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.

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.

First Union said last week it is piloting the technology to clear checks at the point of sale, a long-sought holy grail in banking. However, the initiative drew yawns from analysts, who noted that the advance, while nice, won’t lure customers away from other bank competitors.

"The consumer in this country has learned to love his float. That has been traditionally the resistance in the U.S. to the acceptance of cash card, debit cards. We have an entire credit culture here," said John B. Moore, Jr., bank analyst at Interstate/Johnson Lane. He said, however, that merchants will love the innovation that allows the check to be turned into debits that clear electronically through the automated clearing house network. He added, "The real impetus here is to get rid of float, but we’ve yet to see a clear set of enticements to get the consumer to give up his float."

"It will reduce costs to the commercial customers and the bank. The retail customer gets nothing," said Larry Cohn, head of research at Ryan Beck.

Sandra Flannigan, bank analyst at Merrill Lynch, was one of several who had not made it a point to focus on the new program, but said the additional channels of delivery certainly couldn’t hurt. "It’s something that’s interesting and it shows once again their innovation. Is it something that’s going to make or break the bank? No. But the more options that customers have as far as product and delivery channels, the more likely they are able to retain customers."

The Charlotte, N.C.-based giant’s pilot program will begin in about two months with a Virginia-based hairdressing chain.

He said that within the month, he hoped to be able to hook customers up to the bank’s brokerage unit, Midwest Capital Management, Inc., so they can execute trades on-line. A little bit of that is making sure Gold Banc "gets in front of the money," he said, adding that banks should get more aggressive in the securities area. "We have been letting investment strategy go to Wall Street as opposed to letting that money go to the market through the bank." The securities unit finished 1998 with 27% of net interest income for the bank up from 16% in 1997. Gullion said the bank’s goal for the brokerage unit is to be in the 30% range within a year. Part of the expansion of the firm, bought in March 1998 for $4.25 million, will come from the ongoing project of putting investment centers in each of the 28 locations.

The company also provides wholesale services to banks throughout the Midwest. Gullion said that, typically, Gold Banc wants its service companies, which include The Trust Company and Gold Banc Insurance Agency, to shoot for a 20% return on revenue. "We are looking for not just 8-10% growth a year, but 30%–not just in terms of earnings-per-share growth, but income. That is a factor of improving efficiencies and income streams and growing the company in terms of acquisitions," he said.

The insurance agency, while centralized, is a work in progress, as management evaluates how best to deliver the product in the future. The goal is to have an agent in 75% of the branches. The company sells property and casualty, life and health insurance. Gullion said the bank is not interested in getting involved in bond underwriting, professional insurance, or any areas "requiring a high degree of expertise."

The company is at work on a business plan for The Trust Company, acquired at the end of last year. The idea is to bring the service to all banks by mid-year, with officers in the larger branches full-time and videoconferencing to the smaller branches. Now, the firm has full-time trust officers at two banks, insurance agents at five banks, and investment retail brokers at four banks.

Gullion said the bank is always looking for new acquisitions, the criteria being number one or two market share and strong leadership by bankers who believe in the community banking model.

Gold Banc has largely left its bank subsidiaries and a thrift–across Kansas, Oklahoma and Missouri–autonomous in terms of decision making and administration. The extra administrative work that resulted was viewed by management, until now, as a necessary burden to avoid uniformity. But the CompuNet Engineering solution is anticipated to relieve the work of its bankers, giving them even more time to devote to customers.

"As we make mergers and acquisitions, we are leaving bank names alone. It’s going against the current of water that says we need to have one bank company name. (But) when you start centralizing decisions, you begin to look like the big companies. Why do we want to emulate the large nationals? We want to empower local decision makers, leaving in place its local charter and board of directors," Gullion said.

He added that he hoped the $4.3-million-acquisition of privately held CompuNet would be a profit center for the bank, because not only did the firm work for 10-to-15 other banks, it provides technology services for about 50 other nonbank companies. The hope is that the firm can pick up even more in the Midwest area.

Gullion said he wanted to continue to grow into states contiguous to Kansas, and beef up the company’s presence in Oklahoma and Missouri, where there is only one Gold Banc office. But, he added, the focus of the mostly commercial-oriented bank is not entirely based on geography.

