Lending in an Uncertain Economic Environment

Joe Evans, chairman and CEO of State Bank Financial Corp out of Atlanta, shares his lending strategy in a weak economy and tumultuous real estate market in Georgia.

Over his 30 year career, Joe Evans has run some of Georgia’s beset community banks. In December 2006, Joe Evans sold Atlanta-based Flag Financial Corp. to the U.S. arm of Royal Bank of Canada for $456 million. Since starting State Bank, Evans and his team have acquired several failed banks in the Metro Atlanta area.

In 2011, State Bank was named the top performing bank in the United States by Bank Director magazine in our 2011 Bank Performance Scorecard, a ranking of the 120 largest U.S. publicly traded banks and thrifts.

Watch the below video filmed during Bank Director and NASDAQOMX’s inaugural Boardroom Forum on Lending held last December in New York City.

Bank Buildings: When Directors Are the Landlords

landlord-keys.jpgDuring the mid-2000s, it was commonplace for a bank, particularly a de novo bank, to lease some or all of their bank facilities from an entity controlled by the bank’s directors.  At the time, these arrangements truly represented a “win-win” situation.  The bank was able to occupy built-to-suit facilities while conserving liquidity so that cash could be deployed  through making loans with attractive yields.  At the same time, the directors, many of whom were real estate professionals, were able to make a sound real estate investment with the knowledge that a very stable tenant would occupy the property.

As we know, much has changed since the mid-2000s.  Vacancies in commercial properties have caused market lease rates to plummet.  Similarly, market values of commercial properties have decreased substantially.  Many banks have excess liquidity caused by soft loan demand, making a potential investment in fixed assets more attractive.

Because many of these leases were written with five-year initial terms, a number of banks are now weighing their options with respect to renewal, extension or renegotiation of the leases.  To make matters more complex, many director-controlled entities borrowed money to construct the bank facilities.  If those notes had five-year terms, they are coming up for renewal, and the lending bank may be eager to move the commercial real estate loans off of its books.

This fact presents a particularly difficult challenge for the affected directors.  Banking regulations require that transactions with affiliates be made on terms at least as favorable to the bank as those terms prevailing at the time for transactions with unaffiliated parties.  Most bank directors understand their duty to act in the best interests of the bank, but they are also facing personal financial exposure if the lease is not renewed on terms that allow the entity to continue to service its debt obligations.  In addition, given public scrutiny of directors and officers who are perceived to have profited at the expense of the bank they serve, creating a proper process to manage these situations has never been more important.

While state law should be consulted regarding the appropriate process for analyzing and approving a transaction with an affiliate, the following best practices are helpful in reaching a fair and appropriate resolution to transactions between a bank and its affiliates.

  • Wear your “bank hat.”  It is imperative that any director with a financial interest in the transaction focus on making the appropriate decision for the bank.  Directors should understand that these transactions are likely to be heavily scrutinized by regulators and could potentially be scrutinized by shareholders.
  • Allow independent directors to take the lead.  To the extent that two or more directors do not have financial interests in the transaction, appoint them to a committee with full authority to analyze and negotiate the renewal of the lease.
  • Rely on third party experts.  Engage trusted third parties, such as appraisers and other real estate experts, to provide information to the board (or independent committee) regarding the bank’s alternatives.  In addition, ask management to prepare a lease/buy analysis based on the bank’s existing and projected liquidity and its ability to leverage that liquidity.
  • Document carefully.  Remember, if it is not documented, it did not happen.  Be sure that all relevant considerations, discussions and reports are fully documented.
  • Consider all relevant factors.  While an appraisal or other analysis of market lease rates is helpful, also consider the “soft” costs of failing to renew the lease, which might include

    • employee downtime related to moving;
    • additional marketing expense created by advertising the move and updating existing marketing materials;
    • reputation risk created by leaving the existing location vacant; or
    • loss of branding associated with the existing location.

While a situation involving a lease of property from a director-controlled entity can be addressed using these best practices, they also can be used in analyzing a lease between the bank and its holding company.  In addition, they can be helpful in renegotiating a lease with a third party or deciding to purchase facilities that the bank currently leases.  Regardless of the circumstances surrounding a decision regarding the bank’s facilities, bank directors should familiarize themselves with all available alternatives in order to make the best decision for the bank.

