Assessing the Value of Your Loan Review Department

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Bank directors know that while there are many risks that all banks face — including some serious emerging issues — the major, ever-present risk that causes the most bank failures is credit risk.

The question then becomes: how well do they know the key components of an effective credit risk management system that can protect the bank’s safety and soundness and minimize the liability of the directors? The loan review department is a key aspect of an effective risk management system — yet it may not be functioning effectively. While bank directors are justifiably concerned about future economic conditions and the potential impact on their loan portfolios, are their institutions’ loan review departments really effective “early warning systems” for credit risk?

Part of the loan review challenge today is the difficulty in finding and retaining credit risk professionals. Loan review analysts are not on a typical bank “career path;” finding people with the right skills who are interested in a loan review position is a growing challenge. Is a hybrid staffing model blended with outsourced loan review services a necessity to address staffing issues today?

Other relevant challenges for banks include a growing acceptance and desire for a remote work arrangement, which can minimize collaboration, peer exchange and interpersonal communications. Only now are affordable technology tools emerging to support the loan review function to assist remote workers. Are banks investing in automation of this area? How can directors determine if loan review is bringing in the value it should to you and your bank?

Bank-Specific Considerations
When assessing the value of a loan review department, including efficiency and effectiveness of their functions, a lot depends on the characteristics of the bank itself. Smaller banks may have no choice than to use an outsourced model or hybrid blend of resources due to a lack of available internal skilled resources. Much larger banks typically staff their department with internal resources, which can present different management and career path issues. A bank with a rapidly growing book of loans may face difficult decisions on their model.

The specific responsibilities of a loan review department differ depending on the institution’s history and credit culture. Some banks virtually re-underwrite their sampled loans during exams — including financial re-spreading and deep dive document compliance. Other banks focus on a current validation of the risk rating and potential risk of credit deterioration. In many banks, loan operations does quality control checking for loans booked and internal audit performs documentation reviews, while other banks consider such duties to be part of loan review. Obviously, each bank needs to assess and clarify its department’s structure and responsibilities scope, along with its staffing model.

Other areas that differentiate different loan review departments include sample penetration thresholds and goals. Some departments have goals to review 60% or more of all borrowers over a certain threshold of loan size, while other’s objectives have less volume and more “risk targeted” exams. A more forward-looking model in vogue today is using “continuous monitoring” to watch emerging risk patterns and trends.

When assessing the value of a loan review department, management and the board should thoroughly understand the current state and how these bank-specific characteristics factor into the model of their team. It’s appropriate to challenge the current model and question its business value. As part of their responsibilities to the bank, directors must perform their duty of care and “trust but verify” the effectiveness of their loan review department.

Banks today are looking at any and every opportunity to build efficiency and cut costs, even in important areas of risk control like loan review. Many institutions have not been considered the loan review department’s cost-effectiveness in years. While banking has seen rapid change in many operational areas, thanks to automation and process changes put in place during the pandemic, loan review has languished. Many departments today are doing running the same way they have been in the past. Rapid and meaningful assessment of the effectiveness and efficiency of the loan review department can bear significant fruit in two of the most important areas of banks today: risk management and operational efficiency. Now is a good time for the board to exercise its duty of care and assess the loan review department’s ability to deliver these benefits.

Current Compliance Priorities in Bank Regulatory Exams

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Updated examination practices, published guidance and public statements from federal banking agencies can provide insights for banks into where regulators are likely to focus their efforts in coming months. Of particular focus are safety and soundness concerns and consumer protection compliance priorities.

Safety and Soundness Concerns
Although they are familiar topics to most bank leaders, several safety and soundness matters merit particular attention.

  • Bank Secrecy Act/anti-money laundering (BSA/AML) laws. After the Federal Financial Institutions Examination Council updated its BSA/AML examination manual in 2021, recent subsequent enforcement actions issued by regulators clearly indicate that BSA/AML compliance remains a high supervisory priority. Banks should expect continued pressure to modernize their compliance programs to counteract increasingly sophisticated financial crime and money laundering schemes.
  • In November 2021, banking agencies issued new rules requiring prompt reporting of cyberattacks; compliance was required by May 2022. Regulators also continue to press for multifactor authentication for online account access, increased vigilance against ransomware payments and greater attention to risk management in cloud environments.
  • Third-party risk management. The industry recently completed its first cycle of exams after regulators issued new interagency guidance last fall on how banks should conduct due diligence for fintech relationships. This remains a high supervisory priority, given the widespread use of fintechs as technology providers. Final interagency guidance on third-party risk, expected before the end of 2022, likely will ramp up regulatory activities in this area even further.
  • Commercial real estate loan concentrations. In summer 2022, the Federal Deposit Insurance Corp. observed in its “Supervisory Insights” that CRE asset quality remains high, but it cautioned that shifts in demand and the end of pandemic-related assistance could affect the segment’s performance. Executives should anticipate a continued focus on CRE concentrations in coming exams.

