Using Sub Debt To Play Offense

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Subordinated debt can be an attractive capital option for many banks. Will Brackett, managing director at Performance Trust Capital Partners, breaks down how bankers can think through their approach to using subordinated debt. He recommends that every financial institution take a hard look at its balance sheet and how it could perform under myriad interest rate scenarios. Those banks with strong track records, and little or no existing subordinated debt, are best positioned to fetch better than market pricing in an issuance. 

Topics include: 

  • Advantages of Subordinated Debt
  • Which Banks Benefit Most 
  • Achieving the Best Pricing 

Recent Developments to Combat Redlining

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Regulators have worked on a variety of anti-redlining proposals in recent months, including a joint initiative by the Department of Justice, the Consumer Financial Protection Bureau, and the Office of the Comptroller of the Currency.

These proposals come in tandem with recent initiatives from the Securities and Exchange Commission to increase the emphasis on ESG factors, a set of non-financial environmental, social and governance factors that publicly filed companies can use to identify material risks and growth opportunities.

Though anti-redlining legislation initially came into law when Congress enacted the Community Reinvestment Act in 1977, it has recently seen a refocus in the Combatting Redlining Initiative led by the DOJ Civil Rights Division’s Housing and Civil Enforcement Section. During Acting Comptroller Michael Hsu’s initial unveiling of this initiative, he highlighted the importance of providing “fair and equitable access to credit — to everyone” in order to build wealth among minority and underrepresented groups. He emphasized that modern redlining, as compared to its 20th century predecessor, is “often more subtle, harder to detect, and resource-intensive to find.”

Initial reactions to the initiative expected it to focus on the redlining seen in the Trustmark Corp. settlement, where the Jackson, Mississippi-based bank discriminated against Black and Hispanic neighborhoods by “deliberately not marketing, offering, or originating home loans to consumers in majority Black and Hispanic neighborhoods in the Memphis metropolitan area,” according to the CFPB. The $17.6 billion bank settled for a $5 million penalty.

But in recent weeks, though a final rule is not yet in place, the acting comptroller made it clear the focus is not only on direct discrimination, but also on indirect discrimination through climate redlining. Climate redlining occurs when certain minority communities are subject to heightened climate change risks based on where they are located; those heightened risks pose a disproportionate impact on minority groups.

Though official rules have yet to be proposed related to the policies, banks can take the following actions in preparation:

1. Review any neutral algorithms used in the lending process. Redlining is not always overt; it may be a byproduct of algorithms that appear neutral on the surface but disproportionately target minority communities based on targeting certain income brackets, risk factors or the demographic compensation of the surrounding area. Bankers should make time to carefully review the factors being input into their institution’s algorithms and consider whether those factors might create inadvertent bias.

2. Review any policies related to geographic filtering. Minority groups are disproportionately impacted by the effects of climate change; this disparate impact is expected to grow as the frequency of climate events increases. Rising water, more frequent fires and extreme weather events are all examples of events some banks might choose to geographically exclude in order to keep lending risk portfolios low. But by filtering out these events and impacts, banks may be inadvertently redlining. Banks should take the time to carefully examine any exclusions they make based on geography or weather history in preparation of any final rules, and compare them to demographic information on the bank’s lending practices.

3. Review branch locations. One of the reasons regulators found Trustmark to have engaged in redlining practices was its lack of branch locations in majority Black and Hispanic communities. This meant that not only were those residents not able to receive banking services, they also were not being marketed to when it came to potential lending opportunities. Banks should review the footprints of their branches relative to the demographics in the cities in which they are located to determine whether they are over- or under-represented in certain demographics.

4. Public bank holding companies should review ESG factors. With both proxy season and annual filing season upon publicly traded companies, now is a good time for publicly traded bank holding companies to evaluate their current treatment of environmental, social and governance risks. If a bank identifies that it may be inadvertently engaging in redlining, the affiliated bank holding company should carefully think through potential disclosures.

The Coming Buyback Frenzy

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Capital planning is examined as part of Bank Director’s Inspired By Acquire or Be Acquired. Click here to access the content on BankDirector.com.

The banking industry hasn’t been this well capitalized in a long time. In fact, you have to go back to the 1940s — almost 80 years ago — before you find a time in history when the tangible common equity ratio was this high, says Tom Michaud, president and CEO of investment bank Keefe, Bruyette & Woods, during a presentation for Bank Director’s Inspired By Acquire or Be Acquired platform.

That ratio for FDIC-insured banks has nearly doubled since 2008, he says, reaching 8.5% as of Sept. 30, 2020, says Michaud.

A big part of the industry’s high levels of capital goes back to the passage of the Dodd-Frank Act in 2010, the Congressional response to the financial crisis of 2008-09. Because of that law, banks must maintain new regulatory capital and liquidity ratios that vary based on their size and complexity.

