Mobile Banking Attracts Deposits; Does It Aid Their Exit?

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Mobile banking channels, which banks have used to attract deposits, are helping deposits flow out faster as rates rise, a May research paper shows. 

The combination of higher interest rates and technology means that banks with robust mobile banking capabilities have also seen more deposit runoffs — even before the spring banking crisis — according to researchers from Columbia University, the University of Chicago and the National Bureau of Economic Research.  

They found that mobile banking has increased the sensitivity of deposits to interest rates, reducing their stickiness: it’s easier for customers to shop rates, open accounts and move funds. The paper refers to the slow or gradual pace of deposits leaving banks as “deposit walks” versus deposit runs, where many customers overwhelm a bank with withdrawal requests.

“Average deposits have become more sensitive to changes in the federal funds rate in the last decade,” they found. This is “particularly pronounced for banks with a digital platform and banks with a brokerage account.” 

In the study, banks were considered digital if their mobile application had at least 300 reviews, and as having brokerages if they report brokerage income in their call report. In the study, 64% of banks that had between $1 billion and $250 billion in assets — admittedly a wide swath — were considered digital. The impact of digital bank channels on deposits appeared in third quarter 2022 as deposit growth between digital and nondigital banks diverged; a quarter later, digital banks began losing both insured and uninsured deposits. 

“Whatever happened in the banking system in late 2022 and early 2023 was not just about the flight of uninsured deposits,” they wrote.

A 400 basis points increase in the federal funds rate leads to deposit decline of 6.4% at banks that don’t have a brokerage and aren’t considered digital, compared to 11.6% for digital banks with a brokerage. They also found that digital banks slowed their “deposit walks” by increasing deposit rates and their overall deposit betas.

Although larger banks with brokerages certainly could have more rate-sensitive customers than smaller banks without brokerages, the researchers attempted to account for that adding another analysis: internet usage among depositors. 

“We find that banks’ deposit outflows are more pronounced in markets with higher internet usage, but that this is only the case for digital banks (regardless of whether they report brokerage fees or not),” the researchers wrote.

Digital banking capabilities contributed to the rapid failure of Silicon Valley Bank, Signature Bank and First Republic Bank, according to testimony from bank officials and regulators. Silicon Valley Bank customers “sought to withdraw nearly all” of the bank’s deposits in less than 24 hours, said Federal Deposit Insurance Corp. Chair Martin Gruenberg in May 18 testimony to the U.S. Senate. He added that “the ease and speed of moving deposits to other deposit accounts or non-deposit alternatives with the widespread adoption of mobile banking” is a development that has increased the banking industry’s “exposure to deposit runs.”

First Republic Bank’s run was “exacerbated” in part by “recent technological advancements that allow depositors to withdraw their money almost immediately,” said former First Republic Bank CEO Michael Roffler in May 17 Congressional testimony. The bank experienced $40 billion in deposit outflows on March 13, after the failures of Silicon Valley and Signature, and a total of $100 billion in withdrawals in the ensuing weeks. 

Not everyone is concerned about the impact of mobile apps on deposits and its implications on bank stability. Ron Shevlin, managing director and chief research officer of Cornerstone Advisors, believes that a small percentage of banks will face notable deposit exits, with most banks able to keep funds stable. Additionally, he points out that banks benefited from having digital and mobile banking channels, especially in the earliest days on the coronavirus pandemic. 

“I don’t think it’s that big of a problem because I think a lot of financial institutions are fairly sophisticated in looking at this,” he says. Banks aren’t just looking at account closures to study deposit outflows; they also analyzing changes in account behavior and transactions. “This is not super new behavior anymore. It’s been in the making for 15 to 20 years.”

Both Shevlin and Luigi Zingales, one of the authors on the paper and a professor at the University of Chicago Booth School of Business, see digital transformation as an inevitability for banks. Zingales points out that apps — not branches — will shape the next generation’s experience with banks. As more community banks become digital banks, he says they may need to adjust their assumptions and expectations for how these capabilities could alter their deposit base, costs and overall balance sheet.

“I think what you need to do is be much more vigilant in how you invest your assets. In the past, you had this natural edge and now this natural edge is much smaller. And if you think you have this natural edge and you take a lot of duration risk, you get creamed,” he says. “I think the [solution] is not to resist technology — to some extent, it’s irresistible. The [solution] is learning to live with a new technology and understanding that the world has changed.”

Risk issues like these will be covered during Bank Director’s Bank Audit & Risk Conference in Chicago June 12-14, 2023.

The Opportunistic Upside of New Capital Rules

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Looming new capital rules are an opportunity for banks to improve strategic planning and data management as they strengthen their compliance and reporting processes.