In addition to those perennial concerns, several other current priorities are attracting regulatory scrutiny.

  • Crypto and digital assets. The Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC have each issued requirements that banks notify their primary regulator prior to engaging in any crypto and digital asset-related activities. The agencies have also indicated they plan to issue further coordinated guidance on the rapidly emerging crypto and digital asset sector.
  • Climate-related risk. After the Financial Stability Oversight Council identified climate change as an emerging threat to financial stability in October 2021, banking agencies began developing climate-related risk management standards. The OCC and FDIC have issued draft principles for public comment that would initially apply to banks over $100 billion in assets. All agencies have indicated climate financial risk will remain a supervisory priority.
  • Merger review. In response to congressional pressure and a July 2021 presidential executive order, banking agencies are expected to begin reviewing the regulatory framework governing bank mergers soon.

Consumer Protection Compliance Priorities
Banks can expect the Consumer Financial Protection Bureau (CFPB) to sharpen its focus in several high-profile consumer protection areas.

  • Fair lending and unfair, deceptive, or abusive acts and practices (UDAAP). In March 2022, the CFPB updated its UDAAP exam manual and announced supervisory changes that focus on banks’ decision-making in advertising, pricing, and other activities. Expect further scrutiny — and possible complications if fintech partners resist sharing information that might reveal proprietary underwriting and pricing models.
  • Overdraft fees. Recent public statements suggest the CFPB is intensifying its scrutiny of overdraft and other fees, with an eye toward evaluating whether they might be unlawful. Banks should be prepared for additional CFPB statements, initiatives and monitoring in this area.
  • Community Reinvestment Act (CRA) reform. In May 2022, the Fed, FDIC, and OCC announced a proposed update of CRA regulations, with the goal of expanding access to banking services in underserved communities while updating the 1970s-era rules to reflect today’s mobile and online banking models. For its part, the CFPB has proposed new Section 1071 data collection rules for lenders, with the intention of tracking and improving small businesses’ access to credit.
  • Regulation E issues. A recurring issue in recent examinations involves noncompliance with notification and provisional credit requirements when customers dispute credit or debit card transactions. The Electronic Fund Transfer Act and Regulation E rules are detailed and explicit, so banks would be wise to review their disputed transaction practices carefully to avoid inadvertently falling short.

As regulator priorities continue to evolve, boards and executive teams should monitor developments closely in order to stay informed and respond effectively as new issues arise.

The Community Bank Board Guide to Crossing $10 Billion

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Community banks that have weathered the economic extremes of the coronavirus pandemic and a rapidly changing interest rate environment may find themselves with another important looming deadline: the $10 billion asset threshold.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (often called Dodd-Frank) created a regulatory demarcation for banks above and below $10 billion in assets. In 2018, regulatory reform lessened one of the more-stringent expectations for $10 billion banks, but failed to eliminate many of the other regulatory burdens. Experts that have worked with banks to cross the divide since the law went into effect recommend that institutions around $5 billion begin preparing for the costs and expectations of being a larger bank.

“The list of changes when going from $9.9 billion to $10 billion isn’t long. It’s the significance of those changes that can create challenges if not appropriately planned for,” writes Brandon Koeser, financial services senior analyst with RSM US LLP, in an email. “Banks need to take a thorough look at their entire institution, including people, processes and risk oversight.”

The pandemic may have delayed or complicated the work of banks who are preparing to cross the threshold. Anna Kooi, a partner and national financial services industry leader at Wipfli, says she has clients at banks whose growth accelerated over the last two years and are approaching the $10 billion asset line faster than expected.

Bank Director has assembled a guide for boards that reviews some areas that are impacted by the threshold, along with questions directors can use to kick off conversations around preparation.

Lost Income
The Dodd-Frank Act’s Durbin Amendment capped the interchange fees on debit card transactions that banks above $10 billion can charge; interchange fees are not reduced for banks under $10 billion. The capped fees have cost card issuers nearly $106 billion in interchange revenue since 2012, including an estimated $15.2 billion in 2020, according to an Electronic Payments Association analysis in August 2021 using data from the Federal Reserve.

