Because of the devastating effect that the COVID-19 pandemic has had on the entire U.S. economy, the federal Bank Regulators1 have warned of the possibility that small, medium and large banks may soon be forced to recognize loan losses, which would include increasing allocations to a bank’s allowance for loan and lease losses (“ALLL”) and enforcing rights in collateral. These and similar GAAP and bank regulatory accounting requirements will adversely affect a bank’s capital—and will likely result in a new cycle of regulatory enforcement actions and possible bank failures commencing in early 2021.2
Regulatory reaction by the Bank Regulators to bank capital deterioration is typically implemented through the issuance of enforcement orders against a bank that contain: (a) a capital directive that raises a bank’s capital ratio requirement to a level that exceeds the minimum capital level necessary to be deemed a “well-capitalized” institution; (b) a prompt corrective action order that limits the range of a bank’s discretionary functions; and (c) a multitude of regulatory improvements intended to improve the ability of bank management and a board of directors to perform their management and oversight functions.3
Responding at an early stage to a bank’s capital deterioration presents the possibility of mitigating or avoiding personal liability to bank insiders, including a bank’s senior management and its board of directors. Further, advance preparation may benefit a bank’s holding company and its exposure to insolvency and bankruptcy. Unfortunately, the ability to adequately protect insiders and a holding company from claims brought by the Banking Regulators can become more difficult as a bank begins to recognize reportable capital losses.
Accordingly, this Alert is intended to focus on practical steps that a bank’s management and board of directors can begin to consider prior to having to recognize significant credit losses and accompanying capital deterioration. The discussion in this Alert is excerpted from a comprehensive article to be published in the Banking Law Journal in December of 2020 that analyzes bank enforcement actions and bank failures in detail.
What follows is a summary of actions that might be considered when a bank is at the early stages of recognizing loan losses, including: (a) ensuring compliance with applicable bank regulatory governance requirements; (b) ensuring that prior regulatory criticisms have been properly addressed; and (c) governance and operational protections that might be implemented to protect bank management and directors against allegations of breach of fiduciary duty.
Bank Regulatory Governance Review
Over the past twenty years, the focus on managing a bank has resulted in vast amounts of guidance issued by the Bank Regulators under the umbrella of risk management. Policies and…