Banks Have Started Recording Goodwill Impairments, Is More to Come?

A growing number of banks may need to record goodwill impairment charges once the coronavirus crisis finally shows up in their credit quality.

A handful of banks have already announced impairment charges, doing so in the first and second quarter of this year. Some have written off as much as $1 billion of goodwill, dragging down their earnings and, in some cases, dividends. Volatility in the stock market could make this worse in the second half of the year.

“It was a very hot topic for all of our financial institutions,” says Ashley Ensley, a partner in DHG’s financial services practice. “Everyone was talking about it. Everybody was looking at it. Whether you determined you did … or didn’t have a triggering event, I expect that everyone that had goodwill on their books likely took a hard look at that amount this quarter.”

Goodwill at U.S. banks totaled $342 billion in the first quarter, up from $283 billion a decade ago, according to the Federal Deposit Insurance Corp.

Goodwill is an intangible asset that reconciles the premium paid for acquired assets and liabilities to their fair value. It’s recorded after an acquisition, and can only be written down if the subsequent carrying value of the deal exceeds its book value. Although goodwill is an intangible asset excluded from tangible common equity, the non-cash charge can have tangible consequences for acquisitive banks. It immediately hits the bottom line, reducing income and, potentially, even capital.

Several banks have announced charges this year. PacWest Bancorp, a $27.4 billion bank based in Beverly Hills, California, took a charge of $1.47 billion. Great Western, a $12.9 billion bank based in Sioux Falls, South Dakota, took a charge of $741 million. And Cadence Bancorp., an $18.9 billion bank based in Houston, Texas, recorded an after-tax impairment charge of $413 million.

Boston-based Berkshire Hills Bancorp announced a $554 million charge during its second-quarter earnings that wiped out all its goodwill. The charge, combined with higher loan loss provisions, led to a loss of $10.93 a share. Without the goodwill charge, the bank would’ve reported a loss of only 13 cents a share.

The primary causes of the goodwill impairment were economic and industry conditions resulting from the COVID-19 pandemic that caused volatility and reductions in the market capitalization of the Company and its peer banks, increased loan provision estimates, increased discount rates and other changes in variables driven by the uncertain macro-environment,” the bank said in its quarterly filing.

Goodwill impairment assessments begin by evaluating qualitative factors for positive and negative evidence — both internally and in the macroeconomic environment — that could cause a bank’s fair value to diverge from its book value.

“It really is not a one-size-fits-all analysis,” says Robert Bondy, a partner in Plante Moran’s financial services group. “Just because a bank — even in the same marketplace — has an impairment, it’s hard to cast that shadow over everybody.”

One reason banks may need to consider impairing their goodwill is that bank stock prices are meaningfully down for the year. The KBW Regional Banking Index, a collection of 50 banks with between $9 billion and $63 billion in assets, is off by 33%. This is especially important given the deceleration in bank deals, which makes it hard to evaluate what premiums banks could fetch in a sale.

“[It’s been] one or two quarters and overall markets have rebounded but bank stocks haven’t,” says Jay Wilson, Jr., vice president at Mercer Capital. “You can certainly presume that the annual impairment test, when it comes up in 2020, is going to be a more robust exercise than it was previously.”

Banks could also write off more goodwill if asset quality declines. That has yet to happen, despite higher loan loss provisions — and in some cases, banks saw credit quality improve in the second quarter.

The calendar could influence this as well. Wilson says the budgeting process and cyclical cadence of accounting means that annual tests often occur near year-end — though, if a triggering event happens before then, a company can conduct an interim test.

That’s why more banks could record impairment charges if bank stocks don’t rally before the end of the year, Wilson says. In this way, goodwill accumulation and impairment mirror the broader economy.

“Whenever the cycle turns, banks are inevitably in the middle of it,” he says. “There’s no way, if you’re a bank to escape the economic or the business cycle.”

Why This Crisis Is Different

The USS Economy is steaming into dangerous waters and the country’s banks are trapped aboard with the rest of the passengers.

A public health policy of social distancing and lockdowns in response to the COVID-19 virus is creating a devastating impact on the U.S. economy, which in recent years has been driven by consumer spending and a historically low unemployment rate. According to the Bureau of Labor Statistics, the U.S. labor market added 273,000 jobs in February, while private sector wages grew 3%. Moody’s Investors Service also says that the U.S. economy grew 2.3% last year, with personal consumption expenditures contributing 77% of that growth.

That is changing very quickly. Brace yourself for the virus economy.

Wall Street firms are forecasting that the U.S. economy will contract sharply in the second quarter — with Goldman Sachs Group expecting a 24% decline in gross domestic product for the quarter.

“The sudden stop in U.S. economic activity in response to the virus is unprecedented, and the early data points over the last week strengthened our confidence that a dramatic slowdown is indeed already underway,” Goldman’s chief economist Jan Hatzius wrote in a March 20 research note.

My memory stretches back to the thrift crisis in the late 1980s, and there are others that have occurred since then. They’ve all been different, but they generally had one thing in common: They could be traced back to particular asset classes — commercial real estate, subprime mortgages or technology companies that were grossly overfunded, resulting in dangerous asset bubbles. When the bubbles burst, banks paid the price.

What’s different this time around is the nature of the underlying crisis.

