Should Community Bankers Worry About Digital Transformation?

fintech-8-28-15.pngI was sitting in a group discussion at Bank Director’s Chairman/CEO Peer Exchange earlier this year when the subject of the fast growing financial technology sector came up. That morning, we had all heard a presentation by Halle Benett, a managing director at the investment bank Keefe, Bruyette & Woods in New York. The gist of Benett’s remarks was that conventional banks such as those in attendance had better pay attention to the swarm of fintech companies that are targeting some of their traditional product sectors like small business and debt consolidation loans.

The people in the room with me were mostly bank CEOs and non-executive board chairmen at community banks that had approximately $1 billion in assets, give or take a hundred million dollars. And I would sum up their reaction as something like this: “What, me worry?”

In one sense I could understand where they were coming from. Most of the participants represented banks that are focused on a core set of customers who look and act a lot like them, which is to say small business owners and professionals in their late forties, fifties and sixties. The great majority of community banks have branches, which means they also have retail customers, but their meat and potatoes are small business loans, often secured by commercial real estate, and real estate development and construction loans. I suspect there’s a common dynamic here that is shared across the community banking sector, where baby boomer and older Gen X bankers are doing business with other boomers and Gen X’ers, and for the most part they relate to each other pretty well.

There are two trends today that bear watching by every bank board, beginning with the emergence of financial technology companies in both the payments and lending spaces. The latter is the subject of an extensive special section in the current issue of Bank Director magazine. I believe the fintech trend is being driven in part by a growing acceptance—if not an outright preference—for doing business with companies—including banks and nonbank financial companies—in digital and mobile space. The fintech upstarts do business with their customers almost exclusively through a technical interface. There is no warm and fuzzy, face-to-face human interaction. Today, good customer service is as likely to be defined by smoothly functioning technology as by a smiling face on the other side of the counter.

The other trend that all banks need to pay attention to is the entry of millennials—those people who were born roughly between the early 1980s and early 2000s—into the economy. Millennials can be characterized by a number of characteristics and behaviors: they are ethnically diverse, burdened with school debt, late bloomers from a career/marriage/home ownership perspective and they generally are social media junkies. They are also digital natives who grew up with technology at the center of so many of their life experiences and are therefore quite comfortable with it. In fact, they may very well have a preference for digital and mobile channels over branches and ATMs. Although digital and mobile commerce have found widespread acceptance across a wide demographic spectrum, I would expect that the digital instincts of millennials will accelerate their popularity like the afterburner on a jet fighter.

Although they now outnumber boomers in the U.S. population, millennials are not yet a significant customer segment for most community banks. And the universe of fintech lenders is still too small to pose a serious market share threat to the banking industry. But both of these trends bear watching, especially as they become more intertwined in the future. The youngest boomers are in their early fifties. The cohort that follows, the Gen X’ers, is much smaller. Who will bankers be doing business with 10 years from now? Millennials, you say? But will millennials want to do business with bankers then if an increasing number of them are developing relationships with a wide variety of fintech companies now?

A board of directors has an obligation to govern its company not only for today, but for tomorrow as well. And these two trends, particularly in combination, have the potential to greatly impact the banking industry. Learning how to market to millennials today by focusing on their financial needs, and studying the fintech companies to see how community banks can adapt their technological advancements, is one way to prepare for a future that is already beginning to arrive.

For research on millennials and growth in banking, see Bank Director’s 2015 Growth Strategy Survey.

How to Safely Generate Bank Income Through SBA Loans

sba-loans-8-19-15.pngSmall Business Administration (SBA) lending is one of the key lending activities that can quickly and dramatically improve the bottom line of a community bank. It is not that difficult for a bank to generate $20 million in SBA loans, which will earn the institution between $1.0 to $1.2 million in pretax net income, if the loan guarantees are sold. Some bankers get concerned because they have heard stories of the SBA denying loan guarantees and that the SBA loan process is too time consuming and complex.

Sourcing SBA Loans
The basic strategies that most successful SBA lenders use to source SBA loans are as follows:

  1. Hire an experienced SBA Business Development Officer (BDO), who can find loans that fit your credit parameters and geography.
  2. Source loans from brokers or businesses that specialize in finding SBA loans.
  3. Utilize a call center to target SBA borrowers.
  4. Train your existing staff to identify and market to SBA loan prospects.

