Bank Director’s Story: How a Community Bank Survived the Financial Crisis and Continues to Thrive

2-25-14-alarion-bank.pngCo-founding two banks in the past 15 years, one right before the financial crisis hit, has taught me many invaluable lessons as a director. The first bank, which opened in 1999, was an incredible success. The second bank, opened in 2005, was one of the few banks that got started in that time frame to survive in Florida. That bank, Alarion Bank, has had two years of positive net income growth and a healthy dose of fee income. First, I will give you a historical picture.

I was an advisory board member of SouthTrust Bank in North Central Florida in the mid-1990s. Three of us left the bank and raised the money to open a state chartered community bank in 1999, Millenium Bank in Gainesville, Florida. Our greatest problem with the new bank back then was the expenses and worry over the impact of Y2K on our computer and banking systems. After January 1, 2000, when the technological and banking world did not end, it was smooth sailing all the way until we sold the bank for three times book value in just four years.

Shortly after the sale, I was approached by an executive of a larger bank who wanted to open another community bank. We opened Alarion Financial Services in 2005 after handpicking a board of directors and raising $20 million. By our organizational documents, we were only allowed to raise $15 million, so we had to return $5 million to our enthusiastic potential shareholders. We sold to more than 500 shareholders in order to increase our potential customer base and spread the ownership to include grassroots investors in our two communities. We had six locations in Alachua and Marion Counties in North Central Florida. In addition to our board of directors, we created an advisory council in each county. These community councils became very powerful in helping us attract new and veteran businesses as clients for Alarion Bank.

We were achieving all our milestones and were on top of the world. It looked like another success story in the making. Then came the economic crash, which was much worse in Florida than most other states. After tourism, one of the largest economic generators in Florida is real estate. Therefore, it made perfect sense that our bank, like most other community banks in the state, had a higher concentration of loans in real estate than other banks in the country. We had almost no manufacturing in our state.  In addition, Taylor Bean & Whitaker Mortgage Corp. suddenly closed in 2009 in Marion County, where our bank headquarters was located, and 1,000 jobs, many high paying, were lost.

How did we get through it? What are we doing today to make our $275-million asset bank grow successfully and be profitable? In 1999, I had attended a bank conference and the keynote speaker was Charles Hughes, former CEO of SouthTrust Bank of Florida, who spoke emphatically about how important fee income would be in the future because interest margins were thinning. Remembering this strong advice, when we opened Alarion in 2005, our approved organization plan contained a template for a strong residential mortgage division. We wanted this strong, stable fee income stream. My main role as a director in the new bank was to help build the mortgage division. I have owned the number one market share real estate company for more than 25 years in Gainesville, Florida. We put together a marketing agreement between my real estate company, Bosshardt Realty Services, and Alarion’s residential mortgage division. This plan was approved by all the appropriate regulators prior to the bank opening. Desk rental and marketing agreements are still working and working well. These agreements are common in the industry and, if done correctly, can be very profitable for banks. I had previously partnered in a joint venture with SunTrust Bank and it was profitable from the first month due to the base that was created by the real estate salespeople. However, my partner was in Richmond, Virginia, and my company was in Florida, and there was also a third party manager who was 40 miles from us. In the end, it was too complicated.

This time around, Alarion Bank hired two originators who rented prime spaces in our real estate offices and a processor as well. The poor economic conditions did not hurt our residential mortgage division because it derived its income from the top real estate salespeople in our area. Even though real estate sales were down dramatically, the top real estate associates still were productive. Refinances helped our business; however, our basic bread and butter has always been referrals from real estate agents. When Realtors find a good originator who gives good service, they keep bringing more buyers to them. The mortgage division of Alarion experienced great repeat business from our Realtors and the bank subsequently opened three more desk agreements with other real estate companies in surrounding counties.

Alarion has the top market share in mortgage purchase volume in our county, which is pretty good for a community bank. No one has really been able to understand why such a small bank with only six locations could do better than the banking giant in residential purchases. It even has had the regulators surprised. In 2013, Alarion did $150 million in residential mortgage volume. We did not do subprime loans: We work strictly within the Fannie Mae/Freddie Mac guidelines, and we sell to investors rather than direct to Fannie and Freddie. These investors each have their own requirements (known as overlays) in addition to Fannie and Freddie’s guidelines, so there is a tremendous amount of scrutiny over our files. Our bank also has its own in-house portfolio for various deals where we only do short-term, adjustable rate mortgages.

We hired and continue to retain an outside auditing firm to review all of our residential loans on a monthly basis, in addition to our extremely competent in-house compliance team. Our mortgage division has carried our bank through the worst of times. Our regulators seem pleased with our system of originating, selling and auditing loans. We are always coming up with more creative ways to secure more business and have built a template for success in residential lending for the future. What was once a small side line has now become the business with the best risk model.

At Alarion Bank, we found our banking niche to make the bank very profitable and get us through the difficult financial crisis. Diversity and economies of scale were very important to keep us going through the past six years. A community bank can still compete and win over the larger financial institutions by creating a “hypermart” model which puts different related financial businesses under one company with one set of overhead expenses. Those businesses could be insurance brokerage, warehousing, investment brokerage, or in our case, residential mortgage lending.