Banks preparing to cross $10 billion should analyze how big the reduction of debit interchange revenue could be, as well as alternatives to make up for that difference, Kooi says. The interchange cap impacts banks differently depending on the depositor base: commercial banks may not miss the income, while institutions with a larger retail base that use their debit cards may experience a significant hit. Banks that have more time to consider alternatives will be better positioned when the interchange cap goes into effect, she says.

Regulatory Expectations
Banks over $10 billion in assets gain a new regulator with a new round of exams: the Consumer Financial Protection Bureau. While other banking regulators tend to focus on prudential safety and soundness, the CFPB aims to promote “transparency and consumer choice and preventing abusive and deceptive financial practices” among markets for financial services and products, according to the agency’s mission statement. This exam shift means banks may want to reach out to consultants or other external partners that have familiarity with the CFPB to prepare for these exams.

“The focus is going to be more intense in certain areas,” says Adam Maier, partner and co-chair of Stinson’s banking and financial services division. “They’re going to bring in a different regulatory approach that is very unique, and at times, can be difficult.”

Expectations from other regulators may also increase, and increased scrutiny could lead to a higher risk that examiners discover something at a bank that needs to be addressed.

“A guaranteed place of focus from regulators will be over the bank’s risk program,” Koeser writes. “Undertaking an assessment of the risk management function, including the risk program, staffing levels and quality of talent will be key. In a new world above $10 billion, the old mantra of ‘If it isn’t broke, don’t fix it,’ won’t fly.”

While banks don’t have to participate in the annual Dodd Frank Act Stress Test, or DFAST, exercise until they are $100 billion, regulators may want to see evidence that the bank has some way to measure its credit and capital risk exposure.

“What I’ve heard [from] banks is the regulators, the OCC in particular, still want to talk about stress testing, even though [the banks] don’t have to do it,” Maier says. “I would follow the lead of your primary regulator; if they want you to still demonstrate something, you still have to demonstrate it.”

And importantly, the Dodd-Frank Act mandates that bank holding companies above $10 billion have a separate board-level risk committee; this provision was changed to $50 billion in the 2018 financial reforms bill. The committee must have at least one risk management expert who has large-company experience.

Staffing and Systems
Heightened regulatory expectations may require a bank to bring on new talent, whether it’s for the board or the executive team. Some titles Kooi says a bank may want to consider adding include a chief risk officer, chief compliance officer and a chief technology officer — all roles that would figure into a robust enterprise risk management framework. These specialty skill sets may be difficult to recruit locally; Kooi says that many community banks preparing for the threshold retain a recruiter and assemble relocation packages to bring on the right people. Oftentimes, banks seek to poach individuals who have worked at larger institutions and are familiar with the systems, capabilities and expectations the bank will encounter.

Additionally, boards will also want to revisit how a bank monitors its internal operational systems, as well as how those systems communicate with each other. Maier says that banks may need to bulk up their compliance staff, given the addition of the CFPB as a regulator.

M&A Opportunities
A number of banks have chosen to cross $10 billion through a transaction that immediately offsets the lost revenue and higher compliance expenses while adding earnings power and operational efficiency, writes Koeser. M&A should fit within the bank’s strategic and long-term plans, and shouldn’t just be a way to jump over an asset line.

Banks that are thinking about M&A, whether it’s a larger bank acquiring a smaller one or a merger of equals, need to balance a number of priorities: due diligence on appropriate partners and internal preparations for heightened regulatory expectations. They also need to make sure that their prospective target’s internal systems and compliance won’t set them back during integration.

Additionally, these banks may need to do this work earlier than peers that want to cross the threshold organically, without a deal. But the early investments could pay off: An $8 billion institution that is prepared to be an $11 billion bank after a deal may find it easier to secure regulatory approvals or address concerns about operations. The institution would also avoid what Maier calls “a fire drill” of resource allocation and staffing after the acquisition closes.

Questions Boards Should Ask

  • Do we have a strategy that helps us get up to, and sufficiently over, $10 billion? What is our timeline for crossing, based on current growth plans? What would accelerate or slow that timeline?
  • Will the bank need to gain scale to offset regulatory and compliance costs, once it’s over $10 billion?
  • What do we need to do between now and when we cross to be ready?
  • What role could mergers and acquisitions play in crossing $10 billion? Can this bank handle the demands of due diligence for a deal while it prepares to cross $10 billion?
  • Are there any C-level roles the bank should consider adding ahead of crossing? Where will we find that talent?
  • Do we have adequate staffing and training in our compliance areas? Are our current systems, processes, procedures and documentation practices adequate?
  • How often should the board check in with management about preparations to cross?
  • Have we reached out to banks we know that have crossed $10 billion since the Dodd-Frank Act? What can we learn from them?

