Compliance Burden Grows Heavier

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The Grant Thornton LLP Bank Executive Survey polled nearly 400 bank CEOs and CFOs in April and May about the economy and regulatory reform’s impact. Nichole Jordan, Grant Thornton’s national banking and securities industry leader, talks about some of the highlights, and offers some insights on the new compliance burden.

What did you find particularly significant about the survey’s findings?

Thirty-nine percent of respondents indicated they thought the Dodd-Frank Act would be effective or somewhat effective in preventing or reducing the threat of a future taxpayer-funded bailout.  As we take a look at Dodd-Frank one year later, we’ve been evaluating some of the more positive benefits: having compensation linked more closely to long-term performance with a focus on reducing riskier behavior and having more data transparency with a greater focus on risk management and an emphasis on a culture of compliance.  In addition, living wills create a formal structure that will benefit both those within and outside of the systemically important institution.

What did you think of the more stringent capital requirements in Dodd-Frank?

Internally within an institution, those are heavy demands to meet and it certainly limits growth in certain aspects.  However, the perception externally and in the marketplace is that having increased capital requirements is very important in this environment, especially with what we’ve seen over the last 18 months.

It certainly would seem to put more pressure on management teams.

We are seeing management teams making a shift in focus as they look at how to increase margins and overall, how to improve profitability in the institutions. We’re seeing an emphasis on trying to increase growth, but at the same time, recognizing the challenges associated with that in the current environment. Efficiency initiatives are increasing as well in banks from the standpoint of striving to develop efficiency enhancements into various processes and ensure internal controls are properly in place.

Where do you see the greatest potential for efficiency gains?

There has been a lot of success within certain institutions as they evaluate the centralization of various processes handled in multiple locations.  One example to look at from an accounting standpoint: If there are several individuals at multiple locations handling accounting for a particular branch or the reporting structure at various branches, you could centralize that process, not to reduce headcount, but to centralize by region or even at the headquarter’s location.

In the survey, there was a nearly unanimous agreement that the regulatory burden is the top concern and yet, half feel it won’t be effective at all in preventing the next crisis.

How do you react to that?

It’s difficult for any law to fully reduce the risk of the failures. Dodd-Frank would likely mitigate the risk scenario that we have just experienced, so if the pattern stays the same from what we have had over the past couple of years, Dodd-Frank would have a significant impact in reducing the risk of economic failure.  The likelihood of that same pattern occurring is relatively small, but do I think it will reduce risk? Yes.

What should the banks be doing from a compliance standpoint right now to get ready for Dodd-Frank?

One best practice would be to fully evaluate the impact and develop a timeline and an action plan that will address some of the key areas.  As we have seen, in today’s climate, an enterprise risk management process, a risk management committee and a chief risk officer are the new normal.

How should management decide whether to invest internal resources to handle the increased compliance burden or engage third parties?

Because everything is so new, it lends itself more toward being outsourced and hiring individuals who live and breathe this every day and can share that knowledge gained from serving a variety of institutions.  In future years, the inside management team can then lead the maintenance and compliance effort after the complexities of the implementation phase have been addressed.

Joining Forces to Capitalize a New Bank

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Private equity funds are playing an increasingly vital role in recapitalizing the U.S. banking industry. A unique example of this trend occurred earlier this year when four independent PE firms joined forces to make a $160 million capital investment in Birmingham, Alabama-based AloStar Bank of Commerce, a new institution which acquired the deposits and certain assets of the failed Nexity Bank from the Federal Deposit Insurance Corp.

Advised by FBR Capital Markets Corp. and the law firm Davis Polk & Wardell LLP, AloStar successfully negotiated an 80/20 loss-sharing agreement with the FDIC on $384.2 million in assets. The four PE firms are Fortress Investment Group, Oaktree Capital Management, Stone Point Capital and Pine Brook Road Partners, and each owns approximately 24.9 percent of the company.

FBR worked closely with AloStar’s founders, Chairman and CEO Michael Gillfillan, who previously was chief credit officer and vice chairman at Wells Fargo & Co., and Executive Vice President Andrew McGhee, the former head of asset-based lending at SunTrust Banks Inc. AloStar is a banker’s bank that will use consumer and commercial deposits collected nationwide largely over the Internet to fund an asset-based lending program for small- and medium-sized businesses. Recently, FBR Capital Markets Senior Managing Director Ken Slosser talked about the deal and its importance to the industry.

What are the unique aspects of this transaction?

We believe this is the first time that four private equity firms bid on a failed bank through the resolution process and won. We also believe this is the first time that the FDIC has approved a business plan for a bank receiving assistance that will use, as a primary deposit strategy, a nationwide Internet deposit gathering system to fund asset-based lending for small businesses across the country. There have been a whole host of transactions, both assisted and unassisted, where they have not allowed Internet deposits as a primary funding strategy.

Was it hard getting four private equity firms to agree on a transaction?

It was very difficult to raise capital for Nexity without government assistance because of the level of perceived losses in its loan portfolio. Once it was decided that any transaction would need to involve an FDIC receivership action, and we started working on an assisted deal with Michael Gillfillan and Andrew McGhee at AloStar, it was very straight forward to assemble the private equity group. All four firms really worked well together evaluating the opportunity, although they each evaluated the opportunity independently and their boards approved their bids.

