Dual Deal Accounting Challenges During a Pandemic

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Bank mergers and acquisitions are not easy: balancing the standard process of due diligence to verify financial and credit information, adapting processing methods and measuring fair value assets and liabilities. The ongoing pandemic coinciding with the implementation of the current expected credit loss model, or CECL, by larger financial institutions has made bank mergers even more complex. As your financial institution weighs the benefits of a merger or acquisition, here are two important accounting impacts to consider.

Fair Value Accounting During a Pandemic

When two banks merge, the acquiring bank will categorize the loans as performing or purchase credit impaired/deteriorated and mark the assets and liabilities of the target bank to fair value.

This categorization of loans is difficult — the performance of these loans is currently masked due to the large number of loan modifications made in the second quarter. With many customers requesting loan modifications to defer payments for several months until the economy improves, it is difficult for the acquiring bank to accurately evaluate the current financial position of the target bank’s customers. Many of these customers could be struggling in the current environment; without additional information, it may be very difficult to determine how to classify them on the day of the merger. 

One of the more complex areas to assess for fair value is the loan portfolio, due to limited availability of market data for seasoned loans. As a result, banks are forced to calculate the fair value of assets while relying on subjective inputs, such as assumptions about credit quality. Pandemic-response government programs and significant bank-sponsored modification programs make it difficult to fully estimate the true impact of Covid-19 on the loan portfolio. Modifications have obscured the credit performance data that management teams will base their assumptions, complicating the process even further.  

U.S. Generally Accepted Accounting Principles (GAAP) allows for true-up adjustments to Day 1 valuations for facts that were not available at the time of the valuation to correct the fair value accounting. These adjustments are typically for a few isolated items. However, the lagging indicators of Covid-19 have added more complexity to this process. There may be more-pervasive adjustments in the coming year related to current acquisitions as facts and circumstances become available. It is critical for management teams to differentiate between the facts that existed the day the merger closed versus events that occurred subsequent to the merger, which should generally be accounted for in current operations.  

CECL Implementation

For large banks that implemented CECL in the first quarter of 2020, a significant change in the accounting for acquired loans can create a new hurdle. Under the incurred loss model, no allowance is recorded on acquired loans, as it is incorporated in the fair value of the loans. Under the new CECL accounting standard, the acquirer is required to record an allowance on the day of acquisition — in addition to the fair value accounting adjustments. While this allowance for purchase deteriorated credits is a grossing-up of the balance sheet, the performing loan portfolio allowance is recorded through the provision for loan losses in the income statement.

This so-called “double-dip” of accounting for credit risk on acquired performing loans is significant. It may also be an unexpected change for many users of the financial statements. Although CECL guidance has been available for years, this particular accounting treatment for acquired performing loans was often overlooked and may surprise investors and board members. The immediate impact on earnings can be significant, and the time period for recapturing merger costs may lengthen. As a result, bank management teams are spending more time on investor calls and expanding financial statement disclosures to educate users on the new accounting standards and its impact on their transactions.  

The two-fold accounting challenges of implementing CECL during a global pandemic can feel insurmountable. While the CECL standard was announced prior to Covid-19, management teams should take a fresh look at their financial statements as they prepare for earnings announcements. Similarly, if your bank is preparing to close an acquisition, plan on additional time and effort to determine the fair value accounting. By maintaining strong and effective communication, financial institutions will emerge stronger and prepared for future growth opportunities.

Four Questions for Three CEOs

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The coronavirus pandemic has thrown the banking industry into an environment that is both rapidly changing and a prolonged grind.

The recession induced as a result of public and private response to Covid-19 has lowered the revenue outlook and increased credit risk for institutions across the country. Bankers must navigate an extraordinarily uncertain operating environment and make tough decisions. To that end, Bank Director created the AOBA Summer Series — a free, on-demand compilation of pragmatic information, honest conversations and real-world insight.  

The series goes live on Aug. 12. As a preview, we sat down (virtually) with three executives featured in the series — Chuck Sulerzyski, Jill Castilla and John Asbury — for a glimpse into where they see challenges, opportunities and inspiration. Sulerzyski is CEO of Peoples Bancorp in Marietta, Ohio, which has $5 billion in assets; Castilla is chairman and CEO of Citizens Bancshares, which has $317 million in assets and is based in Edmond, Oklahoma; and John Asbury is CEO of Richmond, Virginia-based Atlantic Union Bankshares Corp., which has $19.8 billion in assets. These conversations were conducted independently, and have been lightly edited for length and clarity.

BD: What is the biggest challenge you see for your bank?

JC: I think about businesses that aren’t able to recover as quickly and making sure that you have the tools available to get to the other side. These are unprecedented times and these businesses are struggling — not due to something they caused; it was something inflicted upon them. I think it’s going to be difficult moving through that.

JA: Navigating the credit risk implications of the Covid-19-induced recession. We remain confident in our overall asset quality, credit loss reserves, capital position and preparedness for this event. However, the duration of Covid-19 will largely determine just how great a challenge this will be. Time will tell.