I have put these in the order of which approach is likely to be the most successful. However, ultimately it is the speed of execution that enables one lender to beat out another in the SBA business. So if you want to hire that high producing SBA BDO, the bank needs to have a clear idea of the types of credits that they will approve and a process that can quickly get them approved.

This can create a catch 22 for the lender, since in order to justify hiring SBA underwriters and processing personnel, you have to make sure that you generate loans. But in order to recruit those top performing SBA BDOs, you will need to show them that you have a way of getting their loans closed quickly.

The most effective solution for solving these problems is to hire a quality SBA Lender Service Provider (LSP).  This is the quickest way to add an experienced SBA back shop that will warranty its work and handle the loan eligibility determination, underwriting, processing, closing, loan sale and servicing. This gives the bank a variable cost solution, and allows them to have personnel to process 100s of loans per year. While some of the better LSPs will help the lender with the underwriting of the loan, it is solely the bank that makes the credit approval decision. SBA outsourcing is very cost effective and allows a bank to begin participating and making money with these programs immediately, even if they only do a few loans.

Making a Profit
Let us look at the bank’s profits from a $1.0 million SBA 7(a) loan that is priced at prime plus 2.0 percent with a 25-year term.

Loan amount $1,000,000  
Guaranteed portion $ 750,000  
Unguaranteed portion $ 250,000  
Gain on the sale of the SBA guaranteed portion $ 90,000 (12% net 14% gross)
Net interest income(5.25%-0.75% COF = 4.5%) $ 11,250 (NII on $250,000)
Servicing Income ($750,000 X 1.0%) $ 7,500  
Total gross income $ 108,750  
Loan acquisition cost (assumed to be 2.5%) $25,000 (BDO comp, etc.)
Outsource cost (approximately 2.0%) $ 20,000 (per SBA guidelines)
Annual servicing cost (assumed to be 0.50%) $ 5,000  
Loan loss provision (2.0% of $250,000) $ 5,000  
Total expenses $ 55,000  
Net pretax income $ 53,750  
ROE ($53,750/$25,000 risk based capital) 215%  
ROA ($53,750/$250,000) 21.5%  

In this example the bank made a $1.0 million SBA loan and sold the $750,000 guaranteed piece and made a $90,000 gain on sale. The bank earned $11,250 of net interest income on the $250,000 unguaranteed piece of that loan that the bank retained. When an SBA guaranty is sold, the investor buys it at a 1.0 percent discount, so the lender earns a 1.0 percent  ongoing fee on the guaranteed piece of the loan for the life of the loan. This example  did not account for the amortization of the loan through the year.

I believe that the expenses are self explanatory, but you can see if the bank made $20 million of SBA loans using these assumptions, they would earn $1.075 million in the first year.

As you can see, SBA lending can add a substantial additional income stream to your bank; however, you need a certain amount of loan production and a high quality staff, or you need an SBA outsource solution to underwrite and process the loans. As you can see, the ROE and ROA for SBA loans is much higher than conventional financing, which is why you see community banks that have an SBA focus generate higher returns.

How the New FDIC Assessment Proposal Will Impact Your Bank

growth-strategy-8-14-15.pngIn June, the Federal Deposit Insurance Corp. (FDIC) issued a rulemaking that proposes to revise how it calculates deposit insurance assessments for banks with $10 billion in assets or less. Scheduled to become effective upon the FDIC’s reserve ratio for the deposit insurance fund (DIF) reaching a targeted level of 1.15 percent, these proposed rules provide an interesting perspective on the underwriting practices and risk forecasting of the FDIC.

The new rules broadly reflect the lessons of the recent community bank crisis and, in response, attempt to more finely tune deposit insurance assessments to reflect a bank’s risk of future failure. Unlike the current assessment rules, which reflect only the bank’s CAMELS ratings and certain simple financial ratios, the proposed assessment rates reflect the bank’s net income, non-performing loan ratios, OREO ratios, core deposit ratios, one-year asset growth, and a loan mix index. The new assessment rates are subject to caps for CAMELS 1- and 2-rated institutions and subject to floors for those institutions that are not in solid regulatory standing.