Was there anything else about this deal that you thought was distinctive or unusual?

The regulators, including the Federal Reserve and the Alabama Banking Department, worked very closely with the old Nexity management team and the new AloStar team for months. They were unbelievably helpful in terms of evaluating and facilitating this transaction. We felt that the regulators were partners in solving a problem and they worked with both management teams to find the lowest cost solution for a troubled bank. I really believe that was critical.  We also had an outstanding management team at AloStar that had the depth of experience to work through the deal and also had the expertise to implement the new business plan.

Why is this deal important to the rest of the industry?

It demonstrates that thoughtful and creative solutions involving private equity, when they are appropriately structured, will be well received and approved by the regulators. I think the private equity partners here were terrific and cooperative and very helpful. They put in $160 million and were thoughtful and constructive about how that was done.

Why bank stocks underperform

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Fred Cannon and Melissa Roberts of Keefe, Bruyette and Woods spend a lot of time dissecting the markets to understand financial stocks. Here, they give their views on how capital raises have affected the long-term performance of bank stocks, and which banks will do best when interest rates rise.

melissa-roberts.jpgMelissa Roberts is the senior vice president of quantitative research at Keefe, Bruyette & Woods. She leads a team of financial services research analysts. She holds a degree in Economics from Colgate University.

fred-cannon.jpgFred Cannon is the director of research and chief equity strategist for Keefe, Bruyette and Woods.  He has worked as Director of Investor Relations both for Golden State Bancorp and Bank of America. Fred holds a Master’s Degree from Cornell University and BS Degree from the University of California at Davis, both in agricultural economics.

What might change the underperformance of banks going forward?

Fred: It’s very important to recognize that the banks have underperformed the broad market for the last couple of years not necessarily because they haven’t been able to generate earnings, but because they’ve diluted the share count so much because of the capital raising.  It means stock prices just can’t recover to their pre-crisis levels. Citibank’s share count went from 5 billion shares to 30 billion shares.   

How much equity are financial companies raising?

Melissa:  For the entire market, they usually contribute roughly 40 percent to 50 percent in a non-crisis period.  When we got to the height of the crisis in 2008, they contributed as much as 87 percent of the total additional capital that was being raised, and that was primarily due to the TARP issuances.  In the first quarter of 2011, we found out financials were around 50 percent, but the bulk of that additional capital was really for real estate companies, not banks. 

You do a lot of other research on financials.  What surprising or interesting factors have you found influence bank stocks?

Melissa:  If you look at a stock that has a large amount of short interest, it could sometimes be thought of as a future positive for the stock, because if you’re not saying that that stock’s going to go to zero, at some point, those shorts have to cover. The large-cap banks had a maximum short interest level on March 31, 2009, where 5.9 percent of tradable shares were owned by investors shorting the stock.  Then they came down to a minimum on August 13th of 2010 of 2.6 percent. As the short interest levels were coming down in large-cap banks, those shorts were forced to cover the stock and that probably was a contributing factor to some of the outperformance of the large-cap banks.  What’s also interesting here is that if you look at when the large-cap banks hit a minimum, it’s almost simultaneous with when the regional banks hit a maximum. It seems like investors are rotating their themes.

Fred:  But I have to say some heavily shorted stocks did go to zero, so that theory doesn’t always work.

What will be the impact of rising interest rates on bank stocks?

Fred:  What you’re really looking for is banks that have both very sticky deposits that won’t leave, even when rates go up, and variable rate loans that will adjust upward with higher interest rates. I think on our list some of the ones who’ll benefit the most include Silicon Valley Bank, The PrivateBank out of Chicago, and Comerica. We believe that the Fed is on hold for short-term interest rates until the second half of 2012.  We think that until bank lending begins to grow, the Fed is going to be on hold. Ironically, the region of the country that has the slowest loan growth historically is now having the best, which is the Northeast. M&T Bank and then First Niagara, I think those are two good examples of banks who avoided much of the sins of the financial crisis, as their region did, and now are able to grow. 

What are bank investors looking for now?

Fred:  The bank stocks haven’t performed great in the first quarter, but 74 percent of the 79 bank stocks we track met or beat earnings in the first quarter. It’s not just about beating earnings; it’s also about showing that you can grow your revenue.

Forward looking statement:  We believe that the Fed is on hold for short-term interest rates until the second half of 2012.  We think that until bank lending begins to grow, the Fed is going to be on hold.

What audit committees need to know

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Robert Fleetwood, a partner in Chicago-based law firm Barack Ferrazzano who specializes in financial institutions, will be speaking at Bank Director’s Bank Audit Committee conference June 14-15 in Chicago.  Here, he discusses the increasing importance of audit committees understanding capital issues, the advent of risk committees, and the one thing all audit committee members should do.

What is the most important thing that audit committees should be focusing on in today’s environment?

