Tough as Nails

These are the toughest times the banking industry has seen in a generation, maybe a lifetime. More than 60 banks have failed since the beginning of the financial crisis, and hundreds more are teetering. Big names-Wachovia Corp., Washington Mutual Inc., National City Corp., and others-have vanished under the weight of bad lending decisions, plunging real estate prices, and a nasty recession. Many bank boards have their hands full simply trying to manage through loan losses that analysts say have yet to fully play out.

And then there’s First Niagara Financial Group, one of a small group of industry players that looks like it’s living in some sort of parallel banking universe. The Lockport, New York-based thrift company earned $72.6 million in the first quarter-almost exactly the same as a year earlier. Net chargeoffs were just 0.43% of loans, about half the peer median calculated by SNL Financial, while nonperformers as a percentage of assets were 0.56%, or a third of the median in that same peer group. At a recent price of $14, shares were trading right about where they were a year earlier-and that after two recent equity issuances.

John Koelmel, CEO and a director, credits First Niagara’s stable markets with part of the success. “For years, we had to defend (to investors) how we could be successful in a low-growth market,” says Koelmel, 56. “Now people look at us and say, ‘It must be nice to do business in a market where there was no boom, and hence no bust.’”

But there’s more to the story than mere geography. Richard Weiss, director of bank and thrift research for Janney Montgomery Scott in Philadelphia, notes that First Niagara’s conservative approach to balance sheet management helped it steer clear of toxic loans and securities when others were chasing yields. “They’ve been smart,” he says. “If all the banks in the country were run like First Niagara, we wouldn’t be having a financial crisis.”

Being conservative with the balance sheet doesn’t translate to being meek on strategy. First Niagara’s nine-member board has sought to exploit its relative strength by putting pedal to the metal on an aggressive growth strategy that, if directors have their way, could nearly triple the $9.6 billion company’s size over the next several years.

Since September, the company has snatched up jittery customers and lending talent from bigger in-market rivals, and even made a game-changing acquisition, bankrolling the whole affair with several capital-raising events. “We’re all about playing offense,” Koelmel declares. “This is truly a transformational moment for us. We’ve put ourselves in a very unique position.”

As First Niagara’s recent experience illustrates, plotting a long-term strategy in the middle of a distressed environment requires a light-footed, diligent board. Directors proactively laid the initial groundwork for a series of moves-many of them related to capital management-then struck with cobra-like quickness when the time was right.

In early October, First Niagara raised $115 million from the equity markets and followed up that move less than a month later by accepting $184 million in government capital under the Troubled Asset Relief Program.

The same week the TARP decision was made, First Niagara went to work on what eventually would be the purchase of 57 former National City branches in Pittsburgh from giant PNC Financial Services Group Inc. The deal brings $4.2 billion in deposits and gives First Niagara the No. 3 market share position in the Steel City. Almost immediately after announcing that deal, First Niagara hit the capital markets again, raising another $380.4 million. Afterward, it began plotting its exit from TARP.

Along the way, the board has had to educate itself on global markets, delve into the minutiae of marketing and technology investments, and professionalize some of its own internal processes. It established an ad hoc committee of directors with financial expertise to do the legwork on its second capital raise and, for the first time, is using a consultant to help find director candidates with Pittsburgh roots.

From the outside, it appears First Niagara’s board has choreographed its moves well ahead of time. The truth is more complicated than that. To be sure, board members can and must have a broad vision of where they want to take the institution, along with a road map for getting there, and First Niagara’s directors do.

But trying to implement strategy in the middle of an industry crisis, even for a relatively strong company, is a messy business. The crisis has spawned unexpected challenges and opportunities, turning on its ear the sort of patient, methodical approach to franchise building that might be employed in ordinary times. Regulatory agencies have been more assertive, as well. It might not be accurate to label First Niagara’s strategic approach as “reactive,” but it wouldn’t be too far off, either.

“This isn’t a time for an esoteric remaking of the company,” says nonexecutive Chairman G. Thomas Bowers, 65. “Right now is all about taking advantage of our competitors’ weakness to grab market share and build the bank so we’re bigger and stronger when we come out on the other side of this crisis.”