The coronavirus pandemic has delayed deadlines for complying with the latest round of capital guidelines dictated by Basel IV. Still, financial institutions should not lose sight of the importance of preparing for Basel IV, the difficulties it will create along the way and the ways they can leverage it as a potential asset. Compliance and implementation may be a significant expenditure for your bank. Starting now will lengthen your institution’s path to greater productivity and profitability to become a better bank, not just a more compliant one.

At Wolters Kluwer, we broke down the task — and opportunity — at hand for banks as they approach Basel IV compliance in our new whitepaper “Basel IV – Your Path to a more Profitable Business.” Here are some of the highlights for your bank:

Making Basel IV For Business
Where there is a will — along with the right tools — there’s a way to leverage the work required to comply with Basel IV for other commercial objectives. The new capital rules emphasize using forward-looking analysis, a holistic, collaborative organizational structure and data management capabilities for compliance and reporting purposes. These tools can all be leveraged for strategic planning and other commercial objectives, reducing or controlling long-term expenses while enhancing efficiency.

Central to this approach, however, is adopting the right attitude and approach. Executives should view Basel IV compliance as a potential asset, not just a liability, and be willing to make changes to the structure of operations and supporting data management systems.

A Familiar Approach
Basel IV is not a monolithic set of edicts; instead, it’s a package of regulatory regimens through which the Basel Committee on Banking Supervision’s guidelines will be put into practice. These measures are actually the final version of the Basel III guidelines issued in 2010 but were seen as such an expansion of what came before as to be thought of as an entirely new program. It contains elements that encourage and even require banks to act in ways that enhance business practices, not just compliance.

One element is the mandate for a holistic, collaborative approach to compliance. All functions within an institution must work in concert with one another, to create a data-driven, dynamic, three-dimensional view of the world. Another point of emphasis is the importance of prospective thinking: anticipating events from a range of alternatives, instead of accumulating and analyzing data that shows only the present state of play.

“What now?” to “What if?”
Banks can use Basel’s compliance and reporting data for business intelligence and strategic planning. Compliance efforts that have been satisfactorily implemented and disseminated allow  executives to create dynamic simulations displaying prospective outcomes under a range of scenarios.

The possibilities of leveraging Basel IV for business extends to the individual deal level. Calculations and analysis used for compliance can be easily repurposed to forecast the rewards and risks of a deal under a range of financial and economic scenarios whose probabilities themselves can be approximated. And because a firm’s risk models already will have been vetted in meeting Basel IV compliance standards, bankers can be confident that the results produced in the deal evaluation will be robust and reliable.

Another big-picture use of Basel IV for business is balance sheet optimization: forecasting the best balance sheet size for a given risk appetite. This can show the board opportunities that increase risk slightly but obtain far more profit, or sacrifice a bit of income to substantially reduce risk.

To turn Basel IV’s potential for business into practice requires openness and communication from senior executives to the key personnel who will have to work together to bring the plan to fruition. It will mean adopting a mindset that considers each decision, from the details of individual deals to strategic planning, along with its likely impact. Staff must also be supported by similarly structured data management architecture.

The emphasis on forward-looking analysis and a holistic, collaborative organizational structure for compliance and reporting purposes, supported by data management capabilities designed along the same lines, can be leveraged for strategic planning and other commercial objectives. Success in streamlining operations and maximizing productivity and profit potential, and any edge gained over the competition, can reap especially great long-term rewards when achieved at times like these. Leaders of financial institutions have a lot on their minds these days, but there is a persuasive case to be made right now for seizing the opportunity presented by Basel IV for business.

The Significance of Size, Scale and Structure in BOLI

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A bank is only as strong as its people, its client base and its assets. If your bank owns bank-owned life insurance (BOLI) among its assets, it’s important to know that your BOLI is only as strong as your BOLI insurance provider.

Bank executives familiar with the broad contours of BOLI may not be aware of other important considerations relative to their policies — considerations that may be unique to the product or the insurance carrier. Understanding these nuances can provide valuable insights into the resiliency, financial stability, and performance of your BOLI policy.

BOLI can be one of the most attractive assets on a bank’s balance sheet; in a low-rate environment with market volatility, it’s a good idea to consider including BOLI as part of a well thought-out asset strategy.

Two popular approaches for determining the crediting rates applicable to general account BOLI products are the “portfolio rate” and the “new money rate” methods. The new money rate method features crediting rates based on currently available securities, whereas portfolio-rate general account BOLI policies feature crediting rates based on the performance of an underlying seasoned portfolio. Crediting rates derived from well-diversified, low-turnover portfolios can serve as a form of hedge against volatile and lower market interest rates, while a new money rate product can benefit during a period of persistent and material increased market interest rates.

Each BOLI policy’s minimum guaranteed rate is backed by the credit quality, size and diversification of the issuing insurer’s investment portfolio. A portfolio’s resilience and financial strength are derived from the interplay between the core of investment-grade fixed income securities and holdings of potentially higher-yielding assets.

