Legal/Reputational Risk

Legal risk arises from the potential that unenforceable contracts, lawsuits, or adverse judgements can disrupt or otherwise negatively affect the operations or condition of a banking organization. Reputational risk is the potential that negative publicity regarding an institution's business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.

Risk Committee Legal/Reputational Risk Observations

The Fed's September 2008 Risk Committee identified the following key legal/reputational risks facing Seventh District financial institutions:

Anti-Money Laundering (AML) Issues
Consumer Compliance in a Changing Environment

AML Issues

Compliance with the Bank Secrecy Act (BSA), the USA PATRIOT Act, and the Office of Foreign Assets Control (OFAC) requirements has become increasingly important during the past few years. The U.S. banking agencies expect financial institutions to maintain compliance with these laws and regulations, and the agencies have taken formal and informal action against institutions that have less than satisfactory BSA/AML programs. Maintaining compliance can prove challenging, as new or revised requirements continue to be issued. These issuances, combined with other information from the agencies, can create an information overload, or at the very least a challenge to manage. Therefore, District state member banks must remain diligent in this area and ensure that their BSA/AML programs comply with all applicable laws and regulations. Noncompliance with BSA/AML regulations can have a substantial on financial institutions, including formal enforcement actions, monetary penalties, informal enforcement actions, or enhanced supervisory monitoring.

Based on Federal Reserve examination findings, most banks are making progress on BSA issues. However, the high legal and reputational risks associated with noncompliance require institutions to remain diligent in their compliance efforts, and some institutions still do not have adequate BSA/AML programs. One key element is strong oversight by the institution's board and senior management. Another is the use of an effective risk assessment to drive the overall BSA/AML compliance program.

The Bank Secrecy Act/Anti-Money Laundering Manual, offsite link updated in August 2007 by the Federal Financial Institutions Examination Council, represents an important step forward in the effort to ensure consistent application of the BSA to all depository institutions.

Consumer Compliance in a Changing Environment

Consumer compliance is operating in a rapidly changing environment. Credit, liquidity, and capital-adequacy concerns are rising, which will likely increase bank management's focus on these safety-and-soundness issues. As resources are re-focused toward safety-and-soundness concerns, they may be taken away from consumer compliance management, as well as anti-money laundering and IT specialty programs. The oversight or overall quality of these compliance programs may deteriorate as a result.

Lending standards and practices are also changing. Given the current real estate market and declining property values, some mortgage lenders are changing lending strategies and imposing restrictions in areas considered to be declining. Banks may be less willing to lend in deteriorating markets, or may impose higher lending standards there. This could increase fair-lending risks such as redlining and increase the potential for discriminatory practices. It could also affect areas with high proportions of minority or low- and moderate-income borrowers.

Institutions should assess their consumer compliance programs in the current environment. They should ensure that compliance is supported by adequate resources. They should also assess the impact of any changes to lending and underwriting standards and practices on overall fair-lending compliance and compliance with the Community Reinvestment Act. Compliance staff should be involved in reviewing any such changes to ensure they do not increase fair-lending risks. As lending standards are tightened, institutions should ensure that practices and loan terms are not unfair and/or predatory, and do not intentionally target or negatively affect a protected class. Finally, institutions should proactively take measures to prevent unjustified disparate treatment (that is, inconsistent application of rules and policies to one group over another).

More information on current consumer compliance issues is available from the Federal Reserve's new publication offsite link Consumer Compliance Outlook. In addition, the Federal Reserve has issued guidance on compliance risk management and oversight at banks with complex compliance profiles.