Organic growth is a big part of the equation. So, too, are acquisitions. While some other banks have fared relatively well in the present environment, few have been as aggressive about exploiting that advantage as First Niagara.

“We’re seeing some differentiation between the industry’s winners and losers, and First Niagara is definitely in the winner camp,” says Weiss, who compares the company’s recent moves to the board game Risk. “It’s like they’re coming out of Australia and getting extra armies at every turn for taking a continent. Each move is a building block for the next one.”

In this climate, directors say, success is all about being nimble and engaged. Koelmel prizes having directors on the same page-“It never serves a good purpose to have someone too far off the reservation,” he says-and keeps everyone abreast of current thinking through regular phone calls, e-mails, and a monthly update that provides management’s views on “highlights and headlines on what’s happening externally and internally.

“I want them to be in tune with the ‘why’ behind what we’re doing, not just the ‘what,’” Koelmel explains. “Most of our time is devoted to things that are forward-looking and strategic, trying to anticipate the macroeconomic environment and figure out how we can best take advantage of our position of relative strength.”

To aid the education process, directors hold annual offsite strategy retreats, typically at one of several upstate New York resorts. Last fall, a four-member strategic planning committee took field trips to Washington, D.C. and Manhattan, meeting with lawmakers, economists, and even a futurist who discussed “how the cell phone would evolve and what that might mean for banking,” recalls Bowers, a board member since 2003 and former CEO of Finger Lakes Bancorp, which First Niagara bought in 2002.

“There was no specific agenda, and I can’t even say there was a specific outcome,” Bowers says of the trips. “But they helped us to think a little more outside of the box.”

Having a relatively small board has helped. Just a few years ago, First Niagara boasted 14 directors-too many, board leaders now say, to be effective. This spring, two directors didn’t seek reelection-one hit the board’s mandatory retirement age of 70; the other didn’t have enough time free from her day job to devote to bank business.

Board Vice Chairman David Zebro, 58, says having fewer directors makes everyone more involved and accountable. “When the group is smaller, there’s nowhere to hide. You have to pull your weight,” says Zebro, a principal of Strategic Investments & Holdings Inc., a Buffalo, New York-based buyout firm focused on mid-market manufacturing companies, and a director since 2002.

It also requires more time. The group met in full session 11 times in 2008, and each of the nine directors serves on at least two of the board’s five committees. Asked to sum up his bank-related activities for one recent week, Zebro ticked through a list of loan reviews, risk management reviews, prospective employee interviews, a lunch with Koelmel, and media interviews-and that was during a relatively calm period.

The workload increases substantially during crunch times. In the present environment, decisions often must be made quickly. Directors did plenty of advance homework to prepare for each of the company’s two capital raises, for instance. In both cases, investment bankers identified on Friday a small window of opportunity to sell some shares early the following week, leading to intense weekends hammering out details and gaining comfort. “Sometimes we’ve had to make quick decisions within a context that we’ve been discussing over a period of time,” Koelmel explains.

For all that, First Niagara’s board members appear justifiably pleased that they’re able to plot long-term growth strategies, instead of worrying about the future. “Why do people sit on boards? You want to do community service, you get some compensation,” says Bowers, who ran a troubled thrift during the early-90s savings and loan crisis. “But to be on a winning team makes everything better. It’s been very exciting.”

First Niagara spent much of its 140-year existence as sleepy Lockport Savings Bank, a mutual thrift based in Lockport, a town of 25,000 people about 20 miles east of Niagara Falls and 20 miles north of Buffalo. The company didn’t hit $1 billion in assets until the late 1990s. About that same time, the company dipped its toe into insurance and wealth management. In 1998, it became a mutual holding company. Five years later, it converted into a public company with aspirations for greater growth.