Maximizing the Value of Being Publicly Traded

1-20-14-OTCMarkets.pngMore than 600 community and regional banks trade on OTCQB, a public marketplace operated by OTC Markets Group, a company that operates financial marketplaces for 10,000 U.S. and global securities. R. Cromwell Coulson, president and CEO of OTC Markets Group, answers questions about how community banks can maximize the value of public trading even when they are not listed on a stock exchange. 

Q: What is your experience with the community and regional bank market?

I traded and invested in community banks when I worked as an institutional trader and portfolio manager at Carr Securities in the early 1990s. I specialized partly in value-oriented securities, so I was naturally drawn to small, publicly traded community banks, many of which traded on the off-exchange market.  

Years after I left Carr Securities, I led a group of investors to acquire the company that published the stock sheets where these and thousands of other off-exchange-traded securities were quoted. Our goal was to modernize what was inefficient and phone-based trading into modern, electronic trading and to create better informed and more efficient markets.

Today, my company, OTC Markets Group, operates three separate and distinct marketplaces: OTCQX, OTCQB and OTC Pink. Community banks continue to make up an important sub-sector of our market: There are more than 600 banks and thrifts ranging in size from $25 million in assets to $16 billion trading primarily on our OTCQB marketplace. 

Q: What are the benefits to banks of being publicly traded? 

There are five main benefits of being publicly traded that apply to all companies, including community banks: visibility, liquidity, valuation, capital, and reputation or trust.  

Community banks, like many companies, think of going public primarily as a way to raise capital that can be used as currency for capital improvements, purchases or to make acquisitions. Banks with a publicly available stock price are also viewed more favorably as acquisition candidates than those with a more opaque valuation. 

But the most successful publicly traded community banks, like the most successful public companies, are those that actively engage their shareholders and ensure their information is widely available to investors, whether through SEC filings or by publishing their news and disclosure through our OTC Disclosure & News Service  or on their own shareholder relations page.  

By making its information widely available, a community bank can increase its visibility with investors and other stakeholders in their community, which can, in turn, be reflected in its public share price.  

Q: Is trading on the NYSE or NASDAQ the only way for banks to improve their visibility, valuation and share liquidity? 

There is a perception among some in the banking community that the only way to go public is through a traditional initial public offering (IPO) on a U.S. stock exchange and that that is the only way to achieve public visibility with an attractive valuation and stock liquidity. They are mistaken. 

There are, in fact, several ways for banks to go public and provide liquidity to shareholders without registering with the SEC and going through the costly and onerous IPO process.  

And many of the banks that trade on our OTCQB marketplace trade as actively as those on a U.S. exchange. For example, Harleysville Savings Financial Corp., a Pennsylvania-based bank with $800 million in assets, deregistered and delisted from NASDAQ on December 27, 2012. Around that time, Harleysville was trading between $17 and $18 per share and had an average daily dollar volume of $32,901. Today, the bank is trading on OTCQB at $17.37 per share and has an average daily dollar volume of $40,134.  

Q: How can community/regional banks maximize the value of being publicly traded? 

Many community banks believe distributing their quarterly Call Reports to regulators is sufficient communication with investors. The truth is that Call Reports are too lengthy and hard to decipher for most investors, depositors and other stakeholders in the market community.  Furthermore, the information in Call Reports and other financial data is not integrated or available through electronic brokers and financial portals. 

Banks would benefit more by distributing material investors can understand, such as annual reports, quarterly earnings and press releases that include their stock symbol as well as holding regular conference calls with investors, presenting at investment conferences and meeting more frequently with investors.   

This year, we plan to introduce some changes that will make it even easier for community banks to gain visibility and maximize the value of their public trading.  We will be contacting banks on our marketplaces in the coming months to let them know about the changes and how to qualify. 

Bankers’ View: Thoughts on Qualified Mortgages and Basel III

12-30-13-Emily.pngThe Consumer Financial Protection Bureau’s ability-to-repay rules go into effect on January 10, 2014, and many community bank heads believe that the qualified mortgages (QM) required by the law will have a negative impact on their bank’s business strategy.

Mark Field, president of Liberty, Illinois-based Farmers Bank of Liberty, with $85 million in assets, thinks the new rule could prompt consumer lawsuits against community banks, targeting those that offer non-qualified mortgages.

“The CFPB tells us, ‘Oh, it’s OK, go ahead and make a loan even if it’s not QM’,” Field says, but “what a bank would be doing in that case is painting a big target on its bank.”

Bank Director polled 24 chief executive officers of community banks by phone in December 2013, asking for their insight on the regulatory issues facing their banks in 2014. When asked about the impact of QM on their institutions, half of those polled feel the impact will be negative, forcing changes to the bank’s mortgage business strategy. Twenty-nine percent expect to see little impact on the way they do business. Community bankers were also asked about how they plan to prepare for the Basel III standards in 2014.

When asked for his opinion on QM, Field believes the rules are too restrictive, and will result in harm to the very consumers the new rule aims to protect, like those in his rural community. “My main office is in a town of 600 people. We try to help people, and there are times when it makes perfectly good sense to help someone with a home loan based on things you know,” he says. “They’re removing the bank’s ability to use the borrower’s character [and] the personal knowledge that the loan officer has of the situation or the borrower.”

