By Al Barbarino

Law360 (May 11, 2020, 12:28 PM EDT) -- In part two of an interview with Blake Paulson, the new chief national bank examiner with the Office of the Comptroller of the Currency looks beyond the coronavirus, detailing the steps the agency and banks can take to prepare for the next financial downturn, whenever that may come.

"[One] major thing we're thinking about is making sure examiners are prepared for the next recession or economic downturn, and making sure bankers think about how they can best prepare," he said.

In part one of the interview on Friday, Paulson detailed how critical examinations would continue unabated amid the COVID-19 pandemic.

Paulson, who is also the senior deputy comptroller for midsize and community bank supervision at the agency, spoke in the second installment about the importance of ensuring that banks have sufficient liquidity and are appropriately assessing certain risks within their loan portfolios.

He also detailed his approach to enforcing rules and regulations, one that requires working hand-in-hand with the banks, and noted a forthcoming final rule related to the Community Reinvestment Act that he said will bring important changes to the regulation.

What are some key focus areas as you look beyond the COVID-19 crisis?

One of the most significant initiatives we've had over the last couple years as part of Comptroller [Joseph] Otting's policy priorities, which he brought day one, was strengthening the Community Reinvestment Act regulation.

We've done a tremendous amount of work to first put out an advanced notice of proposed rulemaking to request, which was a series of questions on the CRA and then a proposed rule. Now we've gotten all those comments back, and we're working on drafting the final rule. We expect that, working in conjunction with the FDIC [Federal Deposit Insurance Corporation], we will release a final rule this year.

I think that will be a very important update and modernization to regulations that have been in place for a very long time. The changes are needed to really reflect how banks operate in the current economy.

Another major thing we're thinking about is making sure examiners are prepared for the next recession or economic downturn, and making sure bankers think about how they can best prepare.

We've been in a long stretch of strong economic growth and, as examiners, we always remember that those periods are followed by some sort of a downturn — while not knowing exactly what it will look like.

We've been talking the last year or more about that topic and, unfortunately now with the COVID-19 situation, we're certainly facing that. And to the extent that we spent time talking about it, I think it was helpful for bankers and examiners and might prepare us a little bit better than we otherwise would have been. The agency's perspective on the risks facing the industry are shared in the Semiannual Risk Perspective, twice a year.

What sorts of violations have a tendency to ramp up in a recession?

We're seeing a lot of forbearance activity relative to mortgage loans, auto loans, consumer loans and commercial loans. Banks are providing various types of forbearance, such as loan restructurings.

On the consumer loan side, there's a lot of regulation around those types of things and when loan volume picks up, that can really test a bank's processes in various ways, and maybe in ways that their processes were not prepared for.

So obviously we'll be looking at whether or not the banks are making good faith efforts to take care of those types of problems early, as opposed to letting them linger and become more systemic.

Beyond the technical and legal requirements, banks need to assess risk as it's building in their loan portfolios, accurately risk-rate loans and ensure they have appropriate loan-loss reserves. Those are the primary areas where banks and examiners will be focused as we move into challenging economic times.

What directives are you giving examiners regarding midsize and community bank exams as the economy turns?

The thing that traditionally causes the most problems for community and midsize banks is concentrations of credit where a bank may have significant exposure as relates to capital levels.

Banks make loans according to their policies and levels of acceptable risk, but they also make exceptions to underwriting policies. We are asking examiners to think about the volume and types of exceptions the banks are making and whether they continue to be appropriate in the current economic conditions.

They will also be making sure banks have adequate liquidity on their balance sheets, which serves as a kind of insurance policy for banks in the early days of financial stress.

How do you effectively assess whether or not a bank has enough liquidity?

To start with, we want to understand how the bank views this. What's their analysis? What's their risk assessment in a stress-type scenario? What have they done to think about how much liquidity they should have on hand?

We would challenge that analysis and likely come to some type of an agreement for what the bank should have for liquidity and, if the bank agrees to that, we might include what we refer to as a matter requiring attention in the reported examination explaining our concerns, including what the bank committed to do about it and a time frame for that commitment.

We would then follow up, usually at our upcoming quarterly calls with senior management of the bank, and they would send us documentation to show what they had done to follow through. If at that point we were confident they took action and would continue to take that action into the future, we would terminate that "matter requiring attention."

What if they don't take the appropriate steps? At what point does that become more of an enforcement situation?

That happens in a minority of cases. When it does, we would look at whether it's an unsafe or unsound practice or a violation of law. And if there is a necessity for us to take an enforcement action, we would consider the variety of tools we have, from informal actions up to formal actions that are legally binding and public.

Those actions would then lay out in more specific detail what things the bank needs to do to correct the violation of law or the unsafe or unsound practice. The board of directors of the bank would be responsible for ensuring that management took action in having the follow-up work performed, whether through an internal or external audit or review, to validate that those actions had indeed been taken.

Of course, we would then do our own assessment to determine if those actions have been taken.

What's your enforcement approach as it relates to systemic issues versus one-off violations or glitches?

In any circumstance where we identify a violation, we do consider whether it's an isolated instance or if it's more widespread or systemic. We're also looking at what the real cause is, why it occurred and what is maybe missing in a bank's process or policy that allowed it to happen.

We'll use supervisory actions, including enforcement actions where warranted, to address the root cause and to make sure the violations don't occur going forward. We'll also look at why the bank's own risk management processes didn't catch the violations before the examiners found them.

There are internal audit, external audit and the various lines of defense we expect a bank to have to ensure processes are working properly, so we'll assess why these didn't catch a violation to begin with. The objective is to address the bank's various lines of defense, including audit or risk-management programs, and to ensure that those are doing their job to catch potential violations as early as possible.

--Editing by Jill Coffey and Marygrace Murphy.

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