Shock Sets in When Nonbank Affiliates Get Examined

Article excerpt

Many bank holding companies are building a diverse structure by expanding into specialized aspects of financial services. Increasingly, bank holding companies and banks acquire or establish non-bank affiliates such as mortgage banking firms or finance companies.

As nonbanks, these companies can react quickly to market demands and opportunities. They can relocate offices without filing for permission. They can readily develop credit products and target them to specialized audiences.

Such diversification can strengthen the parent, and, hopefully, creates a competitive edge. However, diversification and acquisition has an unexpected consequence: when the mortgage bank or finance company becomes part of a banking organization, it can suddenly become subject to bank compliance standards.

A higher-powered magnifying glass

It is not that new regulations apply to a company when it becomes part of a banking family. Laws such as Truth in Lending, the Real Estate Settlement Procedures Act, and the Equal Credit Opportunity Act apply to all creditors. The change comes in the high standard of compliance performance that is now necessary.

Nonbanks such as finance companies have never been held to the same compliance standards as banks. It is therefore a shock to such a company when it enters the bank compliance world.

Nonbank creditor affiliates often resist changes to the way in which they have treated compliance. To defend their position, they point to the compliance standards of other members of their industry. However, failure to raise the affiliate to the bank standard of compliance can have an adverse impact on the holding company.

Increasingly, bank regulators include a review of compliance in the bank's nonbank affiliates as a routine part of the bank examination. The results of such an examination can come as a significant shock to the holding company system.

Why? The vast majority of finance companies and mortgage banks have never been examined. Only chartered financial institutions such as banks and thrifts are subject to regular examinations by their supervisory agency.

In contrast, mortgage bankers, officially "regulated" by the federal Department of Housing and Urban Development and the Federal Trade Commission, do not have regular examinations. These agencies may open an investigation based on a consumer complaint or a pattern of such complaints. But only a small number of finance companies and mortgages bankers are ever investigated.

Essentially, whether to comply and the amount of resources to commit to compliance is a choice that has been open to finance companies based on the degree of compliance risk the company is willing to assume. A lawsuit based on consumer complaints is a low risk which, even if it occurs, may be less expensive than managing a high level of compliance.

The risks new parents face

On the other hand, the bank examination system raises compliance to an entirely different level of risk. Regular examinations almost guarantee that violations will be identified. Companies never before subject to the bank examination process can easily become a rich mine for identified compliance violations. Long before an examination is scheduled, the holding company should audit its nonbanks for compliance.

Inadequate compliance with laws such as Truth in Lending can lead quickly to expensive restitution Failure to determine whether real property securing a loan is located in a flood hazard area results in the lender becoming the effective insurer. However, violations such as these are recorded on paper and easy to identify. The secondary market prorides informal enforcement simply by refusing to purchase loans that have documented compliance violations.

Violations of other compliance requirements are not usually apparent from the file. These are areas where a lender that is not examined can place less effort. …