When it comes to BOLI, size and scale matter. Larger insurers are typically better equipped to purchase and provide exposure to a wider range of diversified assets, which contribute to the portfolio’s yield and BOLI crediting rates that banks value. Smaller carriers may not necessarily have access to the wide range of investment asset classes and market opportunities relative to larger carriers like MassMutual.

Beyond comparisons of the carriers’ investment portfolios and crediting rate approaches, there can be important differences when it comes to the insurers themselves. Because there is a limited universe of BOLI carriers, and their capabilities and strengths vary, each carrier brings unique types and levels of resources to bear. Each insurer offers banks different results based on its investment philosophy and expertise in managing the general investment account underlying its BOLI policies. Certain characteristics that differentiate insurers from each other include company structure, business mix, asset/liability management strategy, access to less widely available investment opportunities, and culture. The expertise, breadth and depth of experience of the insurer’s investment and business professionals should not be overlooked.

As a large mutual life insurer, MassMutual has a dedicated investments group that leverages our expertise in fixed income, equities and alternative assets, including real estate. The asset managers are insurance investors first and foremost, and they understand the business and the characteristics of the liabilities that the investments support.

The mutual structure enables insurers like MassMutual to take a long-term perspective. Decisions made with the next several decades in mind, not the next quarter, better align with the long-term nature of BOLI assets. This long-term view fuels our approach to maintaining financial strength and stability and drives our competitiveness.

Further, a carrier’s long-term market presence and commitment can be aided by diversification within its own subsidiaries, business lines and income streams. Just like in banking, having a diverse set of businesses can help reduce the economic sensitivity of an insurer. Diversified insurance carriers that offer a variety of solutions with varying characteristics are built to weather economic cycles and provide stability to a carrier. The combination of diverse income streams with a diversified pool of assets is a sound approach to help endure a wide variety of economic environments.

Banks have a variety of options when it comes to which BOLI insurer they select. Understanding each carrier’s structure, business mix, investment philosophy and market approach can inform executives’ choices as they embark on financial relationships that last decades.

Insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111-0001.

How to Respond to LendingClub’s Bank Buy

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For me, the news that LendingClub Corp. agreed to purchase Radius Bancorp for $185 million was an “Uh oh” moment in the evolution of banking and fintechs.

The announcement was the second time I could recall where a fintech bought the bank, rather than the other way around (the first being Green Dot Corp. buying Bonneville Bank in 2011 for $15.7 million). For the most part, fintechs have been food for banks. Banks like BBVA USA Bancshares, JPMorgan Chase & Co and The Goldman Sachs Group have purchased emerging technology as a way to juice their innovation engines and incorporate them into their strategic roadmaps.

Some fintechs have tried graduating from banking-as-a-service providers like The Bancorp and Cross River Bank by applying for their own bank charters. Robinhood Markets, On Deck Capital, and Square have all struggled to apply for a charter. Varo is one of the rare examples where a fintech successfully acquired a charter, and it took them two attempts.

It shouldn’t be surprising that a publicly traded fintech like LendingClub just decided to buy the bank outright. But why does this acquisition matter to banks?

First off, if this deal receives regulatory approval within the company’s 12 to 15 month target, it could forge a new path for fintechs seeking more control over their banking future. It could also give community banks a new path for an exit.

Second, banks like Radius typically leverage technology that abstract the core away from key digital services. And deeper pockets from LendingClub could allow them to spend even more, which would create a community bank with a dynamic, robust way of delivering innovative features. Existing smaller banks may just fall further behind in their delivery of new digital services.

Third, large fintechs like LendingClub don’t have century-old divisions that don’t, or won’t, communicate with each other. Banks frequently have groups that don’t communicate or integrate at all; retail and wealth come to mind. As a result, companies like LendingClub can develop and deploy complementary banking services, whereas many banks’ offerings are limited by legacy systems and departments that don’t collaborate with each other.

The potential outcome of this deal and other bifurcations in the industry is a new breed of bank that is supercharged with core-abstracted technology and a host of innovative, complementary technology features. Challenger banks loaded with venture capital funds and superior economics via bank ownership could be potentially more aggressive, innovative and dangerous competitors to traditional banks.

How should banks respond?

Start by making sure that your bank has a digital channel provider that enables the relatively easy and cost-effective insertion of new third-party features. If your digital channel partner can’t do this, it’s time to draft a request for proposal.

Next, start identifying and speaking to the myriad of enterprise fintechs that effectively recreate the best features of the direct-to-consumer fintechs in a white-label form for banks. Focus on solutions that offer a demonstrable path to revenue retention, growth and clear cost savings — not just “cool” features.