CS: Maybe not in the next three months, but in the upcoming quarters, I think credit is going to be the biggest challenge, and helping our customers get through all of this. We feel good about our portfolio and its diversification. The places where we feel the most stress is in the hotel portfolio. Obviously, businesspeople aren’t traveling, and consumers are starting to travel a little more but way below normal levels. It’s very difficult for hotel operators to [meet] cash flow.

BD: What is the biggest opportunity for your bank?

JC: The biggest opportunity is continuing to be a leader and advocate, and restoring trust in financial services — both nationally as well as locally —  and being seen as a trusted advisor and a trusted advocate.

JA: The bank has demonstrated resilience, agility, courage and innovation in its response to Covid-19. We developed and launched an online portal and automated workflow system to take Paycheck Protection Program loan applications in five days because we remained agile and knew the stakes were high as our customers were counting on us. We were also quick to make difficult decisions to align our expense structure to the expected lower-for-longer rate environment, beginning in March, to ensure we emerge on the other side of Covid-19 positioned for success. Permanently ingraining these characteristics into our culture will result in an even better, stronger and more capable company.

CS: Peoples really crushed it on the PPP program. We were open for new customers and brought them in with the understanding they would become full-service customers. The biggest opportunity over the next three to six months is taking in these relatively new people and cross-selling them loans, deposits, insurance and investments. Already, we bought in over $40 million dollars of loans and deposits, and over $150,000 in fee income. 

BD: Where are you getting inspiration right now?

JC: So many places. I’m fortunate to be in a city that has diverse leadership. Whether it’s in our underrepresented and underserved communities, those leaders that have fought the odds for decades and are striving for their communities to reach higher levels and pull more out of me to be a better person, a better leader and a better businessperson, and provide access to capital and liquidity and things that. That’s been extraordinary. Seeing our leaders make hard decisions for the welfare of their communities or for the business community as well — that courage, whether I agree with the actions or not — seeing the willingness to take a stand and to stand up for something has been inspirational.

JA: Our teammates! They amaze me with their determination, resourcefulness, effort and caring for our customers and each other. Their efforts on PPP in particular were heroic.

CS: There’s much going on in the world. The healthcare workers, I’ve been touched by everything that they have done. One of my kids is a doctor, one is a nurse, and another is working on a Ph.D. in public health. All of what’s going on with healthcare workers and first responders has been very motivational. 

I know we’ve gone through a lot of social unrest, but I find inspiration in [Senator] John Lewis’ passing and everything that he stood for. I was eight years old when the Voting Rights Act was passed. It’s mind-numbing that folks of color didn’t have the opportunity to vote, and here we are, 50 years later, fighting similar fights and hopefully making progress.

BD: What has been the best thing you’ve read or watched since the pandemic began?

JC: Maybe because it’s on my mind, but the timeliness of the release of “Hamilton” [on the Disney+ streaming service]. I got to see it live in Oklahoma City a year ago; I had tickets and had waited forever to go see it. And then I got hit by a truck walking across my street two days before the show.

We ended up [seeing] the last performance before it left Oklahoma City. I’ve been really excited to see it coming back in my life a year later and in this time. The boldness of the vision to create a musical that uses a diverse cast and a difficult topic, the timeliness of the messaging and then making something accessible to everyone.

It’s the last thing I’ve seen that’s blown me away. But there’s been so many instances where someone has blown me away with something they’ve written online, an article I’ve read or a podcast I’ve listened to. This crisis is so bad, but again, you get to see this beauty of leadership, this boldness of action and constant inspiration of people stepping up and doing wonderful work.

JA: Despite having never worked longer or harder for such a sustained period of time, since Covid-19 hit I’ve read books extensively. The most impactful is “How to Be an Antiracist” by Ibram X. Kendi. It has given me a perspective on social injustice and systemic racism that I did not have before, as well as a better understanding of its root causes and what can be done about it.

CS: I’m a Yankees fan; Aaron Judge had two home runs [in the Aug. 2 game against the Boston Red Sox], and I liked that a great deal. I also think John Lewis’ obituary goodbye letter in The New York Times was the best thing that I’ve read. We shared that so that our employees could read it.

The Opportunistic Upside of New Capital Rules

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Looming new capital rules are an opportunity for banks to improve strategic planning and data management as they strengthen their compliance and reporting processes.

The coronavirus pandemic has delayed deadlines for complying with the latest round of capital guidelines dictated by Basel IV. Still, financial institutions should not lose sight of the importance of preparing for Basel IV, the difficulties it will create along the way and the ways they can leverage it as a potential asset. Compliance and implementation may be a significant expenditure for your bank. Starting now will lengthen your institution’s path to greater productivity and profitability to become a better bank, not just a more compliant one.

At Wolters Kluwer, we broke down the task — and opportunity — at hand for banks as they approach Basel IV compliance in our new whitepaper “Basel IV – Your Path to a more Profitable Business.” Here are some of the highlights for your bank:

Making Basel IV For Business
Where there is a will — along with the right tools — there’s a way to leverage the work required to comply with Basel IV for other commercial objectives. The new capital rules emphasize using forward-looking analysis, a holistic, collaborative organizational structure and data management capabilities for compliance and reporting purposes. These tools can all be leveraged for strategic planning and other commercial objectives, reducing or controlling long-term expenses while enhancing efficiency.