During the pandemic, banks were in much better shape. You can see the impact by looking at the capital ratios of just a handful of big banks. Citigroup, for example, had a tangible common equity ratio in the third quarter of 2020 that was nearly four times what it was in 2008, Michaud says.

With a deluge of government aid and loans such as the Paycheck Protection Program, the industry’s losses during the pandemic have been minimal so far. The Federal Deposit Insurance Corp. has closed just four banks, far fewer than the deluge of failures that took place during the financial crisis. So far, financial institutions have maintained their profitability. Almost no banks that pay a dividend cut theirs last year.

Meanwhile, regulators required many of the large banks, which face extra scrutiny and stress testing compared to smaller banks, to halt share repurchases and cap dividends last year, further pumping up capital levels.

That means that banks have a lot of capital on their books. Analysts predict a wave of share repurchases in the months ahead as banks return capital to shareholders.

“The banking industry continues to make money,” said Al Laufenberg, a managing director at KBW, during another Bank Director session. “The large, publicly traded companies are coming out with statements saying, ‘We have too much capital.’”

Investors have begun to ask more questions about what banks are doing with their capital. “We see investors getting a little bit more aggressive in terms of questions,” he says. “‘What are you going to do for me?”

Bank of America Corp. already has announced a $2.9 billion share repurchase in the first quarter of 2021. In fact, KBW expects all of the nation’s universal and large regional banks to repurchase shares this year, according to research by analysts Christopher McGratty and Kelly Motta. They estimate the universal banks will buy back 7.3% of shares in 2021, while large regionals will buy back 3.5% of shares on average. On Dec. 18, 2020, the Federal Reserve announced those banks would again be allowed to buy back shares after easing earlier restrictions.

Regulators didn’t place as many restrictions during the pandemic on small- and medium-sized banks, so about one-third of them already bought their own stock in the fourth quarter of 2020, according to McGratty.

In terms of planning, banks that announce share repurchases don’t have to do them all at once, Laufenberg says. They can announce a program and then buy back stock when they determine the pricing is right.

Shareholders can benefit when banks buy back stock because that can reduce outstanding shares, increasing the value of individual shares, as long as banks don’t buy back stock when the stock is overvalued. Although bank stock prices compared to tangible book value and earnings have returned to pre-Covid levels, the KBW Regional Banking Index (KRX) has underperformed broader market indices during the past year, making an argument in favor of more repurchases.

Robert Fleetwood, a partner and co-chair of the financial institutions group at the law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP, who spoke on the Bank Director session with Laufenberg, cautions bank executives to find out if their regulators require pre-approval. Every Federal Reserve region is different. Regulators want banks to have as much capital as possible, but Fleetwood says they understand that banks may be overcapitalized at the moment.

High levels of capital will help banks grow in the future, invest in technology, add loans and consolidate. For the short term, though, investors in bank stocks may be the immediate winners.

Strategic Insights From Leading Bankers: Bank OZK

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RankingBanking will be examined further as part of Bank Director’s Inspired By Acquire or Be Acquired virtual platform, which will include a panel discussion with Gleason and Mark Tryniski, CEO of Community Bank System. Click here to access the agenda.

Is Bank OZK misunderstood?

The $26.9 billion bank may be based in Little Rock, Arkansas — with offices primarily in the southeastern United States — but Chairman and CEO George Gleason II will quickly, but politely, correct you if you refer to Bank OZK as a community bank.

“We consider our bank a truly national bank and presence,” Gleason says, adding that in 2019, he spent 153 days outside of the bank’s headquarters traveling across the United States and internationally. “Sometimes people [comment] that we do a lot of loans outside of our area,” he adds. “I consider it absurd, because the United States is our market, and we do loans all over the United States. It’s a very balanced, diversified portfolio by product type and geography.”

Bank OZK’s unique business model positioned it to top Bank Director’s 2021 RankingBanking study, sponsored by Crowe LLP. To delve further into the bank’s performance, Bank Director Vice President of Research Emily McCormick interviewed Gleason about his views on factors impacting long-term performance, including how OZK positions itself to take advantage of opportunities in the marketplace. The interview was conducted on Oct. 26, 2020, and has been edited for brevity, clarity and flow.

EM: First off, tell me how you approach long-term performance for Bank OZK and balance that with short-term expectations.

GG: I’ve been doing this job over 41 years now, and I hope to continue to do it a number of years more. When you’ve been in a job a long time, and you expect to be in it a long time in the future, thinking about long-term performance is much easier than if you’re new to a job, and you’re in it for a very short period of time. With that said, we all live in a world where our stock price moves day to day based on short-term results, and many investors seem to be overly focused on short-term results. So, it takes a lot of discipline and a willingness to be viewed as not doing the best you can do in the short run to achieve the long-term results.