The deals soon followed. In 1999, it bought two small local thrifts, adding $375 million in assets. In 2002, it paid $80 million for Iroquois Bancorp, a $595 million company in Auburn, New York; less than a year later, First Niagara acquired $387 million Finger Lakes in Geneva, New York, Bowers’ former company, for $67 million. It also bought several insurance brokers and a couple of health-plan administrators, diversifying its income stream.

Along the way, First Niagara endured some management turmoil. In 2003, then-CEO William Swan committed suicide after being criticized heavily for his role in a basketball recruiting scandal at his alma mater, St. Bonaventure University, where he was chairman of the board of trustees.

Swan’s replacement, Paul Kolkmeyer, led First Niagara through another growth spell, including two more big New York thrift acquisitions-$1.2 billion Troy Financial Corp. and $2.6 billion Hudson River Bancorp-but the board ousted him in December 2006. Directors don’t like to talk much about the turnover. “It was time for a change,” Zebro says. “The board has to have confidence in the strategy and leadership.”

Koelmel, a burly former KPMG bank audit partner who joined the company as its chief financial officer in 2004, was named CEO. He brought strong connections to the upstate New York banking community, forged over 30 years as an auditor, and an aggressive vision for further growth. “We wanted to roll up and expand without losing our way in terms of who we are and how we serve the customer,” Koelmel explains.

Within months of his appointment, the first signs of the subprime blowout began to emerge. First Niagara aggressively battened down the hatches. The company exited the indirect auto and student lending businesses, where Koelmel says the business models “were all about volume and skinny margins,” and First Niagara lacked the scale to compete. It also let go of some less-profitable branches-and some employees-in the name of efficiency, and halted a share repurchase plan.

“We needed to position ourselves,” Koelmel explains. “The underlying fundamentals were getting out of whack. The industry’s risk-reward model had lost its sense of balance.”

As the industry careened through the summer of 2008, management and the board spent more time assessing First Niagara’s capital and liquidity positions. Early on, some directors thought the company had enough capital and that raising more would simply dilute existing shareholders. At the close of the second quarter, First Niagara had a Tier 1 capital ratio of 10.08% and a tangible common equity, or TCE, ratio of 7.56%-both well above industry averages.

The sentiment began to change after an August meeting Koelmel had with the Office of Thrift Supervision. The regulators had become preoccupied with safety and soundness, and “it was very clear they were intending to raise the bar on capital standards,” Koelmel recalls.

At the board’s next meeting, directors approved a shelf registration with the Securities and Exchange Commission, giving them the flexibility to pull the trigger quickly, should they decide to proceed with an offering.

By September 2008, market conditions had deteriorated significantly. Mortgage giants Fannie Mae and Freddie Mac had been taken over by the government, Bank of America had bought Merrill Lynch & Co., and Lehman Bros., the big investment bank, had filed for bankruptcy protection.

Even so, on a Friday in mid-September, an investment banker from Keefe Bruyette & Woods called Koelmel: If the board was willing, “there might be a window of relative opportunity to go to market early next week,” the CEO recalls. By coincidence, the board’s strategic retreat was scheduled for the coming weekend at the Sagamore, a resort in New York’s Adirondacks. “We canceled the retreat and just convened the board meeting in Buffalo,” Koelmel says.

Board members arrived late on Friday afternoon, and quickly began mulling the pros and cons of an offering. Management, along with bankers from both KBW and Sandler O’Neill & Partners, and outside counsel John Gorman, a partner with the Washington, D.C. law firm Luse Gorman Pomerenk & Schick, walked them through a rigorous presentation. Directors examined whether the capital was necessary to support First Niagara’s strategy and balance sheet. The trade-off between dilution and potential long-term gains was another hot topic. Everyone worried, to various extents, about the pricing, while some directors also “wondered about our ability to execute,” Koelmel explains.

Management argued in support of the capital raise: Not only did the regulators want it, dry powder was needed to pounce on emerging growth opportunities, including acquisitions of troubled banks, when they arose. By Saturday, board members felt convinced. “We didn’t need the capital to bolster the balance sheet,” Bowers says. “We needed it to be opportunistic and take advantage of the environment.”

