Here’s How to Address CECL’s Biggest Question


CECL-4-26-19.pngA debate is raging right now as to whether the new loan loss accounting standard, soon to go into effect, will aggravate or alleviate the notoriously abrupt cycles of the banking industry.

Regulators and modelers say the Current Expected Credit Loss model, or CECL, will alleviate cyclicality, while at least two regional banks and an industry group argue otherwise. Who’s right? The answer, it seems, will come down to the choices bankers make when implementing CECL and their view of the future.

CECL requires banks to record losses on assets at origination, rather than waiting until losses become probable. The hope is that, by doing so, banks will be able to prepare more proactively for a downturn.

This debate comes as banks are busy implementing CECL, which goes into effect for some institutions as early as 2020.

Last year, internal analyses conducted by BB&T Corp. and Zions Bancorp. indicated that CECL will make cycles worse compared to the existing framework, which requires banks to record losses only once they become probable.

Both banks found that CECL will force a bank with an adequate allowance to unnecessarily increase it during a downturn. Their concern is that this could make lending at the bottom of a cycle less attractive.

The increase in provisions would “directly and adversely impact retained earnings,” wrote Zions Chief Financial Officer Paul Burdiss in an August 2018 letter, without changing the institution’s ability to absorb losses. BB&T said that adjusting its existing reserves early in a recession, as called for under CECL, would deplete capital “more severely” than the current practice.

BB&T declined to comment, while Zions did not return requests for comment.

The Bank Policy Institute, an industry group representing the nation’s leading banks, said in a July 2018 study that the standard “will make the next recession worse.” CECL’s lifetime approach forces a bank to add reserves every time it makes a loan, which will increase existing reserves during a recession, the group argued.

“The impact on loan allowances due to a change in the macroeconomic forecasts is much higher under CECL,” the study says.

And in Congressional testimony on April 10, JPMorgan Chase & Co. Chairman and CEO Jamie Dimon said CECL could impact community banks’ ability to lend in a recession.

“I do think it’s going to put smaller banks in a position where, when a crisis hits, they’ll virtually have to stop lending because putting up those reserves would be too much at precisely the wrong time,” he said.

Those results are at odds with research conducted by the Federal Reserve and firms like Moody’s Analytics and Prescient Models. Some of the differences can be chalked up to modeling approach and choices; other disagreements center on the very definition of ‘procyclicality.’

Moody’s Analytics believes that CECL will result in “easier underwriting and more lending in recessions, and tighter underwriting and less lending in boom times,” according to a December 2018 paper. The Federal Reserve similarly found that CECL should generally reduce procyclical lending and reserving compared to the current method, according to a March 2018 study.

Yet, both the Fed and Moody’s Analytics concluded that CECL’s ability to temper the credit cycle will vary based on the forecasts and assumptions employed by banks under the framework.

“The most important conclusion is that CECL’s cyclicality is going to depend heavily on how it’s implemented,” says Moody’s Analytics’ deputy chief economist Cristian deRitis. “You can … make choices in your implementation that either make it more or less procyclical.”

DeRitis says the “most important” variable in a model’s cyclicality is the collection of future economic forecasts, and that running multiple scenarios could provide banks a baseline loss scenario as well as an upside and downside loss range if the environment changes.

The model and methodology that banks select during CECL implementation could also play a major role in how proactively a bank will be able to build reserves, says Prescient Models’ CEO Joseph Breeden, who looked at how different loan loss methods impact an economic cycle in an August 2018 paper.

A well-designed model, he says, should allow bankers to reserve for losses years in advance of a downturn.

“With a good model, you should pay attention to the trends. If you do CECL right, you will be able to see increasing demands for loss reserves,” he says. “Don’t worry about predicting the peak, just pay attention to the trends—up or down—because that’s how you’re going to manage your business.”

In the final analysis, then, the answer to the question of whether CECL will alleviate or aggravate the cyclical nature of banking will seemingly come down to the sum total of bankers’ choices during implementation and execution.