After coming up with a plan, find a partner to help you market the new services either through  the third-party vendors you select or another marketing partner. Banks are notorious for not doing the best job of marketing new products and features to their clients. You can’t just build it and hope that new and existing customers will come.

Finally, leverage the assets you already have: physical branches, a mobile banking app that should be one of the top five on a user’s phone, and pricing advantage over fintechs. Most fintechs won’t be given long runways by their venture capital investors to lose money in order to acquire clients; at some point, they will have to start making money via pricing. Banks still have multiple ways to make money and should use that flexibility to squeeze their fintech competitors.

Change is the only constant in life — and that includes banking. And it has never been more relevant for banks that want to stay relevant in the face of rapidly developing technology and industry-shifting deals.

Evolving Considerations in the CECL Countdown

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CECL-7-23-19.pngExecutives gearing up for the transition to the new loan loss accounting standard need to understand their methodologies and be prepared to explain them.

Many banks are well underway in their transition to the current expected credit loss methodology, or CECL, and coming up with a preliminary allowance estimate under the new standard. CECL will require banks to book their allowance based on expected credit losses for the life of their assets, rather than when the loss has been incurred.

The standard goes into effect for some institutions in 2020, which is slightly more than six months away. To prepare, executives are reviewing their bank’s initial CECL allowance, beginning to operationalize their process and preparing the documentation around their decision-making and approach. As they do this, they will need to keep in mind the following key considerations:

Bankers will need time to review their bank’s preliminary results and make adjustments as appropriate. Banks may be surprised by their initial allowance adjustments under CECL. Some banks with shorter-term portfolios have disclosed that they expect a decrease of their allowance under CECL, compared to the incurred loss estimate.

Some firms may find that they do not have the data needed to segment assets at the level they initially intended or to use certain loan loss methodologies. These findings will require a bank to spend more time evaluating different options, such as identifying simpler methodologies or switching to a segmentation approach that is less granular.

These preliminary CECL results may take longer to analyze and understand. Executives will need to understand how the assumptions the bank made influence the allowance. These assumptions include the periods from which the bank gathered its historical loss information for each segment, the reasonable and supportable forecast period, the reversion period, its prepayment assumptions, the contractual life of its loans—and how these interact. Bankers need to leave enough time for their institutions to iterate through this process and become comfortable with their results.

Incorporate less material or non-mainline loan asset classes into the overall process. Many banks spent last year determining and analyzing various loan loss methodologies and how those approaches would potentially impact their larger and more material asset classes. They should now broaden their focus to include less material or non-mainline asset classes as well.

Banks may be able to use a simplified methodology for these assets, but they will still need to be integrated into the bank’s core CECL process to satisfy internal controls and management and financial reporting.

Own the model and calculations. Executives will need to support their methodology elections and model calculations. This means they will need to explain the data and detailed calculations they used to develop their bank’s CECL estimate. It includes documenting why they decided that certain models or methodologies were the most appropriate for their institution and for specific portfolios, how they came to agree upon their key assumptions and what internal processes they use to validate and monitor their model’s performance.

Auditors and regulators expect the same level of scrutiny from executives whether the bank uses an internally developed model, engages with a vendor or purchases peer data. Executives may need specialized resources or additional internal governance and oversight to aid this process.

Know the qualitative adjustments. Qualitative adjustments may shift in the transition from an incurred loss approach to an expected lifetime one. Executives will need a deep understanding of the bank’s portfolios and how their concentration of risk has changed over time. They will also need to have an in-depth knowledge of the models and calculations their bank uses to determine the CECL allowance, so they can understand which credit characteristics and macro-economic variables are contemplated in the models. This knowledge will inform the need for additional qualitative adjustments.

Anticipate stakeholder questions. CECL adoption will require most banks to take a one-time capital charge to adjust the allowance. Executives will need to explain this charge to internal and external stakeholders. Moving from a rate versus volume attribution to a more complex set of drivers of the allowance estimate, including the incorporation of forecasted conditions, will require the production of additional analytics to properly assess and report on the change. Executives will need ensure their bank has proper reporting framework and structure to produce analytics at the portfolio, segment and, ultimately, loan level.

The Evolving Buyer Landscape in Bank M&A

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buyer-7-16-19.pngThe recent acquisition of LegacyTexas Financial Group by Prosperity Bancshares serves as a microcosm for the changing bank M&A landscape.

The deal, valued at $2.1 billion in cash and stock, combines two publicly traded banks into one large regional institution with over $30 billion in assets. Including this deal, the combined companies have completed or announced 10 acquisitions since mid-2011. Before this transaction, potential sellers had two active publicly traded buyers that were interested in community banks in Texas; now, they have one buyer that is likely going to be more interested in larger acquisitions.