Central to this approach, however, is adopting the right attitude and approach. Executives should view Basel IV compliance as a potential asset, not just a liability, and be willing to make changes to the structure of operations and supporting data management systems.

A Familiar Approach
Basel IV is not a monolithic set of edicts; instead, it’s a package of regulatory regimens through which the Basel Committee on Banking Supervision’s guidelines will be put into practice. These measures are actually the final version of the Basel III guidelines issued in 2010 but were seen as such an expansion of what came before as to be thought of as an entirely new program. It contains elements that encourage and even require banks to act in ways that enhance business practices, not just compliance.

One element is the mandate for a holistic, collaborative approach to compliance. All functions within an institution must work in concert with one another, to create a data-driven, dynamic, three-dimensional view of the world. Another point of emphasis is the importance of prospective thinking: anticipating events from a range of alternatives, instead of accumulating and analyzing data that shows only the present state of play.

“What now?” to “What if?”
Banks can use Basel’s compliance and reporting data for business intelligence and strategic planning. Compliance efforts that have been satisfactorily implemented and disseminated allow  executives to create dynamic simulations displaying prospective outcomes under a range of scenarios.

The possibilities of leveraging Basel IV for business extends to the individual deal level. Calculations and analysis used for compliance can be easily repurposed to forecast the rewards and risks of a deal under a range of financial and economic scenarios whose probabilities themselves can be approximated. And because a firm’s risk models already will have been vetted in meeting Basel IV compliance standards, bankers can be confident that the results produced in the deal evaluation will be robust and reliable.

Another big-picture use of Basel IV for business is balance sheet optimization: forecasting the best balance sheet size for a given risk appetite. This can show the board opportunities that increase risk slightly but obtain far more profit, or sacrifice a bit of income to substantially reduce risk.

To turn Basel IV’s potential for business into practice requires openness and communication from senior executives to the key personnel who will have to work together to bring the plan to fruition. It will mean adopting a mindset that considers each decision, from the details of individual deals to strategic planning, along with its likely impact. Staff must also be supported by similarly structured data management architecture.

The emphasis on forward-looking analysis and a holistic, collaborative organizational structure for compliance and reporting purposes, supported by data management capabilities designed along the same lines, can be leveraged for strategic planning and other commercial objectives. Success in streamlining operations and maximizing productivity and profit potential, and any edge gained over the competition, can reap especially great long-term rewards when achieved at times like these. Leaders of financial institutions have a lot on their minds these days, but there is a persuasive case to be made right now for seizing the opportunity presented by Basel IV for business.

Designing a Pandemic-Proof Compensation Plan

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The ability to pivot and adapt to a changing landscape is critical to the success of an organization.

The coronavirus pandemic has created a unique challenge for banks in particular. Government stimulus through the Paycheck Protection Program tasked banks with processing loans at an unheard-of rate, turning bankers working 20-hour days into economic first responders. Simultaneously, the altered landscape forced businesses to adopt a remote work environment, virtual meetings and increase flexibility — amplifying the need for safe and reliable technology platforms, enhanced data security measures and appropriate cyber insurance programs as standard operating procedure.

Prior to Covid-19, a major driver of change was the demographic shift in the workforce as baby boomers retire and Generation X and millennials take over management and leadership positions. Many businesses were focused on ways to attract and retain these workers by adapting their cultures and policies to offer them meaningful rewards. The pandemic will likely make this demographic shift more relevant, as the workforce continues adapting to the impending change. 

Gen X and millennial employees are more likely than previous generations to value flexibility in when and where they work. They may seek greater  alignment in their career and life, according to Gallup. The pandemic has forced businesses to either adapt — or risk the economic consequences of losing their top performers to competitors.

Many employees find they are more productive when working remotely compared to the traditional office setting, which could translate into increased employee engagement. In fact, the Gallup’s “State of the American Workplace” study finds that employees who spend 60% to  80% of their time working remotely reported the highest engagement. Engagement relates to the level of involvement and the relationship an employee has with their position and employer. Gallup finds that engaged employees are more productive because they have increased autonomy, job satisfaction and desire to make a difference. Simply put, increase engagement and performance will rise.

The demographic shift and a force-placed virtual office culture means that designing programs to attract and retain today’s workers require a well thought out combination of strategies. An inexpensive — though not necessarily simple — method of employee retention includes providing recognition when appropriate and deserved. Recognition is a critical aspect in employee engagement, regardless of demographic. Employees who feel recognized are more likely to be retained, satisfied and highly engaged. Without appropriate recognition, employee turnover could increase, which contributes to decreased morale and reduced productivity.

In addition to showing appreciation and recognizing employees who perform well, compensating them appropriately is fundamental to attracting and retaining the best. The flexibility of a non-qualified deferred compensation program allows employers to customize the design to respond to changing needs.