Why Checking Products Matter More Than Ever


checking-4-17-19.pngThe battle is on among all banks to acquire new customers and their low-cost deposits. The key to winning the battle for low-cost deposits is owning the primary banking relationship and, in particular, the consumer checking account relationship.

The checking account is the central way consumers identify “their bank.” It is the only banking product that consumers use daily to navigate the intersection of their life and their money.

If this navigation is smooth, your bank is in the best position to collect even more deposits, loans and fee income.

Banks that understand this best have been successful at capturing primary banking relationships, which in recent years have been the four biggest U.S. banks. They are the ones investing the most to continue this trend and defend their success.

If you’re a community bank or even a regional one, a recent AT Kearney survey detailed the ways you are being attacked.

  • The four biggest banks (Bank of America Corp., JPMorgan Chase & Co., Citigroup and Wells Fargo & Co.) have 40 percent of the U.S. consumers’ primary banking relationships. Superregional banks have 19 percent. The remaining 41 percent is split between other institution types, with credit unions at 14 percent, community banks at 12 percent, regional banks at 8 percent and relatively new direct banks like Marcus and Ally already at 5 percent.
  • The four biggest banks are collectively budgeting more than $30 billion in technology investments, about one-third of which is on digital banking around the checking account.
  • Digital channels drive 35 percent of primary banking relationship moves, while branches only drive 26 percent. The Big Four banks are capturing 41 percent of consumers that do switch their primary relationship. Superregional banks are capturing 28 percent. This leaves 31 percent for everyone else, and the new digital-only banks have 11 percent of that remainder.

Big Banks Rule
The reality is the biggest banks have the upper hand. The resources they are investing in digital platforms to maintain and increase market share can’t be replicated by community or regional banks.

But let’s not confuse the upper hand with the winning hand. Community and regional banks can fight back, because there is a chink in the armor of big banks.

While the digital experience provided by the four biggest banks may be superior, a review of the actual product benefits their consumer checking accounts provide isn’t that impressive. They are as ordinary as the checking accounts at most other banks.

Their checking lineups, terms and conditions are complicated with significant product overlap. They mask this weakness with an allure in the marketing and digital delivery of these ordinary benefits.

When smaller banks discuss growing consumer retail accounts, they talk more about acquisition pricing and marketing strategy, and not enough about first improving and simplifying products and lineups. Many banks start by spending on the promotion of unappealing, undifferentiated checking products at the lowest price in a confusing lineup. This isn’t a winning battle plan.

Smaller banks should first make their lineup simple for consumers to understand. The best practice here is a good, better, best methodology, which we have previously discussed in my article, Use Good/Better/Best for Checking Success.

While doing this, why not offer checking products as good, modern and different as you can afford?

Nontraditional Benefits Work
Recent research by Cornerstone Advisors, titled “Reinventing Checking Accounts,” shows how positively consumers respond to switching to checking accounts that include nontraditional benefits like cell phone insurance, roadside assistance and pharmacy/vision discounts alongside traditional benefits.

These nontraditional benefits are central to consumers’ lives away from the bank but can be captured in their checking account.

There’s no debating the importance of acquiring new checking relationships in gathering low-cost deposits. While the biggest banks dominate currently, are investing heavily in technology and paying handsome incentives to attract even more new customers, smaller banks can attack where these big banks are vulnerable.

Don’t fight them toe-to-toe with a complex lineup of look-a-like checking products. That’s a losing battle. Instead, focus on the appeal of a simple lineup and products that competing banks don’t offer. That’s a battle worth fighting, and one that can be won.

Why Great RMs Matter So Much


manager-4-17-19.pngImagine you have given two commercial relationship managers (RMs) at your bank the same potential deal to work on.

Same credit worthiness. Same opportunity for cross-sell. The market is the same, the internal approval process is the same. So is the pricing technology they’re using.

Would the two RMs produce the same result?

Probably not. Even with all conditions being equal, the RMs working on it are not.

Some RMs are just better than others.

But how much better? Earlier this year, PrecisionLender looked for that answer. Our findings were published online in our report: “Measuring RM Performance: Proving Impact and Dispelling Myths.”

