Is Your Bank Ready for CECL?


CECL-12-28-16.pngConsidered by some bank accounting’s most significant change in 40 years, the FASB’s Current Expected Credit Loss (CECL) standard is inching toward reality.

Are you and your board colleagues studying the standard’s fundamentally new requirements for booking loan losses? Do you have a sense for its implications on reserves? Are you considering the penetrating questions to ask about management’s preparedness and processes to comply?

For some directors, the standard might seem straightforward: Build reserves to cover losses over the life of a loan. But it means much more: The timing of adding to the reserve has changed considerably. The entire expected lifetime losses must be booked in the quarter in which the loan is made.

Make no mistake; preparing to meet the demands of the standard, effective January 1, 2020, for most Securities and Exchange Commission (SEC) registrants, promises be a complex, time-consuming endeavor.

Other questions bank directors must ask themselves include whether they understand the standard’s implications and if they are confident that bank management is prepared for the formidable changes affecting modeling, data collection and analysis, calculation of losses, and information technology (IT) systems.

For some bank management teams, the answer may be a confident, “Yes.’’ For others, it might be a tentative, “Well … let us get back to you on that.’’

It is worth noting that 83 percent of bankers who answered a recent survey at the American Institute of Certified Public Accountants conference said they expected CECL to require substantial changes to banks’ policies, procedures and IT systems. Half said they were most concerned about how they would manage the amount of data needed to comply.

Consider this counterintuitive CECL scenario: the bank has a quarter it considers successful because of the number of new organically grown loans it made. But, it might show a quarterly loss because the bank must book expected losses for the entire life of those loans in the quarter in which the loans were made. Under current rules, banks book losses after they are incurred.

Further, when calculating expected losses under CECL, banks must incorporate reasonable and supportable forecasts in their loss evaluations. In other words, how strong are your bank’s modeling capabilities?

That forecast would include a bank’s expectation, for example, of the future yield curve and an expectation of the economic future over the life of the loan–and how these factors would impact the performance of each loan for the life of the loan.

For some banks, the timing issue could mean between now and 2020, they will need to add to their capital base through earnings. Capital planning considerations are most effectively dealt with when given sufficient lead time, especially if a number of institutions need to raise capital upon adoption of the standard.

Directors must prepare to challenge management’s process to meet the standard. That may mean that directors ask management if they’ve examined commercial loans by type or vintage, and if they’ve done preliminary lifetime loss calculations based on past experience and future economic considerations.

Consequently, directors need comfort that management has established a robust CECL planning process in order to know which data will be required. It’s no wonder, then, that for many directors, that standard looming on the horizon suddenly is getting closer.

Regulatory Scrutiny Focuses on Inadequate Strategic and Capital Planning


capital-planning-9-24-15.pngOnce again, regulators are zeroing in on inadequate strategic and capital planning processes at many community banks.

The Office of the Comptroller of the Currency (OCC) listed “strategic planning and execution” as its first supervisory priority for the second half of 2015 in its mid-cycle status report released in June. That echoes concerns from the latest OCC semiannual risk perspective, which found that strategic planning was “a challenge for many community banks.”

FDIC Chairman Martin J. Gruenberg said in May that regulators expect banks “to have a strategic planning process to guide the direction and decisions of management and the board. I want to stress the word ‘process’ because we don’t just mean a piece of paper.”

He said that effective strategic planning “should be a dynamic process that is driven by the bank’s core mission, vision and values. It should be based on a solid understanding of your current business model and risks and should involve proper due diligence and the allocation of sufficient resources before expanding into a new business line. Further, there should be frequent, objective follow-up on actual versus planned results.”

In writing about strategic risk, the Atlanta Federal Reserve’s supervision and regulation division said that “a sound strategic planning process is important for institutions of all sizes, although the nature of the process will vary by size and complexity.” The article noted that the process “should not result in a rigid, never-changing plan but should be nimble, regularly updated (at least annually) and capable of responding to risks and changing market conditions.”

Given economic changes and increased market competition, community banks must understand how to conduct effective strategic planning. This is more important now than ever, says Invictus Consulting Group Chairman Kamal Mustafa.