The landscape of bank M&A has evolved over the years, but is rapidly changing for prospective sellers. Starting in the mid-1990s to the beginning of the Great Recession in late 2007, some of the most active acquirers were large publicly traded banks. Wells Fargo & Co. and its predecessors bought over 30 banks between 1998 and 2007, several of which had less than $100 million in assets.

Since the Great Recession, the largest banks like Wells and Bank of America Corp. slowed or stopped buying banks. Now, the continued consolidation of former buyers like LegacyTexas is reducing the overall buyer list and increasing the size threshold for the combined company’s next deal.

From 1999 to 2006, banks that traded on the Nasdaq, New York Stock Exchange or a major foreign exchange were a buyer in roughly 48 percent of all transactions. That has declined to 39 percent of the transactions from 2012 to the middle of 2019. Deals conducted by smaller banks with over-the-counter stock has increased as a total percentage of all deals: from only 4 percent between 1999 and 2006, to over 8 percent from 2012 to 2019.

Part of this stems from the declining number of Nasdaq and NYSE-traded banks, which has fallen from approximately 850 at the end of 1999 to roughly 400 today. At the same time, the median asset size has grown from $500 million to over $3 billion over that same period of time. By comparison, the number of OTC-traded banks was relatively flat, with 530 banks at the end of 1999 decreasing slightly to 500 banks in 2019.

This means that small community banks are facing a much different buyer landscape today than they were a decade or two ago. Many of the publicly traded banks that were the most active after the Great Recession are now above the all-important $10 billion in assets threshold, and are shifting their focus to pursuing larger acquisitions with publicly traded targets. On the bright side, there are also other banks emerging as active buyers for community banks.

Privately traded banks
Privately traded banks have historically represented a large portion of the bank buyer landscape, and we believe that their role will only continue to grow. We have seen this group move from being an all-cash buyer to now seeing some of the transactions where they are issuing stock as part or all of the total consideration. In the past, it may have been challenging for private acquirers to compete head-to-head with larger publicly traded banks that could issue liquid stock at a premium in an acquisition. Today, privately traded banks are more often competing with each other for community bank targets.

OTC-traded banks
OTC-traded banks are also stepping in as an acquirer of choice for targets that view acquisitions as a reinvestment opportunity. Even though OTC-traded banks are at a relative disadvantage against the higher-valued publicly traded acquirers when it comes to valuation and liquidity, acquired banks see a compelling, strategic opportunity to partner with company with some trading volume and potential future upside. The introduction of OTCQX marketplace has improved the overall perception of the OTC markets and trading volumes for listed banks. This has helped OTC-traded banks compete with the public acquirers and gain an edge against other all-cash buyers. Some of these OTC-traded banks will eventually choose to go public, so it could be attractive to reinvest into an OTC-traded bank prior to its initial public offering.

Credit Unions
In the past, credit unions usually only entered the buyer mix by bidding on small banks or distressed assets. This group has not been historically active in community bank M&A because they are limited to cash-only transactions and subject to membership restrictions. That has changed in the last few years.

In 2015 there were only three transactions where a credit union purchased a bank, with the average target bank having $110 million in assets. In 2018 and 2019, there have been 17 such transactions with a bank, with the average target size exceeding $200 million in assets.

The bank buyer landscape has changed significantly over the past few years; we believe it will continue to evolve over the coming years. The reasons behind continued consolidation will not change, but the groups driving that consolidation will. It remains important as ever for sellers to monitor the buyer landscape when evaluating strategic alternatives that enhance and protect shareholder value.

Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.

Why Purchase Accounting Matters So Much During a Bank Deal

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accounting-12-24-18.pngBank management must understand how purchase accounting works, how it can impact a transaction, and being involved can ensure all assumptions are complete and accurate. Here’s a specific look at interest rate mark and Core Deposit Intangible (“CDI”) purchase accounting analyses.

These analyses establish fair value of balance sheet assets and liabilities through a series of mark-to-market valuations. In addition to cost savings and transaction expenses, purchase accounting is one of the transaction adjustments that can have the largest impact on the metrics of a deal. Purchase accounting, however, is often seen as less straight-forward than other transaction adjustment components.

Overview of Mark-to-Market Impact of Assets and Liabilities
To evaluate and engage in discussions with a financial advisor, management must first understand the mechanics of interest rate mark adjustments. A premium on an asset marked-to-market will increase the value of the asset and in capital on day 1, which is then amortized through interest income over the remaining life of the asset. Conversely, a discount on an asset marked-to market will decrease the value of the asset and in capital on day 1, which is then accreted into interest income over the life of the asset. 