"We think there’s a retail strategy that’s much more dynamic than brick and mortar," said Gullion of the Internet. He said part of that strategy is to use the technology to bring more of the bank’s products to consumers. Sometime this week or next, the bank will unveil a new interactive capability on its Web page so customers can pay bills, "not just move money," he said.

BankAmerica will soon introduce a desk-top delivery program for cash managment it has been piloting since November to all of its largest corporate clients, placing it far ahead in the race to give customers the most modern, high-tech service.

The pilot, part of the 15-month-old system called BankAmerica Direct, uses software from Atlanta-based technology provider Diffusion to let customers choose how to receive information critical to their accounts: telephone, fax, e-mail, beeper. The strategy is to strengthen the relationship with the customer base.

Rick Leander, senior vice president of strategic technology and integrated payments services at BankAmerica, said the new program has been very well-received and that many customers had suggestions how the program could be expanded. He declined, however, to provide those details. Although the program is only available now for large corporate customers, Leander said the firm thinks the program could be valuable to all business customers, but he declined to name a time when it would trickle down to smaller businesses.

"We’re using technology to be much more customer sensitive. The buzz for the last 18 months has been on making information available on the browser. Our vision has been to provide information to customers using channels they want to use," Leander said.

He added that as the first phase of the pilot is ending and being rolled out to all corporate customers, a new function will begin piloting. He declined to give details on the new pilot program, or disclose information as to how much any of the services will cost corporate customers. BankAmerica defines corporate customers as those companies with market capitalization at $500 million or more.

Bank One also signed up with Diffusion in December to get the program, which is still in the planning stage.

"This is a relatively new wrinkle. There are tons of CRM (client relationship manager) solutions; they all automate the bank’s internal database, which the account manager can use, but you still have to call that customer. There could still be a time delay. (Now) banks can keep in touch with customers and get improved services. It decreases client defections and increases customer loyalty," said Rajeev Agarwal, analyst at The Tower Group, a technology research firm.

Securities analysts and representatives of the banking and insurance underwriting industries are saying that the legislation pushed through by Senate Banking Committee Chairman Phil Gramm, R-Texas, is a positive despite the threat of a presidential veto. The bill was voted out of the committee last week under a narrow 11-9 final vote along party lines (see p. 6-7 to compare competing bills).

However, an analyst said that the banking industry must be concerned about a trend toward passage of legislation that reduces the industry’s powers, and, at the same time, the insurance agents industry says it is neutral at best over provisions that extend the "significantly prevent or interfere" standard established by the Supreme Court in the Barnett case in 1996. The insurance agency provisions in the Senate bill were taken at the last minute from those contained in last year’s H.R. 10 as it was re-drafted after being reported out by the Senate Banking Committee.

A bill generally supported by the banking industry and the Clinton administration is being marked up in the House Banking Committee. The panel dealt with Title 1, which concerns the rules for affiliations between insurance companies, securities firms and banks, last Thursday. The panel plans to renew work this Wednesday.

Steven Blumenthal, an analyst with Schwab Capital Markets & Trading Group in Washington, saw the Senate action as a positive. "To a degree that Schwab Washington Research Group has never seen, the elected representatives working on financial services reform legislation are trying to reach agreement and pass a bill," wrote Blumenthal in a memo to clients obtained by Financial Modernization Report.

But he called it a "measured step forward. The compromises reached in the Senate on insurance issues are almost certainly going to cost the bill some support in the banking industry." He added that the product of the House Banking panel is almost certainly going to be rewritten in the House Commerce Committee. "That is not likely to be a result that favors banks. Combined with the Senate developments on insurance, the reasons for the major portion of the banking industry to support the bill are disappearing."

Dean Sackett, vice president of government affairs for the Professional Insurance Agents of America, said the agents industry will be merely neutral to the Senate Banking bill and will seek changes.

The American Bankers Association voiced support for the Senate bill, which will allow banks to affiliate with securities and insurance companies, but does allow for a definition of insurance that would reduce the ability of banks to underwrite hybrid products, such as annuities. It does establish a system of functional regulation that will allow state regulators as well securities regulators to oversee those activities when conducted by banks.