The smartest banks are using new analytics to develop their strategic plans— not because of regulatory pressure, but because it gives them an edge in the marketplace and a view of their banks they cannot otherwise see, Mustafa said.

Strategic planning is useless without incorporating capital planning. The most effective capital planning is built from the results of stress testing. These critical functions—strategic planning, capital planning and stress testing—must be integrated if a bank truly wants to understand its future,” he said.

He advises banks to use the same fundamental methodology for both capital planning and strategic planning, or else they will run the risk of getting misleading results. This strategy is also crucial in analyzing mergers and acquisitions.

OCC Deputy Comptroller for Supervision Risk Management Darrin Benhart also advises community banks to use stress testing to determine if the bank has enough capital. “Boards also need to make sure the institution has adequate capital relative to all of its risks, and stress testing can help,” he said in a February speech. “We also talk about the need to conduct stress testing to assess and inform those limits as bank management and the board make strategic decisions.”

Why Your Bank Should Have a Capital Plan


strategic-planning-7-24-15.pngThree significant events have altered expectations for capital plans. First, as of January 1, 2015, banks need to comply with the new BASEL III capital requirements, including the new “capital conservation buffer.” Second, regulatory authorities now view strategic planning and capital planning as risk appetite and risk mitigation documents, respectively. Finally, the demise of the market for trust preferred securities has reduced the ability to raise just–in–time capital, which was a prevalent concept from 2005 to 2009.

Every board should ask the hard question of whether or not the depository institution has sufficient capital to (1) address BASEL III regulatory requirements, (2) navigate the current economic environment, and (3) implement the desired strategic plan for the depository institution. If the answer is no, management should focus on how much capital is needed, and the board and management should determine the sources for funding those needs.

Even if you currently have a capital plan, it may not “chin the bar” with the regulators. Traditional two–page or five–page capital plans are falling short of what regulators expect to see in capital plans. Such plans are now becoming much more robust and are truly a management planning tool rather than simply something that is “nice to have.” A strong capital plan is a critical document, as it ensures that there is enough fuel to drive the bank’s strategic plan and ensures that there is adequate insurance against the bank’s risk profile. Every depository institution, even healthy depository institutions, should have a comprehensive capital plan that dovetails with its strategic plan and its enterprise risk management plan.

The regulatory agencies are clearly steering institutions away from the concept of just–in–time capital that resulted in many depository institutions finding trouble in 2008 and 2009. Some regulators have even hinted that a comprehensive capital plan may soon be an integral part of the safety and soundness examination process, perhaps showing up as an element in the capital or management component of the CAMELS–rating system. Some of our clients have already received questions in this regard in light of upcoming regulatory examinations, so it is likely a trend that will only continue to become more frequent and ultimately a requirement.

The breadth and depth of a comprehensive capital plan will, of course, depend on the risk profile of the depository institution. While there is no magic outline for a capital plan, almost all capital plans should have a few critical components: (a) background on the depository institution’s strategic plan, operations, economic environment and current capital situation, (b) tolerances and triggers, (c) alternatives for available capital, (d) perhaps a dividend policy and (e) financial projections.

The tolerances and triggers may be the most important part of the capital plan, as this is how the institution will avoid needing just–in–time capital. The identification of tolerances and triggers operate as an early warning system to alert management that capital may become stressed in the near future. Careful planning should take place when considering what the tolerances and triggers will be, as these are the key drivers in making the capital plan a true planning tool.

In summary, capital planning is an important, if not necessary, tool for any depository institution, regardless of condition. There is a growing sea change in how the regulators view the necessity of a capital plan, and a growing expectation that every depository institution have a viable capital plan. It is important to note, however, that there is no one–size–fits–all capital plan that can be pulled off of a shelf as a form document. Instead, the plan should be carefully considered and evaluated, either as part of the institution’s strategic plan or as a separate plan working in tandem with the strategic plan. Finally, after it is prepared, the capital plan cannot simply sit on the shelf, but should instead be treated as a living, breathing document that will need to be revised as the economic and regulatory environment, risk profile, strategic direction and capital resources available to the institution change over time.