We delved into our database, which includes commercial relationships (loans, deposits and other fee-based business) from over 200 banks in the United States, from small community banks to the top 10 institutions. In addition to size, these banks are also geographically diverse, with headquarters in 35 states and borrowers in all 50.

We found three things.

  • The best RMs matter much more than we hypothesized.
  • They win on all fronts, without costly trade-offs.
  • They share common traits and tactics.

Right now it’s assumed that to gain in volume, an RM must give on price. By that logic, RMs with the thinnest margins should have the largest portfolios. Yet we found the RMs with the biggest portfolios aren’t compromising on price.

When normalizing for loan mix and looking at RMs in one line of business pursuing similar borrowers, we found the RMs winning the most volume were also earning the highest risk-adjusted spreads.

We found a similar lack of compromise when it came to risk. Some of the top RMs we studied managed to negotiate higher spreads on a higher-quality portfolio than their peers achieved on weaker-rated books.

Winning On Fees and Price
Most banks we looked at displayed a tremendous dispersion in fee incidence across their RMs. While market aggregate fees showed variance by product type, deal size and term, perhaps the most significant factor in fee performance was the RM.

That performance matters, because RMs who included fees achieved consistently higher risk-adjusted return on equity than those who did not.

To get those fees, top RMs didn’t have to give on price. In most sample banks, there was a positive correlation between spread and fees, largely due to RM talent. Those ranked at the top for fee penetration had above-average spreads. Those ranked near the bottom for fees were also the low performers on spreads.

With today’s thin credit margins, banks often lead with credit to win more ancillary business. RMs routinely justify below-target credit pricing by including an anticipated cross-sell.

Putting aside whether those cross-sell promises are fulfilled, it would be easy to assume relationships with non-credit revenue carry lower spreads. We found the opposite.

Our data suggests relationships with above-average cross-sell revenue tended to carry higher credit pricing than those with below-average cross-sell revenue. RMs often cited the strength of the relationship—thanks to a track record of delivering value—as the biggest reason.

How Do Great RMs Do It?
The evidence we’ve collected points to a set of best practices that top RMs have in common.

  • They act like trusted advisors instead of order takers.
  • They deliver tailored solutions.
  • They know what matters to the customer and the relative priorities.
  • They provide alternatives.
  • They maintain meaningful, ongoing communication.
  • They explain their pricing.
  • They leverage internal resources.
  • They implement performance-based pricing.
  • They are proactive in managing renewals.
  • They negotiate well.

Some RMs manage to achieve volume, add fees, cross-sell and minimize risk, without conceding on rate. Look closer, and you’ll find a common set of tactics and strategies.

Banks that understand what makes their top performers great can turn a best practice into a common practice.

The Flawed Argument Against Community Banks


deposit-4-5-19.pngA few weeks ago, The Wall Street Journal published a story that struck a nerve with community bankers.

The story traced the travails of National Bank of Delaware County, or NBDC, a $375 million asset bank based in Walton, New York, that ran into problems after buying six branches from Bank of America Corp. in 2014.

It’s not that things were going great for NBDC prior to that, because they weren’t. Like many banks in small towns, it had to contend with stiff economic and demographic headwinds.

“As in other small towns that were once vibrant, decades of economic change altered the fabric of Walton,” Rachel Louise Ensign and Coulter Jones wrote in the Journal. “The number of area farms dwindled and manufacturing jobs disappeared.”

“Being located in, and serving, an economically struggling community could bring any bank down,” wrote Ron Shevlin, director of research at Cornerstone Advisors, in a follow-up story a week later.

NBDC hoped the branches acquired from Bank of America, for a combined $1 million, would revive its fortunes. But the deal only made things worse.

The branches saddled NBDC with higher costs and $12 million in added debt. Even worse, half the acquired deposits quickly went elsewhere, provoked by a poorly executed integration as well as, ostensibly, NBDC’s antiquated technology.