But we have always focused preeminent attention on achieving longer-term objectives, and that has paid off for us tremendously well. Probably the best example of that is our unwavering commitment to asset quality, credit quality. There have been a number of times in my 41-year career where our growth for a few quarters or even a few years has been disappointing, relative to what people thought we were capable of doing, because we held to our credit standards and our discipline, and let competitors take share from us when we thought some of those competitors were being too aggressive. That has always paid off for us in the long run, every single time.

EM: Out of the last crisis, Bank OZK participated in several FDIC deals. We’re in another, very different crisis. Are you applying some lessons that you learned through the last crisis, or through your experience in banking, to what we’re going through now?

GG: I’ve been through a lot of downturns, and the causes are always different. It may be excesses in real estate; it may be excesses in subprime mortgage finance. It may be a bust in the oil and gas industry [or] the savings and loan crisis. [N]ow you’ve got the Covid-19 pandemic-induced recession. Causes vary, but all economic downturns result in people being out of work and suffering economically, and businesses struggling and suffering, and businesses closing. Every economic downturn creates challenges for people that are in the credit business, as we are, but it also creates a lot of opportunities.

The key to being able to capitalize on the opportunities is No. 1, being appropriately disciplined in the good times so that you are not so consumed with problems in the bad times that you can’t think opportunistically. No. 2, you’ve got to have adequate capital, adequate liquidity and adequate management resources. If you have those ingredients and combination … you’re able to spend much more time in a downturn focused on capitalizing on opportunities, as opposed to mitigating your risk. That’s been an important part of our story for several decades now, is we have almost universally been able to find great opportunities in those downturns. … [W]e’re already finding some ways to benefit in this downturn. So, the causes are different, but the result is always the same: [Y]ou’ve got challenges, you’ve got opportunities and you’ve got to be ready to capitalize on those opportunities.

EM: What opportunities are you seeing now, George?

GG: Obviously in the very early days, there was some tremendous dislocation in the bond market. We had a couple of good weeks where we were able to buy things at really advantageous prices. The Fed was so aggressive in their efforts to fix the plumbing of the monetary system that they took those opportunities away literally in a matter of weeks.

We’ve seen a lot of competitors pull back from the [commercial real estate] space; that’s given us an opportunity to both gain market share and improve pricing. We have seen customers evolve [in] how they deal with our branches; it’s given us an opportunity to create some efficiencies [and] advance our rollout of some future technology, all of which have helped us accelerate our movement toward a more consumer-friendly, technology-oriented way of dealing with our customers.

And frankly, Emily, we’re so early in seeing all of the economic impacts from this recession. Some of the impacts, I think, have been pushed out several quarters by the aggressive monetary and fiscal policy actions out of Washington. I think that really good, attractive opportunities will appear in 2021 and 2022. I think we’re just getting started on seeing opportunities begin to emerge.

EM: OZK maintains high capital levels. Why do you view that as important, and how are you strategically thinking through capital?

GG: We’re operating from a position of having excess capital, and that is probably a great and appropriate thing in this environment. [We’re] certainly in an environment where you’d rather have too much capital than too little today and … I believe there are a lot of opportunities that will emerge over the next four to eight quarters where we’ll be able to put that capital to work in a very profitable manner for our shareholders. So, we feel very good about the fact that today we have one of the highest capital ratios of all of the top 100 banks.

EM: Bank OZK has seen some high-level departures in the past few years; most recently, your chief credit officer. I think sometimes that gives people pause, and I wanted to give you the opportunity to address that.

GG: The reality of that is we are very dependent upon human capital and intellect in running our business. … I have always put an emphasis on hiring, training and developing really smart people who have intense work ethics, and who love to win and want to be part of a winning team. We have an abundance of talent in our company, and we’re constantly training, grooming and improving that talent.

When you hire and develop that quantity and quality of well-trained, well-developed staff, hard-charging people who want to win and want to succeed and want to push, some of those people are going to go on and pursue other opportunities, and that is great. And because we have such an abundance of talent, we’re in a position where we can say, “Congratulations, we’re happy for you. Thank you for everything you have done for us,” and I can turn around and say, “Next man up; let’s go.” That really is our culture. So yes, we plan for people to leave. We have plans in place on how we’re going to replace people if they are not available for one reason or another, and we’ve got the depth of talent that it lets us move on without missing a beat.

EM: One more question: Bank OZK has a record of strong performance, which is why it’s included in this year’s RankingBanking study. That said, I sometimes hear whispers of doubt about what you guys are doing, perhaps due to your unique model. I’m curious about how you respond to those doubts from the financial and investment communities.