Though still relevant, the traditional Supplemental Executive Retirement Plan has been used to attract and retain leadership positions. It is an unsecured promise to pay a future benefit in retirement, with a vesting schedule structured to promote retention. Because Gen X and millennials may have 25 years or more until retirement, the value of a benefit starting at age 65 or later could miss the mark; they may find a more near-term, personally focused, approach to be more meaningful.

Taking into consideration what a younger employee in a leadership, management, or production position values is the guide to developing an effective plan. Does the employee have young children, student loan debt or other current expenses? Using personalized criteria, the employer can structure a deferred compensation program to customize payments timed to coincide with tuition or student loan debt repayment assistance. Importantly, the employer is in control of how these programs vest, can include forfeiture provision features and require the employee perform to earn the benefits.

These benefits are designed to be mutually beneficial. The rewards must be meaningful to the recipient while providing value to the sponsoring employer. The employer attracts and retains top talent while increasing productivity, and the employee is engaged and compensated appropriately. Banks can increase their potential success and avoid the financial consequences of turnover.

Ultimately, the pandemic could be the catalyst that brings the workplace of tomorrow to the present day. Nimbleness as we face the new reality of a virtual office, flexibility, and reliance on technology will holistically increase our ability to navigate uncertainty.

A Rare Opportunity for Change

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Jeff Rose believes there’s no rush to reopen his bank’s branches.

Davenport, Iowa-based AmBank Holdings’ eight branch lobbies have been closed since March, limiting physical interactions to drive-thru lanes and by appointment. Even then, the $373 million bank is exercising caution — customers who schedule appointments have to complete a questionnaire, have their temperature taken by an American Bank & Trust employee, wear a mask and socially distance.

“A lot of banks in our area did reopen their lobbies [around] mid-June,” says Rose, the bank’s CEO. “Many of those are now reclosing, some of them because of the spike in the virus.”

The Covid-19 pandemic has forced banks and other businesses to change their operations to remain open. But while the health crisis underlying the economic downturn may be temporary, it offers banks an opportunity to rethink the role of the branch in serving the customer.

For some financial institutions, Covid-19 has merely accelerated this shift.

Bank OZK, based in Little Rock, Arkansas, doesn’t focus singularly on branch strategy, explains Carmen McClennon, chief retail banking officer of the $26 billion bank. Instead, OZK considers how the combination of its digital, ATM, call center and branch channels can build a high-quality client experience. Its lobbies have remained open during the pandemic, but social distancing measures still limit in-person connection.

“The reality is, we’re not face-to-face and having that critical contact with our clients on such a regular basis,” she adds. “What worries me is I’ve got to think about what we’re doing in these other channels so we’re at the top of the consideration when our client has their next financial need.”

An analysis of consumer traffic trends by the advisory firm Novantas finds weekly branch visits down by 20% as of July 14, since the pre-pandemic period of Jan. 30 through Mar. 4, 2020. An earlier survey found branch activity unlikely to recover, with only 40% of consumers saying they’d return to their local branch once the pandemic abates.

Separately, Fidelity National Information Services (FIS) reported that new mobile banking registrations increased by 200% in April, and mobile banking activity rose by 85%.

McClennon believes that personalization across channels will be important. “We’re looking at things like smart offers when they’re logging in to pay a bill,” she explains. Also, “how do we personalize an ATM experience so we’re maintaining that relationship with our client? I think we’ve got to challenge ourselves [to do that].”

OZK plans to unveil mobile app enhancements soon, and will thoroughly train branch and call center staff on its features. “We want them to confidently promote it” to clients, says McClennon.

Covid-19 doesn’t appear to be driving OZK to close locations. These decisions will be made by branch and by market, McClennon explains, based on OZK’s ability to serve its clients and meet its strategic objectives.

It recently sold four branches — two each in South Carolina and Alabama. “Candidly, we didn’t have enough density to deliver a strong client experience. That’s really challenging in a low-density market,” says McClennon. But she points out that the bank opened as many branches as it closed — three — in 2019.

Rose says AmBank will soon field surveys to better understand customer preferences and help the bank’s leadership team plot a path forward. While drive-thru transactions have risen 10% over the past couple of months — which Rose partially attributes to the warmer weather — mobile and online usage are back to pre-pandemic levels.

Data will drive AmBank’s reopening plans, but Rose believes that some lobbies will remain closed in less-frequented locations where customers have adapted to drive-up service.

When its lobbies reopen, Rose believes it will be a rare opportunity to change how customers interact with his bank. AmBank has invested in new technology, including DocuSign and improved payment capabilities; they’re also looking at self-service technology, like interactive teller machines. Rose is inspired by Apple’s stores and the hair salon chain Great Clips, which let customers schedule service appointments digitally.

“We’ve got one shot at modifying the client experience for the betterment of our customer,” he says. “We love our customers, we want to see them, but if they can self-serve and not have to drive to the bank, it’s going to be a better experience for them overall. How do we take advantage of the pandemic situation to permanently upgrade the client experience?”

Exploring Customer Service in the Pandemic Age

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Banks across the country are grappling with the right approach to branch banking as the Covid-19 pandemic lingers.

