RMA's new Chair Richard L. Harbaugh believes in RMA's mission

RMA Chair Rick Harbaugh believes strongly in RMA's mission to advance sound enterprise-wide risk management principles throughout the financial services industry. A community bank CEO, Rick also believes that our members' diversity in asset size and geographic location is a great benefit in accomplishing that mission. His main goal as RMA's 2004-05 chair is to promote the initiatives of operational and market risk globally without losing sight of the need to be relevant to all RMA constituents.

RMAJ: How would you describe RMA's mission?

RH: RMA lives its mission statement. It is a member--driven member-focused professional association consisting of both institutional and individual members. It advances the use of sound enterprise-wide risk management principles in the financial services industry. That's pretty simple, but that's our mission in a nutshell.

RMAJ: RMA is unique in that its membership includes institutions of all sizes, and its Board is made up of people with very, very diverse backgrounds.

RH: I agree. RMA serves a very diverse constituency with very large banks on one end of the scale and very, very small banks on the other end. Another group of banks is clustered in the middle. We also have geographic diversity, which is well reflected on our Board. RMA offers a forum where a banker from a $150 million community bank can sit around a table with individuals representing the nation's and the world's largest financial institutions to discuss issues of mutual concern.

RMAJ: Your chairmanship this year underscores that diversity. Our outgoing chair is Suzanne Labarge, vice chair of RBC Financial in Toronto, and you are from Equitable Federal Savings Bank in Grand Island, Nebraska.

RH: Absolutely. We represent RMA's diversity in both institution size and geography.

RMAJ: RMA's focus on enterprise-wide risk management began a number of years ago. Many larger institutions are now establishing a chief risk officer position. In fact, Suzanne Labarge is the chief risk officer at RBC and, as the CEO at Equitable, you are the chief risk officer; too.

RH: Exactly. By virtue of our size, we can't afford to have a chief risk officer, so that's another hat I wear. I get a lot of help from senior officers in my bank, but at many smaller community banks the final responsibility for risk rests with the CEO.

RMAJ: Enterprise-wide risk management is a concept that many community banks are adopting. It's not something that only the big banks are doing.

RH: Enterprise-wide risk management is the new focus of RMA. We're celebrating our 90th anniversary this year, and for the majority of those 90 years, RMA was the thought leader in credit risk management issues. With the decision to expand our focus into the areas of operational risk and market risk, RMA has widened its concept of risk management to enterprise-wide risk management.

RMAJ: As you know, every spring the Community Bank Council meets with the regulatory agencies in Washington to discuss issues of mutual concern. Our role with the regulator's is unique since we don't lobby, and we have a similar stake in maintaining credit quality. One of the primary focuses at the meeting last May was the rising interest rate environment. Are bankers ready to handle a rising interest rate environment?

RH: That's a good question, and it was on the front burner for all the regulators. We can expect examiners to focus strongly on how rising rates would affect banks' portfolios in terms of the impact on consumers and on interest rate risk. It's important to understand that the way a rising interest rate environment affects banks is as different as the composition of the balance sheet of each institution.

If a bank is liability sensitive, the initial impact of increasing interest rates will probably negatively impact its earnings. If it were asset sensitive, the short-term impact on earnings would probably be positive.

Banks can take steps to mitigate the long-term impact of rising rates. Since the industry measures its profitability in basis points, it's extremely important to have a very good understanding of the effect of rising interest rates on the bank's portfolio.

Many community banks have a history of lending long and borrowing short, and this practice could have a serious impact on their portfolios. Large money center banks, which have access to different funding sources and to different capital markets, will not see their portfolios affected as dramatically.

Community banks have done a pretty good job of mitigating the risk of rising rates by taking advantage of longer-term, lower-rate advances from the Federal Home Loan Bank. We've gone through a period where we have seen historically 50-year-low rates. As a result, the advance rates by the Federal Home Loan Bank have presented opportunities to create some longer-term, lower fixed-rate lending. Banks that have been able to originate and sell off some of their longer-term assets have been able to mitigate some of the impact of rising rates.