Article was updated on Nov. 15, 2022, to reflect that $50 billion banks are now mandated to have a board-level risk committee.

How The Fed Changed The Game for Private Banks

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stock-11-20-18.pngIn late August 2018, the Federal Reserve issued an interim final rule increasing the asset threshold from $1 billion to $3 billion under the Fed’s Small Bank Holding Company Policy Statement. The interim policy now covers almost 95 percent of the financial institutions in the U.S., significantly enhances the flexibility in capital structure, acquisitions, stock repurchases and ownership transfers, among other things, for institutions organized under a holding company structure.

No Consolidated Capital Treatment
The most significant benefit of small bank holding company status is that qualifying banks are not subject to consolidated capital rules. Instead, regulatory capital is evaluated only at the subsidiary bank level. As a result, small bank holding companies have the unique ability to issue debt at the holding company level and contribute the proceeds to its subsidiary bank as Tier 1 common equity without adversely impacting the regulatory capital condition of the holding company or the bank. Due to the expanded coverage of the new rule, banking organizations with up to $3 billion in assets can now take advantage of this benefit to support organic and acquisitive growth, stock repurchases and other corporate transactions.
Acquisition Leverage

Perhaps the most significant application of this benefit is in acquisitions by private institutions, whose equity may be less attractive or undesirable acquisition currency. For these institutions, an acquisition of any scale often requires additional capital, and, without access to public capital markets, utilizing leverage may represent the only viable option to fund the transaction.

Under the Small Bank Holding Company Policy Statement, an acquiring bank holding company may fund up to 75 percent of the purchase price of a target with debt, which equates to a maximum debt to equity ratio of 3-to-1, so long as the acquirer can reduce its debt to equity ratio to less than 0.3-to-1 within 12 years and fully repay the debt within 25 years. The enhanced ability to utilize debt in this context is designed to enable private holding companies to be more competitive with other institutions who have access to the public capital markets or who have a public currency to exchange.

Stock Repurchases
Ownership succession also remains a critical issue for many private holding companies, and the new rule extends the ability to use debt to enhance shareholder liquidity to an expanded group of organizations. In many cases, and especially for larger blocks of stock, a holding company represents the only prospective acquirer for privately-held shares. By using debt to fund stock repurchases, a small bank holding company can create liquidity to a selling shareholder, while providing a benefit to the remaining shareholders through the increase in their percentage ownership.

Moreover, stock repurchases often present themselves at times and in amounts that make equity offerings a less suitable alternative for funding. Finally, as discussed below, stock repurchases can be utilized to enhance shareholder value.

Attractiveness to Investors
While the new rule increases the operating flexibility of banking organizations by providing additional tools for corporate transactions, the use of leverage as part of an organization’s capital structure also results in a number of meaningful benefits to shareholders. First, holding company leverage, whether structured as senior or subordinated debt, generally carries a significantly lower cost of capital, as compared to equity instruments. The issuance of debt is non-dilutive to common shareholders, which means existing shareholders can realize the full benefit associated with corporate growth or stock repurchases funded through leverage without having to spread those benefits over a larger group of equity holders. In addition, unlike dividends, interest payments associated with holding company debt are tax deductible, which lowers the effective cost of the debt. Accordingly, funding growth or attractively priced stock repurchases through leverage can be immediately accretive to shareholders.

Final Thoughts
Funding growth, stock repurchases and other corporate transactions can be a challenge for banking organizations that do not have access to public capital markets or have a public currency. However, the revised Small Bank Holding Company Policy Statement provides management teams and boards of directors with additional tools to fund corporate activities and growth, manage regulatory capital, and enhance shareholder liquidity and value.

What Does the $10 Billion Asset Barrier Mean For Banks?

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ThePurposefulBanker.jpgCrossing the $10 billion asset threshold has a big impact on a growing bank, due to enhanced regulations mandated by the Dodd-Frank Act. In March, Bank Director President & CEO Al Dominick sat down with Dallas Wells of PrecisionLender for “The Purposeful Banker” podcast, to explain the implications of crossing the $10 billion mark, and what banks should do to prepare for it.

