Chairman Calls for Improved Bank Regulation

By Catherine Hubbard, M.A., CCH Washington News Bureau.

The Securities and Exchange Commission and the Federal Reserve Board need to clamp down on deceptive practices by banks, according to the chairman of a Senate panel overseeing the industry’s response to the Enron Corporation debacle. “One year after Enron’s collapse, we need the regulators to tell our banks and securities firms that the deceptions and the era of self-regulation are over,” said Senate Government Affairs Permanent Subcommittee on Investigations Chairman Carl Levin, D-Mich., at a December hearing. “There is a regulatory gap right now,” Levin said, noting that the SEC “does not generally regulate banks, and bank regulators don’t regulate accounting practices or ensure accurate financial statements.”

Levin said the SEC should issue a policy stating that it will take action against financial institutions that sell deceptively structured finance or tax products or knowingly or recklessly participate in deceptive structured transactions. He also called on the bank regulators to state that violation of that policy would constitute an unsafe and unsound practice, thereby enabling bank examiners to take regulatory action during bank examinations. In addition, he said the SEC and bank regulators should conduct a comprehensive, joint review of the structured finance products financial institutions sell or participate in “so we can root out the ones that corrupt financial statements.”

DECEPTIVE TRANSACTIONS

Citigroup and J.P.Morgan Chase repeatedly used deceptive transactions, called “prepays,” to grant Enron huge loans that were disguised as energy trades and thereby enabled Enron to misstate the loan proceeds as cash flow from business operations, said Levin. In addition, Enron, which declared bankruptcy in late 2001, made a sham asset sale to Merrill Lynch before the end of the year 2000, so that it could book the fake sale revenue and boost both its year-end earnings and cash flow from operations, he added.

Another set of deceptive transactions that took place between December 2000 and June 2001 involved Enron’s ventures in the pulp and paper business, according to Levin. In the four transactions, known as Fishtail, Bacchus, Sundance, and Slapshot, Citigroup and Chase apparently aided Enron despite knowing they employed deceptive accounting or tax strategies, he said. Levin asked the SEC and Fed witnesses what concrete steps they have taken to prevent U.S. financial institutions from engaging in illegitimate, structured financial transactions.

Ranking member Susan M. Collins, R-Maine, said Enron “could not have gotten away with what it did for so long without the active participation of [cooperating] financial institutions.” She questioned whether government regulators have the authority and expertise to oversee the complicated transactions and whether the current regulatory structure has kept pace with changes in the financial markets and the innovations in structured finance.

RESPONSE

Robert Traband, vice president of J. P. Morgan Chase & Co., said in a written statement that had the bank known of Enron’s practices, it would not have engaged in the transactions. Also with J. P. Morgan Chase, Michael Patterson said the bank this year put in place “a new set of procedures designed to reinforce our focus on reputation risk and provide a senior level of review of transactions with clients.” Business units are required to submit to regional policy review committees proposed transactions that may raise reputation risk, specifically when a material objective of a transaction is to achieve a particular accounting or tax treatment. Other transactions that could jeopardize the bank’s reputation include those with unusual or highly complex structures or cash flow profiles, those that provide financing in the form of derivatives or cases in which there is material uncertainty about legal or regulatory treatment, he said.

Richard Spillenkothen, the Federal Reserve Board’s Director of the Division of Banking Supervision and Regulation, said the Fed has revised its examination plans for larger institutions. It also is considering additional supervisory guidance and refinements to its examination and regulatory policies and procedures, he added. Banks should analyze credit risk and evaluate a borrower’s character. Banks must recognize that although they are not directly accountable for the actions of their customers, to the extent their name or product is implicitly associated with a customer’s misconduct, additional legal and reputational risks may arise. “Many banks need to strengthen a credit risk analysis of investment grade customers by performing more due diligence and independent analysis while placing less reliance on third parties,” he said.

While bank examiners assess the adequacy of a bank’s credit risk analysis, said Spillenkothen, they should not be required to perform an independent legal, tax or accounting analysis of a transaction from the customer’s perspective. “Examiners are not qualified to perform such a review and, moreover, it would be inappropriate for them to do,” he said in written testimony, adding that the analysis would involve matters that are the responsibility of corporate management.

Banks must obey the law, yet they “should not be held legally responsible for the judgments, actions or malfeasance of their customers,” the director said. They should not be “required to second guess their customers’ accountants, tax or legal experts or police their customers’ activities,” he said, adding that such an expectation would “place potential legal liability on banking organizations” and impose significant costs on banking organizations to audit the activities of their customers.

REGULATORY REACTION

The Fed is evaluating findings of examiners and other regulators, providing institutions with feedback, evaluating the steps banks are taking to address deficiencies and considering additional supervisory guidance or regulatory changes, especially in the area of structured finance, Spillenkothen said. It also plans to evaluate the range of reforms banking organizations are adopting and consider whether there are some sound practices that should be adopted more widely within the industry, he added.

Structured Transactions

Structured transactions are not inherently improper, said Annette Nazareth, Director of the SEC’s Division of Market Regulation. However, given the overall increased use of structured transactions and the potential for their use in arbitrage strategies as window-dressing, investors and creditors have begun to focus not only on the amounts and trends of earnings, but also on the quality of these reported measures. The SEC “takes the need for clear and transparent disclosures very seriously,” she stated, adding that the need for transparent financial reporting “is crucial to our capital markets.” She said that transparent financial reporting enables investors, creditors and the market to evaluate the financial condition of a company and increases confidence.

Financial Reporting Model

Companies such as Enron, Xerox, and WorldCom disclosed that their financial statements were not in compliance with Generally Accepted Accounting Principles, Nazareth said, noting that in these cases the financial reporting model “did not necessarily fail.” Instead, the SEC alleges that these companies “failed to properly apply the financial reporting model,” she said in a written statement. The SEC is trying to improve the overall financial reporting model, she noted. Also, the agency looks to the Financial Accounting Standards Board to establish and improve accounting principles used to prepare financial statements filed with the Commission, she said, observing that the SEC is responsible for setting accounting standards for registrants.

OCC Supervision

Douglas W. Roeder, Senior Deputy Comptroller at the Office of the Comptroller of the Currency (OCC), said the OCC will refine its approach to supervising aspects of bank operations that may cause reputation, litigation and other operational risks in the area of complex structured transactions. In addition, the office “will sample more extensively transactions going through the new products approval process,” he said. In particular, the office “will check on whether banks are following their own processes and whether proper review and authorization are received prior to engaging in complex structured transactions,” he added. Also, the OCC is considering whether an amendment to its safety and soundness guidelines is needed, said Roeder. He also noted that the OCC “will evaluate the changes banks have made and will continue to monitor and assess these reforms.”

Assigning Accountability

In contrast, Muriel Siebert, CEO of Siebert Financial Corp., said regulations pertaining to financial products are unable to stay ahead of fast-moving, new technology. Rather than crafting new regulations covering off-balance-sheet special purpose entities and other specific transaction types, the focus should be on assigning accountability within public corporations, providing investors with more information and demanding principled behavior from our financial institutions, she said.

She noted that the SEC has implemented regulations requiring officers and directors to report trades within two or three days, including trades facilitated with derivatives. Also, CEOs and CFOs of public companies should be required to certify in a signed declaration that the company’s financial reporting is correct. “We must go further to bring [about] greater accountability and transparency.”