While the proposed assessment rates reflect a number of measures of an institution’s health, provisions relating to annual asset growth and loan mix may influence a bank’s focus on certain categories of loans and the growth strategies employed by many community banks in the future. We’ll discuss each of these new assessment categories in turn.

One Year Asset Growth
Under the proposed assessment rules, year-over-year asset growth is subject to a multiplier that would have, all other things being equal, the effect of creating a marginal assessment rate on a bank’s growth. In the supporting materials for the FDIC’s rulemaking, the FDIC indicates that it found a direct correlation between rapid asset growth and bank failures over the last several years. But while organic asset growth is subject to the new assessment rate, asset growth resulting from merger activity or failed bank acquisitions is expressly excluded from the proposed assessment rate. This approach is somewhat counterintuitive in that most bankers would view merger activity as entailing more risk than organic growth or growing through the hiring of new teams of bankers. While the new assessment rate might not be significant enough to impact community bank growth strategies on a wide scale, it may offset some of the added expense of a growth strategy based upon merger and acquisition activity.

Loan Mix Index Component
This component of the assessment model requires a bank to calculate each of its loan categories as a percentage of assets and then to multiply each category by a historical charge-off rate provided by the FDIC. The higher the 15-year historical charge-off rate, as weighted according to the number of banks that failed in each year, the higher the assessment under the proposed rules. Unsurprisingly, the proposed rules assign the highest historical charge-off rate (4.50 percent) to construction and development loans, with the next highest category being commercial and industrial loans at 1.60 percent. Interestingly, the types of loans with the lowest historical charge rates are farm-related, with agricultural land and agriculture business loans each having a 0.24 percent charge-off rate.

While the new loan mix index component is a clear reflection of the impact of recent bank failures on the current assessment rates, it may also create economic obstacles to construction lending, which continues to be performed safely by many community banks nationwide. Despite these positive stories, there is no doubt as to the regulators’ views of construction lending—in conjunction with the new Basel III risk-weights also applicable to certain construction loans, community banks face some downside in continuing to focus on this category of loan.

However, when considering the asset growth and loan index components together, community banks that have a strong pipeline of construction loans may have added incentive to complete an acquisition, particularly of an institution in a rural market. Not only can the acquiring bank continue to grow its assets while incurring a lower assessment rate, it can also favorably adjust its loan mix, particularly if the seller has a concentration of agricultural loans in its portfolio. In general, acquirers have recently focused their acquisition efforts on metro areas with greater growth prospects, but the assessment rules may provide an incentive to alter that focus in the future. In many ways, the proposed assessment rates provide bankers an interesting look “behind the curtain” of the FDIC, as this proposal clearly reflects the FDIC’s current points of regulatory concern and emphasis. And while none of the components of the proposed deposit insurance assessments may have an immediate impact on community banks, some institutions may be able to reap a substantial benefit if they can effectively reflect the new assessment components in their business plan going forward.

Some Forms of Bank Capital Are Making a Comeback

capital-markets-8-10-15.pngSubordinated debt and preferred equity securities are making a comeback, with small community banks placing private offerings among high net worth investors and pooled investment vehicles alike with greater frequency and ease than in years past.

After years of worrying about whether community banks would survive the economic downturn, investors appear to be willing to tolerate the higher risks of subordinated debt, which falls behind senior debt but ahead of equity instruments in a bankruptcy. Major players like StoneCastle Financial and EJF Capital have established investment vehicles to acquire subordinated debt and other fixed-rate securities from community banks. These funds generally seek investments from $2 million to $15 million per institution, with rates from 6 percent to 8 percent and maturities of five, seven or 10 years.

For smaller community banks that have largely been frozen out of capital markets since the beginning of the Great Recession, the thaw presents a welcome opportunity because the benefits of such securities are significant for issuers. First, they do not dilute existing shareholders as occurs in any issuance of common stock. Second, for debt securities, interest payments are tax deductible, unlike dividends to holders of common or preferred shares. Finally, the proceeds of such securities, which may qualify as Tier 2 capital at the bank holding company level, are treated as Tier 1 capital when injected into a subsidiary bank if the company qualifies as a “small bank holding company.”