  • Implications of Being a $10 Billion Asset Bank
  • M&A and Scale
  • Infrastructure and Talent
  • Technology

Transcript excerpt:

Dallas Wells: Welcome to another episode of “The Purposeful Banker,” a podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today’s best bankers. I’m Dallas Wells, and thank you for joining us.

Today, we’re talking about the $10 billion asset threshold and why it has become so critically important for banks. To help us with this conversation, I’m joined by one of the industry’s foremost experts on bank strategy, Al Dominick. Al is the president and CEO at Bank Director and has lots of commentary out there about how banks are handling this exact issue. Al, welcome and thank you so much for taking the time to do this.

Al Dominick: Yeah, my pleasure. Great to be a part of this.

Dallas Wells: Al, for anyone who might not be familiar, tell us a little bit about yourself and what you all do at Bank Director…

For a complete transcript of this “The Purposeful Banker” podcast, please view here.

Time to Develop an M&A Survival Strategy

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Thirty years ago there were a record high 18,000+ banks in the United States. We’re now down to around 6,700 with all indications pointing to further consolidation. Meanwhile, new bank charters have dwindled to near non-existence with one new bank opened between the end of 2010 and 2013.

  20 years ago 10 years ago Today
 Total number of institutions 12,644 9,129 6,739
 Total number of banks $1 – $50B in assets 554 553 642
 Total number of banks $50B+ in assets 8 27 37
 Total number of banks less than $500MM in assets 11,688 8,022 5,382

Between the number of industry disrupters trying to win a slice of the traditional banking business and the plethora of investment opportunities in other industries with less regulation, it’s easy to imagine the number of banks falling by a full 50 percent in the next 20 years.

For better or worse, banking has become a scale business. The costs of regulatory compliance, necessary investments in new technology, physical and digital channels, and thinning industry margins mean banks will either need to be of a certain size or have a defensible niche built on knowledge rather than transactions.

For the better part of the past decade, the folks at Cornerstone have touted the $1 billion asset threshold as a marker of scale. Because of our friends in Washington and the dizzying pace with which technology has changed our industry, I think the new threshold to reach in the next five to seven years is more in the $5 billion asset neighborhood. If my prediction bears out, the vast majority of M&A activity and consolidation will take place in the midsize bank space ($1 – $50 billion), either with smaller midsize banks buying community banks or banks at the upper end acquiring $5 and $8 billion banks.

I have always been a proponent of having a solid organic growth strategy, but midsize banks will need to develop AND execute upon a solid M&A strategy to survive. Most banks lamely describe their M&A strategy as “opportunistic,” which is code word for: “waiting for the investment banker to call with a proposed deal.” This simply won’t cut it in the fast-consolidating, commoditized industry we call banking today. Here are some key areas your M&A strategy should address.

  • Define Your Value Proposition. Define in financial AND human terms what makes you an attractive acquirer. The list of possibilities are endless: opportunities for stock value gains, opportunities for employee growth at a larger bank, track record of performance, a willingness to negotiate system choices, or a holding company type business model that allows the acquired bank to maintain its brand and management team.
  • Identify M&A Partners. Define filters to narrow down what targets make the list including qualities like geography, asset size, branch network, balance sheet mix, capital levels and niche businesses. Tools like the Federal Deposit Insurance Corp. website or SNL Financial can easily help you produce your target list. Stack rank your target list starting with the most attractive to the least by assigning weighted values to your filters.
  • Cultivate the Courtship. If you are the acquirer, you need an active outreach program that includes management, directors and shareholders, with the mix changing depending on the target. Your outreach program needs to involve a consistent manner of communicating your value to your targets. Get creative. Courtship could involve providing shared services for a common core platform, inviting select management and directors to your strategic planning session, or offering to outsource from your niche expertise like trust and wealth management platforms.
  • Define the Merger Value. Once you find a receptive bank, you will need to paint a clear picture of the value a merger will bring to shareholders and management of the target bank that goes beyond the pro forma financial model. The target bank will want to know about management team composition, board seats, branch closures, surviving systems and products, efficiency targets, headcount reductions, and branding, to name a few.
  • Conduct Due Diligence and Begin Negotiations. If you’ve made it this far, the M&A strategy and framework you have laid out is obviously working. Now, the formal process begins.

At the end of the day, midsize banks have two choices: rely on a decades-old organic growth strategy combined with opportunistic M&A, or get in the game and execute upon a carefully defined M&A strategy. The risk of being left behind as other midsize banks scale up is not one I would want to take with my bank.