Directors monitored the situation through the weekend, and met again on Sunday night. Conditions still looked favorable, but the Monday market sentiments in Asia and Europe-both of which would open before the U.S. stock exchanges-still had to be weighed. At 6 a.m. Monday morning, directors convened again. “The overseas markets still looked strong,” Bowers remembers. “It was a go.”

Koelmel and CFO Michael Harrington left almost immediately for a two-day road show in New York, and checked in regularly with directors when they returned. Zebro recalls vividly discussing final numbers over the phone while standing in the doorway of a Boston hotel on Sept. 30, his birthday. The next day, on Oct. 1, the $115 million offering closed. First Niagara’s TCE ratio now stood at 9.1%.

That proved to be just the beginning in a flurry of significant decisions. By Oct. 14, Treasury had announced plans to inject TARP money into banks as capital. At the board’s monthly meeting a few days later, opinions about TARP were mixed. The company seemed stronger than ever and local markets weren’t doing that badly. Even so, the broader economic and industry backdrop had deteriorated rapidly, and comparisons to the Great Depression began to feel like they might hold some water.

Koelmel didn’t know yet if he wanted the government’s money, but he at least wanted First Niagara to apply for TARP. About halfway through a management-led review of the program, Harrington’s assistant walked into the boardroom with a message: The OTS was on the phone, asking in strong terms that First Niagara apply for TARP funds. “We literally were on page 8 of the presentation, and bang! The OTS was on the horn, wanting us to fax in our application that day,” Koelmel says. (The regulators undoubtedly knew when the board would be meeting.)

With the pressure on, board members raised what by now are familiar concerns. The open-ended TARP contract granted Treasury and Congress the power to change terms and conditions retroactively. Some wondered if the government might try to dictate strategy or compensation practices to TARP recipients.

“Getting into bed with the government made us all nervous,” Zebro adds. “We weren’t exactly sure about the implications of taking the money.” Given that the company had just raised money, some wondered, was it really necessary to get more?

Yet, as they probed and questioned management and the advisers, directors say they came to one overriding conclusion: With the economic outlook so glum, capital-in whatever form and for whatever purpose-was king; getting as much as possible would be wise. “In my mind, it came down to, ‘The system is showing serious cracks, and here’s a big slug of capital we can get for 5% plus some warrants,’” Bowers says now. “I remember thinking, ‘If we don’t do this, and six months from now we’re all in deeper trouble, we’re going to be sorry we didn’t take it.’”

As for concerns about government restrictions, “I took comfort in the fact that there would be hundreds of banks taking the money,” Bowers adds. “There was too much at stake for the government to get it wrong.”

On Oct. 27, First Niagara was approved to sell $184 million in preferred shares to the government. Two days later, Koelmel and Bowers were in Florida attending a New York state banking conference. Over a bacon-and-egg breakfast with two Sandler investment bankers, they discussed the latest breaking news: PNC’s purchase of ailing National City.

The marriage of the two giants would require divesting 57 National City branches in PNC’s hometown of Pittsburgh, enough for a No. 3 market share position. Bowers admits he didn’t think much of it at the time. For Koelmel, however, it was a light bulb moment: First Niagara had been stockpiling capital for a big, opportunistic move, and a sizeable franchise within driving distance was available.

The board didn’t meet in November, but Koelmel began talking informally with individual directors about the former National City branches, and even “editorialized about the idea” in his monthly e-mail update. “I was priming the pump, keeping them in touch and in tune.”

At first, some directors were leery. Sizewise, it felt like a stretch. It would be a bigger deal than any First Niagara had attempted before, and in a new, more competitive, big-city market. The times were uncertain. Koelmel himself expected bidding competition and was committed to not overpaying. “It wasn’t a do-or-die deal for us,” he says.

Even so, after a lengthy discussion at the December meeting, directors decided to “throw our hat in the ring and see what happens,” Bowers recalls. The deal included $4.2 billion in deposits and about $840 million in performing loans. “We said, ‘It might be a long shot. We’re not going to be overly aggressive. But let’s get the book and take a look.’”