This shift in the market comes as more banks have the opportunity to use holding company debt to finance bank growth thanks to recent amendments to the Federal Reserve’s Small Bank Holding Company Policy Statement, which increase the policy’s consolidated assets threshold from $500 million to $1 billion and extend coverage to savings and loan holding companies.

As bankers consider whether these securities are the right way to boost their balance sheets, there are at least three major legal issues to consider before making an offering:

  • First, does the instrument qualify for capital treatment under Federal Reserve and Federal Deposit Insurance Corp. rules? For subordinated debt securities, there are a number of boxes that need to be checked to ensure an offering will qualify for Tier 2 capital treatment under Federal Reserve rules, such as subordination requirements, the elimination of common acceleration provisions, minimum maturity periods and the absence of other provisions designed to protect debtholders. Likewise, for preferred securities to qualify for favorable capital treatment, dividends must be noncumulative and redemption rights, if any, must be at the option of the issuer only. Federal Reserve regulations and policy statements generally require that redemption of these securities be conditioned upon receipt of prior Reserve Bank approvals.
  • Second, does the offering comply with federal and state securities laws? To qualify for an exemption under the securities laws, it is common to limit subdebt and preferred stock offerings to accredited investors only. However, even under those circumstances, it is important to provide full and fair disclosure to prospective investors to ensure that the offering is eligible for an exemption. As such, an offering memorandum should be prepared for the private offering that complies with applicable federal and state securities laws.
  • Finally, will the subdebt be sold to individuals or to a pooled investment vehicle? The aggregation of community banks’ subdebt into pools that will be sold to institutional buyers bears a striking resemblance to the pools of trust-preferred securities that proved so challenging to deal with during the last financial crisis. If your company’s subdebt will be issued to a pool, it is important to understand the legal mechanisms that will be available and with whom you will be dealing if there is an event that causes a payment to be missed.

Many community banks are seizing the moment, using such offerings to refinance debt, finance growth, redeem the Small Bank Lending Fund or trust-preferred securities, and pursue acquisitions in a way that is not dilutive to holders of common stock.

That said, subdebt or preferred stock may not be the best option available for all banks, particularly those with minimal holding company senior debt. For those that have not exhausted options to obtain bank stock loans, that market also has thawed and offers rates that are often 100 to 200 basis points less than coupons payable on subordinated debt or preferred equity.

How Community Banks Can Grow Loans by Partnering With Competitors

bank-capital-8-5-15.pngWhat many bankers have seen as the industry’s greatest peril is suddenly becoming their most powerful possibility: shadow banking. Shadow banking is frequently the term used to describe nonbanks who offer services and products that are similar to what banks offer. A new business model for community banks is transforming shadow banks from rivals to partners, enabling the two worlds to partner to compete with the biggest banks in ways community banks standing alone never could.

How could shadow banks that often compete directly with banks instead enable something entirely different? Imagine a world in which community banks—currently limited by their smaller scale in the array of products and services they can deliver to their customers—combine their acclaimed community focus, service and customer experience with the reach, depth, technology and convenience of direct nonbank lenders.

That sounds, but isn’t, almost too good to be true. The explanation lies in both what community banks already know—what separates them from the largest banks—and in what they may not: the ways in which shadow banking has evolved, offering products that can complement and empower rather than compete and threaten.

The biggest institutional banks—the five to 10 largest—are often inefficient, stodgy and misaligned. They resist innovation. Their legacy burdens include bad systems, faceless and painful customer experiences, and regulatory issues. Yet they have the capital and reach to provide consumer loans, often at interest rates that can top 20 percent (think credit cards) in a less competitive environment because community banks lack the scale to go up against them.

The more than 5,000 community banks in the country are innovative, agile and acclaimed for customer service. By definition, they can never be too big to fail. Together, they hold $2.3 trillion in assets—14 percent of the economy.

Yet as many types of lending have shifted from relationships to technology, community banks have lacked, first, the expertise, resources and scale to offer these services themselves, and, second, the technology to connect their own platforms with those that can. It’s little surprise that their share of the consumer lending market has collapsed from more than 80 percent to less than 10 in the last 25 years.