The root cause of this crisis isn’t an asset bubble, but a public health emergency that is wreaking havoc on the entire U.S. economy. Enforced governmental policies like social distancing and sheltering in place have been especially hard on small businesses that employ 47.5% of the nation’s private workforce, according to the U.S. Small Business Administration. It puts a lot of people out of work when those restaurants, bars, hardware stores and barber shops are forced to close. Economists expect the U.S. unemployment rate to soar well into double digits from its current rate of just 3.5%.   

Bank profitability will be under pressure for the remainder of the year. It began two weeks ago when the Federal Reserve Board began cutting interest rates practically to zero, which will put net interest margins in a vice grip. One bank CEO I spoke to recently told me that every 25-basis-point drop in interest rates clips 4 basis points off his bank’s margin — so the Fed’s 150 basis point rate cut reduced his margin by 20 basis points. Worse yet, he expects the low-rate environment to persist for the foreseeable future.

Making matters worse, banks can expect that loan losses will rise over time — perhaps precipitously, if we have a long and deep recession. Many banks are prepared to work with their cash-strapped borrowers on loan modifications to get them through the crisis; federal bank regulators have said lenders will not be forced to automatically categorize all COVID-19 related loan modifications as troubled debt restructurings, or TDRs.

Unfortunately, a prolonged recession is likely to outpace most banks’ abilities to temporarily forego principal and interest payments on their troubled loans. A sharp rise in loan losses will reduce bank profitability even more.

There is another way in which this crisis is different from previous crises that I have witnessed. The industry is much stronger this time around, with roughly twice the capital it had just 12 years ago at the onset of the subprime mortgage crisis.

Think of that as first responder capital.

During the subprime mortgage crisis, the federal government injected over $400 billion into the banking industry through the Troubled Asset Relief Program. The government eventually made a profit on its investment, but the program was unpopular with the public and many members of Congress. The full extent of this banking crisis remains to be seen, but hopefully this time the industry can finance its own recovery.

Are You Prepared to Manage a Crisis?

7-14-14-article.pngMore than most companies, banks rely on the trust and confidence of the public. The 81-year-old deposit insurance program has made Depression-era bank runs, where frightened depositors once lined the street waiting to withdraw their money, a relic of the past. But there’s a new risk that the deposit insurance system can’t protect against—the theft of sensitive customer information by cyber crooks—and banks of all sizes need to have a crisis management plan at the ready in case they get hacked.

Recently, I participated in Bank Director’s 2014 Bank Audit & Risk Committees Conference in Chicago, where there were several presentations on cyber security, and one message came through loud and clear: All banks are at risk, including even small and medium-sized ones. In fact, smaller institutions might be in even greater danger than much larger ones because the bad guys—and I’m talking about hackers in Eastern Europe and Russia—figure that they’re an easier mark.

Any community bank CEO or director who thinks their institution is too small to worry about cyber crime is living in an altered reality.

There were also a couple of presentations on crisis management, which goes together with cyber crime like ham and eggs. Not only is your bank at risk of getting hacked, but you need to have a crisis management plan that can be put into effect quickly in case it does. This is important! If your data systems are broken into and sensitive customer information gets into the wrong hands, your customers will feel differently about the bank unless something is done quickly and done well.

The issue here is public trust and confidence.

It’s important to know in advance what to do—and what not to do when a crisis explodes (and often that’s how crises announce themselves to the world, with a big boom) because you probably won’t have a lot of time to react.

In her presentation on crisis management, Rhonda Barnat, a managing director at the New York-based communications firm The Abernathy MacGregor Group, cautioned against the urge to over-disclose information such as how many customers were impacted by the breach, or how the breached occurred, because this factual information will end up becoming the story. Barnat also said banks should be careful how they use social media during a crisis—for example, they shouldn’t necessarily respond to a negative video on YouTube with a rebuttal video. Instead, the bank’s primary focus should be on taking care of the affected customers. In other words, the best way to rebuild trust and confidence is to fix the problem and make customers whole, not wage a public relations campaign. Do the right thing and word will get around soon enough.

Barnat says there are 10 common mistakes that companies make when managing a crisis, including getting out in front of the story, which often just leads to confusion because facts have a way of changing.

Maureen Morrissey Brown, who is the senior vice president and public relations director at Huntington Bancshares, also gave a presentation on crisis management. Brown said it’s important to have a plan in place so that if a data breach does occur the bank can hit the ground running. This plan should do the following:

  • Create a crisis management team that can quickly go to work if the bank is hacked and customer information is stolen. This team would normally include the CEO, legal counsel, the bank’s compliance officer, senior public relations officer and an outside public relations firm.
  • Take some time to identify possible scenarios – a data break is one such scenario obviously, but others might be an acquisition gone bad, an earnings restatement if it’s a public company or old-fashioned fraud by an insider.
  • Create what Brown refers to as “holding statements,” which are statements that you will release to the public if any of those scenarios occur. These might have to be modified depending on the circumstances, but at least you’ll have something to work with.
  • Appoint a spokesman to deal with the media and give that person training on how to respond publicly in crisis situations.
  • Assign roles and responsibilities to team members so that everyone knows who does what.

Brown had this last bit of advice: Design the plan to be comprehensive but allow for unforeseen situations, update the plan frequently, always be on the lookout for developing challenges, and monitor the reactions of competitors, peers, customers and suppliers.

Brown ended her presentation with a recent comment that Warren Buffet made to CNBC about General Motor’s poor handling of the controversy involving faulty ignition switches, which have been blamed in 13 deaths.

“Get it right. Get it fast. Get it out. And get it over.”