“Technology is causing strains throughout the banking industry, especially among smaller rural banks that are struggling to fund the ballooning tab,” Ensign and Jones wrote. “Consumers expect digital services including depositing checks and sending money to friends, which means they don’t necessarily need a local branch nearby. This increasingly means people are choosing a big bank over a small one.”

This echoes a common refrain in banking: that smaller regional and community banks can’t compete against the multibillion-dollar technology budgets of big banks—especially JPMorgan Chase & Co., Bank of America and Wells Fargo & Co.

Community bankers took issue with the article, Shevlin noted, because it seemed to portray the story of NBDC, which was acquired in 2016 by Norwood Financial Corp., as representative of community banks more broadly.

“This is so misleading,” tweeted Andy Schornack, president of Security Bank & Trust in Glencoe, Minnesota. “Pick on one under-performing bank to represent the whole.”

“Community banks are profitable and thriving,” tweeted Tanya Duncan, senior vice president of the Massachusetts Bankers Association. “Most offer technology that makes transactions seamless.”

Schornack and Duncan are right. One doesn’t have to look far to find community banks that are thriving, with many outperforming the industry.

A textbook example is Germantown Trust and Savings Bank, a $376 million asset bank based in Breese, Illinois.

Germantown has generated a higher return on assets than the industry average in 11 of the past 12 years. The only exception was in 2013, when it generated a 1.52 percent pre-tax ROA, compared to 1.55 for the overall industry.

 Germantown-Bank-chart.png

Germantown’s performance through the financial crisis was especially impressive. While most banks reported lower earnings in 2009, with the typical bank recording a loss, Germantown experienced a surge in profitability.

Germantown has gained local market share, too. Over the past eight years, its share of deposits throughout its four-branch footprint in Clinton County, Illinois, has grown from 27.8 percent up to 29.7 percent.

This is just one example among many community banks with a similar experience. For every community bank that’s ailing, in other words, you could point to one that’s thriving.

Yet, there’s another, more fundamental issue with the prevailing narrative in banking today. Namely, the data doesn’t support the claim that the biggest and most technologically-savvy banks are gobbling up share of the national deposit marketTwitter_Logo_Blue.png

In fact, just the opposite has been true over the past five years.

Let’s start with the big three retail banks—JPMorgan Chase, Bank of America and Wells Fargo—which are spending tens of billions of dollars a year on technology.

These three banks saw their combined share of domestic deposits swell in the wake of the financial crisis, climbing from 21.7 percent in 2007 up to 33.2 percent six years later. Since 2013, however, this trend has gone in the opposite direction, falling in four of the past five years. As of 2018, the three biggest banks in the country controlled 31.8 percent of total domestic deposits, a decline of 1.4 percentage points from their peak.

 Deposit-share-chart.png

The same is true if you broaden this out to include the nine biggest commercial banks. Their combined share of domestic deposits has dropped from a high of 47.6 percent in 2013 down to 45.6 percent last year.

Given the number of branches many of these banks have shed over the past decade, it’s surprising they haven’t lost a larger share of domestic deposits. Nevertheless, it’s worth reflecting on the fact that, despite the gloomy sentiment toward community banks that’s often parroted in the press, their current and future fortunes are far from bleak.

Bank M&A in 2019: Is It a New World?


Much like the countless dystopian novels and movies released over the years, the environment today in banking begs the question of whether we’ve entered a so-called new world in the industry’s M&A domain.

Deal volume in 2018 was roughly equal to 2017 levels, though many regions in the country saw a decline. And while it’s still early in 2019, the first two months of the year have been marked by a pair of large, transformative deals: Chemical Financial Corp.’s merger with TCF Financial Corp., and BB&T Corp.’s merger with SunTrust Banks. These deals have raised hopes that more large deals will soon follow, creating a new tier of banking entities that live just below the money-center banks.

Aside from these two large deals, however, M&A volume throughout the rest of the industry is down over the first two months of the year. As you can see in the chart below, this continues a slide in deal volume that began at the tail end of 2018.

Announced Bank Deals.png

Bank Director’s 2019 Bank M&A Survey highlights a number of the factors that might impact deal volume in 2019 and beyond.