The Loan Conundrum

Steve-Trager.jpgSteve Trager is president and CEO of Republic Bancorp, Inc., a Louisville, Kentucky-based, $3.1 billion-asset publicly traded company with 43 bank branches in Kentucky, Florida, Indiana and Ohio. Despite the crummy economic environment, poor loan demand and high regulatory demands, Republic Bancorp has maintained high profitability; even with half its loans in residential mortgages, and most of the rest in commercial real estate, construction, business and consumer loans.

Republic Bancorp had the second and third highest return on average assets and return on average equity last year, and the fifth best performance overall in Bank Director magazine’s ranking of the top 150 banking companies in the nation.

To be sure, the bank has experienced problems, too.  Its non-performing assets are 1.28 percent of total loans as of the second quarter, a decline from previous quarters, and it took a $2 million charge in second quarter earnings over a civil penalty from the Federal Deposit Insurance Corp. relating to its IRS tax refund anticipation loan service.  (The company says it will contest the fine before an administrative law judge and will work to make sure its tax firm clients comply with applicable banking regulations).

Trager talked to Bank Director recently about how he’s handling the challenges of the current regulatory and economic environment.

Can you talk about what sort of lending you do?

The challenge for us in residential mortgages is we compete with a government product that is a 15- and 30-year fixed rate at 3.5 percent for 15 years and 30 years at 4.25 percent and only the government would make a 15- or 30-year fixed rate loan at those kind of rates, with that kind of interest-rate risk. We are proud to be able to offer that government product to our customers as well and we service that product as a competitive edge. Every single one of our products is delivered by a Republic Bank banker as opposed to a broker and that is competitive difference for us. We sell those (government-backed) loans on the secondary market so we don’t keep them on our books.

So what kind of residential mortgages do you keep in your portfolio?

There’s an expanding universe of people who aren’t able to comply with the government’s rigid requirements. Some of those requirements don’t reflect credit quality. Some folks are very capable with good debt service characteristics, low loan-to-value. They might want to buy a condo and the secondary market is very difficult for condos.

We would love to expand our offering to an even bigger group of customers who are very credit worthy, if we could get a little better pricing. The biggest risk today is regulatory risk. The mortgages we do, the rates we do, and whom we make them to, is just subject to so much scrutiny, that we can’t take a chance to expand our portfolio credit offering to those who need it.

Didn’t your $2.2 billion loan portfolio grow a little bit in the second quarter, by 2 percent?

Absolutely, (it grew) by about $50 million. That was a little bit more than half commercial and some residential. I think customers see Republic Bank and our financial health as a stable, long-term option.

We’re still in the market for residential mortgages because we have enough size and enough volume. The risks are so great that it has pushed a lot of other lenders out of the market. Any mortgage loan we make, we’ve got to gather tons of fields of demographic information, for thousands of loans per year. It frustrates customers.

Have you loosened your underwriting standards recently?

We have not. Our underwriting standards have remained relatively stable over the last five years. I do worry that in this market, where there is not much loan demand and a lot of banks in desperate need of loans that that’s a dynamic that might cause some to stretch their underwriting models. We’re never going to sacrifice the long-term viability of Republic Bank or our customers for short-term gain.

Your focus has been maintaining a highly profitable bank. You saw profits rise 50 percent in the first half of the year compared to the same time a year ago to $80 million. How?

I think it’s a combination of the stability that our core bank provides. We haven’t been haunted by credit quality. We have had good demand from both the deposit and loan side. It’s just trying to do the right thing over and over again for a long period of time, and having the right people do it. We’ve got 780 associates and they do a spectacular job.

We also have niche businesses that supplement our bottom line. We are the largest provider of electronic tax refunds in the country. We service folks like Jackson Hewitt, Liberty and other tax services around the country, processing electronic refunds for their customer base. A small percentage of the customers would like to get an advance on their refund within 24 or 36 hours. That represented about 700,000 of our four million tax refund customers in the first quarter.  For the rest, when the IRS pays it, we make sure our customers get it quickly.

What advice do you have for other bankers in this difficult time to grow lending?

Go out and encourage and support a good lending staff. Get out and pound the pavement. Our lending staff is very incentivized to do that. Their incentives are tied to loan quality. Part of their annual bonus is determined by production and delinquency. We are fortunate enough to have had a lot of folks who have been with us for a long period of time, and that helps.