Assess, Don’t Assume: The Board’s Role in Basel III


With the change in capital requirements quickly approaching, many community banks believe they are well capitalized under the new Basel III standards. Yet most banks have not used the Basel III calculator provided by the regulators to truly assess their capital levels. In this video, Orlando Hanselman of Fiserv shares his thoughts on why the majority of community banks are not ready for this unprecedented shift to the basic banking business model, and outlines what boards should do to ensure their bank is not caught off guard.

For more information, check out Orlando Hanselman’s article on this topic

Drivers of Bank Valuation, Part I: Defining Value


3-4-13_Commerce_Street.pngWhen looking at a bank’s value, whether as a going concern or through the merger process, the headline is the price.  This can be expressed as a dollar value per-share or as a multiple of earnings or tangible book value (“TBV”).  Either way, price is the critical metric for boards to assess management’s performance, for shareholders who must approve merger transactions, or for financial advisory firms who must opine on a transaction’s fairness.

It follows, then, that boards should spend time during the strategic planning process evaluating what drives bank value and what steps they and the bank’s management can take now to improve the organization’s overall valuation and worth in the marketplace. This process pays dividends in growing share value, improving the bank’s perception in the marketplace (especially important for banks with publicly listed stock), and ultimately receiving a satisfactory price in a merger or sale transaction.

Defining Value

The baseline for valuation is the net worth or book value of the company.  Typically, buyers and investors look to the bank’s TBV—or the bank’s net worth after all intangibles and hybrid capital instruments are netted out.  After TBV, the most critical factor in assessing value is earnings. Earnings grow TBV and they allow boards flexibility in providing benefits to shareholders through stock buybacks and dividends. Plus, they allow management the flexibility to invest in people, processes and new lines of business.  Also, in a sale of the company, buyers rely on the acquired company’s earnings to repay them for the dilution they take as a result of paying a control premium.  More earnings, more premium—and more benefit to shareholders.  

In the first of a three part series, we will examine some of the attributes that drive tangible book value and are perceived as valuable to prospective acquirers and merger partners.  In this issue’s installment, we will look at the TBV metric in detail and how focusing on TBV is critical to driving shareholder value.

Growing Tangible Book Value

Since the financial crisis in 2008, regulators, investors and prospective purchasers have all migrated toward discounting the capital benefits of so-called Tier 2 capital and other intangibles that make up a bank’s “book value.”  The use of TBV as the standard metric for assessing a bank’s equity and pricing deals should drive boards toward placing a premium on growing TBV through organic growth.  This isn’t necessarily an argument not to do deals, but deals involve premiums and thus are dilutive—even if only for a time—to the organization’s TBV. If boards are eyeing an exit in the short-to-medium term, growing TBV should be an overriding priority.  

Consider a simplistic example.  If a bank organizes and raises capital at $10 per share and runs a five-year business plan that yields growth in TBV of 15 percent per year, the share value at the end of the business plan will be approximately $20 per share.  Assuming an exit at 2 times TBV, the bank’s investors will realize a 4 times return on their original investment of $10. Fair enough. Now, take that same bank and grow the TBV at 20 percent instead of 15 percent and the investor will exit at $50—moving the return from 4 times cash-on-cash to 5 times.  

The point here is that incremental changes in TBV over the life of a bank’s business plan can have a significant beneficial impact on the bank’s shareholders.  Likewise, poor capital planning—including raising capital at significant premiums or poor M&A strategy—can erode TBV and significantly erode the return to shareholders.  

So, how to grow TBV?  This is certainly a challenge given the compressed margins and lower earnings in the current banking market.  But running the bank efficiently, allocating capital to higher margin businesses, controlling cost of funds, expanding fee income opportunities and careful pricing in the M&A markets can all help push more of the bank’s earnings capacity into the company’s net worth—and yield a better price for the bank’s shares in the open market or in an outright sale.  

In the next article in this series, we will explore several operating metrics that assist in TBV growth and drive higher valuations in open market stock sales and the merger markets.

Lee’s comments are strictly his views and opinions and do not constitute investment advice.