Fifty-seven percent of survey respondents indicated that organic growth is their current priority, for instance, though respondents were open to M&A opportunities. This suggests that banks are more willing to focus on market opportunities for growth, likely because bank management can more easily influence market growth than M&A. The strength of the economy, enhanced earnings as a result of tax reform, easing regulatory oversight and industry optimism in general also are likely contributing to the focus on market growth.

The traditional chasm between banks that would like to be acquirers and banks that are willing to be sellers seems to be another factor influencing banks’ preference for organic market growth. In all the surveys Crowe has performed of bank directors, there always are more buyers than sellers.

The relationship between consolidation and new bank formation also weighs on the pace of acquisitions. If the pool of potential and active acquirers remains relatively stable, the determiner is the available pool of sellers. Each year since 2008, the number of acquisitions has exceeded the number of new bank formations. The result is an overall decrease in the number of deals. It stands to reason, in turn, that this will lead to fewer deals each year as consolidation continues.

Current prices for bank stocks also have an impact on deal volume. You can see this in the following chart, which illustrates the “tailwind” impact on deal volume for publicly traded banks. Tailwind is the percentage by which a buyer’s stock valuation exceeds the deal metrics. When the percentage is high, trading price/tangible book value (TBV) exceeds the deal price/TBV and deal volume is positively affected. The positive impact sometimes is felt in the same quarter, but there can be a three-month lag.

Deal Volume.png

In the beginning of 2019, bank stock prices recovered some of the declines they experienced in the latter half of last year, but they still are at a negative level overall. If bank stock prices continue to lag behind the broader market, as they have over the past year (see the chart below), deal volume likely will be affected for the remainder of the year.

Bank Stock Prices.png

It’s still too early to predict how 2019 will evolve for bank M&A. Undoubtedly there will be surprises, but it’s probably fair to assume a slightly lower level of deals for 2019 compared to 2018.

The Big Picture of Banking in Three Simple Charts


banking-3-22-19.pngOne thing that separates great bankers from their peers is a deep appreciation for the highly cyclical nature of the banking industry.

Every industry is cyclical, of course, thanks to the cyclical nature of the economy. Good times are followed by bad times, which are followed by good times. It’s always been that way, and there’s no reason to think it will change anytime soon.

Yet, banking is different.

The typical bank borrows $10 for every $1 in equity. On one hand, this leverage accelerates the economic growth of the communities a bank serves. But on the other, it makes banks uniquely sensitive to fluctuations in employment and asset prices.

Even a modest correction in the business cycle or a major asset class can send dozens of banks into receivership.

“It is in the nature of an industry whose structure is competitive and whose conduct is driven by supply to have cycles that only end badly,” wrote Barbara Stewart in “How Will This Underwriting Cycle End?,” a widely cited paper published in 1980 on the history of underwriting cycles.

Stewart was referring to the insurance industry, but her point is equally true in banking.

This is why bankers with a big-picture perspective have an advantage over bankers without a similarly deep and broad appreciation for the history of banking, combined with knowledge about the strengths and infirmities innate in a bank’s business model.

How does one go about gaining a big-picture perspective?

You can do it the hard way, by amassing personal experience. If you’ve seen enough cycles, then you know, as Jamie Dimon, the CEO of JPMorgan Chase & Co., has said: “You don’t run a business hoping you don’t have a recession.”

Or you can do it the easy way, by accruing experience by proxy—that is, by learning how things unfolded in the past. If you know that nine out of the last nine recessions were all precipitated by rising interest rates, for instance, then you’re likely to be more cautious with your loan portfolio in a rising rate environment.

You can see this in the chart below, sourced from the Federal Reserve Bank of St. Louis’ popular FRED database. The graph traces the effective federal funds rate since 1954, with the vertical shaded portions representing recessions.

Fed-Funds-Rate.png

A second chart offering additional perspective on the cyclical nature of banking traces bank failures since the Civil War, when the modern American banking industry first took shape.

This might seem macabre—who wants to obsess over bank failures?—but this is an inseparable aspect of banking that is ignored at one’s peril. Good bankers respect and appreciate this, which is one reason their institutions avoid failure.