Recently, new nonbank lenders like Lending Club have exploited the inefficiency of the big banks by providing direct loans with best-in-class customer experiences. They offer better returns to investors and better rates to customers. But these new nonbank lenders have come to recognize they lack existing relationships with customers and low-cost, stable capital—exactly what community banks have in abundance.

A new model holds out the promise of combining the ideals of community banking—trust, service, relationships, low cost capital—with the best of these new nonbank lenders: scale, efficiency, technology and superior customer experience. The idea is to bind community banks together into alliances with nonbank lenders. This blends the service of the former with the lending platforms of the latter and allows each to do what it is uniquely good at—all while providing the customer with the best possible product and experience. The only losers: the biggest banks.

My organization, for example—BancAlliance—has gathered more than 200 bank members across 41 states into a collaborative pool with the scale and expertise to compete with the largest banks. We’ve assembled an innovative partnership between this group and Lending Club to offer community banks a consumer lending platform so they no longer have to turn away customers looking for consumer loans—and so they can focus on what they do and know best, which is serving individuals face-to-face. The first bank went live with offering loans through this partnership via its website just this summer.

Surely other models will emerge, and there will be enormous opportunities to replicate this approach to other products, such as unsecured small-business loans, that make sense (but are challenging) for community banks. Some trends are clear. One is that the big banks no longer own an exclusive title to this space. Another is that community banking remains as competitive—and crucial—as ever. Finally, and every bit as important, shadow banking is no longer solely competition for community banks. For community banks, the opportunities it presents are suddenly compelling and potentially transformative.

When Your CEO Becomes a Million Dollar Baby

5-20-15-Pearl.pngCEO compensation at community banks is often approaching $1 million or greater as bank profits and stock prices improve, and as merger and acquisition activity increases. Compensation committees are finding they must now address the cumbersome and confusing $1 million pay cap limitation under Internal Revenue Code (IRC) Section 162(m) in order to preserve the bank’s tax deduction for certain compensation payments. Understanding the regulation and how it applies to the bank’s compensation programs is the first step in developing an effective process for maintaining compliance. 

What is IRC Section 162(m)?

Public companies are prohibited from receiving a corporate tax deduction for compensation over $1 million paid to a covered employee (i.e., proxy-reported executive).  Under the code, compensation is based on the executive’s realized taxable wages in any given year, including actual incentives paid and the value of any vested shares and exercised stock options.  

However, Section 162(m) provides an exception for “qualified performance-based compensation” and this exception is widely used to exempt annual incentive plan payments and equity compensation from the $1 million limit. The requirements to qualify compensation as performance-based are summarized below.

Understanding How IRC Section 162(m) Applies

In general, the following types of compensation can qualify for the performance-based exception if Section 162(m) requirements are met:

  • Short-term incentive compensation with specific performance goals.  Discretionary components can be managed by creating a process that funds the plan at a maximum level using specific goals and exercising negative discretion to reduce the payouts.
  • Performance-based stock or stock units.  Goals need to be specified at the beginning of the performance period and generally should not include discretionary elements.
  • Stock option and stock appreciation rights.
  • Certain deferred compensation as long as the contribution is funded using specified performance goals.

What makes Section 162(m) confusing to many directors is that compensation must be qualified as performance-based at the time of award, even though realization of the compensation and its deductibility may be several years in the future.  In thinking through whether 162(m) may apply, directors need to foresee the level of compensation likely to be provided in the future. The future may include growing to an asset size where market-based compensation above $1 million is a reality for the CEO and other proxy-named executives.

Creating an Effective 162(m) Process

The first step in the process is to determine whether the bank is likely to be affected by 162(m). Target compensation provided to CEOs at banks with assets exceeding $1 billion generally begins to approach the $1 million level. Therefore, it is usually wise for public banks growing to that size during the time period in which a compensation program is paying out to proactively plan for compliance. The following suggestions can aid compensation committees in ensuring an effective process:

  • Incorporate all 162(m) language into an omnibus incentive plan. Having one plan in which annual incentives and equity compensation may be awarded keeps shareholder approval simple and eliminates the need to track multiple plans.
  • Add the process to qualify compensation as performance-based per 162(m) to the compensation committee’s calendar, keeping in mind the timing requirements for approval.
  • Develop a reminder system to ensure performance measures are approved by shareholders every five years as required by 162(m).
  • Obtain expert guidance whenever the committee is contemplating modifications to goals, accelerations and vestings. Individual modifications can disqualify awards from the performance-based exception for all covered employees.