Again, based upon their allocations of assets and liabilities, each bank will be affected differently by rising rates.

RMAJ: How will rising rates affect consumers?

RH: The consumer is very susceptible. Many banks have offered adjustable-rate mortgages, which, in a rising interest rate environment, will push up housing costs for many Americans. We've just gone through one of the largest refinancing booms in history. Consumers have taken nondeductible debt and converted it into mortgage debt, eroding some of their equity. For the first time in many years, we're seeing a situation where consumers' debt service capacity as a percentage of their total mortgage debt is increasing in lockstep, indicating that the equity shield protecting these consumers no longer exists.

If we consider the possibility that prices for consumer goods and services will increase, it's very likely that we'll see increases in delinquencies, defaults, and foreclosures.

RMAJ: What are you doing to prepare for that?

RH: We've monitored our portfolio very, very closely, taking a long-term view. So we don't expect to see a dramatic impact on our consumer portfolio. We have a seasoned portfolio of mortgage loans. We don't have the same degree of concern as an institution that was trying to find alternative forms of investment and booked a lot of adjustable-rate mortgages. But because the average consumer is going to be stressed, we are looking for overall higher delinquencies and defaults.

RMAJ: Do you expect the commercial pipeline to pick up at all, offseting the higher delinquencies on the consumer side?

RH: There's still an awful lot of pent-up demand on the commercial side. We had hoped that we would begin to see more growth in that area than what we have. Businesses are still not comfortable with our economy. For example, the Fed raised rates by 25 basis points at the end of June, and we expected that overall long-term rates would begin to increase, drying up mortgage originations. Instead, there was a period of time where mortgage rates fell back and mortgage originations increased. I think there is still concern about the overall strength of the economy.

Businesses do not seem willing to make needed investments in property, plant, and equipment until they feel the economy is on more solid ground. Everybody says that the economy is beginning to percolate along quite well, yet the financial indicators, such as the markets, don't indicate that.

RMAJ: There's still caution.

RH: Probably the best description is cautious optimism.

RMAJ: Another issue discussed at the Council meeting in Washington is the almost overwhelming regulatory burden that community banks face. Community banks already had a huge regulatory burden vis-a-vis the rest of the industry, but over the past three years Sarbanes-Oxley and the USA Patriot Act compounded it. Some people have described recent regulations as a "perfect storm" of overwhelming compliance costs.

RH: I couldn't agree more. There is an inordinate amount of regulatory burden on community banks, and it causes two problems. Number one, the cost and time of complying are relative to a bank's size and its ability to implement the compliance. And number two, the costs and time involved in complying disadvantage community banks to some degree and lessen our competitive posture.

The regulators themselves are just the individuals who implement and ensure compliance with the regulation. If there needs to be a change, and I believe there does, it needs to start in the legislative process. We need to organize our efforts to present a clear picture to the legislators of the burden these regulations have created for the industry and for community banks in particular.

We've talked about regulatory relief in the past, but it's been no more than lip service. When you combine the requirements of the USA Patriot Act, Sarbanes-Oxley, and all the provisions of the Bank Secrecy Act with everything else community banks have to comply with, the cost in terms of both time and financial resources is terribly inordinate to the overall outcome.

RMAJ: Many large banks agree. A mid-size regional--about a $4 billion bank--expected its Sarbanes-Oxley compliance costs would be $60,000. It turned out to be $300,000, not an insignificant amount for an institution of that size.

RH: Definitely, that's a major expense. To us, $60,000 would be a tremendous amount of money. I haven't had the opportunity to totally quantify our compliance costs in terms of their financial impact on our institution. I do know what the human resource impact is. We used to have one employee who monitored compliance with regulation, and now we nearly have two full-time people involved in it. One person monitors the pieces of CRA and Reg B, Reg C, and Reg Z, and the other acts as our full-time Bank Secrecy Act officer. In addition, we now spend a tremendous amount of time educating our staff about compliance issues. We have ongoing annual training to ensure that our staff is meeting the burdens of compliance.

RMAJ: Does that training extend to your Board as well as your staff?