As an offsetting entry in purchase price allocation, the higher fair value of an asset the lower the amount of goodwill created. A premium on an asset will increase tangible book value per share (TBVS) but decrease forward earnings as the mark is amortized, while a discount on an asset will decrease TBVS on day 1 but increase forward earnings as the mark is accreted. Liabilities are intuitively the opposite of assets, with a premium resulting in a negative hit to capital on day 1, but lower forward interest expense over the life of the products. A discount will bolster capital on day 1 but will increase forward interest expense over time.

One item of note in the mark-to-market of loans is exit pricing. To represent additional risk assumed with a loan acquisition, an exit premium should be applied to each loan type and should capture a liquidity discount as well as an underwriting discount. Exit prices should vary by loan type. The liquidity and underwriting risk on a 1-4 family residential loan is very different than a speculative construction loan, and the different characteristics should be captured in market values and exit prices.

Publicly reporting institutions now have to to begin reporting the fair value of its loan portfolio under the “exit” price application, which illustrates the importance and proliferation of exit price methodology across the industry, not just in M&A transactions.

Land and buildings are assessed by comparing the net book value (with accumulated depreciation) against a third-party valuation. The mark on buildings will be accreted/amortized over the remaining life of the property.

The CDI takes into account the qualitative value of deposit relationships. There are multiple variables that can impact a CDI but the following provides an overview of major components: weighted average life of a product, cost of core deposit related activities, fee income on core deposits and alternative cost of funding and discount rates. The higher the values for any of these components, the higher the CDI. These variables may be offset by noninterest expense associated with core deposit related activities and the discount rate, for which higher values will reduce the CDI.

Management Involvement
Given the intricacies with mark-to-market purchase accounting, it is clear management should engage a financial advisor to explain the assumptions driving each adjustment and the impact. 

Mark-to-market purchase accounting is not something that should be approached only as a requirement of closing. The financial advisor in a transaction should also be conducting purchase accounting as part of due diligence.

If detailed purchase accounting is not occurring, there could be material marks not accounted for that can drastically affect the metrics of a transaction. Your financial advisors should on a regular basis explain the fair value assessment process and the methodologies.

Key Takeaways
Transaction adjustments are rarely detailed in pro forma analytics, which limits management’s ability to engage in meaningful conversation with its financial advisor. The best financial advisors provide a detailed breakout of all transaction adjustments to provide management with as much knowledge as possible. Without that, it is impossible for management to have the understanding required to ask important questions and actively participate in review of assumptions.

Always request full detail on all adjustments and to have management walked through each adjustment, along with the assumptions and methodologies used. Have calls throughout the process, and remember that fair value analyses are not reserved for closing. This should start early in due diligence. Interest rate marks and CDI can have a meaningful effect on the metrics of a transaction and, if not modeled properly, can create a misleading picture. It is crucial to first verify that the firm has the capacity to model with management and have a meaningful dialogue on critical assumptions.

These assumptions will make or break a deal and will continue drive the resultant entity’s accounting long after the transaction closes.

A Valuable Lesson from the Best Bank You’ve Never Heard of

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strategy-8-24-18.pngThere are a lot of places you would expect to find one of the highest performing banks in the country, but a place that wouldn’t make most lists is Springfield, Missouri—the third-largest city in the 18th-largest state.

Yet, that’s where you’ll find Great Southern Bancorp, a $4.6 billion regional bank that has produced the fifth best total all-time shareholder return among every publicly traded bank based in the United States.

Since going public in 1989, just two years before hundreds of Missouri banks and thrifts failed in the savings and loan crisis, Great Southern has generated a total shareholder return, the ultimate arbiter of corporate performance, of nearly 15,000 percent.

What has been the secret to Great Southern’s success?

There are a number of them, but one is that the Turner family, which has run Great Southern since 1974, owns a substantial portion of the bank’s outstanding common stock. Between CEO Joe Turner, his father and sister, the family controls more than a quarter of the bank’s shares, according to its latest proxy report, which places most of their net worth in the bank.

The importance of having “skin in the game” can’t be overstated when it comes to corporate performance. This is especially true in banking, where a combination of leverage and the frequent, unforgiving vicissitudes of the credit cycle renders the typical bank, as one of the seminal books on banking written over the past decade is titled, “fragile by design.”

The trick is to implement structural elements that combat this. And one of the most effective is skin in the game—equity ownership among executives—which more closely aligns the interests of executives with those of shareholders.

“Having a big investment in the company…gives you credibility with institutional investors,” says Turner. “When we tell them we’re thinking long-term, they believe us. We never meet with an investor that our family doesn’t own at least twice as much stock in the bank as they do.”

An interesting allegory that speaks to this is the way the Romans and English governed bridge builders many years ago, as Nassim Taleb wrote in his book Antifragile:

For the Romans, engineers needed to spend some time under the bridge they built—something that should be required of financial engineers today. The English went further and had the families of the engineers spend time with them under the bridge after it was built.

