washingtonpost.com
By Switching Their Charters, Banks Skirt Supervision

By Binyamin Appelbaum
Washington Post Staff Writer
Thursday, January 22, 2009

At least 30 banks since 2000 have escaped federal regulatory action by walking away from their federal regulators and moving under state supervision, taking advantage of a long-standing system that allows banks to choose between federal and state oversight, according to a Washington Post review of government records.

The moves, known as charter conversions, highlight the tremendous leverage that banks hold in their relationships with government supervisors.

The financial crisis has pushed regulatory reform high up the agenda of the Obama administration and congressional leaders. Timothy F. Geithner, the Treasury secretary nominee, sounded the theme at his confirmation hearing yesterday, calling for a "stronger, more resilient system."

Some regulatory experts say that eliminating the opportunity to switch regulators is critical to strengthening oversight.

The number of public enforcement actions nearly tripled last year as federal regulators struggled to contain the spreading financial crisis. The actions typically require banks to make major changes that improve their financial health and reduce the risk of failure. But because regulators cannot prevent charter conversions, banks also have the option of changing their regulator.

Federal regulators, for instance, came down hard on Commerce Bank/Harrisburg last February, ordering the Pennsylvania lender to limit its dealings with companies owned by its officers and directors. The bank submitted an application to be chartered and supervised by the state of Pennsylvania, which was granted in November. As a result, the company said, the federal limitations no longer applied.

Since 2000, about 240 banks have converted from federal to state charters. Regulators and bank executives say many of those institutions simply wanted to save money. While national charters allow banks to operate more easily across state lines, state charters are cheaper. State regulators also advertise their accessibility and say they better understand local conditions and concerns.

But the pursuit of leniency is an important undercurrent. About 12 percent of the banks that moved to state charters escaped federal regulatory actions, and experts on bank oversight say such cases are the tip of a broader pattern. They note that some banks convert in anticipation of a public enforcement action, or after persuading federal regulators to terminate an action.

Other banks may have converted after being subjected to less serious regulatory actions, which are typically confidential. Only the most serious problems draw a public order, such as indiscriminate lending, flawed accounting or refusing to make requested changes voluntarily.

The consequences of any conversion are hard to measure. One of the 30 banks that terminated a public enforcement action by switching charters subsequently filed for bankruptcy protection and several others were sold. Experts say that when banks avoid taking necessary medicine, the economy ultimately is weakened.

Most of the proposals to overhaul financial regulation are variations on the idea that the government should oversee more kinds of financial companies, such as hedge funds and mortgage lenders. But a number of experts say the existing system also needs urgent reform, including the relationship between state and federal banking regulators. They warn that putting more companies beneath the government's umbrella must be combined with a plan to patch its holes.

"The whole framework of our system was set up at a different time in American history, and it's really much more a matter of history than logic," said Eugene Ludwig, who served during the 1990s as Comptroller of the Currency, the chief regulator for national banks.

The roughly 1,550 banks with national charters are regulated by the Office of the Comptroller of the Currency. The 5,600 state-chartered banks are regulated under 50 sets of state rules. In a parallel system, the federal Office of Thrift Supervision competes with state regulators to charter savings-and-loans. While every bank and thrift requires a charter to operate, they all have at least two choices.

State chartered banks are still subject to secondary oversight by the Federal Deposit Insurance Corp. or the Federal Reserve.

Regulators are funded by assessments on the banks they oversee, so the agencies tend to treat the banks as customers because they end up competing for their business. Critics have long complained that the system allows banks to play regulators against one another, creating what former Federal Reserve Chairman Arthur Burns memorably described as a "competition in laxity."

The Post reported in November that OTS actively sought new customers. The agency adopted a strategy of accommodating the institutions it regulated, interpreting key rules more leniently than other regulators. In early 2007 agency officials persuaded Countrywide Financial, then the nation's largest mortgage lender, to move under OTS supervision by promising more flexible oversight.

States including Texas, Oklahoma and Tennessee also have marketed themselves to national banks.

Even some supporters of the choose-a-charter system say that banks should not be allowed to switch while they are subject to a regulatory action.

Robert Lamont, general counsel for the West Virginia Division of Banking, said the state would not issue a charter to a bank until it resolved any outstanding regulatory issues.