“The net effect will be that they will hurt more consumers than they will help by implementing these rules,” says Field. “Most community banks were not the cause of the mortgage meltdown.”

The home loans offered at Farmers Bank of Liberty are typically balloon mortgages with three-year terms, which stay in the bank’s portfolio. The bank’s mortgages are funded by certificates of deposit, which, due to consumer preference in the continued low interest rate environment, typically mature within 12 months. The CFPB will temporarily allow balloon mortgages for banks with less than $2 billion in assets that do fewer than 500 first lien mortgages per year, but the agency requires a term of at least five years for a balloon mortgage to be a qualified mortgage. Field says that places the bank at odds with regulators like the Federal Deposit Insurance Corp. that have renewed concerns about interest rate risk.

“The CFPB is forcing us to do one thing, and the FDIC and the Fed and the OCC [Office of the Comptroller of Currency] are beating banks down [in] the other direction. So I don’t know what the net effect will be, [whether] banks will have to scale back on their portfolio loans in order to monitor their interest rate risk,” Field says.

A survey by the Independent Community Bankers of America (ICBA) conducted in February of 2013 found that 73 percent of community banks offer balloon mortgages. Most community banks offer balloon mortgages that don’t have the onerous terms that got balloon mortgages such as bad rap before the financial crisis. Community bankers typically refinance the loans without fees at the end of the three- or five-year terms.

In the meantime, will the new international standards for bank and thrift capital, Basel III, be a hardship for community institutions, who have to get ready next year? Almost all banks and thrifts except those with more than $250 billion in assets were given until January 1, 2015, to comply with the capital standards, and all community bank CEOs polled by Bank Director in December say they’re ready. However, feeling ready and being ready may be two different things. Field feels that his bank is prepared for Basel III, though he remains uncertain about the capital conservation buffer of 2.5 percent, which the standards require on top of the 8 percent minimum total capital requirement. The buffer will be phased in beginning in 2016. According to the FDIC, banks not meeting the buffer could be penalized and certain payments, like dividends, could be restricted.

Regal Financial Bank, a $102-million asset institution based in Seattle, Washington, is ready for Basel III, says Randy James, the bank’s chairman and CEO, but he thinks many community banks may be caught unprepared. “If they’re not preparing for it, I think they’ll be caught short. It’s very difficult for a community bank to change its [capital] ratios quickly,” he says. “If they’re close, if they think they’re scratching by the guidelines, then I think they need to be better prepared.”

C&I and Commercial Real Estate Lending Still Growing for Community Bankers

12-13-13-Emily.pngJames Tibbetts, vice chairman and former president and CEO of $260-million asset First Colebrook Bank, based in Colebrook, New Hampshire, credits a strengthening New Hampshire economy for the growth he’s seeing at his bank. The bank has locations throughout the state, and the rural economy at the bank’s home in northern New Hampshire depends on tourism and timber harvesting, with Tibbetts seeing increased investment in property and equipment purchases among the small businesses that comprise the core of the bank’s customer base. “Our growth is coming from commercial real estate and C&I lending,” he says. “We do quite a bit of equipment lending.”

With competition for loans and deposits stiff, many community bank executives and boards are looking for the right formula for growth. Many banks are sticking to mortgages, despite rising interest rates and lower volume, instead vying for an increased share of the mortgage market. Still others are focused on the growth they are seeing in commercial real estate and commercial and industrial (C&I) lending.

Industry-wide, C&I loans grew 8.1 percent in the third quarter compared to the same period a year ago, according to the Federal Deposit Insurance Corp. Meanwhile, residential loans secured by real estate fell by .8 percent. Home equity lines of credit fell 8.8 percent.

In November, Bank Director informally polled over 30 bank directors and executives by email to get their views on lending and saw similar trends. In what areas are institutions seeing loan growth? Most of those polled, 73 percent, reported growth in commercial real estate in 2013 and 65 percent reported growth in commercial and industrial lending.

In contrast, the mortgage market remains stagnant, with many reporting a flat market for home mortgage purchase loans in 2013 and almost half seeing a decline in home mortgage refinancing. Looking ahead to 2014, how will the new ability-to-repay rule and creation of “qualified mortgages” impact the mortgage business? Most bankers polled that already offer mortgages indicate that they will continue to be part of their banks’ business in the near future, though some may no longer consider it to be a core part of the business.

Kevin Lemke, a director at Grand Forks, North Dakota-based Alerus Financial Corp., a financial holding company with $1.3 billion in assets, says that while mortgages have slowed a bit, it’s still a strong business for his company, which as of the third quarter of 2013 reported an increase of 4 percent in mortgage originations and loan servicing from the previous year. “I don’t know if we’ll have a record year in originations this year,” says Lemke, “but it will be close.”

Alerus’s broad geographic reach, in Arizona, Minnesota and the bank’s home base in North Dakota help the bank take advantage of strong demand in some areas even as the mortgage business wanes in others. The Minneapolis/St. Paul area of Minnesota is strong for mortgages, and Alerus plans to expand in Arizona.

