Making the Right Decisions

A bank director’s job is always a challenge.

First, the job isn’t easy, doesn’t pay well, and carries a lot of liability. The prestige of being a director is often under fire. Second-guessing board decisions is a good living for a few, conversation for others, and great sport for the media.

Second, the world of banking is rapidly changingu00e2u20ac”new regulations, rising interest rates, the potential bursting of the real estate bubble, Basel II, and of course, China’s impact on the world as we know it today. The best advice I ever heard on all of the above was from the former chairman of J.P. Morgan, Dennis Weatherstone, who told me, ” I don’t worry about things I can’t do anything about,” which is one of the benefits of having a large, highly paid staff. Unfortunately, that solution doesn’t apply to the majority of the rest of us.

Third, there’s an expectation that bank directors understand everything. This is, again, somewhat unrealistic, even though they are faced with nearly every imaginable type of business challenge in the course of their tenure at the bank. But against the backdrop of these challenges, directors are faced with one underlying responsibility which is the hardest part of their jobs: making the right decisions.

People matter most

Banking excellence at the end of the day is 100% people. Directors, officers, and employeesu00e2u20ac”from the CEO to the tellersu00e2u20ac”it’s all about people communicating with customers, regulators, investors, and most important, with one another. The importance of people in banking is pervasive, even with regard to loan pricing. As a banking friend of mine, Billy Woodward, said, “Alex, if I can get the people, I can get the price.”

Above all else, the board’s most important decision is selecting the right CEO, because ultimately, every bank is the reflection of its CEO and those who preceded him or her. The CEO provides the vision, establishes the values, and builds the organizationu00e2u20ac”day in and day out. Harry Truman said it best with a plaque on his desk: ” The buck stops here.”

Ultimately the CEO is responsible for making it all happen, not through technology, but through people. And the most important group of people working with him is the board. Together, the board and the CEO address the three most important drivers of success: soundness, profitability, and growthu00e2u20ac”in that order. Every decision, every day should fuel these goals.

Long-term strategy: Acquire, be acquired, or grow independently

Determining whether the bank can remain viable for the long term is largely driven by the following factors:

– its ability to attract and retain the right people

– being in a market either with real growth potential or weak competition

– having rational competitors with regard to pricing

More and more, banks are falling into three categories: those with strategies to be acquirers, those who really want to be acquired (sooner not later), and all those in between.

“All those in between” include banks that will occasionally make an acquisition but not pursue M&A as a way of life. It also includes those institutions reluctantly forced to sell because the price offered is too good to be refused or the perceived challenges are too great to be overcome in the long termu00e2u20ac”both of which are perfectly legitimate reasons for selling. For many bank owners who have no intention of ever selling, the key is to run and build the bank so that if a buyer comes along willing to overpay, everything will be in place to maximize shareholder value.

A bank director’s job is always a challenge, but the challenge becomes particularly acute when the board is going through the sell/remain independent decision. While this can be a stressful situation, considering all the issues associated with discharging the board’s fiduciary duty to shareholders, it also presents an opportunity for the board to really shine. Getting the entire process right is a wonderful chance for the members of the board to earn the respect and admiration of the constituents whose interest they represent.

At times, internal developments specific to the organization might be what prompt a board of directors to seriously look at a selling strategy in a more formal manner. Changes in the bank’s current financial situation, a proposed change in senior management, the success or failure of recent marketing initiatives, or other similar factors might lead the board to seriously analyze a potential sale. At other times, the board may find that external developments, in the form of potentially significant events in the technological, economic, and regulatory fields, make undergoing this decision-making process a necessity. What, then, is the best road map directors can use to guide them through this process?

Responding and adapting: Lessons learned

Justifying a course of action is not a black-and-white matter. There are many shades of gray that involve the perceptions of those who are affected most by a potential sale. For banks whose decisions to sell are influenced by the external factors mentioned above, the board’s action may mitigate their shareholders’ exposure to prospective risks beyond management’s control. At the same time, the selling shareholders may have obtained a very attractive price given higher than historical multiples in the bank mergers and acquisition field.

Conversely, for those who choose not to sell in the face of these external events, our historical experience shows that the community banking sector is more resilient than many outsiders would imagine. This should be heartening to many bankers, but what must not be overlooked is that the remaining independent institutions did not go through the experience unchanged. The outside forces described above motivatedu00e2u20ac”in fact requiredu00e2u20ac”banks to become more efficient. Many successful banks that have maintained their independence are prospering today because they have taken a Darwinian approach to their business modelu00e2u20ac”successfully adapting and responding to outside developments, and, in doing so, achieving a level of performance that historically may have seemed unobtainable.

Thus, adapting to the environment is a critical component of long-term success. When we look at relevant peer data from before this most recent phase of the industry’s development, we see that what are common performance targets today were rare or nonexistent 15 or 20 years ago. These efficiency improvements took place in an evolutionary rather than revolutionary manner; thus, cumulatively over time a remarkable number of techniques have been employed to adapt well-run financial institutions for today’s environment. A short list of these competitive adaptations would include trust-preferred securities, more sophisticated incentive compensation plans, bank-owned life insurance, stock buybacks, overdraft checking, fractional pricing, and S corporation elections, among others.

Building resilience

The resilience of the banking industry, therefore, requires forward-thinking boards of directors who embrace change when needed and empower their CEOs to stay on the cutting edge and manage change effectively.

Unfortunately, the resilience of the community banking sector has also left some bankers with an attitude that is, at times, too complacent. In some isolated instances, inertia, combined with a benign credit environment, has led certain financial institutions to pile up huge amounts of retained earnings relative to their asset sizes. Yet the same institutions have not pursued earnings enhancement opportunities that are both readily available and will work to maintain a sufficiently attractive return on equity. This has the effect of being stuck with nowhere to go. When these suboptimal conditions are allowed to existu00e2u20ac”when returns on equity are diminished from both directions in the form of below-average earnings and large amounts of excess capitalu00e2u20ac”it creates a path to nowhere. Such banks can even get to the point where their shareholders could make more money buying federally insured certificates of deposit. At that point, they become ripe for the picking.

The Chicken Little theory

Knowing when to sell and when to stay independent is both art and science. The signs may be on the wall, but tapping into the correct instincts of a savvy board of directors who are working together with the CEO can often disprove conventional wisdom.

When Chicken Little proclaimed, “The sky is falling!” her friends were quick to follow her without asking the right questionsu00e2u20ac”leading to their ultimate demise. In banking, sometimes the hardest decisions to make are the one that go against the tide. Yet, directors must ask the right questions and work together to make the best decision possible for themselves and their constituents. If not, they, like Chicken Little, Henny Penny, and all the others, also run the risk of peril.

The bottom line is that in banking, something of major significance “that will reshape the entire industry” is always about to fall from the sky. More regulation, the yield curve, technology, and even competition from Wal-Mart are a few such examples of sky-falling disasters waiting to happen, depending on who you listen to. The challenge for your board is to have a sound game plan in place that will withstand such challenges and help the institution maintain a clear path toward its future.