Failures.png

Not surprisingly, the incidence of bank failures closely tracks the business cycle. The big spike in the 1930s corresponds to the Great Depression. The spike in the 1980s and 1990s marks the savings and loan crisis. And the smaller recent surge corresponds to the financial crisis.

All told, a total of 17,365 banks have failed since 1865. A useful analog through which to think about banking, in other words, is that it’s a war of attrition, much like the conflict that spawned the modern American banking industry.

A third chart offering insight into how the banking industry has evolved in recent decades illustrates historical acquisition activity.

Acquisitions.png

Approximately 4 percent of banks consolidate on an annual basis, equating to about 200 a year nowadays. But this is an average. The actual number has fluctuated widely over time. Twitter_Logo_Blue.png

From 1940 through the mid-1970s, when interstate and branch banking were prohibited in most states, there were closer to 100 bank acquisitions a year. But then, as these regulatory barriers came down in the 1980s and 1990s, deal activity surged.

The point being, while banking is a rapidly consolidating industry, the most recent pace of consolidation has decelerated. This is relevant to anyone who may be thinking of buying or selling a bank. It’s also relevant to banks that aren’t in the market to do a deal, as customer attrition in the wake of a competitors’ sale has often been a source of organic growth.

In short, it’s easy to dismiss history as a topic of interest only to professors and armchair historians. But the experience one gains by proxy from looking to the past can help bankers better position their institutions for the present and the future.

Take it from investor Charlie Munger: “There’s no better teacher than history in determining the future.”

Exclusive: How U.S. Bancorp Views Expansion


bancorp-3-14-19.pngGreat leaders are eager to learn from others, even their competitors. That’s why Bank Director is making available—exclusively to our members—the unabridged transcripts of the in-depth conversations our writers have with the executives of top-performing banks.

Few banks fit this description as well as U.S. Bancorp, the fifth-largest retail bank in the United States. It has generated one of the most consistently superior performances in the banking industry over the past decade. It’s the most profitable and efficient bank among superregional and national banks. It’s the highest-rated bank by Moody’s. It’s also been named one of the world’s most ethical companies for five years in a row by the Ethisphere Institute. And it has emerged as a leader of the digital banking revolution.

Bank Director’s executive editor, John J. Maxfield, interviewed U.S. Bancorp Chairman and CEO Andy Cecere for the first quarter 2019 issue of Bank Director magazine. (You can read that story, “Growth Through Digital Banking, Not M&A,” by clicking here.)

In the interview, Cecere sheds light on U.S. Bancorp’s:

  • Strategy for expanding into new markets
  • Progress on the digital banking front
  • Perspective on the changes underway in banking
  • Experience through the financial crisis

The interview has been edited for brevity, clarity and flow.

download.png Download transcript for the full exclusive interview

How A New Court Decision Could Change Bank M&A


merger-3-11-19.pngA recent decision by the Delaware Supreme Court relating to a merger between two pharmaceutical companies that was terminated before closing could have implications on bank mergers and acquisitions.

On Dec. 7, 2018, the Delaware Supreme Court affirmed the lower court’s ruling in Akorn v. Fresenius Kabi that a Material Adverse Effect (“MAE”) had occurred with respect to Akorn under the terms of its merger agreement with Fresenius.

The Supreme Court upheld the lower court’s determination that (1) Akorn had suffered an MAE under the terms of the agreement that excused Fresenius from its obligation to close the transaction, and (2) Fresenius properly terminated the merger agreement because of Akorn’s breach of its regulatory representations and warranties under the merger agreement, which gave rise to an MAE, and Fresenius had not materially breached the merger agreement (which would have prevented it from exercising its termination rights).

Why the Akorn Case Is Important

  • This is the first ruling in Delaware that an MAE had occurred in a merger transaction, allowing the buyer to walk away from a signed merger agreement.
  • The lower court’s opinion provides unprecedented guidance for future negotiation and litigation of MAE clauses.
  • The decision is applicable to all industries, including the banking industry, and makes it clear that, first, the heavy burden to establish an MAE with respect to the target remains with the buyer.