RH: Absolutely. We recently took our entire Board to an Office of Thrift Supervision compliance forum in Kansas City.

RMAJ: Has any good come out of these regulations?

RH: Yes. There are some issues that come under the USA Patriot Act, which makes us more aware of information technology security. Down the road, it will help us manage operational risk, because it has made us more aware of intrusion opportunity on our systems and the perpetration of external fraud.

RMAJ: So that'll have some long-term pay off, perhaps.

RH: Here's a little bit of information we learned at the OTS forum. When the regulators talked about the foreign money that could be used to fund terrorist activities, they said that part of the money that financed the 9/11 terrorists' activities came into this country through a community bank in Arkansas. The OTS said that community banks represent a tremendous opportunity for money laundering because many of them have unsophisticated policies and procedures to guard against it.

We were also told that a lot of money funnels into the United States from south of our borders. Interstate 35, which dissects the country, running northward from Texas through Minneapolis and all the way to the Canadian border, is a major highway used by those bringing dollars into the United States. They travel up I-35, and then turn west at some point, traveling through Iowa, Nebraska, North and South Dakota, Kansas, and Oklahoma. These are states with a large number of community banks, and these banks have a high degree of probability of having some type of illegal money funneled into them.

If regulatory compliance can prevent something of that nature from happening in the future, I am all for it. But let's also consolidate regulations where we can and eliminate regulations that are no longer relevant.

RMAJ: What is your greatest concern for community banks?

RH: My greatest concern is in the area of fraud, identity theft, and external issues beyond our control. I don't mean to be a prophet of doom and gloom, but I believe that there will probably be another terrorist attack in our country. I'm concerned about its effects on our economic infrastructure and the systems that handle the day-to-day banking transactions. I don't believe Al Qaeda intended to cause the economic disaster that occurred after 9/11, but going forward they may specifically focus on our financial infrastructure. Also, I'm concerned about the growing number of fraud issues such as "phishing" and Internet-based scams. We had two recent fraud attempts at our bank where our well-trained staff, thankfully, thwarted them before they became losses. I myself have been a target of an e-mail seam recently. I received e-mail from what purported to be a large credit card provider. It tried to direct me to a site where I would be asked to supply information about myself, including my PIN code.

As we enter an increasing interest rate environment, I continue to be concerned about credit risk issues. Those are going to be with us as long as we're in this business. There's an old saying: The worst of loans are made in the best of times. A few years ago, bankers were really stretching to compete for loans. That stretching may have created some opportunities for loan problems to crop up again. Although regulators say they've not seen credit problems manifest themselves in the quality of the portfolios they're grading, they have talked about decreased underwriting standards and loan covenants that have been waived or reduced. I don't think we can be sure that something isn't going to raise its head and cause problems for us. Memories too often are too short, and we should not be caught up in the euphoria that everything's rosy with our credit issues.

RMAJ: An interesting point in that context is that there were some big credit losses through this recession, but they were all taken by the larger banks. The community hanks didn't really have the kind of charge-off ratios that the larger banks suffered during this last downturn.

RH: To coin a phrase from nay good friend and past chair of RMA, Bill Scholl, we in the community bank arena have somewhat of a herd mentality. We follow what our big brothers do, and sometimes it takes a little longer for it to show up in our activities. I hope that's not the case.

But the good news is that if we do run into credit problems, our capital levels are higher. Also, the internal identification systems of community banks are better because they now use a system of risk ratings. All of those factors will help to mitigate credit problems, if they happen.

RMAJ: In respect to Basel II, what impact will a bifurcated capital system have down the road?

RH: I think it's going to be more difficult to monitor from a supervisory standpoint. But a bifurcated system will be necessary because there's no way that the capital structure as proposed under Basel II relates to me in the same way it does to the 10 or 12 banks in our country that will be required to comply with Basel II.

Things have changed dramatically since the Basel Committee on Banking Supervision implemented Basel I in 1988. The requirements of Basel II, as they relate to more complex, globally active banks, are probably necessary. But I don't think much has changed for community-focused institutions that are not looking at cross-border, competitive equality.