"A bank that's under an enforcement order may be trying to just get out from under that enforcement order," Lamont said. "We don't think as a matter of public policy that that's prudent bank regulation."

Other state regulators say they can make their own judgments and, if they agree with federal regulators, impose their own limitations.

"It is important to know that in Nebraska we do our own entrance examination," said Patricia Humlicek Herstein, general counsel for the Nebraska Department of Banking and Finance.

Nebraska has issued three charters that terminated federal actions since 2000. The recipients include the former First National Bank of Lewellen, which was chartered four months after federal regulators cited the bank for problems including "violations of law and unsafe and unsound banking practices relating to its compensation practices, credit administration and credit underwriting, and information security and audit."

Among other things, federal regulators restricted compensation for the bank's chairman, Carol Beard.

The Nebraska charter came without any restrictions, according to Beard's son, bank president Clarence Beard.

Herstein said she could not comment on specific cases, but added, "We would expect a bank to have cleaned up or made substantial progress before we would have accepted a bank or given it a state banking charter."

Most states have not chartered any banks facing regulatory action. Only 10 states have chartered even one such bank since 2000. Texas has chartered eight such banks, the most of any state, including Surety Bank of Fort Worth.

Federal regulators started cracking down on the institution in the late 1990s after disclosure of a scheme by executives to inflate the bank's profits. Both the former chairman and the president eventually pleaded guilty to federal criminal charges. A series of regulatory actions followed, culminating in a final enforcement order in June 2004.

The bank applied for a state charter two months later and remained in business as a state bank for two years. Then it filed for bankruptcy.

Banking Commissioner Charles Cooper, whose department issued six of the Texas charters, declined to comment on specific cases as a matter of policy but said that all applicants for Texas charters received a rigorous examination.

"If there's an historic problem, it has to be something that's being addressed," Cooper said. "No chartering agency wants to bring on a problem."

An OCC spokesman, Robert Garsson, declined to comment on specific cases or on the broader pattern of conversions to state charters.

A smaller number of banks, about 90, have converted from state to federal charters since 2000. The converted banks often were units of larger companies, banks operating in multiple states or banks planning to expand across state lines. On average, the converted banks were three times larger than those that moved in the opposite direction, from a federal to state charter.

Regulators and consultants said they were not aware of a bank that converted to avoid a state regulatory action. Checking is difficult because many states do not disclose those actions, while others do not maintain searchable records. Some banks do prefer national charters because they are exempt from certain state consumer-protection laws that are more strict than comparable federal laws.

Garsson said that the OCC closely examined applicants for national charters and would not generally accept a bank that was under regulatory action.

"If we allowed the conversion, we would want to make sure that we either imposed our own enforcement action or imposed terms and conditions that would have the same effect, to make sure whatever the deficiency is, it is cured," he said.

Pennsylvania has converted four banks facing regulatory action since 2000, second only to Texas, including Commerce Bank/Harrisburg.

The company first attracted regulators' attention during an investigation of a sister company, New Jersey-based Commerce Bank, which also had an unusual number of business relationships with companies connected to its executives.

Such deals can raise concern about whether shareholders are getting the best possible value.

In the case of Commerce Bank/Harrisburg, the company had hired a law firm owned in part by one of its directors, and it paid a real estate firm owned in part by its chief executive to find sites for future bank branches, according to the company's regulatory filings.

In 2007, the OCC required the company to make changes to its business practices.

The following year, the OCC issued an even more serious enforcement action, limiting the bank's ability to enter new contracts.

Commerce responded by applying for a state charter. The bank's chief executive at the time told a local newspaper, the Patriot-News of Harrisburg, that the enforcement action was "unnecessary" and "onerous." The state granted the charter without any of the federal limitations.

A spokesman for Commerce declined to comment, instead referring to a statement the company issued at the time.

"We look forward to developing positive and constructive relationships with both the Pennsylvania Department of Banking and the FDIC," it read. "We believe this change will be conducive to the growth of our business and, at the same time, ensure our customers that the bank is a well-managed and sound financial institution on which they can depend in these difficult economic times."

A spokesman for the Pennsylvania Department of Banking said that Commerce received no guarantee that it would not face limitations at the time that it applied, and that the state made the decision following a thorough review.

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