When bank examiners get it wrong: financial institution appeals of material supervisory determinations.

• Author: Hill, Julie Andersen
• Position: Abstract through II. Appeals Processes by Regulator C. FDIC, p. 1101-1149

Abstract

Banks and credit unions sometimes complain that the examination process regulators use to police banking practices is oppressive. These financial institutions complain that regulators reach unduly negative examination conclusions known as "material supervisory determinations." Institutions are wary because negative determinations can subject an institution to further regulatory scrutiny or enforcement actions.

To guard against erroneous determinations, Congress, in 1994, enacted a statute requiring federal financial institution regulators to provide an appeals process. Each of the four regulators (the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, and the National Credit Union Administration) adopted a unique material supervisory determination appeals process.

Using data (some collected through Freedom of Information Act requests) about material supervisory decision appeals since 1994 and interviews with top regulators, this Article provides the first in-depth analysis of the appeals processes. It shows that the appeals processes are sometimes dysfunctional and seldom used.

To improve the appeals processes, the Article recommends three changes. First, once a regulator issues a material supervisory determination, financial institutions should have direct access to a dedicated appellate authority outside of the examination function. Second, the appellate authority should engage in a robust review; it should consider a broad scope of appealable matters and employ a clear and rigorous standard of review. Third, regulators should release detailed information about each decision reached by the appellate authority.

TABLE OF CONTENTS INTRODUCTION I. REGULATORY STRUCTURE A. Examination and Enforcement B. Appealing Material Supervisory Determinations II. APPEALS PROCESSES BY REGULATOR A. OCC 1. OCC Appeals Process 2. OCC Appeals B. Federal Reserve 1. Federal Reserve Appeals Process 2. Federal Reserve Appeals C. FDIC 1. FDIC Appeals Process 2. FDIC Appeals D. NCUA 1. NCUA Appeals Process 2. NCUA Appeals III. WEAKNESSES IN THE APPEALS PROCESSES A. Variations Among Regulators 1. Scope of Appealable Matters a. CAMELS Ratings b. Enforcement-Related Determinations 2. Standard of Review B. Few Appeals C. Little Transparency IV. STRENGTHENING THE APPEALS PROCESSES A. Strengthened Independence of Review B. Robust Review Authority 1. Broad Scope of Appealable Matters a. Examination Ratings b. Enforcement-Related Determinations 2. Clear and Rigorous Standard of Review C. Public Disclosure of Appeal Decisions D. Another Proposal: The Super-Ombudsman CONCLUSION INTRODUCTION

Financial institutions' are among the most heavily regulated businesses in the United States. To ensure that institutions comply with the complex web of laws, regulators conduct regular examinations. During an on-site examination, regulators comb the institution's books, records, policies, and practices, looking for evidence of legal infractions and financial stress. Examiners then make a number of "material supervisory determinations" ("MSDs") about the institution's financial health and compliance with the law. (2) The examiners prepare an examination report detailing these findings. In between on-site examinations, regulators collect and review institutions' financial information, looking for potential issues. This review can also lead to MSDs.

MSDs become the building blocks of regulatory enforcement. In cases where MSDs suggest a financial institution needs to improve, regulators employ formal or informal enforcement mechanisms to ensure that the institution corrects any problems. For example, a regulator might issue a cease-and-desist order instructing the institution to stop certain lending activities. (3) In more extreme cases, regulators might close the institution. (4)

MSDs are often the initial findings that set the regulatory enforcement mechanism in motion.