According to Federal Reserve data, more than 93% of the banks that are outside of the top 20 banks have risk-weighted capital ratios in excess of 10%, which is about 25% higher than the minimum of 8% established by Basel I.

When you look at the 8,800 banks in this country with tess than $1 billion in assets, the numbers become even more striking. Banks with less than $100 million in assets have aggregate risk-weighted capital of approximately 16.6%, and banks with assets of $100 million to $1 billion have aggregate risk-weighted capital of 13.8%.

This data shows that community banks, for the most part, are very well capitalized. On the other hand, for banks with more than $10 billion in assets, the aggregate figure is 9.14%. Community banks tend to hold more capital because they're generally either individually or closely held and don't have access to capital markets, as do the larger banks. As a result, I'm not sure there is any way that you'd apply Basel II to community banks that would benefit them, unless they would be able to selectively apply it to certain portfolios to decrease the amount of capital allocation on those specific loan portfolios.

RMAJ: You've been active in your chapter for 30 years. Can you tell us what chapter involvement has meant to you?

RH: Number one, it has created a networking organization for me that I have benefited from throughout my career. I've been to round tables all across the country. I have met members of banks all across the area and had an opportunity to network with them. I can telephone them and say, "Hey, I've got this problem. Have you ever experienced this, and what have you done in this particular kind of situation?" For 30 years my chapter involvement has provided an opportunity to exchange information about key risk indicators. We've been able to put into place best practices from institutions of a similar and even larger size that have crossover relevance to us.

Membership in RMA has definitely increased my knowledge base. It's just a tremendous learning experience. The chapter network is the backbone of RMA. It's that piece of RMA that probably represents the largest degree of community banks in the Association.

That RMA now has four overseas chapters and more on the way is an indication of the tremendous importance of the chapter network. It helps us advance the concepts of the operational and market risk management practices of RMA.

RMAJ: What is your overriding goal as chair of RMA this year?

RH: I will continue to promote the initiatives of operational and market risk on the global frontier without losing sight of the need to be relevant to all of our constituents. I want our members from institutions with less than $1 billion in assets to understand that we will continue to provide products and services that are relevant to them. We will not lose our focus on credit risk management, which is where community banks often find the greatest value. Yet, at the same time, I want RMA to be able to expand its initiatives both nationally and internationally.

As I have traveled to chapters and round tables, I have taken note that members from the big banks think we're doing too much for the little banks. Yet members from the little banks think we're doing too much for the big banks. Our challenge is to make sure that we engage everybody by communicating the message that we want to advance sound risk management principles throughout the financial services industry--for banks of all sizes. That's who we are and it's what we are trying to do.

Portrait of a Community Banker

Richard L. Harbaugh, president and CEO of Equitable Federal Savings Bank, Grand Island, Nebraska, changed the strategic focus of this traditional, $150 million mutual thrift to a full-scale commercial banking enterprise shortly after joining the bank in November 2000. Commercial lending now represents about 25% of the bank's total assets.

Rick began his banking career in 1967 as a management trainee for American Loan Plan, a consumer finance company in Omaha. American Loan Plan was subsequently purchased by AVCO Financial Services, and Rick worked in various capacities as a branch and office manager until 1973. During his tenure with AVCO, he managed offices in Liberty, Missouri; Davenport, Iowa; and Grand Island, Nebraska.

In 1973 he joined Commercial National Bank in Grand Island as a consumer loan officer, eventually heading the Commercial Loan Department, where he also was responsible for internal loan review and policy development and implementation.

In 1979, Rick joined First National Bank of Kearney, Kearney, Nebraska, as executive vice president. In 1982, he was promoted to bank president. Then in 1995 he became president of Overland National Bank and was transferred back to Grand Island. Both First National and Overland were affiliates of First Commerce BancShares. When First Commerce BancShares was acquired by a multinational banking operation in 2000, Rick helped Overland through the conversion with the new bank, then left to become president and chief executive officer of Equitable Federal Savings Bank in Grand Island.

Connie Swanson. Pam Martin is director of Regulatory Relations and Communications and Kathleen Beans is senior writer at RMA.

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