Compensation committees have a responsibility to ensure that the bank preserves the tax deductibility of performance-based compensation. In doing so, compensation committees need to consider the bank’s future growth and how it relates to the compensation of their executive officers. Proper planning and development of a well-defined 162(m) process now can ensure the future deductibility of compensation expenses.

The key performance-based compensation requirements under the law:

  • The compensation terms (or plan) and performance measures are approved by shareholders within five years of the award date
  • Plan includes the maximum amount payable to any one covered employee
  • Performance goals are substantially uncertain at the time the goal is established
  • Compensation is awarded by a committee of at least two independent directors
  • Performance goals are established by the compensation committee within the lesser of 90 days or 25 percent of the performance period
  • Performance achievement is certified in writing by the compensation committee.

Opening the Consumer Lending Market for Community Banks

As recently as 1990, community banks had a 79 percent market share in consumer lending. Today, that share has dropped to just 8 percent as the biggest banks have capitalized on economies of scale to displace community banks. As a result, many community banks no longer have viable independent consumer lending businesses. Brian Graham, chief executive officer of Alliance Partners, an SEC-registered investment adviser that provides administrative services to BancAlliance and advisory services to BancAlliance members, explains how BancAlliance has partnered with Lending Club to offer community banks the chance to participate in this $3.2 trillion market.

Why did BancAlliance get into consumer lending?
BancAlliance exists to serve the goals of our member community banks, and those members have been asking us to explore approaches that would let them compete with the biggest banks for consumer loans. Based on extensive diligence and audits of potential partners, we have joined with Lending Club due to the scale and quality of its consumer finance business. 

How can community banks compete with large national banks in consumer lending?
BancAlliance allows community banks to collaborate, pooling their individual capabilities. Collectively, we are taking advantage of Lending Club’s highly efficient and advanced servicing and origination functions in order to provide our member banks a “plug and play” consumer finance platform. BancAlliance members can mimic the economies of scale that larger national banks experience by utilizing the tools Lending Club has had in place for years. Recent OCC guidance has encouraged community banks to “achieve economies of scale and other potential benefits of collaboration” in a January 2015 paper, and BancAlliance offers banks an opportunity to join together with a premier name in consumer lending.

Why Lending Club?
Lending Club is the market leader among lenders in unsecured consumer installment credit. Lending Club, which recently went public, is very focused on regulatory compliance matters, given that it works with several bank partners in addition to BancAlliance. Lending Club has well-defined policies and procedures that BancAlliance has validated through several outside reviews. BancAlliance believes Lending Club is a strong partner and is well-positioned to work with us and our members to help them return to their consumer lending roots. Additionally, Lending Club has stated that forming partnerships with community banks is a critical strategic activity, and is focused on fully developing the BancAlliance relationship.

What does this partnership entail?
BancAlliance partnered with Lending Club to allow community banks to offer their customers very competitive consumer loans, as well as to provide an opportunity for BancAlliance members to purchase bank-quality consumer loans from Lending Club’s platform. The joint nature of this relationship allows both parties to benefit from the other’s strengths.

What benefits does this partnership bring to bank customers?
For most bank customers, the interest rate on the consumer loan is well below that on credit cards or other debt. Lending Club provides consumers with a simple, fixed-rate product without teaser rates that can cause a consumer’s debt service to increase unexpectedly. On average, consumers borrowing on the Lending Club platform experience savings equivalent to 32 percent when compared to high-rate credit cards. In addition, since these loans are fully amortizing, the program puts customers on a path to reduce debt and improve their financial outlook and credit. According to Lending Club historical data, customers that take out a loan see an average FICO score increase of 23 points within three months of obtaining a Lending Club loan.