How The Case Impacts Bank M&A

  • Merger partners should carefully consider the categories of events or changes, as well as any specific events, that should be excluded from the MAE definition, ensuring that the definition accurately reflects the agreed upon allocation of risk between the parties.
  • Sellers should exclude industry-wide changes impacting the seller, while buyers should be mindful to provide that broad industry changes that disproportionately affect the seller are not carved out from the definition.
  • Typical carve-outs from the MAE definition in a bank merger agreement include: changes in laws and regulations affecting banks or thrift institutions, changes in GAAP, changes in the value of securities or loan portfolio or value of deposits or borrowings resulting from a change in interest rates, and changes relating to securities markets in general.
  • Buyers who are uncomfortable with the broad definition of an MAE, even following Akorn, and are significantly larger than the seller may wish to consider inclusion of a few specific financial closing conditions to supplement the broad MAE clause.
  • Buyers in the bank M&A context should in good faith continue the regulatory approval process even while contemplating terminating the deal over a possible MAE — having “clean hands” matters.

How the Court Found an MAE
Fresenius, a German pharmaceutical company, and a U.S. generic drug manufacturer, Akorn, formally agreed in April 2017 to merge.

Shortly after, Akorn’s financial performance “fell off a cliff;” its revenues declined the next four quarters by 29 percent, 29 percent, 34 percent and 27 percent, respectively. Its operating income plummeted 84 percent, 89 percent, 292 percent and 134 percent, respectively, during the same period.

Fresenius terminated the merger agreement in April 2018, asserting that Akorn had suffered a general MAE. Fresenius further asserted it had an explicit right to terminate the merger agreement because Akorn breached its regulatory compliance representations and warranties. Akorn’s lawsuit followed, seeking for the court to force Fresenius to close the transaction.

The Court of Chancery determined Akorn suffered a general MAE, which resulted from issues that disproportionately affected Akorn compared to similar companies in its industry. Focusing on the plain text of the merger agreement, the court determined that Akorn bore the general risk of the MAE and through several carve-outs to the provision, Fresenius bore the “systemic” risks related to Akorn’s industry. However, through specific exclusions from these carve-outs, the risk was shifted back to Akorn in the event that the risks disproportionately affected Akorn’s business as compared to other participants in its industry. In analyzing whether the effect was “material,” the court stated the effect should “substantially threaten the overall earnings potential of the target in a durationally-significant manner.”

In other words, the court determined that Akorn’s dramatic downturn in performance was significant because it had persisted for a year and had no sign of abating, rejecting Akorn’s argument that any assessment of the decline in its value should be measured not against its performance as a standalone entity but against its value to Fresenius as a buyer.

Conclusion
This case is directly applicable to the banking industry. Many banks suffered dramatic declines in earnings during the financial crisis that would be considered durationally significant within the framework reinforced by Akorn. Causes included massive credit losses, drastic margin compression and the regulatory reaction to the crisis. Banks need to take into account their risk profile and that of their merger partner when negotiating the MAE definition and consider how it would work under a variety of adverse economic environments.

Three New Ways the FDIC Is Helping Community Banks


regulation-3-8-19.pngIf there’s one takeaway from the Federal Deposit Insurance Corp.’s latest annual report, it’s that there’s a new sheriff in town.

The sheriff, Jelena McWilliams, isn’t literally new, of course, given the FDIC’s new chairman was confirmed in May 2018. Yet, it wasn’t until last month that her imprint on the FDIC became clear, with the release of the agency’s annual report.

In last year’s report, former Chairman Martin Gruenberg spent the first half of his Message from the Chairman—the FDIC’s equivalent to an annual shareholder letter—reviewing the risks facing the banking industry and emphasizing the need for banks and regulatory agencies to stay vigilant despite the strength of the ongoing economic expansion.

“History shows that surprising and adverse developments in financial markets occur with some frequency,” wrote Gruenberg. “History also shows that the seeds of banking crises are sown by the decisions banks and bank policymakers make when they have maximum confidence that the horizon is clear.”