Lemke feels that his bank is prepared for the qualified mortgage rule, and doesn’t expect an adverse impact on business at his bank. He’s more concerned about rising interest rates. “I think interest rates will have an impact, and already are. I think we will see a decrease in our volume,” he says. “There’s no doubt about it.”

Competition with other banks for loan business continues to be a key concern. To address this, many are hiring new loan staff, offering more attractive loan terms or looking to technology to make the loan process more efficient for clients.

Tibbetts says his bank doesn’t see a lot of competition in northern New Hampshire, but the southern part of the state is a tough market. Pricing is competitive. “It’s all about developing relationships, and that’s how we’re able to grow the amount we have grown,” he says. “We’ve developed those relationships and we price competitively.”

First Colebrook, like many banks, is emerging from a challenging four years. A lot of the bank’s business development and commercial lending staff was stuck tackling problem loans, Tibbetts says, but now the bank can devote more personnel to growing business. “We’re now able to focus on the future and the strengthening economy,” he says.

U.S. Basel III: Guide for Community Banks

Davis-Polk-White-Paper.pngExecutive Summary

U.S. Basel III is the most complete overhaul of U.S. bank capital standards in nearly a quarter of a century. It comprehensively revises the regulatory capital framework for the entire U.S. banking sector and will have significant implications for community banks from a business, operations, M&A and regulatory compliance perspective. This article provides an overview of the key aspects of U.S. Basel III for community banks.

Introduction to U.S. Basel III

U.S. Basel III is a highly complex, 1,000-page regulation published by the U.S. banking agencies, the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp. (FDIC), to implement the international Basel III capital standards in the United States. Developed originally in 2010, Basel III is an internationally agreed-upon set of reform measures to increase the quality and quantity of regulatory capital at banks. In addition to implementing Basel III, U.S. Basel III also gives effect to key provisions in the Dodd-Frank Act, including the Collins Amendment and the prohibition on references to credit rating agency ratings in federal regulations. The U.S. Basel III final rule makes a number of important changes to the U.S. Basel III proposal that was issued by the U.S. banking agencies in June 2012.

U.S. Basel III Will Affect All Community Banks

U.S. Basel III will apply to all national banks, state member and non-member banks, state and federal savings associations and covered savings and loan holding companies (SLHCs) regardless of size. The regulation will also apply to all bank holding companies (BHCs) other than certain small BHCs with less than $500 million in total assets. However, the bank and thrift subsidiaries of these small BHCs will still be subject to U.S. Basel III.

U.S. Basel III: Key Takeaways for Community Banks

  • The compliance date for community banks is January 1, 2015. The new capital conservation buffer and deductions will be phased in over several years.
  • U.S. Basel III introduces a new tier of capital—Common Equity Tier 1—and a new minimum Common Equity Tier 1 risk-based capital ratio of 4.5 percent.
  • On top of the tougher new minimum capital ratios, community banks must maintain a common equity capital conservation buffer of greater than 2.5 percent of risk-weighted assets (RWAs) to avoid restrictions on dividends, redemptions and executive bonus payments.
  • Compared with existing capital rules, U.S. Basel III will require community banks to deduct much more mortgage servicing assets (MSAs) and deferred tax assets (DTAs) from their common equity capital, shrinking their capital base.
  • Community banks can opt out of a rule requiring banks to include accumulated other comprehensive income (AOCI) in their common equity capital. Opting out could help reduce volatility in a community bank’s regulatory capital levels.
  • U.S. Basel III retains the existing capital treatment of residential mortgages and certain other types of exposures.
  • BHCs with less than $15 billion in total consolidated assets as of year-end 2009 can continue to treat existing trust preferred securities (TruPS) as Tier 1 capital, subject to certain conditions. M&A activity may affect the grandfathering of TruPS in Tier 1 capital.

How Will U.S. Basel III Increase Capital Requirements for Community Banks?

U.S. Basel III contains two types of capital ratio requirements: the risk-based capital ratio and the leverage ratio.

A bank’s risk-based capital ratio is the ratio of its regulatory capital to its risk-weighted assets (RWAs). The risk-based capital ratio is not a new concept, but U.S. Basel III introduces a new tier of capital: Common Equity Tier 1. Thus, under U.S. Basel III, regulatory capital is divided into three different tiers: Common Equity Tier 1 (e.g., common stock, related surplus and retained earnings), Additional Tier 1 (e.g., certain preferred stock) and Tier 2 capital (e.g., certain subordinated debt and other capital instruments). U.S. Basel III subjects banks to three different risk-based capital ratio requirements: Common Equity Tier 1 risk-based capital ratio; Tier 1 risk-based capital ratio (Tier 1 capital is sum of Common Equity Tier 1 and Additional Tier 1 capital); and total risk-based capital ratio (total capital is the sum of Tier 1 and Tier 2 capital).

RWAs constitute the denominator of the risk-based capital ratio. In summary, a community bank must calculate RWAs by multiplying the amount of an asset or exposure by the standardized risk weight (percentage) associated with that type of asset or exposure. The standardized risk weights prescribed in U.S. Basel III reflect regulatory judgment regarding the degree of risk of a type of asset or exposure. RWAs must be calculated for both on- and off-balance sheet assets and exposures. All else being equal, a higher risk weight results in a higher RWA amount which, in turn, gives rise to a lower risk-based capital ratio.