What benefits does this partnership bring to BancAlliance?
First, BancAlliance member banks benefit from the broader and deeper relationship with their customers and a larger share of wallet. Banks no longer have to tell their customers they cannot offer them this product. Second, banks enjoy higher levels of loans with attractive yields, as well as incremental fee income from referred loans. Banks enjoy risk benefits as well, diversifying their portfolios by loan type and geography. Most important, BancAlliance banks receive all of these benefits without having to make any material upfront investment and with minimal ongoing operational costs. Consumer lending is most efficient when done on a large scale basis, and this program allows community banks to mimic this scale without incurring the costs necessary to create it on their own.

Ownership Succession for Family-Owned Banks: Building the Right Estate Plan

4-15-15-BryanCave.pngFor a number of community banks, the management and ownership of the institution is truly a family affair. For banks that are primarily controlled by a single investor or family, these concentrated ownership structures can also bring about significant bank regulatory issues upon a transfer of shares to the next generation.

Unfortunately, these regulatory issues do not just apply to families or individuals that own more than 50 percent of a financial institution or its parent holding company. Due to certain presumptions under the Bank Holding Company Act and the Change in Bank Control Act, estate plans relating to the ownership of as little as 5 percent of the voting stock of a financial institution may be subject to regulatory scrutiny under certain circumstances. Under these statutes, “control” of a financial institution is deemed to occur if an individual or family group owns or votes 25 percent or more of the institution’s outstanding shares. These statutes also provide that a “presumption of control” may arise from the ownership of as little as 5 percent to 10 percent of the outstanding shares of a financial institution, which could also give rise to regulatory filings and approvals.

Upon a transfer of shares, regulators can require a number of actions, depending on the facts and circumstances surrounding the transfer. For transfers between individuals, regulatory notice of the change in ownership is typically required, and, depending on the size of the ownership position, the regulators may also conduct a thorough background check and vetting process for those receiving shares. In circumstances where trusts or other entities are used, regulators will consider whether the entities will be considered bank holding companies, which can involve a review of related entities that also own the institution’s stock. For some family-owned institutions, not considering these regulatory matters as part of the estate plan has forced survivors to pursue a rapid sale of a portion of their controlling interest or the bank as a whole following the death of a significant shareholder.

To preserve the institution’s value, significant shareholders should consider the regulatory and tax consequences associated with their estate plans. Here are some issues to consider:

  • Combined family ownership interests. A significant shareholder should consider not only her own stock ownership, but also that of her immediate family, when determining if any bank regulatory issues may apply. For purposes of the various statutory thresholds for determining control, ownership of immediate family members, including grandparents, siblings, and children, can be aggregated, leading to unexpected presumptions of control.
  • Types of estate planning entities. For many larger estates, a variety of estate planning vehicles can be involved, including revocable and irrevocable trusts, testamentary trusts, family partnerships, charitable trusts and other charitable entities, such as private foundations. However, federal regulations only provide a narrow “safe harbor” from the requirements of the Bank Holding Company Act, which has led to a number of estate planning structures being unexpectedly classified as bank holding companies.
  • Impacts to S corporations. Many family-controlled banks have elected to be taxed as S corporations in order to allow the institution’s earnings to be distributed to shareholders more directly. Estate planners should consider any barriers to transfer under an applicable shareholders’ agreement, especially if the owner contemplates transferring stock to an entity that is an ineligible shareholder under S corporation rules.
  • Corporate governance issues. Individuals that own a controlling interest in a financial institution should consider the impact of his or her death on the governance of the institution until the estate is settled and the shares transferred to new owners. If the controlling shares are unable to be voted due to an estate or trust dispute, governance tasks for the bank, such as holding an annual meeting or approving a merger, can be held in limbo. As a result, the appointment of capable and responsible executors and trustees is a critical step in any estate plan.
  • Strategic planning. Significant shareholders should consider the desires of the next generations when formulating an ownership succession plan. While some family members may have a desire to manage the bank in the future, others may simply desire liquidity or have other investment goals. Considering these desires and determining how an estate plan may affect the strategic plan of the institution can preserve value for the controlling family, the institution, and minority shareholders.