The net result, wrote Gruenberg, is that, “[w]hile the banking system is much stronger now than it was entering the crisis, continued vigilance is warranted.”

Gruenberg’s tone was that of a parent, not a partner.

This paternalistic tone is one reason that bankers have grown so frustrated with regulators. Sure, regulators have a job to do, but to imply that bankers are ignorant of the economic cycle belies the fact that most bankers have more experience in the industry than regulators.

This is why McWilliams’ message will come as a relief to the industry.

It’s not that she disagrees with Gruenberg on the need to maintain vigilance, because there’s no reason to think she does. But the tone of her message implies that she views the FDIC as more of a partner to the banking industry than a parent.

This is reflected in her list of priorities. These include encouraging more de novo formations, reducing the regulatory burden on community banks, increasing transparency of the agency’s performance and establishing an office of innovation to help banks understand how technology is changing the industry.

To be clear, it’s not that Gruenberg didn’t promote de novo formations, because he did. It was under his tenure that the FDIC conducted outreach meetings around the country aimed at educating prospective bank organizers about the application process.

But while Gruenberg’s conversation about de novo banks was buried deep in his message, it was front and center in McWilliams’ message, appearing in the fourth paragraph.

“One of my top priorities as FDIC Chairman is to encourage more de novo formation, and we are hard at work to make this a reality,” wrote McWilliams. “De novo banks are a key source of new capital, talent, ideas, and ways to serve customers, and the FDIC will do its part to support this segment of the industry.” Twitter_Logo_Blue.png

To this end, the FDIC has requested public comment on streamlining and identifying potential improvements in the deposit insurance application process. Coincidence or not, the number of approved de novo applications increased last year to 17—the most since the financial crisis.

The progress on McWilliams’ second priority, chipping away at the regulatory burden on community banks, is more quantifiably apparent.

The FDIC eliminated over 400 out of a total of 800 pieces of outstanding supervisory guidance and, in her first month as chairman, launched a pilot program that allows examiners to review digitally scanned loan files offsite, reducing the length of onsite exams.

Relatedly, the number of enforcement actions initiated by the FDIC continued to decline last year. In 2016, the FDIC initiated 259 risk and consumer enforcement actions. That fell to 231 the following year. And in 2018, it was down to 177.

“We will continue [in 2019] to focus on reducing unnecessary regulatory burdens for community banks without sacrificing consumer protections or prudential requirements,” McWilliams wrote. “When we make these adjustments, we allow banks to focus on the business of banking, not on the unraveling of red tape.”

Another of McWilliams’ priorities is promoting transparency at the agency. This was the theme of her first public initiative announced as chairman, titled “Trust through Transparency.”

The substance of the initiative is to publish a list of the FDIC’s performance metrics online, including call center response rates and turnaround times for examinations and applications. In the first two months the webpage was live, it received more than 34,000 page views.

Finally, reflecting a central challenge faced by banks today, the FDIC is in the process of establishing an Office of Innovation that, according to McWilliams, “will partner with banks and nonbanks to understand how technology is changing the business of banking.”

The office is tasked with addressing a number of specific questions, including how the FDIC can provide a safe regulatory environment that promotes continuous innovation. It’s ultimate objective, though, is in line with McWilliams’ other priorities.

“Through increased collaboration with FDIC-regulated institutions, consumers, and financial services innovators, we will help increase the velocity of innovation in our business,” wrote McWilliams.

In short, while the industry has known since the middle of last year that a new sheriff is in town at the FDIC, the agency’s 2018 annual report lays out more clearly how she intends to govern.

Fuel for More M&A in 2019



How will economic factors like today’s strong stock market and rising interest rates, along with the banking industry’s demand for core deposits, impact profitability and growth in 2019? Dory Wiley of Commerce Street Capital predicts we’ll see more deals. Find out why in this video.

  • M&A Drivers in 2019
  • What to Know About Valuations
  • Powering Future Growth
  • Headwinds Facing the Industry