To me, every opinion maker needs to have ‘skin in the game’ in the event of harm caused by reliance on his information or opinion. Further, anyone producing a forecast or making an economic analysis needs to have something to lose from it, given that others rely on those forecasts.

The most important thing having skin in the game has done for the executives at Great Southern is the long-term approach to their family business. “Our dad turned a valuable asset [stock in the bank] over to me and my sister [a fellow director at the bank] and my goal, when I’m finished, is to turn that over to my kids and have it be worth a lot more,” says Turner.

This becomes especially evident when the economy is hitting on all cylinders. “When institutional investors and analysts…are rewarding explosive growth, you need to have a longer-term view,” says Turner. “For instance, the explosive growth you can get from acquisitions is great in terms of the short-term boost to your stock price, but over the longer term that type of thing can reduce your shareholder return.”

Having skin in the game also addresses the asymmetry in risk appetite that otherwise exists between management and shareholders, where the potential reward to management in short-term incentives from taking excessive risk outweighs the potential long-term threat to a bank’s solvency, a principal concern of shareholders.

A long-term mindset promoted by skin in the game also causes like-minded, long-term investors to flock to your stock. This is a point Warren Buffett has made in the past by noting that companies tend to “get the investors they deserve.”

“That point is probably right,” says Turner. “We have a much larger proportion of retail investors than a lot of other companies do. I understand where institutional, especially fund, investors are coming from. It’s great for them to say they’re long-term shareholders, but they have investors in their funds that open their statements every quarter and want to see gains. So it’s harder for big money managers to be truly long-term investors.… It’s a different story with retail investors, who, in my opinion, tend to be longer term by nature.”

This cuts to the heart of what Turner identifies as the biggest challenge to running a successful bank.

“The hardest thing is balancing different constituencies,” says Turner. “We have a mission statement that is to build winning relationships with our customers, associates, shareholders, and communities. What we’re talking about is building relationships that are balanced in a way that allow each of those constituencies to win.”

The moral of the story is that, much like bridge builders in ancient Roman and English times, one of the most effective ways to construct an antifragile bank is by putting skin in the game.

How Community Banks Can Fund M&A

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bank-manda-6-13-16.pngAs bank mergers and acquisitions (M&A) have increased over the past several years, many banks are considering how to participate as buyers and take advantage of growth opportunities. One critical impediment for banks hoping to participate in M&A is funding the purchase. Many community banks lack a publicly traded stock to use as consideration, so they have to offer all cash in a transaction. When common stock is not used in a transaction, no additional capital is created and it becomes difficult to complete the transaction while maintaining adequate capital. Some banks use their holding company as a source of cash through a loan from a correspondent bank or other lender.

The Federal Reserve has a long-standing Small Bank Holding Company Policy Statement indicating that it does not look at capital ratios on a consolidated basis for institutions with consolidated assets under a certain threshold. Initially this threshold was $150 million in consolidated assets, but it increased to $500 million in February 2006. In April 2015, the consolidated assets threshold was increased again to $1 billion. This change is significant because as of March 31, there were more than 3,700 holding companies with less than $1 billion in consolidated assets, according to S&P Global Market Intelligence, formerly SNL Financial. As a result, the overwhelming majority of bank holding companies can take advantage of the Fed’s policy to engage in bank M&A and use leverage to fund acquisitions.

Between Jan. 1, 2015, and May 6, 2016, 183 acquisitions were announced in which the selling bank had less than $250 million in assets. Almost 69 percent of those transactions were not common-stock based. More than two-thirds were deals in which a small bank holding company (by the Federal Reserve’s definition) could have been competitive because consideration did not require common stock for the selling institution to accept the deal.

Funding M&A With Holding Company Debt
As a bank considers its long-term growth plans, acquisitions are a viable option when the size of the seller lends itself well to the type of consideration a bank can use: cash. As banks consider using holding company debt, it would be helpful to be aware of what qualifies a bank holding company to use holding company debt to fund acquisitions under the Fed’s policy statement:

This policy statement applies only to bank holding companies with pro forma consolidated assets of less than $1 billion that (i) are not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) do not conduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission.

For most holding companies, these qualifiers won’t have an impact on their ability to rely on the policy statement. When applying the policy for using bank holding company debt in an acquisition, the Fed also includes the following parameters:

  • Acquisition debt should not exceed 75 percent of the purchase price, meaning a minimum 25 percent down payment should be provided by the acquirer.
  • All acquisition debt must be paid off within 25 years.
  • The debt-to-equity ratio at the holding company should be less than 30 percent within 12 years.
  • No dividends are expected to be paid out of the holding company until the debt-to-equity ratio is less than 1:1.