I am always hesitant to say that there is one “most important” issue or factor on which audit committees should be focused. Proper governance and adhering to practical, sound procedures are always critical, and should never be dismissed or overlooked.

audit-mtg.jpgFrom an issue standpoint, it is critical that audit committees, as well as the entire board, understand the ever-increasing importance of capital in the industry’s current environment. The audit committee must understand the organization’s capital structure, the risks inherent within that structure, and the possible effects of Dodd-Frank, Basel III and the overall regulatory environment. As the past few years have illustrated, capital is key. An organization must have a clear plan regarding how to maximize its capital resources now, and how to keep its options open for the future. The audit committee can play a key and important role in that overall process.

How have the responsibilities for audit committees changed during the last few years?

One change that I have witnessed over the past few years is the audit committee’s evolving role in overall risk management. A few years ago, it was common to have the audit committee oversee the organization’s board-level risk management. As audit committees became more and more overwhelmed, enterprise risk management systems have developed and risk committees have become more common.

Recently, it has become more common that overall risk management is not centered with the audit committee, particularly at larger organizations, but instead with a risk committee or the board generally. This is filtering down to smaller organizations, but in my experience smaller companies still are more likely to have the audit committee involved in overall risk management practices. I expect that this trend will continue to evolve over the next few years.

Name a best practice that you would like to see more audit committees adopt.

There are actually a number of best practices that many audit committees do not adopt or implement, often for very good reasons. We stress that there is not a “one size fits all” when it comes to governance. Just because one of your peers implements something, does not mean that you have to adopt it, particularly if it doesn’t make sense within your organization.

One practice that is applicable to all companies, all boards and all committees, however, is the importance of having directors actively participate, ask questions and engage in meaningful dialogue with management, the company’s advisors and other directors. We often hear of situations in which directors have not asked any questions, or did not engage in any meaningful discussions, regarding important decisions affecting the company. Not only does this potentially hinder the decision-making process, but it may not allow the directors to adequately establish that they satisfied their fiduciary duties in the decision-making process. The lack of participation, or the lack of proper documentation of participation through meeting notes and other mechanisms, opens the organization, as well as the directors, to potential liability if the action ultimately has a negative impact on stakeholders.  

 

Bank Stocks Rise as Loan Losses Decline

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How do investors see the banking sector right now, and why are they buying bank stocks?

Most of the tone is fairly optimistic and bullish. You want to own bank stocks when you’re going through a credit recovery cycle. Mergers and acquisitions is another big theme that stimulates investor interest.

What are some of the factors that will drive bank stock valuations in 2011?

It’s early yet, but the names that are outperforming so far are those that still are seeing declines in nonperforming assets, declines in reserve levels and net interest margin improvement.

How will M&A drive stock values?

With valuations at trough levels for some decent banks, not specifically broken banks, but banks in good markets, with good deposit share, I think there is a great investment opportunity to own a basket of potential sellers.

How much M&A activity do you expect this year?

I expect considerable amount and even more in 2012 and beyond.  My outlook for the economy is still going to be low growth, especially for the banking sector.  Banks are going to have to grow through consolidation. They’re going to have to grow through collapsing the cost structure.

It’s been a couple of years since we had a strong M&A market.  Do you think investors still remember that not all acquirers are created equal and that an acquisition can destroy value if it’s not executed properly? 

We’re reminding investors about exactly your point. You want to be in a position to own the acquirers that have shown a track record of managing the capital base well, extracting earnings power, getting the costs out, and being mindful of the cultural differences within the banks.  I think this year will be a year where any M&A is almost good M&A, but a higher level of scrutiny will be placed on deals the further we get into this cycle.

How did investors react to the Dodd-Frank Act?

The elevated expense structure is probably going to prevent banks from achieving 15 percent return on equity or 1.5 percent return on assets, which they historically produced. You’re going to get volatility in the near term. Partially, that’s because we don’t really know what the profit model is going to look like for banks.

How do investors feel about the higher capital requirements for the industry?

Investors think the capital levels are too high, and they want to see these banks deploy it or leverage it as much as they can. The investment community has much more foresight and vision than the regulatory community. The regulators are looking in the rearview mirror and saying, “We need to build capital now.”  I think the investors have it right, quite frankly, and the regulators have it wrong.

In an environment like this, I thought we’d see more emphasis on efficiency.  I can remember a time, five to seven years ago, when there was a premium in your stock if you were a low-cost operator. Is this something that investors are focused on?

Banks are not very good in general about finding ways to cut the expense line when they see revenue decreasing. I would argue banks, in general, are still overstaffed. From a technological perspective, they still haven’t embraced efficiencies in processes and procedures. I think that’s a theme that’s not being talked about very much right now, but I think it will emerge as a much more important factor as we continue with low revenue growth.

Are there a couple of banks historically that have a reputation for being good low cost operators?

The one that comes to mind is (Paramus, New Jersey’s) Hudson City (Savings Bank). These guys operate at an 18 to 22 percent efficiency ratio.

Forward-Looking Statement

“With valuations at trough levels for some decent banks—not specifically broken banks—but banks in good markets, with good deposit share, I think there is a great investment opportunity to own a basket of potential sellers.”