A bank’s leverage ratio is the ratio of its Tier 1 capital to its average total consolidated on-balance sheet assets (minus amounts deducted from Tier 1 capital). Calculation of the leverage ratio does not involve assigning risk weights to assets. Thus, the leverage ratio is commonly referred to as a non-risk-based capital ratio. U.S. banks have been subject to the leverage ratio requirement for many years.

Higher Capital Ratios under U.S. Basel III

U.S. Basel III increases the minimum risk-based capital ratios for all U.S. banking organizations, including community banks. It also requires all U.S. banking organizations, including community banks, to maintain a capital conservation buffer above the minimum requirements to avoid restrictions on capital distributions and executive bonus payments. These aspects of U.S. Basel III are illustrated below.

Capital Conservation Buffer

U.S. Basel III introduces a capital conservation buffer of Common Equity Tier 1 capital above the minimum risk-based capital requirements. The buffer must be maintained to avoid:

  • Limitations on capital distributions (e.g., repurchases of capital instruments or dividend or interest payments on capital instruments); and
  • Limitations on discretionary bonus payments to executive officers such as the CEO, president, CFO, CIO, CLO and heads of major business lines.

As a community bank dips further below its capital conservation buffer, it will be subject to increasingly stringent limitations on capital distributions and bonus payments. The capital conservation buffer will be phased in over three years, beginning on January 1, 2016.

New Well-Capitalized Standard under U.S. Basel III

U.S. Basel III revises the capital thresholds of the prompt corrective action categories for insured depository institutions (IDIs), including the well-capitalized standard, to reflect the new minimum capital ratios in Basel III. The revised prompt corrective action thresholds will become effective on January 1, 2015.

Prompt Corrective
Action Threshold
Risk-Based Capital Ratios Leverage
Total capital (unchanged) Tier 1
Common Equity Tier 1 capital
Well-capitalized ≥ 10% ≥ 8% ≥ 6.5% ≥ 5%
Adequately capitalized ≥ 8% ≥ 6% ≥ 4.5% ≥ 4%
Undercapitalized < 8% < 6% < 4.5% < 4%
Significantly undercapitalized < 6% < 4% < 3% < 3%
Critically undercapitalized Tangible equity (defined as Tier 1 capital plus non-Tier 1 perpetual preferred stock) to total assets ≤ 2%

New Eligibility Criteria for Capital Instruments

In addition to increasing minimum risk-based capital ratios and introducing the capital conservation buffer, U.S. Basel III also defines new eligibility criteria for capital instruments within each tier of regulatory capital. As a result of the new eligibility criteria, certain types of capital instruments that qualified as Tier 1 capital under existing capital rules will no longer qualify, subject to grandfathering or phase-out arrangements for certain existing instruments.  

The following chart illustrates the impact of the new eligibility criteria for BHCs with less than $15 billion in total consolidated assets as of December 31, 2009.  

Impact of M&A on Non-Qualifying Capital Instruments Grandfathered in Tier 1 Capital

As noted above, BHCs with less than $15 billion in total consolidated assets as of year-end 2009 can continue to treat existing non-qualifying capital instruments such as TruPS and cumulative perpetual preferred stock as Tier 1 capital, subject to certain conditions, including an aggregate limit for non-qualifying capital instruments of 25 percent of Tier 1 capital. U.S. Basel III contains specific rules addressing the impact of M&A activity on the ability of a BHC to continue to benefit from the permanent grandfathering of existing non-qualifying capital instruments in Tier 1 capital.  These rules can create disincentives for community banks to expand through M&A transactions instead of organic growth.

Regulatory Adjustments to and Deductions from Capital

On top of increasing minimum risk-based capital ratios, introducing the capital conservation buffer and defining new eligibility criteria for capital instruments, U.S. Basel III will also require banks to make several new deductions from and adjustments to regulatory capital. Most of these will apply to Common Equity Tier 1 capital and have the effect of focusing bank regulatory capital on tangible common equity. The new deductions for mortgage servicing assets (MSAs) and deferred tax assets (DTAs) are much more stringent than under existing capital rules and will reduce community banks’ equity capital base.

U.S. Basel III’s deductions from Common Equity Tier 1 capital include, among other items:

  • Goodwill and other intangibles, other than MSAs, net of associated deferred tax liabilities (DTLs);
  • DTAs that arise from operating loss and tax credit carryforwards, net of associated DTLs; and
  • Defined benefit pension fund net assets, net of associated DTLs. IDIs are not required to make this deduction. However, non-IDIs such as BHCs and covered SLHCs generally must make this deduction.

U.S. Basel III provides for limited recognition of the following items, which are subject to a 10 percent individual threshold and a 15 percent aggregate threshold of Common Equity Tier 1 (after applying certain regulatory adjustments and deductions):

  • DTAs arising from temporary differences that could not be realized through net operating loss carrybacks, net of any related valuation allowances and net of DTLs;
  • MSAs net of associated DTLs; and
  • Significant investments in unconsolidated financial institutions in the form of common stock, net of associated DTLs.