GG: We feel under-appreciated ourselves sometimes. [W]e have built an extraordinary bank with an extraordinary team of people and a great business model; maybe one of the absolute best business models in the banking industry. I think it will prove to be very durable and very profitable over a long period of time.

Because our model is so heavily involved in commercial real estate, and commercial real estate is something that is sometimes in fashion and sometimes out of fashion, I think we experience that sense of being out of step sometimes. But we do commercial real estate day-in, day-out, every day, up-cycle, down-cycle, and we do it in a way that allows us to be successful no matter which direction the CRE cycle is trending at any point in time.

I believe as this pandemic-induced recession plays out, our business model is going to prove its mettle and equip itself very well. I think that sense [of], “Wow, do we really want to own a CRE bank at this stage in the cycle?” will go away, because people will realize we’re a bank committed to consistent, high asset quality, and we’ve underwritten and will continue to underwrite our portfolios in a way that facilitates that. I think we’ll finally get the credit that my team deserves for the excellent work they’ve done.

I’m told a lot of times by investors, “You’re a great bank. We want to own you. Maybe in a couple of quarters will be the right time to buy a CRE bank.” I think that reflects a less than full understanding of the power of our franchise.

Preparing for an Uncertain Future

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“By failing to prepare, you are preparing to fail.” — Benjamin Franklin

Mergers and acquisitions may be sidelined for the foreseeable future because of considerable economic and market uncertainty related to the coronavirus pandemic, but PNC’s Financial Institutions Group anticipates activity will likely reignite when market volatility eases, and asset quality can be confidently assessed.

Savvy bankers and investors recognize that the best deals generally occur when bank valuations are low, but the credit downturn may just be starting, so the timetable for a pickup in deal activity remains unclear. Not to mention, there may be many coronavirus-related issues to still sort out, so the possibility of future government-assisted deals cannot be ruled out.

Recent history supports this post-crisis resumption. Deal activity slowed measurably at the start of the Great Recession, dropping from 285 deals in 2007 to 174 in 2008, according to S&P Global Market Intelligence. It picked up again once potential buyers gained more clarity regarding both their own balance sheets as well as those of potential sellers.

Credit Quality is Key
The uncertain environment underlines that nothing is more significant to a bank’s capital and earnings than its credit quality. It is anticipated that credit costs will continue to climb and remain elevated for quite some time following the sudden and shocking increase to unemployment and government-mandated business closures. So, looking at balance sheets — not income statements — will provide the necessary clues to differentiate banks in a downward credit cycle. But these issues will eventually get resolved.

The uncertainty could give way to wider pricing disparity among community banks. Bank earnings for the quarter ending on March 31 were inconclusive, and eclipsed by coronavirus-related economic developments and stock market volatility. The vast majority of companies did not provide guidance, but the overall lower direction appears clear, as credit will likely be a major concern for the next several quarters.

Investors and analysts appear to have a wide range of opinions; high levels of market angst seem likely to persist into the foreseeable future. There will, however, be winners and losers among banks across the nation. This emerging pricing gap could lead to increased M&A activity as more deals make financial sense.

Cash, Capital Rule
Bank boards should consider all liquidity and capital options under various economic scenarios to construct stronger balance sheets as credit conditions start to deteriorate. This preparation holds true for all banks: potential buyers, sellers and those committed to independence.

Along with more dynamic trading strategies, there will be a need to vigorously assess capital-raising options, cash dividend payments and stock repurchase programs. To start, companies should seriously consider emphasizing internal “burn down” tangible book value models. We believe that sensitivity models tailored to individual banks can best identify additional capital needs and, if so, what form of capital is best suited for current and longer-term strategic plans.

Equity offerings carry their own pros and cons. They can strengthen bank balance sheets but dilute earnings per share. Given current market conditions, these issuances may be difficult to achieve and limited to high-quality institutions that can issue equity on financially attractive terms (including tangible book value accretion).

The benefits from an equity capital raise include, but are not limited to: the ability to grow organically above the sustainable growth rate; stronger capital ratios and a bigger cushion to withstand the credit downturn; greater liquidity and visibility from institutional investors; and providing support for M&A opportunities, which may be abundant in the post-coronavirus landscape.

Some institutions may find issuing subordinated debt (“sub debt”) to be a better alternative than raising additional equity capital. Debt remains relatively inexpensive due to attractive interest rates and favorable tax treatment. The market for sub debt became more stable by early June, which has facilitated several issuances at favorable pricing levels.

The question for bank directors and management going forward is how to properly value capital raising and any M&A initiatives. They will need to take a hard look at financial models to determine required rates of return and sustainable growth rates along with regulatory needs. Efficient capital management that optimizes long-term shareholder value should always be the primary goal of directors in good markets, bad markets and those in-between.

The views expressed in this article are the views of PNC FIG Advisory, PNC’s investment banking practice for community and regional banks.

