issue is what does it take to change somebody’s opinion of your performance. The answer to that is it depends on the investors." Dean said that his investors do not care so much about revenue as they examine expenses.

The idea of what is material to shareholders has been loosely understood as anything that would affect earnings between 3% and 5%. If not material, an item or piece of news does not have to be disclosed.

The ball is now in the FDIC’s court on the topic of whether the agency has the right to unwind asset securitization deals once a bank that is a party to the deal goes bankrupt.

The agency, which announced a proposal to waive many of its rights of receivership in January, is sifting through the many letters that came in by last week’s comment deadline. Many letters were fired off by the banking community and a special task force of the American Institute of Certified Public Accountants (AICPA) set up to deal with the controversial accounting standard dealing with securitization deals.

The letter from the AICPA’s ad hoc working group on Financial Accounting Standard 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, came with an informal note from several attorneys indicating they were concerned that the agency’s promise to keep its hands off any securitized deals could come unglued. The worry is a future FDIC board could reverse what is now only a statement of policy by the current FDIC board, and further, the about-face might not grandfather existing deals. Given that, the note said, the attorneys cannot give an opinion that is satisfactory to the auditors. And the auditors really want to rely on counsel’s opinion before advising bankers if deals should receive sales treatment.

Bill Leiter, consultant to Banc One’s accounting department, said the AICPA’s letter reflects what a lot of major firms are concerned with in the FDIC policy. He said that the topic has been the talk among big bank accountants when they compare notes on major worries in the industry now.

First Northwest Bank is about to become the first state-chartered bank in Illinois to be approved for an insurance subsidiary owned by the bank.

Although the structure is not new nationwide–at current count 38 states allow their chartered banks to have insurance powers which exceed those of national banks and all but one state, Montana, allow state-chartered banks to sell insurance to the same extent as national banks–it is a first for Illinois, the second most populous bank state after Texas. Illinois has traditionally been stringent on allowing banks insurance powers, but last year passed legislation allowing banks to sell insurance directly.

The subsidiary of the Arlington Heights-based bank is a 50-50% partnership with the Assurance Agency of Rolling Meadows, Ill. The joint venture, called First Northwest Insurance, is under the bank, not the bank holding company.

The way the structure is set up, the bank owns 100% of First Northwest Financial, which is the 50% owner of First Northwest Insurance. The deal has been approved by the state bank controller, and is awaiting final approval by the state insurance commissioner’s office. According to bank Chairman and CEO Michael Silverman, the approval has already been "semi confirmed" by that office and is expected "any minute."

"As a relatively young bank–we were four years old on Feb. 14–we certainly need to look at non-interest income. We need to look at the bottom line. We formed a mortgage subsidiary as well. We want to be a full-service financial center for our community," said Silverman, explaining why the $110- million-asset bank chose to be the pioneer of the new legal structure. The deal was put together for the bank by Chicago law firm Barack Ferrazzano.

John Gorman, partner at Washington, D.C., law firm Luse, Lehman, Gorman, Pomerenk & Schick, said the move shows that even the most restrictive states are catching up to powers expanded for national banks through court decisions over the last five years or so.

Silverman said the bank’s management chose the Assurance Agency to partner with because a bank board member, Jerry Powell, is a principal in that company and with his background, he will be a managing partner in the joint venture.

Richard C. Houseworth, Arizona banking superintendent, has won the support of Senate Majority Leader Trent Lott, R-La., for a vacant seat on the FDIC board of directors that by law must go to a Republican.

Houseworth is being promoted by the Conference of State Bank Supervisors for the post, and the Lott endorsement is significant. The Ohio Bankers Association has been lobbying strongly in recent weeks for John Deal, an enforcement lawyer in Columbus, and had won the support of Ohio’s two Republican senators for him. Some Republicans had even said that former majority leader Bob Dole had put in a good word for Deal.

But the CSBS said that Lott had forwarded his recommendation to President Obama in support of Houseworth.

Houseworth has been Arizona banking commissioner since 1993. He has spent almost 40 years in banking, including 33 years with Arizona Bank, which was acquired by Bank of America. Houseworth was appointed director of the Export-Import Bank in 1988, and served as U.S. alternative executive director at the Inter-American Bank from 1991 to 1993.

If nominated by the president and confirmed by the Senate, Houseworth would take the seat of Joseph Neely, who recently retired from the FDIC board. Neely is the former banking commissioner of Mississippi.

There is expected to be another Republican open seat on the fivemember FDIC board with the expected retirement of Skip Hove.

A major banking trade group, The Mortgage Bankers Association, is voting today via teleconference on whether to lobby the Financial Accounting Standards Board on an issue that could restrict banks’ ability to use a hedge prevalent in the mortgage lending arena.

The group failed to reach an consensus Feb. 25 on which issues stemming from FAS 133–the new standard to account for derivatives–to lobby the standard setter about, and will discuss the numerous issues in the next month or so. However, the 50-or-so representatives did decide to hold a teleconference meeting today to decide on the immediate fate of one issue: accounting for a combination of options used to hedge some market risk, especially mortgage servicing.

The issue first arose when the Derivatives Implementation Group (DIG)–a consortium of accounting experts mandated to analyze conflicts in FAS 133 and provide possible solutions–tentatively decided in January that a combination of options can only be designated a net-purchase option if it meets four strict criteria. Net-purchases receive hedge accounting treatment under the general rules laid out in the standard. DIG’s decisions are subject to approval by the Financial Accounting Standards Board, which has yet to address the option combination issue.

Due to the nature of mortgage banking, according to Allison Utermohlen, senior director of accounting and tax policy at the MBA, most mortgage lenders using the instruments to hedge risk would be unlikely to meet the four criteria, and so would have to designate the option combination as a net-written option. Such designations can only accounted for as hedges under very specific and limited circumstances, Utermohlen said, meaning many mortgage lenders would be unable to use what has proven to be an effective hedging strategy.

"Combinations of options are often used to hedge servicing rights, deemed to be one of the most cost-effective ways of hedging servicing. Given DIG’s consensus, some mortgage lenders won’t qualify."

Utermohlen said the MBA would likely have a letter ready to send to FASB on the issue a week after any decision. The combination option issue is one of many issues the MBA is concerned about–including the definition of a hedged portfolio and measuring the effectiveness of hedges– and may seek to lobby FASB into providing clarification or some relief.