Management concerns surrounding logistics and safety must give way to longer-term considerations aimed squarely at the bottom line. Executives need to contemplate the future of their branch operations and  business model, incorporating the guidance that large-scale pandemics may persist in some shape or form in the future. Read on to explore key considerations relating to the long-term implication of pandemics on customer service delivery.

Will customers ever come back into our branches? How will that impact our bank?
Branch visits have irrevocably changed. A recent study asked consumers to rank their preference of seven different banking channels, before, during and post-pandemic. Six months after the start of the pandemic, branch banking has settled into sixth place. The study predicts “a rapid decrease in the importance of the physical branch as customers become more habituated to the use of digital, which is a behavior that will linger long term.”

Jimmy Ton, senior vice president and director of digital channels at Irvine, California-based First Foundation Bank, agrees. “For those who adopted digital services during this time, they’ll probably stick with them. It takes 60 days to form a habit and people have been reconditioned during the pandemic. There’s no reason to believe they will abandon these services,” said Ton.

Novantas highlights another concern. “The branch network’s competitive advantage for sales has been eliminated overnight, possibly forever. Although sales were already shifting away from branches, they will now need to be even more digital.”

Banks must prepare for a permanent, significant reduction of branch visits. They should discuss this impact on their business models and what changes, internally and customer-facing, will need to occur.

Highly personalized service is our hallmark. How can we possibly digitize that?
Many banks have long leveraged high-touch customer service as a differentiator when competing with national banks. This was often delivered through branch networks and sales teams — until now.

Bankers have witnessed pandemic-induced migration to digital channels. But this is no time to celebrate;  J. D. Power shows overall satisfaction has declined as customers transition from branch to digital channels. That’s because banks have so far been unable to replicate the personalized nature of in-branch experiences digitally.

But it can be done.

Think of it this way: branch staff can glance at a screen filled with information about the customer sitting in front of them to personalize the conversation. That same data can be used to craft a personalized conversation, delivered via email or text message instead. Both methods communicate to the customer that you know who they are, and can offer ways to help them.

Digital engagement platforms offering deep personalization delivered via individualized websites, text messages, video and online chats exist today. They deliver a positive, digital experience with minimal effort, even for data-challenged banks.

“A significant chunk of interactions can move to digital. A great parallel is what we saw happen with telehealth, moving routine physical in-person appointments to virtual ones,” said John Philpott, a partner at FINTOP Capital. “It’s a great example of how professional conversations can be digital; banks can absolutely do the same.”

Banks should plan to shift all or a significant portion of sales and service delivery away from their branch networks and to digital engagement and sales platforms that are ideally powered by insightful data to hyper-personalize the experience.

Strategically speaking, what else should we consider?
With branch-based account opening limited and most banks flush with cash, the pressure for new deposits has lessened. Now is an opportune time to focus on the existing customer base to minimize attrition and boost profitability of those relationships.

Ted Brown, CEO of Digital Onboarding, founded the company based on the idea that opening a new account does not mean you’ve established a relationship.

“[The ] number of new checking accounts is the wrong metric to obsess over,” Brown said. “Are your customers fully utilizing the products and services they’ve signed up for? Are they turning to your bank to satisfy additional needs? Starting with Day One, successful onboarding — and continuous engagement thereafter — increases product usage, cross-sell success and ultimately drives profits.”

Zeroing in on customer engagement and retention, instead of new customer growth, may be a smart, strategic and profitable move in the current environment. Responsible bank leadership must contemplate what changes and investments they will need to make to stay relevant with customers post-COVID 19.

The $700 Billion Credit Question for Banks

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It’s the $700 billion question: How bad could it get for banks?

That’s the maximum amount of losses that the Federal Reserve modeled in a special sensitivity analysis in June for the nation’s 34 largest banks over nine quarters as part of its annual stress testing exercise.

Proportional losses could be devastating for community banks, which also tend to lack the sophisticated stress testing models of their bigger peers and employ a more straight-forward approach to risk management. Experts say that community banks should draw inspiration from the Fed’s analysis and broad stress-testing practices to address potential balance sheet risk, even if they don’t undergo a full stress analysis.

“It’s always good to understand your downsides,” says Steve Turner, managing director at Empyrean Solutions, an asset and liability tool for financial institutions. “Economic environments do two things: They tend to trend and then they tend to change abruptly. Most people are really good at predicting trends, very few are good at forecasting the abrupt changes. Stress testing provides you with insight into what could be the abrupt changes.”

For the most part, stress testing, an exercise that subjects existing and historical balance sheet data to a variety of adverse macroeconomic outlooks to create a range of potential outcomes, has been the domain of the largest banks. But considering worst-case scenarios and working backward to mitigate those outcomes — one of the main takeaways and advantages of stress testing — is “unequivocally” part of prudent risk and profitability management for banks, says Ed Young, senior director and capital planning strategist at Moody’s Analytics.