Window of Opportunity for Sub Debt

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Bankers who have not done so recently may want to revisit their subordinated debt playbooks so they can successfully navigate an emerging window of opportunity.

Market activity is up significantly due to interest rate trends, regulatory developments and other factors. Bank management teams who are prepared to act quickly can capitalize on the opportunity.

Sub debt is a long-term debt obligation with a maturity typically ranging from 10 to 15 years, a fixed (or fixed-to-floating) interest rate and the ability for the issuer to redeem the notes under certain circumstances. It has become a staple of bank capital planning, because it can qualify as Tier 2 capital if properly structured. Most banks can even use it to generate Tier 1 capital at the bank level, a strategy even more banks can employ following the 2018 changes to the Federal Reserve’s Small Bank Holding Company Policy Statement.

However, executives must be mindful of certain limitations of sub debt. In particular, its treatment as Tier 2 capital is phased out by 20% per year, beginning five years before maturity. Additionally, the interest rate typically flips from a fixed rate to a floating rate during the last five years, which is often higher than the fixed rate. Accordingly, banks that issued sub debt in 2014 and 2015 — when they were preparing for Basel III capital rules and, in some cases, repaying comparatively expensive Troubled Asset Relief Program funding — may now have the opportunity to refinance that sub debt.

New Issuances
Banks considering a new sub debt offering need to consider several matters in planning the transaction. These include many familiar decision points, such as selecting a placement agent or underwriter, deciding whether to seek a credit rating, consulting with regulators and determining the proposed offering terms, including offering size, maturity, interest rate structure, use of proceeds and other matters. In addition, banks will need to be mindful of federal securities laws that govern the offering.

There are also new issues for management teams to consider, like selecting a benchmark rate for the floating rate component. Historically, sub debt floating rates have been calculated based on the London Interbank Offered Rate, or LIBOR. Given LIBOR’s likely disappearance after 2021, issuers will need to evaluate whether to preserve the flexibility to select an alternate benchmark rate at the beginning of the floating rate period or to preemptively commit to an alternate benchmark.

Directors will want to make sure they have a clear understanding of how the offering complies with the company’s long-term capital plan and review the pro forma effects of the offering on capital ratios. From a fiduciary perspective, they also need to understand how the sub debt fits into the capital structure and how the organization will use the proceeds.

Given the significant planning needed ahead of a sub debt issuance, banks should begin the process at least two to three months before they need the capital.

Redeeming Existing Sub Debt
The mechanics of redeeming existing sub debt are relatively straightforward, and are governed by the terms of the notes and any applicable indenture. The terms can limit the dates on which a redemption can be completed, require some notice period to holders and dictate that partial redemptions be allocated pro rata among noteholders.

But before taking any steps, it is critical that issuers consult with their regulators and be mindful of related issues, including compliance with the Federal Reserve’s SR letter 09-4, which prescribes certain actions and considerations in connection with return of capital transactions. Depending on an institution’s size and other characteristics, it may need to obtain prior regulatory approval. Directors will need to understand the effects of the redemption on the organization’s capital structure and pro forma capital ratios.

Public Company Considerations
Banks with publicly listed holding companies will also want to evaluate whether to conduct a public offering through their shelf registration statement. This generally requires an indenture, clearinghouse eligibility, prospectus supplements, a free writing prospectus, limitations on credit rating disclosure and other actions. However, it can improve execution by making it easier for purchasers to resell their notes. Public companies also need to comply with their Exchange Act reporting obligations.

While there are several other issues to be considered in connection with any sub debt issuance or redemption transaction, management teams and boards of directors who have a basic understanding of the considerations outlined above will be well positioned to develop and maintain a strong capital foundation to execute their strategic growth initiatives.

Weighing the Value of a Bank Holding Company

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governance-6-24-19.pngIn May, Northeast Bank became the fourth banking organization in two years to eliminate its holding company. Northeast joins Zions Bancorporation, N.A., BancorpSouth Bank and Bank OZK in forgoing their holding companies.

All of the restructurings were motivated in part by improved efficiencies that eliminated redundant corporate infrastructure and activities. The moves also removed a second level of supervision by the Federal Reserve Board. Bank specific reasons may also drive the decision to eliminate a holding company.

Zions successfully petitioned to be de-designated as a systemically important financial institution in connection with its holding company elimination. In its announcement, Northeast replaced commitments it made to the Fed with policies and procedures relating to its capital levels and loan composition that should allow for more loan growth in the long run.

Banks are weighing the role their holding companies play in daily operations. Some maintain the structure in order to engage in activities that are not permissible at the bank level. Others may not have considered the issue. Now may be a good time to ask: Is the holding company worth it?

Defined Corporate Governance
Holding companies are typically organized as business corporations under state corporate law, which often provides more clarity than banking law for matters such as indemnification, anti-takeover protections and shareholder rights.