AOCI Opt-out for Community Banks

AOCI includes unrealized gains and losses on available-for-sale (AFS) securities. Under existing capital rules, unrealized gains and losses on AFS debt securities are not included in regulatory capital, i.e., these unrealized gains and losses are filtered out of regulatory capital. This feature of the existing capital rules is referred to as the AOCI filter. One of the perceived benefits of the AOCI filter is that it reduces volatility in a bank’s capital levels, especially during periods of interest rate movements. In the June 2012 U.S. Basel III proposal, the U.S. banking agencies proposed to remove the AOCI filter. This was one of the most contentious aspects of the proposal.

In a significant change from the June 2012 proposal, the U.S. Basel III final rule permits community banks and many other U.S. banking organizations to make a one-time, permanent election to retain the AOCI filter. This feature of the final rule is referred to as the AOCI opt-out election because the banking organization would be electing to opt-out of the removal of the AOCI filter. An opt-out election must be made in the regulatory report filed for the first reporting period after the banking organization becomes subject to U.S. Basel III. If a top-tier banking organization makes an election, any consolidated banking organization subsidiary must make the same election as its parent. We expect that many community banks will opt out of the removal of the AOCI filter.

New Risk Weights under U.S. Basel III

In addition to making significant changes to the numerator of the risk-based capital ratio (regulatory capital), U.S. Basel III makes important changes to the calculation of RWAs, the denominator of the risk-based capital ratio. Among other things, U.S. Basel III:

  • Retains existing risk weights for residential mortgages, i.e., assigns a 50 percent risk weight to prudently underwritten first-lien exposures that are performing according to their original terms and a 100 percent risk weight to other residential mortgage exposures;
  • Assigns a 100 percent risk weight to most commercial real estate loans; and a 150 percent risk-weight for high volatility commercial real estate loans;
  • Assigns a 150 percent risk weight to past due exposures (except sovereign exposures and residential mortgages);
  • Retains the existing 100 percent risk weight for corporate and retail loans;
  • Increases the risk weight for exposures to qualifying securities firms from 20 percent to 100 percent;
  • Introduces new methods for calculating RWAs for over-the-counter and centrally cleared derivatives;
  • Introduces new methods for calculating RWAs for securitizations;
  • Establishes new methods for calculating RWAs for equity exposures;
  • Introduces new rules for recognizing collateral and guarantees as credit risk mitigants; and
  • Removes references to credit rating agency ratings in methods for calculating RWAs.

Effective Date and Transitional Arrangements

Community banking organizations will become subject to U.S. Basel III beginning on January 1, 2015. Certain aspects of U.S. Basel III will take effect immediately on that date, including new minimum risk-based capital ratios, revisions to the capital thresholds in the prompt corrective action framework and the new risk weights regime. Other aspects of U.S. Basel III will be phased in over several years, including new deductions from and adjustments to regulatory capital and the new capital conservation buffer.

If you are interested in learning more about U.S. Basel III and its impact on your bank, we invite you to visit Davis Polk’s Basel III resources website,, where you can access webcasts, visual memos, interactive web tools and other materials on U.S. Basel III and other related topics.

Banker’s View: How Technology is Making the Bank More Efficient

10-30-technology.pngLast July, Glenn Wilson, chief executive officer of AmeriServ Financial, Inc., a financial holding company with $1 billion in assets based in Johnstown, Pennsylvania, challenged employees to come up with ideas to generate $1 million in cost savings that would go into effect for 2014. Banks always place a priority on cutting costs, but he gives two reasons for making efficiency a key objective for the coming year.

At 87 percent for the year as of September 30, AmeriServ Financial’s efficiency ratio is higher than its peers, negatively impacting the company’s profitability and stock price. In addition, “given the interest rate environment and the margin squeeze that the industry has had, and we’ve all been thinking it’s going to change; it just became pretty obvious [that] it’s here to stay,” says Wilson. “We just had to get a little more serious about cost savings.”

AmeriServ has already met its cost-cutting goal, finding $1.1 million in cuts so far. The company outsourced several functions to the bank’s core system provider, Jacksonville, Florida-based technology firm Fidelity National Information Services Inc. (FIS). AmeriServ avoided the cost of replacing outdated equipment by outsourcing statement rendering, for example. Moves like those will lead the bank to save $300,000 to $400,000 during the next five years.

Last summer, the Bank Board & Executive Survey, conducted by Bank Director and sponsored by consulting firm Grant Thornton LLP, found that 84 percent of bankers plan investments in new technologies to make their institutions more efficient. How banks use technology to generate efficiencies varies. Bank boards and management should “make sure they’re spending their technology money appropriately, depending on their strategic plan, as to where they’re going product-wise, market-wise and customer-wise,” says Jack Finley, banking industry senior advisor at Grant Thornton.

“There’s almost an unlimited amount you can spend on technology and enabling customer interaction, and certainly there are a lot of ‘like to haves’ that we wouldn’t mind having,” says William Pasenelli, president of Waldorf, Maryland-based Community Bank of the Chesapeake, with $979 million in assets. The bank prioritizes its technology investment on relevant services for its customer base of small businesses and professionals, and plans to launch mobile banking by the end of October.