Capital & Liquidity
The results of the Fed’s sensitivity analysis underpinned the regulator’s decision to alter planned capital actions at large banks, capping dividend levels and ceasing most stock repurchase activity. Young says bank boards should look at the analysis and conclusion before revisiting their comfort levels with “how much capital you’re letting exit from your firm today” through planned distributions.

Share repurchases are relatively easy to turn on and off; pausing or cutting a dividend could have more significant consequences. Boards should also revisit the strategic plan and assess the capital intensity of certain planned projects. They may need to pause anticipated acquisitions, business line additions and branch expansions that could expend valuable capital. They also need to be realistic about the likelihood of raising new capital — what form and at what cost — should they need to bolster their ratios.

Boards need to frequently assess their liquidity position too, Young says. Exercises that demonstrate the bank can maintain adequate capital for 12 months mean little if sufficient liquidity runs out after six months.

Credit
When it comes to credit, community banks may want to start by comparing the distribution of the loan portfolios of the banks involved in the exercise to their own. These players are active lenders in many of the same areas that community banks are, with sizable commercial and industrial, commercial real estate and mortgage portfolios.

“You can essentially take those results and translate them, to a certain degree, into your bank’s size and risk profile,” says Frank Manahan, a managing director in KPMG’s financial services practice. “It’s not going to be highly mathematical or highly quantitative, but it is a data point to show you how severe these other institutions expect it to be for them. Then, on a pro-rated basis, you can extract information down to your size.”

Turner says many community banks could “reverse stress test” their loan portfolios to produce useful insights and potential ways to proceed as well as identify emerging weaknesses or risks.

They should try to calculate their loss-absorbing capacity if credit takes a nosedive, or use a tiered approach to imagine if something “bad, really bad and cataclysmic” happens in their market. Credit and loan teams can leverage their knowledge of customers to come up with potential worst-case scenarios for individual borrowers or groups, as well as what it would mean for the bank.

“Rather than say, ‘I project that a worst-case scenarios is X,’ turn it around and say, ‘If I get this level of losses in my owner-occupied commercial real estate portfolio, then I have a capital problem,’” Turner says. “I’ll have a sense of what actions I need to take after that stress test process.”

A key driver of credit problems in the past has been the unemployment rate, Manahan says. Unemployment is at record highs, but banks can still leverage their historical experience of credit performance when unemployment hit 9.5% in June 2009.

“If you’ve done scenarios that show you that an increase in unemployment from 10% to 15% will have this dollar impact on the balance sheet — that is a hugely useful data point,” he says. “That’s essentially a sensitivity analysis, to say that a 1 basis point increase in unemployment translates into … an increase in losses or a decrease in revenue perspective to the balance sheet.”

After identifying the worst-case scenarios, banks should then tackle changing or refining the data or information that will serve as early-warning indicators. That could be a drawdown of deposit accounts, additional requests for deferrals or changes in customer cash flow — anything that may indicate eventual erosion of credit quality. They should then look for those indicators in the borrowers or asset classes that could create the biggest problems for the bank and act accordingly.

Additional insights

  • Experts and executives report that banks are having stress testing conversations monthly, given the heightened risk environment. In normal times, Turner says they can happen semi-annual.
  • Sophisticated models are useful but have their limits, including a lack of historical data for a pandemic. Young points out that the Fed’s sensitivity analysis discussed how big banks are incorporating detailed management judgement on top of their loss models.
  • Vendors exist to help firms do one-time or sporadic stress tests of loan portfolios against a range of potential economic forecasts and can use publicly available information or internal data. This could be an option for firms that want a formal analysis but don’t have the time or money to implement a system internally.
  • Experts recommend taking advantage of opportunities, like the pandemic, to enhance risk management and the processes and procedures around it.

Pandemic Offers Strong Banks a Shot at Transformative Deals

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It’s a rule of banking that an economic crisis always creates winners and losers. The losers are the banks that run out of capital or liquidity (or both), and either fail or are forced to sell at fire-sale prices. The winners are the strong banks that scoop them up at a discount.

And in the recent history of such deals, many of them have been transformative.

The bank M&A market through the first six months of 2020 has been moribund – just 50 deals compared to 259 last year and 254 in 2018, according to S&P Global Market Intelligence. But some banks inevitably get into trouble during a recession, and you had better believe that well-capitalized banks will be waiting to pounce when they do.

One of them could be PNC Financial Services Group. In an interview for my story in the third quarter issue of Bank Director magazine – “Surviving the Pandemic” – Chairman and CEO William Demchak said the $459 billion bank would be on the lookout for opportunistic deals during the downturn. In May, PNC sold its 22% stake in the investment management firm BlackRock for $14.4 billion. Some of that money will be used to armor the bank’s balance sheet against possible losses in the event of a deep recession, but could also fund an acquisition.

PNC has done this before. In 2008, the bank acquired National City Corp., which had suffered big losses on subprime mortgages. And three years later, PNC acquired the U.S. retail business of Royal Bank of Canada, which was slow to recover from the collapse of the subprime mortgage market.

Together, these deals were transformational: National City gave PNC more scale, while Royal Bank’s U.S. operation extended the Pittsburgh-based bank’s franchise into the southeast.

