Better Contract Management Helps Banks Navigate Market and Regulatory Risks

The first half of 2023 marked a volatile period for the banking industry. Three major U.S. regional banks collapsed partly due to poor risk management and the sale of long-term bonds at significant losses. And as we enter the second half of 2023, attention has turned to the commercial real estate (CRE) market, where troubled CRE assets are on the rise due to declining property values, lower occupancy rates, tougher credit and interest rate conditions, and diminished borrower demand.

In response to these market conditions, regulators and lawmakers have sprung into action. In 2018, Congress rolled back certain Dodd-Frank protections, freeing all but the largest banks from strict rules and federal oversight. Now, several lawmakers have pushed to repeal this rollback and strengthen liquidity, stress testing and resolution planning requirements for other large and midsize banks. Additionally, at the end of June, banking regulators updated a 2009 policy statement concerning commercial real estate workouts and accommodations. Under the revised guidance, banks are reminded that prudent CRE loan accommodations and workouts are in the best interest of both lenders and borrowers, and the new statement notably introduces a discussion on short-term loan accommodations. Lastly, as banks continue to build and evolve their third-party relationships—particularly with emerging fintech companies—the FDIC, Fed and OCC have replaced their respective 2008, 2013 and 2013 guidances with a singular inter-agency guidance on third-party risk management.

Taken together, these market and regulatory developments send a clear message to banks: effective risk management in today’s environment is imperative. For example, banks should understand their exposure if a financial institution they trade or lend with is at risk of collapse. They should also be able to modify or remediate the terms of their relationship with their third parties or commercial borrowers based on newer guidance and best practices. However, unpacking these risks and developing better lines of sight are not always easy tasks based on existing systems and processes.

The role of contracts in banking

Banking is an industry built on relationships defined and shaped by contracts. The types and complexity of these contracts and agreements are wide-ranging. Some of the most critical contracts to a bank’s operations, which are likely to fall under the greatest regulatory scrutiny, include but are not limited to:

• Derivative contracts: Banks often engage in derivative contracts to manage their exposure to various risks, such as interest rate risk, foreign exchange risk and credit risk. These contracts may include ISDA master agreements, options, futures or swaps, as well as special provisions for close-out netting and termination events, and as such, are complex instruments that require specialized expertise to manage.

• Foreign exchange agreements: These contracts establish the terms and conditions of foreign exchange transactions, including exchange rates, fees and potential risks.

• Third-party contracts: Financial institutions use numerous contracts and agreements with third parties, including vendor agreements, affiliate agreements, PCS contracts and non-disclosure agreements.

The variability and complexity of these different types of contracts are why better data transparency and contract management will help institutions navigate their risks and compliance responsibilities more easily and effectively. We chat more about this topic below with the SVP of Contract Analytics & Lifecycle Management at Cimplifi, Stuart Brock.

Navigating the growing regulatory burden: a Q&A with Stuart Brock of Cimplifi

Stuart Brock previously held senior management positions at major banking institutions, where he served on the enterprise resolution planning team. He helped manage and collect all information around critical third parties, ensuring those obligations were memorialized, appropriately included in resolution plans and covered by the requisite business continuity plans.

To understand today’s evolving regulatory compliance landscape and explore how banks can best manage this growing burden, we asked Brock to share some best practices learned from his experience leading third-party program compliance at an enterprise bank.

What’s been your experience with regulatory examinations?

In my previous roles, I dealt with several regulatory agencies, each with its own mandates and areas of focus. Broadly speaking, the regulatory exam is a very intense experience. It’s impossible to anticipate all potential questions from the examination team, and you typically have only a finite amount of time to answer their questions. For that reason, you must have a system that allows you to quickly analyze data across multiple repositories and systems of record and that allows you to produce meaningful summaries or other reports.

In my experience, you may not have all the answers, but it’s very important to demonstrate to the examiners that you have processes and systems in place to address any gaps. Doing so not only benefits the exam in the short term but also helps guard against additional concerns that might arise with other examiners or agencies.

What are the biggest contract management challenges for today’s financial institutions?

Unfortunately, many banks are not able to access data quickly, and this was a major contributing factor in the recent bank failures. Banks run on relationships; when they don’t understand these relationships and the associated risks, they’re unnecessarily subjecting themselves to risks that can ultimately lead to failure.

Larger banks benefit from having more mature processes in place, although there’s certainly room to update and optimize them. But Tier 2 and 3 banks traditionally have not fallen under the same level of regulatory scrutiny and reporting requirements. Given the wave of legislative activity following recent bank failures, these banks will likely face new regulatory requirements and must prepare by establishing better systems and processes for gathering and analyzing their data.

The good news is the industry and our customers have begun to recognize the importance of data access and analysis, and they’re already taking steps to deploy solutions to jump-start their compliance.

What are your predictions for what we might see next in the market?

In the near term, we may see more regulatory reporting requirements, in addition to those already in place, and an expanded scope covering more banks.

Tier 2 and 3 banks need to start reviewing their systems and processes now so they’re prepared to take on these new regulatory requirements. This necessarily requires these banks to assess their existing contract management programs to identify any gaps or other roadblocks to compliance. At Cimplifi, we’re seeing an increase in the number of requests for advisory services where our team of financial services experts help banks with their readiness assessments.

It’s important to note that these banks also must deal with new guidance for the management of their third-party relationships. This guidance was published jointly by the Fed, OCC and FDIC and is effective June 6, 2023.

The way forward: principles of better contracting for banks

Given the growing importance of contract management, here are five key elements of establishing an effective, robust contract management process:

• Create a central repository for all contracts: A contract lifecycle management (CLM) system establishes one clear home for critical documents, creating a single source of truth, increasing transparency and improving contracting efficiency.

• Enable intelligent search and data transparency: To quickly identify and extract key data points from complex contract portfolios, it’s critical to be able to execute concept-based searches on key clauses and provisions and use more advanced contract analytics to surface essential data points such as termination events, netting and cross-default provisions.

• Use dashboards to unearth insights and monitor risks: To proactively monitor risks and surface insights, utilize purpose-built, pre-configured dashboards and advanced contract analytics designed for specific use cases.  

• Deploy tools that allow you for systematic modification and remediation: Considering the accelerating pace of regulatory change, solutions that allow the efficient modification of agreements and contract language are vital to supporting ongoing compliance.

• Extract and route key data points: Use modern contract analytics to more readily extract key data points for compliance monitoring, stakeholder review and connection to systems of record, such as portfolio and collateral management solutions.