Community bank boards do face obstacles. Banks must balance automation while still maintaining a level of service that keeps customers satisfied. Slow economic growth will likely remain a challenge, forcing bankers to be even more selective in the investments they make. And while community banks don’t have to be early adopters, they can’t afford to lag when it comes to innovation. “Taking your time and not jumping at every little thing that’s presented is probably a good strategy,” says Finley.

Selective investment means that the technology budget at Community Bank of the Chesapeake hasn’t mushroomed. The budget has grown, but “not as fast as you would think,” says Pasenelli. The cost of providing core banking services continues to decline. Online banking, data storage, cyber security and compliance with regulations like the Bank Secrecy Act are significant drivers of technology costs.

Mark Field, president of Farmers Bank of Liberty, an institution with just $85 million in assets based in small town Liberty, Illinois, faced a dilemma earlier this year when the bank’s core system provider, Waldorf Computer Systems, based in West Des Moines, Iowa, decided to sell. Field spearheaded a move that some may consider a bit unusual: his bank, along with others based in Alabama, Nebraska, Iowa, Virginia and Ohio, decided to buy the software themselves.

Community Bankers Cooperative, a non-profit cooperative of banks with between $15 million and $200 million in assets, will share and support the software, which is called Bancado. The sale of Bancado would have forced the banks to a more expensive core banking system, which Field estimates would add $45,000 in costs to his bank during a five-year period. The six-member board of the cooperative, which includes Field, will represent the interests of member banks and set the direction for the program. BSI Computer Solutions, a technology provider for the banking industry based in Gardendale, Alabama, will provide technical support for member banks, and San Francisco-based Pacific Code Works will do the programming to update the software.

The cooperative should complete the purchase of Bancado in early January. Field declined to reveal how many banks plan to join.

“If community banks would band together and help one another, we could do so much more,” says Field. “We could help each other and save quite a bit of money in the long run.”

Why Small Banks Will Consolidate

While announced deal volume continues at a tepid pace, key drivers of M&A activity are starting to emerge. With more than 90 percent of the banking companies nationwide operating with assets of less than $1 billion, it is inevitable that consolidation will be concentrated at the community bank level. Six factors that point to a pick-up in M&A activity in this space are as follows:  

1. Bank equity prices are rising with an increasing valuation gap between small and large banks. Bank stocks overall have increased nearly 30 percent in 2013; however, banks with less than $1 billion in assets continue to trade at significant discounts compared to larger banks.   


As the chart above indicates, the valuation gap has widened for larger banks, which enjoy a median 51 percentage point premium as of August 31, 2013. Larger banks can use this valuation advantage to present attractive deal pricing to smaller banks.    

2. Very few FDIC-assisted transactions remain. Since 2008, 485 banks have failed representing nearly 7 percent of banking companies in the U.S., according to the Federal Deposit Insurance Corp. Essentially; FDIC-assisted transactions filled the void of traditional open-bank deals. With troubled bank totals dwindling and only a few significantly undercapitalized banks remaining, FDIC-assisted deals are diminishing. Acquisitive companies have moved on from this once lucrative line of business to evaluate more traditional deals.

3. Improved asset quality is leading to reduced credit marks. While merger discussions have occurred in recent years, the due diligence phase often brought deal negotiations to a screeching halt. With elevated credit marks (in some cases exceeding 10 percent), parties were unable to bridge the valuation gap. Over time, banks have made significant progress in reducing classified assets and writing down assets that more closely approximate fair value. With credit marks now modestly exceeding the target’s allowance for loan and lease losses, capital and book value can be preserved, which in turn, translates to more favorable deal pricing.

4. Several high profile deals have been announced at attractive premiums. Achieving certain benchmark pricing levels in M&A often is a catalyst for deal activity. Sellers are always looking for market information to help formulate a strategy on whether or when to sell. On the other side, buyers do not want to be perceived as overpaying, which is usually viewed in the context of pricing relative to other recent deals. Transactions like MB Financial’s acquisition of Cole Taylor Group at 1.82 times tangible book value and Cullen/Frost Bankers’ acquisition of WNB Bancshares at 2.84 times tangible book have already spurred discussion inside many boardrooms.  

5. Economies of scale in the banking industry have never been more crucial. The need and desire to grow exists at virtually every institution. As the chart below indicates, efficiency ratios have remained consistently lower at larger banks.


Whether driven by regulatory costs, technology, marketing, pricing power, expanded lines of business/other revenue sources, larger banks appear to have clear performance advantages. This increasingly important trend will spur institutions to grow via acquisitions in order to spread certain fixed costs over a larger asset base and thereby improve operating efficiencies.  

6. Mergers among community banks. None of the preceding points are intended to suggest that banks under $1 billion will not participate as buyers of other community banks. In fact, since 2010, banks of less than $1 billion in assets have announced or completed 280 acquisitions, comprising more than 41 percent of the deal activity during that period.  A recent example of this type of deal involved Croghan Bancshares, which has $630 million in assets and is headquartered in Fremont, Ohio. Croghan is buying Indebancorp, which has$230 million in assets and is headquartered in Oak Harbor, Ohio. After considering other alternatives, Indebancorp chose Croghan, a larger community bank, as a partner. The deal was structured with 70 percent of the consideration in Croghan stock and priced at 134 percent of Indebancorp’s tangible book value. The deal value per share was 28 percent higher than Indebancorp’s stock trading price and cash dividends to Indebancorp shareholders will increase by almost 200 percent. On a pro forma basis, Indebancorp shareholders will own approximately 26 percent of Croghan’s shares following the deal.  

