Beware! Banks, Consultancies: Regulators are on the prowl

What's Next In Payments®
3:17 PM EDT June 23rd, 2013

By Karuna Kumar, Columnist
Follow @Karuna_Kumar

“People want to know that regulators are looking out for the American public, not the banks,” Sen. Elizabeth Warren, D. Mass asserted at the Senate Banking subcommittee hearing on April 11, 2013. The agenda was to review banks’ use of independent consultants to complete the foreclosure review. Instead, the hearing whipped the regulators.

Warren wasn’t alone in her indignation. Sen. Sherrod Brown, chairing the financial institutions subcommittee hearing, argued that regulators had failed to identify uniform standards governing their actions.

Clearly, the hearing had gone awry. Officials from the Office of the Comptroller of the Currency (OCC) and the Federal Reserve Board soon came to the realization that the complexity of the undertaking had been greatly underestimated. One close look at the number of institutions, the number of consultants, the number of borrowers and the number of decision points involved in the hearing will give anyone a rough estimate of the unusually complex task, the committee was faced with.

“Why didn’t the OCC handle the loan reviews itself instead of forcing banks to hire their own consultants?”, Sen. Jack Reed, D-R.I. questioned the regulators, urging them to hire their own consultants. “I think you’ve got to have a new process. And I think if the process requires modification of federal rules and regulations, then that’s something the OCC and the Fed should immediately demand of us. Because essentially what you describe is a core activity of the OCC — stopping the wrongdoing of regulated institutions and protecting consumers”, he added.

In response, Daniel Stipano, Deputy Chief counsel at the OCC appealed to the lawmakers to give the OCC the power to seek sanctions against independent contractors.

Two months and a week later, the New York State Department of Financial Services declared that it is fining Deloitte Financial Advisory Services $10 million as part of a settlement stemming from its anti-money laundering advisory work with Standard Chartered bank. In addition, the regulator banned Deloitte from working for New York – chartered banks for one year. The consulting firm was also found guilty of disclosing confidential information about other clients to Standard Chartered.

Whether the Senate Banking subcommittee hearing provoked this or whether this is a desperate attempt by the regulators to reaffirm their commitment towards cracking down on money laundering, what does this really mean for banks and the consulting firms?

The one-year ban on consulting for state-chartered banks applies to the smallest of Deloitte’s four units, Deloitte Financial Advisory services. It does not apply to Deloitte Consulting or any other divisions of the auditor. It is also possible for Deloitte to terminate the ban earlier if it puts in place the state’s new rules for financial consultants.

The crackdown by the New York state department will probably not be lethal for Deloitte but it will cast a dark shadow on its fintech consulting business. The ban might be limited in scope, nevertheless it harms the reputation of Deloitte, and is likely to provoke the banking community to take more responsibility in choosing its consultants and red flags the consultancies who are rather liberal in their reporting practices.

Deloitte was involved in committing fraud, damaging the security of the banking system and affecting national security according to New York State. These, by any accord, are not small consequences of an allegedly cavalier attitude and will have a spillover effect on industry-wide reputational risk. Regional and community banks will surely consider the settlements before signing new contracts with Deloitte, vendor management will be scrutinized and new business will be hard to come by for Deloitte. The number of banks directly barred from using Deloitte’s consulting service are significant: they include some of the largest – Goldman Sachs and Bank of New York Mellon, in addition to more than 4,000 other financial institutions including credit unions and insurance companies and New York units of foreign banks.

Taking the cue from Deloitte’s case, the DFS now proposes an explicit code of conduct for consultants to ensure their independence and make it easier to monitor them. This includes absolute disclosure around the financial work they’ve done and to be in a position to certify the final report to regulators as their own work, in addition to maintaining records of all recommendations that don’t get included in the final report and developing policies on complying with confidentiality rules.

The silver lining around this dark cloud of regulation is likely to be a sense of clarity around best practices for consultancies. This would eventually improve the battered reputations of consultancies and give them the credibility they desperately need. But, it is hard to know whether this will be too late for some: Deloitte could be a harbinger to other consultancies being sent for some quality time in Siberia.

This is also just the start of DFC superintendent, Benjamin Lawsky’s crackdown on big banks that now need to take compliance far more seriously than they have been. This could prove disruptive for banks if other states follow New York and choose to issue their own set of regulations. Banks would need to put together contingency plans to prepare themselves for such a crackdown on consultancies.

Another aspect worth the notice is how many top banking regulators have crossed the bridge to sit on the other side of the grass. Ex-banking regulators now run a shadow network between banks and regulators, a kind of ex-regulator omnibus, that at times even substitutes the financial industry supervisors. They assume themselves to be auxiliary, private sector regulators, and blur the line between consultants and regulators, creating a conflict of interest.

The community that forms this shadow network includes former senior officials from the OCC, the Federal Deposit Insurance Corporation, the Treasury Department, the Federal Reserve System, the Securities and Exchange Commission and foreign regulatory bodies. This “revolving door” could be blamed for the unhealthy relationship between the government and the private sector.

Some however, argue that such private sector regulators serve the broader public interest by producing manageable regulation and spirit-of-the-law compliance. Given that a number of banks frequently get themselves into woes with their regulators and don’t have the internal expertise to fight their case, private regulators are not likely to go out of business anytime soon.

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