“We’re more than prepared to do it,” Demchak told me in an interview in late May. “And when you have a safety buffer of capital in your pocket, you can do so with a little more resolve than you otherwise might. The National City acquisition was not for the faint of heart in terms of where we were [in 2008] on a capital basis.”

One of the most profound examples of winners profiting at the expense of the losers occurred in Texas during the late 1980s. From 1980 through 1989, 425 Texas banks failed — including the state’s seven largest banks.

The root cause of the Texas banking crisis was the collapse of the global oil market, and later, the state’s commercial real estate market.

The first big Texas bank to go was actually Houston-based Texas Commerce, which was acquired in 1986 by Chemical Bank in New York. Texas Commerce had to seek out a merger partner after absorbing heavy loan losses from oil and commercial real estate. Through a series of acquisitions, Chemical would later become part of JPMorgan Chase & Co.

Two years later, Charlotte, North Carolina-based NCNB Corp. acquired Dallas-based First Republicbank Corp. after it failed. At the time, NCNB was an aggressive regional bank that had expanded throughout the southeast, but the Texas acquisition gave it national prominence. In 1991, CEO Hugh McColl changed NCNB’s name to NationsBank; in 1998, he acquired Bank of America Corp. and adopted that name.

And in 1989, a third failed Texas bank: Dallas-based MCorp was acquired by Bank One in Columbus, Ohio. Bank One was another regional acquirer that rose to national prominence after it broke into the Texas market. Banc One would also become part of JPMorgan through a merger in 2004.

You can bet your ten-gallon hat these Texas deals were transformative. Today, JPMorgan Chase and Bank of America, respectively, are the state’s two largest banks and control over 36% of its consumer deposit market, according to the Federal Deposit Insurance Corp. Given the size of the state’s economy, Texas is an important component in their nationwide franchises. 

Indeed, the history of banking in the United States is littered with examples of where strong banks were able to grow by acquiring weak or failed banks during an economic downturn. This phenomenon of Darwinian banking occurred again during the subprime lending crisis when JPMorgan Chase acquired Washington Mutual, Wells Fargo & Co. bought out Wachovia Corp. and Bank of America took over Merrill Lynch.

Each deal was transformative for the acquirer. Buying Washington Mutual extended JPMorgan Chase’s footprint to the West Coast. The Wachovia deal extended Wells Fargo’s footprint to the East Coast. And the Merrill Lynch acquisition gave Bank of America the country’s premier retail broker.

If the current recession becomes severe, there’s a good chance we’ll see more transformative deals where the winners profit at the expense of the losers.

Revisiting the Post-Pandemic Strategic Plan

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The coronavirus pandemic has tossed any strategic plans for 2020 — which bank management teams created in late 2019 — out the window.

The banking industry has been directly affected by unprecedented challenges stemming from the Covid-19 crisis, and have quickly addressed emerging issues and adapted their procedures and operations. Revisiting the strategic plan will require executives to holistically reassess risks, challenges, potential opportunities and future goals. While banks will need to re-examine their strategic plans for operational initiatives, it is prudent to also reassess their plans for capital adequacy and approach to M&A.

Capital Planning for Defense and Offense
When reassessing the strategic plan and the impact of Covid-19, banks should consider if current capital ratios provide enough flexibility to both play defense by protecting the balance sheet in a prolonged adverse scenario, and play offense with enough capital to execute on growth opportunities. We believe it is prudent to evaluate multiple scenarios and raise capital when you can — not when you need to.

The capital markets are open today, and many banks have proactively raised subordinated debt in the second quarter. Sub-debt is an attractive form of capital due to its regulatory treatment, no dilution to ownership and relatively low cost in the current rate environment. From a regulatory perspective, sub-debt can qualify as Tier 2 capital at the holding company; proceeds can be down streamed to the bank subsidiary, which qualifies as Tier 1 capital at the bank level, strengthening regulatory capital ratios. The interest expense is tax-deductible, which reduces the effective cost.

The market appetite for sub-debt has been robust: since the beginning of April, commercial banks have raised over $3.5 billion at an average interest rate of approximately 5.50%. Historically, institutional investors were the most active buyers of sub-debt, but the buyer mix has shifted to rely on community and regional banks, insurance companies and asset managers — all looking for attractive yields.

Mergers and Acquisitions        
M&A activity has come to a screeching halt as banks prioritized an internal focus to assess risk. Only nine whole-bank M&A transactions were announced in the second quarter, compared to 67 transactions during the same timeframe in 2019. It seems reasonable to expect valuation multiples will trend lower and deal activity will be subdued until acquirers’ currencies rebound and parties have more visibility and confidence with credit quality and earnings.

On a more positive note, we expect banks to warm to the idea of mergers as strategic partnerships to strengthen the combined company with operational scale and synergies. Of course, these transactions can be challenging to complete and dependent upon similar cultures and management compatibility; however, suppressed M&A valuations provide a window of opportunity since the usual bank buyers aren’t paying rich premiums in the current environment. Economic consideration in a strategic partnership is typically majority stock, not cash, so both parties are reinvesting and have potential to increase the combined company’s value for a more-advantageous positioning when the market recovers.