The simplicity of the small bank holding company acquisition debt policy is that it allows holding companies with less than $1 billion in assets to use the cheapest form of capital for corporate level transactions. Subordinated debt, which counts as Tier 2 capital (with limits), is a good source of available capital. However, it should be used to fund an acquisition purchase only if a holding company’s pro forma assets will exceed $1 billion, because the costs and limitations on the debt make it a more expensive and more restrictive type of debt than a simple bank holding company loan.

Additionally, even if acquisitions are not a part of a holding company’s long-term strategic plan, the bank still should consider holding company debt under the small bank holding company policy to:

  • Fund stock repurchases at the holding company to provide liquidity for shareholders.
  • Provide capital for organic bank growth (the repayment can come from future bank earnings).
  • Retire more expensive forms of holding company capital or debt that no longer is needed as a result of the increase in consolidated asset limits.

Industry observers often are critical of regulatory policy. However, this recent change to the small bank holding company policy should be viewed as positive for the industry and the future of community banks.

A Tale of Three Growth Banks

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4-29-15-Jack.pngFinding themselves stymied by low interest rates and a hyper-competitive business loan market, growth has become the Holy Grail for a great many banks today. There are essentially two strategies that banks can employ to grow their top lines. One is the tried-and-true acquisition method, where banks essentially buy their growth. Over the past several decades vast banking empires in the United States have been built this way, including, but by no means limited to, the country’s two largest banks—JPMorgan Chase & Co. and Bank of America Corp. But acquisitions are not without their risk. A poorly conceived, over-priced and badly executed acquisition can so thoroughly damage a bank’s stock price (not to mention its reputation) that it can take years for it to recover and for the bank to rebuild its credibility with the investor community.

Organic growth is the second growth strategy, and while it is not without its risk—growing too fast in a volatile asset class can lead to significant concentration problems later on—many analysts and investors seem to appreciate a good organic growth story. Three very different growth stories were presented at Bank Director’s 2015 Bank Board Growth & Innovation Conference Tuesday by Bryce Rowe, a senior research analyst at Robert W. Baird & Co.

The first bank that Rowe profiled was $6 billion asset Pinnacle Financial Partners in Nashville, which was founded in 2000. Pinnacle has benefited from two trends over the last two and a half decades, beginning with the impressive growth of the Nashville metro area. Nashville’s economy has grown impressively over this period of time and Pinnacle, which focuses on businesses and their owners and employees, as well as affluent consumers, has benefited handsomely from that growth. The 1990s and early 2000s were also a time of considerable consolidation in many U.S. banking markets, including Nashville, and Pinnacle also benefitted from the service disruptions that many of the market’s big mergers created. By emphasizing service, Pinnacle has been able to beat many larger banks at their own game. Since its inception, Pinnacle has grown its loan portfolio at a compounded annualized growth rate of 53 percent. Investors have rewarded the bank’s stock with a strong valuation, which currently trades around 285 percent of its tangible book value. After a long hiatus, Pinnacle recently returned to the acquisition market with two announced deals for banks in the Chattanooga and Memphis markets. Acquisitions that Pinnacle made in 2006 and 2007 accelerated its penetration of the Nashville market, but also increased its exposure to the commercial real estate market—and credit issues during the recession. Historically, Pinnacle has placed more emphasis on organic growth than growth through acquisitions.

The second bank that Rowe looked at was County Bancorp in Manitowoc, Wisconsin. This $770 million asset institution is heavily focused on agricultural and business banking in the dairy state. County benefits in part from a lack of other lenders in its space. Its primary competitors in most of its markets are the Farm Credit System and BMO Harris, the U.S. subsidiary of Canadian-based Bank of Montreal. County also benefits from specialization, since it knows the agricultural business so well and has a deep appreciation for how that sector performs over time. In fact, County uses a “boots to driveway” philosophy where it currently employs 10 ag lenders who actually grew up on dairy farms. County has been able to achieve strong and consistent loan growth since its inception in 1996 without sacrificing profitability, achieving a pre-provision return on assets (PPROA) of 1.89 percent in 2014.

The final bank in Rowe’s growth trilogy provides something of a cautionary tale. Tristate Capital, a $2.8 billion asset specialized bank lender that focuses on middle market commercial lending from a regional office network, has been able to generate an impressive 45 percent compounded annualized rate for loans since its inception in 2007, but its concentration in the highly competitive commercial loan market–where profit margins tend to be much thinner than in other loan categories—have reduced its profitability. The Pittsburgh-based bank’s price-to-tangible book value was 117 percent in 2014 compared to a peer median of 142 percent. In an effort to improve its profitability, Tristate has pulled back somewhat from the commercial loan market and placed greater emphasis on higher margin private banking loans that it sources via a network of financial intermediaries. The moral to Tristate’s story is that while growth is important, the investor community also wants profitability—which means the two must be kept in balance.