Transaction Flexibility
Holding companies provide flexibility in structuring strategic transactions because they can operate acquired banks as separate subsidiaries. This setup might be desirable for potential partners because it keeps the target’s legal and corporate identity, board and management structure. But even without a holding company, banks can still preserve the identity of a strategic partner by operating it as a division of the surviving bank.

Additional Governance Requirements
A holding company’s status as a separate legal entity subjects it to additional corporate governance and recordkeeping requirements. A holding company must hold separate board of directors and committee meetings with separate minutes, enter into expense-sharing and tax-sharing agreements with its bank subsidiary and observe other corporate formalities to maintain separate corporate identities. In addition, the relationship between the holding company and its subsidiary bank is subject to Section 23A and Section 23B of the Federal Reserve Act, an additional regulatory compliance burden.

Additional Regulatory Oversight
Holding companies are also subject to the Fed’s supervision, examination and reporting requirements, which carry additional compliance costs and consume significant management attention. The Fed also expects bank holding companies to serve as a source of financial strength to their subsidiary banks, an expectation that was formalized in the Dodd-Frank Act.

Diminished Capital Advantages
Historically, holding companies could issue Tier 1 capital instruments that were not feasible or permissible for their bank subsidiaries, such as trust preferred securities and cumulative perpetual preferred stock. They also enjoyed additional flexibility to redeem capital, an advantage that has largely been eliminated by the Basel III rulemaking and Fed supervisory requirements. A holding company with existing grandfathered trust preferred securities or with registered DRIPs may find them useful capital management tools. Holding companies with less than $3 billion in consolidated assets that qualify under the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement are not subject to the Fed’s risk-based capital rules. These companies are permitted to have higher levels of debt than other holding companies and banks.

Broader Activities, Investments
Bank holding companies, especially those that elect to be financial holding companies, can engage in non-banking activities and activities that are financial in nature through non-bank subsidiaries that are bank affiliates. In some cases, these activities may not be bank permissible, such as insurance underwriting and merchant banking. The Fed also has authority to approve additional activities that are financial in nature or incidental or complementary to a financial activity on a case-by-case basis.

Bank holding companies can also make passive, non-controlling minority investments that do not exceed 5 percent of any class of voting securities in any company, regardless of that company’s activities. By comparison, banks are limited to making investments in companies that are engaged solely in bank-permissible activities or must rely on authorities such as community development or public welfare authority to make investments. Banks may also have limited leeway authority to invest in specific securities or types of securities designated under the applicable state banking law or by the applicable state banking regulator.

Banks that are not interested in activities or investment opportunities available to holding companies may be less concerned about eliminating the structure. But an organization that engages in activities at the holding company level that are not permissible for banks or that desires to maintain its grandfathered rights as a unitary savings and loan holding company may not wish to eliminate its holding company.

Operating without a holding company would result in more streamlined regulatory oversight, corporate governance and recordkeeping processes. But a holding company provides the flexibility to engage in activities, to make investments and to create structures that a bank may not. Bank boards should weigh these costs and benefits carefully against their strategic and capital management plans.

Rodge Cohen: Are We Preparing to Fight the Last War?

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risk-3-1-19.pngHis name might not command the same recognition on the world stage as the mononymous Irish singer and song-writer known simply as Bono, but in banking and financial services just about everyone knows who “Rodge” is.

H. Rodgin Cohen–referred to simply as Rodge—is the unrivaled dean of U.S. bank attorneys. At 75, Cohen, who is the senior chairman at the New York City law firm Sullivan & Cromwell, is still actively involved in the industry, having recently advised SunTrust Banks on its pending merger with BB&T Corp.

Cohen has long been considered a valued advisor within the industry.

In the financial crisis a decade ago, he represented corporate clients like Lehman Brothers and worked closely with the federal government’s principal players, including Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke. His character even made an appearance in the movie “Too Big To Fail,” based on a popular book about the crisis by Andrew Ross Sorkin.

Eleven years later, Cohen says the risk to the banking industry is no longer excessive leverage or insufficient liquidity—major contributing factors to the last crisis.

The Dodd-Frank Act of 2010, passed nearly a decade ago, raised bank capitalization levels substantially compared to pre-crisis levels. In fact, bank capitalization levels have been rising for 40 years, going back to the thrift crisis in the late 1980s. Dodd-Frank also requires large banks to hold a higher percentage of their assets in cash to insure they have enough liquidity to weather another financial storm.

The lesson from the last crisis, says Cohen, revolves around the importance of having a fortress balance sheet. “I think that was the lesson which has been thoroughly learned not merely by the regulators, but by the banks themselves, so that banks today have exponentially more capital, and the differential is even greater in terms of having more liquidity,” says Cohen.