Making M&A predictions is always challenging, but here at Austin Associates, we believe many community banks will make the decision to sell within the next few years. When M&A returns to full capacity, expect at least 300 transactions per year, or 20 percent consolidation of the industry within five years. Pricing will continue to increase, but do not expect to see pre-crisis multiples any time soon. Moreover, pricing will be highly dependent on the target’s unique profile (size and performance), as well as local and regional market factors. 

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Bank boards and management teams must stay on top of fast emerging risks.  In this video, Sai Huda of Fidelity National Information Services, Inc., shares three best practices that boards can implement to move risk management from a defensive into offensive strategy, and ultimately transform their financial institutions into high performing banks.

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Final Basel III Rules Revealed: Community Banks Aren’t Completely off the Hook

7-19-13_Naomi.pngThe Basel III final rules recently released make clear one thing: Small, community banks are getting a break. It may not actually feel that way. In fact, community bank CEOs across the country tell me they are very frustrated with new regulation, with Basel III, with the Dodd-Frank Act and with examiners scrutinizing their banks and coming up with problems that never seemed to be a problem before. The overarching theme is that more regulation is coming down the pike, Basel III’s final rules are just one part, and they will be burden to digest and implement.

“It’s a massive rule where they consolidated three notices of proposed rulemakings,” says Dennis Hild, a former Federal Reserve bank examiner and Crowe Horwath LLP director. Even though Hild is based in Washington, D.C. and it is his job to understand this stuff, even he admitted he had a lot of reading to do. So it will be a bundle for a small bank CEO to figure out, too. “There is still much to learn. We need to dig through it. We need to find out what’s important.”

The news in late June and early July that the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corp. (FDIC) would jointly mitigate some of the proposals most onerous to community banks was a welcome, if small, relief in a heavily regulated industry.

Under the final Basel III rule:

  • Banks under $15 billion in assets can continue to count trust-preferred securities—known as TRuPS—as Tier 1 capital.
  • Banks can continue to risk-weight residential mortgages as they had under the original Basel I regime. The final rule abandons a proposal to institute a complicated formula of risk weights for residential mortgages.
  • All but the largest banks (above $250 billion in assets) can keep available-for-sale securities on the balance sheet without having to adjust regulatory capital levels based on the current market value of those securities. Banks have a one-time opportunity to opt-out on their first regulatory call report after Jan. 1, 2015 from what’s called the accumulated other comprehensive income (AOCI) filter. If they miss doing so, they can’t opt-out later.

FDIC Chairman Martin J. Gruenberg specifically said in a press release that changes to the final rule had been made because of community bank objections. The Federal Reserve even published a guide just for community banks to explain the new rules. The Independent Community Bankers of America (ICBA) acknowledged the gesture on behalf of community banks but said in a statement that it still supported an outright exemption from Basel III capital standards for community banks.

It doesn’t appear that community banks will be getting that. The goal of the new rules is to improve the quality and quantity of capital maintained by banks, should another financial crisis take place.

Most community banks will have to comply with the higher regulatory capital standards under the Basel III final rules. Small bank holding companies with less than $500 million in assets are exempt, but their depository institutions must comply. Thrifts and thrift holding companies also must comply with the new rules. The FDIC estimated that 95 percent of insured depository institutions already meet the capital standards required under the final rules. Still, bank management teams, and the bank boards that oversee them, will have to figure out if their banks need to raise capital, and if so, how.

Many other aspects of Basel III will impact community banks as well. Bank officers have been calling consultants and law firms to figure out the impact of the new rules.

One of the biggest questions has been how an acquisition might subject a bank to new rules under Basel III, say if an acquisition bumps the bank above $15 billion in assets. How will the TRuPS on the merged companies’ books be treated?

The biggest banks might feel deterred from M&A if it propels them into the ranks of “advanced approach” institutions, which are those with more than $250 billion in assets or more than $10 billion in on-balance sheet foreign exposure, such as foreign government debt. Such a category subjects those banks to special Basel III rules and higher standards. Also, under yet another proposed rule from all three federal banking regulators, bank holding companies with more than $700 billion in combined total assets or $10 trillion in assets under custody must maintain double the current minimum leverage ratio of 3 percent to be considered “well capitalized.” Regulators estimate only eight institutions in the country would be subject to this leverage requirement.

One aspect of Basel III that might impact community banks is exposure to certain “high volatility” commercial real estate loans, usually acquisition and development loans, which will require higher risk weights. There also will be limitations on certain kinds of deferred tax assets, says Hild.

His advice? Don’t freak out right now. Banks will have time to figure this out.

Although banks with more than $250 billion in assets will have to comply with new capital rules during a phase-in period that starts January 1, 2014, smaller institutions have until January 1, 2015 to begin phasing in the new standards. That will certainly be enough time to figure out if Basel III is a non-event for your organization.

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