In the aftermath of the September 2008 financial market meltdown, some financial institutions complain that regulators are trending toward overly aggressive examination practices. (5) At its root, dissatisfaction with the examination process often indicates that institutions disagree with examiners about MSDs. Some institutions believe that regulators do not consistently apply existing law, claiming that "examiners tended to focus too much on their own view of best practices rather than on legal and regulatory requirements." (6) Institutions also complain that regulators change examination standards without warning. They claim that "[w]hat was once A-OK is no longer A-OK, but no one knows that until after the examination." (7) Some reports even claim that examiners act with bias or malice. (8)

To guard against erroneous MSDs, financial institution regulators are statutorily required to provide an "independent intra-agency appellate process ... to review material supervisory determinations made at insured depository institutions." (9) The Office of the Comptroller of the Currency ("OCC"), the Board of Governors of the Federal Reserve System ("Federal Reserve"), the Federal Deposit Insurance Corporation ("FDIC"), and the National Credit Union Administration ("NCUA") have each implemented a different procedure for handling these appeals. (10)

Since regulators implemented the MSD appeals processes in 1995, little has been done to analyze their effectiveness. Part of the reason for the lack of scrutiny is that regulators keep much of the information about appeals, including some decisions, secret." In addition, regulators themselves have failed to conduct any serious study of the appeals processes. (12) Using data from MSD appeals (some of which I collected through Freedom of Information Act ("FOIA") requests) and my interviews with top-level regulators, (13) this Article provides the previously untold story of these appeals.

The story is that of a dysfunctional and seldom-used system. Regulators vary significantly in the reviews they provide through the MSD appeals processes. They do not agree on which examiner determinations are appealable or on the applicable standard of review. (14) Even considering the state of the regulators' appeals policies, the rate of appeals is astonishingly low. Thousands of financial institutions have been examined every year since regulators adopted their appeals processes in 1995. Yet the OCC Ombudsman has issued only 157 decisions, the Federal Reserve has decided just 25 appeals (although data from 1995-2000 are unavailable for the Federal Reserve), the FDIC's Supervision Appeals Review Committee has issued only 63 decisions, and the NCUA's Supervisory Review Committee has issued 6 decisions. (15) When institutions do appeal, they seldom win. Most shockingly, the NCUA's Supervisory Review Committee has overturned only one MSD--the denial of a $5,000 grant reimbursement from the Office of Small Credit Union Initiatives. (16)

In light of the limited usefulness of the current MSD appeals processes, I recommend three changes. First, all financial institution regulators should adopt a consistent and broad scope of appealable matters. All examination ratings should be appealable. Moreover, institutions should be able to appeal MSDs that underlie enforcement actions if the financial institution consented to the enforcement action. Second, all financial institution regulators should adopt a consistent and robust standard of review for evaluating appeals of MSDs. I favor a de novo standard of review. Third, all financial institution regulators should release decisions from appeals of MSDs. Although the decisions should be redacted sufficiently to protect the anonymity of the appealing financial institution and its customers, the released information should be complete enough to allow institutions, regulators, and the public to learn how the agency reads and applies relevant statutes and regulations. Although the reforms I propose do not go as far as proposals that would create a single super-Ombudsman to hear appeals from all financial institutions, (17) my reforms target observable weaknesses in the current processes.

This Article proceeds in four parts. Part I provides a brief overview of financial institution examinations. It then describes the creation of the MSD appeals processes. Part II provides a description of the MSD appeals processes as implemented by each federal regulator. It details not only the rules governing the appeals processes, but also institutions' usage of the processes. Part III discusses shortcomings of the current appeals processes, and Part IV discusses recommendations for improvement.

1. REGULATORY STRUCTURE

   Financial institutions are subject to a detailed and complex regulatory structure. Reams of safety and soundness laws aim to keep institutions solvent while additional regulations seek to ensure that institutions deal fairly with consumers. Regulators ensure that institutions comply with laws by employing examination and enforcement powers.

   This part describes the financial institution examination and enforcement system, paying particular attention to the role of MSDs in the system. This part then describes the Congressional mandate that financial institution regulators provide an "independent intra-agency appellate process" (18) to review MSDs.

   1. Examination and Enforcement

      Examinations are the cornerstone of a regulatory system designed to keep financial institutions safe and sound. Regulators typically conduct a yearly "full-scope, on-site examination" at each financial institution. (19) During an examination, regulators visit a financial institution to review the institution's policies, procedures, and records. Examiners then rate the institution using the Uniform Financial Institutions Rating System. (20) Under the System, regulators evaluate the safety and soundness of institutions using the "CAMEL" or "CAMELS" factors:

      capital, assets, management, earnings...