But does anyone know if these changes will be enough to help banks survive the next crisis?

“I don’t think it is possible to calculate this precisely, but if you look at the banks that did get into trouble, none of them had anywhere near the level of capital and liquidity that is required now,” says Cohen. “Although you can’t say with certainty that this is enough, because it’s almost unprovable, there’s enough evidence that suggests that we are at levels where no more is required.”

It is often said that generals have a tendency to fight the last war even though advances in weaponry—driven by technology—can render that war’s tactics and strategies obsolete. Think of the English cavalry on horseback in World War I charging into German machine guns.

It can be argued that regulators, policymakers and even customers in the United States still bear the emotional scars of the last financial crisis, so we all find comfort in the fact that banks are less leveraged today than they have been in recent history, particularly in the lead up to the last crisis.

But what if a strong balance sheet isn’t enough to fight the next war?

“I think the biggest risk in the [financial] system today is a successful cyberattack,” says Cohen. While a lot of attention is paid to the dangers of a broad attack on critical infrastructure that poses a systemic risk, Cohen worries about something different.

“That is a very serious risk, but I think the more likely [danger] is that a single bank—or a group of banks—are hit with a massive denial of service for a period of time, or a massive scrambling of records,” he says. This contagion could destabilize the financial system if depositors begin to worry about the safety of their money.

Cohen believes that financial contagion, where risk spreads from one bank to another like an infectious disease, played a bigger role in the financial crisis than most people appreciate. And he worries that the same scenario could play out in a crippling cyberattack on a major bank.

“Until we really understand what role contagion played in 2008, I don’t think we’re going to appreciate fully the risk of contagion with cyber,” he says. “But to me, that is clearly the principal risk.”

And herein lays the irony of the industry’s higher capital and liquidity requirements. They were designed to protect against the risk of credit bubbles, such as the one that precipitated the last crisis, but they will do little to protect against the bigger risk faced by banks today: a crippling cyberattack.

“That’s why I regard [cyber] as the greatest threat,” says Cohen, “because a fortress balance sheet won’t necessarily help.”

Understanding Your Bank’s Capital Alternatives

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capital-10-18-17.pngIt is crucial for executive management to engage their boards in practical conversations surrounding the raising of capital. Important questions include what form of capital is best from a strategic perspective, how much dilution to earnings per share (EPS) is acceptable and how soon can the dilution be earned back. To answer these questions, management must first have a solid understanding of each type of capital.

Common Equity
Common equity tends to receive the most favorable treatment from a regulatory perspective and is fully included in Tier 1 capital. This, however, comes at a cost beyond the 5 to 7 percent fee paid to your investment banker. A common equity raise increases the number of shares outstanding. This translates to dilution of earnings per share and existing ownership until the new capital is leveraged, or put to work.

When a bank undergoes a common equity raise, it also gives up ownership and voting rights. If the bank is unable to raise common equity at or above current tangible book value per share (TBVS), or is concerned with existing ownership dilution, it should seriously consider an alternative source of capital. Banks must have clearly defined parameters in place for raising capital, particularly its impact on TBVS and EPS.

When evaluating a common offering, two key considerations are: (1) whether to conduct a private offering or undergo an IPO, and (2) whether to raise capital internally or externally. Having a strategic plan in place is critical to ensure that the bank can execute on deploying capital and earning back the initial shareholder dilution.

IPO or No?
Not everyone needs to conduct an initial public offering (IPO), but for larger institutions or institutions seeking liquidity, it is an excellent option. An IPO provides liquidity for stockholders, generates capital to accelerate growth, and depending on trading volume establishes currency that can be utilized in acquisitions. Once an institution undergoes an IPO it has also created access to capital markets for follow-on offerings to continue to raise capital as needed. While IPOs provide a faster vehicle to raise capital, they also require more time from key management, detracting from their role in day-to-day operations.

Subchapter-S corporations must consider ramifications of increasing their shareholder base before triggering a requirement to convert to a stock corporation. Once an S-corporation exceeds 100 stockholders, it must convert to a C-corporation, which has immediate tax implications and changes in reporting requirements.

Private Placements
For smaller banks or institutions that are closely held, private placements may be preferable to an IPO. Although the timeframe for a private placement may be longer, less time is required from management. Private placements are limited to existing stockholders, accredited investors and qualified institutional buyers. While private placements are generally smaller and less dilutive to EPS, it can also may be difficult to raise larger amounts of capital using this vehicle. The bank will be able to remain private with less pressure to immediately leverage capital, allowing greater autonomy in strategic decisions.

Alternative Sources of Capital
Noncumulative perpetual preferred stock can be counted towards Tier 1 capital and can be used to increase tangible equity. Banks with a clean risk profile may be willing to operate with lower levels of tangible common equity and focus on bolstering tangible equity. Preferred stock is generally less expensive to raise, although there is a post-tax dividend that can range from 5 to 9 percent.