If you were planning on being a buyer in the next 12 to 18 months, it is important to evaluate how your M&A strategy and priorities may have changed. Buyers with a strong public currency or excess capital will maintain their competitive advantage, but need to be highly selective and strategic for their next deal. Among other things, acquirers will need to bolster the due diligence process to address new challenges and risks.

If you were planning on being a seller in the next 12 to 18 months, focus on identifying your potential buyers, how your valuation may have changed and how you can position the bank to improve the valuation. It is prudent to engage with external advisors in this process, including an investment banker and legal counsel to evaluate these scenarios in detail, even if there is no urgency for a transaction.

These are unprecedented times, and every day seems to bring a new challenge. While it is impossible to predict what will transpire in the next six to 12 months, it is important to update the strategic plan to position your bank to protect shareholder value and take advantage of opportunities.

Information contained herein has been obtained by sources we consider reliable, but is not guaranteed and we are not soliciting any action based upon it. Any opinions expressed are based on our interpretation of data available to us at the time of the original publication of the report. These opinions are subject to change at any time without notice.

The Quiet Crisis You May Be Overlooking

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“In the Covid-19 Economy, You Can Have a Kid or a Job,” reads a recent headline in The New York Times. “You Can’t Have Both.”

As leadership teams consider how they’ll return to some version of “business as usual” when the pandemic abates, there’s one factor they may be overlooking: When daycares and schools close, working parents without effective support systems are forced to prioritize between their children and their career.

“The pandemic has made a bad situation worse,” says Simon Workman, director of early childhood policy at the Center for American Progress.

The supply of high-quality child care couldn’t keep up with demand before the pandemic, and it’s expensive, accounting for 20% to 30% of a family’s monthly income, he says. Providers that are already financially strapped are now earning even less, due to safety and health guidelines that can be costly to comply with. Some providers won’t endure the economic fallout from Covid-19.

Amid the myriad worries facing companies today, child care may seem minor. But it’s a huge stressor for employees, impacting their ability to work. Inadequate child care resources cost working parents and the companies that employ them tens of billions of dollars annually, according to a Care.com study, with parents losing $37 billion in wages and companies experiencing $13 billion in lost productivity. And the problem is larger than those numbers suggest: Care.com’s research only accounts for parents of children under the age of three.

Child care benefits could be an effective tool in a company’s arsenal when it comes to attracting and retaining talent. Roughly half of bank employees are 45 or younger, according to Bank Director’s 2020 Compensation Survey, meaning that many are focused on building families as well as their careers. Yet only 12% of banks offer child care benefits, according to our survey.

Sterling National Bank, a subsidiary of Sterling Bancorp, chose to subsidize backup child care for its employees following conversations between CEO Jack Kopnisky, Chief Human Resources Officer Javier Evans and Margaret Wortley, director of benefits, HR operations and compliance, exploring how Sterling could better compete for talent in New York City.  

“Jack talked to Margaret and [me] and said, ‘I want us to offer contemporary, forward-looking benefits to keep us right there at the leading edge,’” Evans says. The $30 billion bank based in Montebello, New York, competes for customers and talent with the likes of JPMorgan Chase & Co. and Citigroup.

“[They’re] all here in our backyard,” Evans continues. “So, we’ve got to make sure that we stay at least contemporary, from a benefit offering, so we can be competitive from that point of view.”

One provider the bank chose was Helpr, a startup offering a range of services for employees, including backup care, online classes and tutoring for kids, as well as consulting and concierge services.

Sterling initially subsidized 16 hours of backup child care annually, intending to offer employees a chance to take a date night, for example. This grew to 80 hours due to the pandemic. Up to that limit, an employee pays no more than $6 per hour with the bank covering the rest.

For employees seeking long-term care, Sterling also subsidizes the cost to recruit and screen candidates. Employees pay a one-time $500 fee; a similar service would cost $2,500, says Wortley.

“We’re hearing back from companies that primary care is the biggest stressor for their employees right now,” says Sarah Bystrom, a business development executive at Helpr. “That’s causing this anxiety and stress around how to continue to balance family and work life.”

In addition to Helpr, Sterling works with Bright Horizons, another care provider.

In response to the pandemic, the bank increased hourly pay for front-line staff and awarded a $750 bonus to non-executive employees, according to Evans. They also received extra paid time off, which many used to care for children, and Sterling has worked with employees to create more flexible schedules. Virtual education goes beyond banking to cover topics like working at home with children.

Sterling also provided access to Headspace, an app focused on mindfulness and mental health. “We knew right at the beginning of the pandemic that this would take a mental toll on folks,” Evans says.

Working parents need support in these unique times; they’ll also need it after this crisis is in the rearview mirror. According to Workman, about 2 million families experience a job disruption — missed work or even quitting — due to child care challenges.

“That’s bad for the family, but it’s also bad for the employer,” he says. “As a society, as an economy, we all benefit when families have access to high-quality, early childhood education they can afford and access on a reliable schedule.”