Over the next three months, First Niagara’s board monitored a roller-coaster negotiating process. The combination of government involvement and fluctuating markets made it difficult to nail down pricing, and it was unclear who else was bidding, or what they were offering. More than once, First Niagara walked away from the negotiations, mostly because its share price had slumped, only to return with a tweaked bid.

In the meantime, management dispatched a crew to Pittsburgh to go through each branch. Reports came back to the board, and were met with more questions: How healthy were the branches? Were they in good shape and good locations? What was the attitude of employees? What was the competitive landscape like, and how would the brand play in western Pennsylvania? As Zebro, the dealmaker, says: “You make your money in due diligence.”

The more they thought about it, the more directors warmed to the notion of a branch purchase. “You don’t inherit all the problems that come with a whole-bank deal,” explains Zebro, who, along with Bowers and two other directors, served on a special “pricing committee” that oversaw negotiations. “There weren’t pension plans or management contracts to buy out or corporate headquarters to divest. This was a simple divestiture of branches.”

On Monday morning, April 6, the pricing committee gathered to approve what would become the winning bid. A few hours later, the board’s executive committee signed off on the offer. The next day, Bowers got a call from Koelmel: First Niagara had won the bidding.

As it turned out, competition wasn’t as stiff as expected. Big banks were too preoccupied with their own troubles to show much interest, and the deal-PNC was required to sell the branches in a block-was too big for smaller players to seriously consider. That enabled First Niagara to get what analysts agree was a good deal, paying a scant 1.3% deposit premium, or about $54 million, for the branches.

The icing on the cake was PNC’s agreement to help finance the purchase, if needed, by purchasing as much as $150 million in equity and debt from First Niagara when the deal closes this September. One of the board’s biggest concerns, not surprisingly, was capital. “We wanted to complete the transaction in at least as strong of a position as we were [in] going in,” Zebro says. PNC’s willingness to invest “ensured we could keep our balance-sheet ratios where they needed to be.”

Behind the scenes, however, the wheels were already in motion for another capital injection. In Koelmel’s mind, the PNC deal and another equity offering went together. “We didn’t want to do the transaction without the ability to raise more capital,” he says. “And we didn’t think we could raise the money without the benefit of the transaction.”

His assessment was spot on. The market had responded to news of the PNC deal favorably (it’s expected to be immediately accretive), bumping up First Niagara shares 25% for the week. It was Good Friday when the pricing committee decided that the time looked right for another equity offering-this one expected to raise about $330 million.

The directors were scattered for the Easter holiday, but followed the same drill as the first time-by phone, when necessary-finalizing key details on Easter Sunday. Koelmel “had an pastrami sandwich from the Carnegie Deli instead of an Easter ham around the family table,” Bowers recalls. Zebro was on vacation in Florida, but spent much of the holiday with a phone to his ear and rose early on Monday to help make a final decision.

The next day, First Niagara priced its offering at $12.25 per share, a slight discount to its opening price. A week later, it closed an overallotted offering for $380 million, bringing its TCE ratio to 12.6%. (After the PNC transaction closes, it is expected to be about 7.7%. Directors say they probably won’t take PNC up on its capital offer, although the possibility still exists.)

Within a week, the company announced its intention to exit TARP-something it accomplished on May 28. “Having TARP bolstered our capital position and put us in a position to get the branch acquisition done,” Bowers says. “But the rules were becoming more restrictive, and with the latest capital raise, we didn’t need it anymore.”

With a big integration ahead of it, First Niagara clearly has a lot on its plate. As a Pittsburgh newcomer, directors expect to lose some customers, and figured that into the pricing. It also has a still-uncertain economic environment to navigate.

None of that means Koelmel and his board are ready to take a break. In board meetings, “we continue to talk about stretching the core … leveraging our story across a broader geography and positioning ourselves as a sort of miniregional player.

“We’re going to be pushing our shopping cart up and down the aisles, whether it’s for transactions, talent, or other business opportunities,” he adds. There promises to be plenty of those in the months ahead.

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