For banks with a holding company, another form of capital—debt—can be down-streamed in its entirety to common equity at the bank level. Debt is the least expensive form of capital, costing approximately 3 percent to raise with no dividends and tax-exempt interest expense.

Regardless of the approach used to raise capital, be realistic in how much you can effectively leverage. Excess capital may be viewed favorably from a regulatory perspective but can become a value detractor if not effectively deployed. This is particularly true for banks entertaining the possibility of a sale. Over-capitalized targets are likely to be priced on a leveraged capital approach, meaning that tangible common equity in excess of a certain percentage of average assets will be priced at 100 percent TBVS and only the leveraged portion of capital will receive a premium.

When raising capital in any form, proactively communicate with regulators and stockholders remembering that neither party likes surprises. Work with your financial advisor to run pro forma analyses on multiple scenarios and establish parameters for EPS and ownership dilution to maximize the impact of your capital raise.

Banks May Get Capital Relief

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regulation-10-6-17.pngFederal banking regulators are trying to make life easier for regional and community banks by making changes to Basel III capital rules, particularly in areas that have been subject to banker complaints. Whether the changes provide real relief may be up to the bank.

Last week, the Federal Reserve Board, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued a proposal to “reduce regulatory burden” by simplifying regulatory capital rules that dictate how much capital banks must maintain. The rules mostly apply to banks subject to what’s known as “standardized approaches,” so it will generally impact banks and thrifts with less than $250 billion in total consolidated assets or less than $10 billion in total foreign exposure. Comments on the proposal are due within 60 days of publication in the Federal Register, which hadn’t occurred as of Thursday morning.

“This is an effort to make lives for community banks a little bit easier,’’ says Luigi De Ghenghi, a partner in Davis Polk’s Financial Institutions Group. The big picture on all of this is that as the industry approached the 10-year mark for the start of the financial crisis, regulators are looking at ways to update rules as the health of the industry has improved. Still, regulators are sensitive to accusations that they may be exposing the industry to another financial crisis by rolling back rules too enthusiastically, industry observers say.

“The U.S banking agencies are walking a bit of a tight rope because on the one hand they want to be seen as simplifying the capital rules and giving an appropriate level of capital relief,’’ De Ghenghi says. “On the other hand, they don’t want to be seen as substantively weakening capital standards,” especially since lack of capital and risky loans were a factor in the failure of hundreds of community banks during and after the crisis.

It would be wrong to assume that this is coming out of the new Trump administration’s drive to provide financial regulatory relief, as detailed in the Treasury Department report in June. Although politics is always a factor, the latest proposal comes out of an Economic Growth and Regulatory Paperwork Reduction Act, which requires banking agencies to review regulations every 10 years and to get rid of “unduly burdensome regulations” while ensuring the safety and soundness of the financial system. The review kicked off in 2014 and concluded earlier this year.

One of the most important of the proposed changes deals with the definition and risk weighting of high volatility commercial real estate (HVCRE) loans, which are considered among the higher risk loans that banks make to developers and builders, such as non-recourse loans. But community bankers had complained that the HVCRE loan definition and exemptions were too complex to apply and that the risk weightings were too high for the risks these loans posed.

“The banks were pushing the trade associations to push members of Congress to say, ‘We need a fix here,’’’ says Dennis Hild, managing director at Crowe Horwath and former bank examiner and supervisory analyst with the Federal Reserve. “’We think we know what falls under the purview of a high volatility real estate loan and the regulators come in [for an exam] and there is a disagreement on certain sets of loans.’”

To respond to the need for clarification, the proposal creates a new high volatility loan category for loans going forward that focuses less on underwriting criteria and more on the use of the proceeds, according to De Ghenghi. It potentially includes a wider array of commercial real estate loans, but lowers the risk weight from 150 percent to 130 percent, meaning banks have to hold slightly less capital against these loans. Also, banks will be able to include higher amounts of mortgage servicing assets and certain deferred tax assets as common equity Tier 1 capital, a new tier of regulatory capital that was created after the financial crisis as part of the global agreement known as Basel III.

This will help “the institutions that have substantial amounts of mortgage servicing assets or deferred tax assets,” says Hild.

The agencies have summed up the proposal’s impact on community banks here. The 10-year review details several other changes already made or in the works to reduce the regulatory burden. Among them, the agencies made changes to provide institutions with up to $1 billion in assets, instead of the $500 million limit, with the opportunity for an 18-month exam cycle instead of a 12-month exam cycle, if they score highly on their exams. The agencies also proposed this summer to increase the threshold for requiring an appraisal on a commercial real estate loan from $250,000 to $400,000.