Family-owned financial institutions are built over a lifetime and the regulatory and tax issues associated with an ownership transfer can be mitigated with careful planning. Regardless of whether a family intends to transition active management to the next generation or to simply pass down the full value of their shares to their relatives, constructing a plan that considers the family’s goals, in addition to regulatory and tax matters, is essential.

Congress Makes Capital Requirements Easier for Small Banks

3-9-15-BryanCave.pngFor many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?” Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.

President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.

The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.

In light of this new law, the Federal Reserve has proposed these changes to its policy statement and recently announced parallel changes in reporting requirements for these small bank holding companies. The primary benefit of being deemed a “small bank holding company” is the exemption from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans, to finance growth.

This change should affect strategic and capital planning for all bank holding companies with consolidated assets of between $500 million and $1 billion and for all savings and loan holding companies with assets of less than $1 billion. These companies, which previously were required to comply with the capital requirements applicable to much larger institutions, can now use traditional debt at the holding company level to generate higher returns on equity. With trust preferred securities now a thing of the past, larger institutions cannot use debt or hybrid equity to meet their requirements for Tier 1 capital. Instead, larger institutions are left with traditional equity sources such as common stock and non-cumulative preferred stock, which typically carry a higher cost of capital.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.

While new threshold has not received much press, we believe it could and should have an impact on merger discussions involving smaller institutions. Those companies that will soon be considered “small bank holding companies” should revisit their financial projections to consider whether introducing debt funding at the holding company can increase returns on equity without taking on unwarranted financial risk. Boards may find that this change makes the option of staying independent more viable in the future. Potential acquirers of small banks should also be aware of this change in order to demonstrate that a potential transaction provides a better risk-adjusted return to shareholders than remaining independent. On both sides of the transaction, this relatively quiet change should generate a new way of analyzing the question, “Is bigger really better?”

2015 L. William Seidman CEO Panel

During Bank Director’s 2015 Acquire or Be Acquired conference in January, a panel of four community bank CEOs, all of whom are publicly traded, above $5 billion in asset size and are active acquirers discuss their different strategies for the future with our president, Al Dominick. This session is named after the former FDIC Chairman and Bank Director’s Publisher, the late L. William Seidman, who was a huge advocate of a strong and healthy community bank system.

Video length: 46 minutes

About the speakers

David Brooks – Chairman & CEO at Independent Bank Group
David Brooks is chairman and CEO of McKinney-headquartered Independent Bank Group, which currently operates 35 Independent Bank locations spanning across Texas. He has been active in community banking since the early 1980s and founded this company in 1988.

Daryl Byrd – President & CEO at IBERIABANK Corporation
Daryl Byrd is president and CEO of IBERIABANK Corporation. He serves on the boards of directors for both IBERIABANK Corporation and IBERIABANK, where he joined in 1999. Headquartered in Lafayette, LA, IBERIABANK is the 126-year-old subsidiary of IBERIABANK Corporation operating 187 branch offices throughout Louisiana, Arkansas, Alabama, Florida, Texas and Tennessee. With $15.5 billion in assets (as of October 31, 2014) and over 2,700 associates, IBERIABANK Corporation is the largest and oldest bank holding company headquartered in Louisiana.

Ed Garding – President & CEO at First Interstate BancSystem, Inc.
Ed Garding is president and CEO of First Interstate BancSystem, Inc. He has been chief executive officer of First Interstate BancSystem since April 2012, chief operating officer from August 2010 and served as an executive vice president since January 2004. Mr. Garding served as First Interstate’s chief credit officer from 1999 to August 2010, senior vice president from 1996 through 2003, president of First Interstate Bank from 1998 to 2001 and president of the Sheridan branch of First Interstate Bank from 1988 to 1996. In addition, Mr. Garding has served as a director of First Interstate Bank since 1998.

Mark Grescovich – President & CEO at Banner Corporation
Mark Grescovich is president and CEO at Banner Corporation. He joined Banner in April 2010 as president and became CEO in August 2010 following an extensive banking career specializing in finance, credit administration and risk management. Under his leadership, Banner has executed an extremely successful turnaround plan involving credit stabilization, improved risk management, a secondary public offering and other capital raising activities and a return to profitability based on net interest margin improvements.