Regulatory Scrutiny Focuses on Inadequate Strategic and Capital Planning


capital-planning-9-24-15.pngOnce again, regulators are zeroing in on inadequate strategic and capital planning processes at many community banks.

The Office of the Comptroller of the Currency (OCC) listed “strategic planning and execution” as its first supervisory priority for the second half of 2015 in its mid-cycle status report released in June. That echoes concerns from the latest OCC semiannual risk perspective, which found that strategic planning was “a challenge for many community banks.”

FDIC Chairman Martin J. Gruenberg said in May that regulators expect banks “to have a strategic planning process to guide the direction and decisions of management and the board. I want to stress the word ‘process’ because we don’t just mean a piece of paper.”

He said that effective strategic planning “should be a dynamic process that is driven by the bank’s core mission, vision and values. It should be based on a solid understanding of your current business model and risks and should involve proper due diligence and the allocation of sufficient resources before expanding into a new business line. Further, there should be frequent, objective follow-up on actual versus planned results.”

In writing about strategic risk, the Atlanta Federal Reserve’s supervision and regulation division said that “a sound strategic planning process is important for institutions of all sizes, although the nature of the process will vary by size and complexity.” The article noted that the process “should not result in a rigid, never-changing plan but should be nimble, regularly updated (at least annually) and capable of responding to risks and changing market conditions.”

Given economic changes and increased market competition, community banks must understand how to conduct effective strategic planning. This is more important now than ever, says Invictus Consulting Group Chairman Kamal Mustafa.

The smartest banks are using new analytics to develop their strategic plans— not because of regulatory pressure, but because it gives them an edge in the marketplace and a view of their banks they cannot otherwise see, Mustafa said.

Strategic planning is useless without incorporating capital planning. The most effective capital planning is built from the results of stress testing. These critical functions—strategic planning, capital planning and stress testing—must be integrated if a bank truly wants to understand its future,” he said.

He advises banks to use the same fundamental methodology for both capital planning and strategic planning, or else they will run the risk of getting misleading results. This strategy is also crucial in analyzing mergers and acquisitions.

OCC Deputy Comptroller for Supervision Risk Management Darrin Benhart also advises community banks to use stress testing to determine if the bank has enough capital. “Boards also need to make sure the institution has adequate capital relative to all of its risks, and stress testing can help,” he said in a February speech. “We also talk about the need to conduct stress testing to assess and inform those limits as bank management and the board make strategic decisions.”

Avoiding Pitfalls in Your Bank’s Data Processing Agreement


vendor-management-9-23-15.pngA bank’s core processing agreement is often, by far, its most significant vendor agreement. These lengthy and complex agreements are commonly weighted heavily in favor of the vendor and can be rife with traps, such as steep change-in-control and early termination penalties. Nonetheless, many banks enter into core processing agreements without prior review by counsel, or even reading the agreement themselves. In the current regulatory environment, which stresses and scrutinizes vendor risk management and diligence, a bank’s failure to review and negotiate its core processing agreement could easily result in regulatory criticism, as well as unanticipated costs and potential liability.

In the past few years, the bank regulatory agencies have issued new or updated guidance related to vendor diligence and risk management. In those issuances, the regulators express concern that banks’ vendor risk management practices may be inadequate, citing instances in which management has failed to properly assess and understand the risks and costs of their vendor relationships. Regulators are concerned that banks may enter into agreements that are detrimental to the bank’s employees, customers or other stakeholders. Banks are expected to have risk management processes that correspond with the level of risk and complexity of their vendor relationships. Those processes include due diligence, careful vendor selection, contract negotiation, proper termination mechanisms and ensuring proper oversight. Regulators further expect banks to have more comprehensive and rigorous oversight of management of third-party relationships that involve critical activities, which may include significant bank functions, such as payments, clearing, settlements and custody, or significant shared services, such as information technology.

Regulators conducting bank examinations expect to see adequate risk management policies and procedures in place. Proper due diligence, negotiation, and oversight for data processing contracts should be integral to those procedures. Contrary to what many may think, the terms of data processing agreements are negotiable. Some of the most unfavorable terms may be eliminated simply by emphasizing the regulatory or business necessity for those changes during negotiations. Key terms to address in the negotiation process include termination provisions, regulatory provisions, audit rights and performance standards, among others.

A less obvious concern with core processing agreements arises in the context of a bank merger or acquisition. Steep termination fees in a data processing contract can change the economics of a bank acquisition transaction, making the selling bank a less attractive target and negatively impacting shareholder returns on the sale. It is typical for the initial proposal of a data processing agreement to include contract termination fees equal to roughly 80 percent of the remaining fees payable during the term of the contract. In most cases, these termination fees are negotiable, and data processing providers may be receptive to a graduated termination fee schedule, such that termination fees are less severe later in the term of the contract. In addition, termination fee calculations in core processing agreements are often complex. As such, it will be important for bank management to understand the practical implications of those calculations. Data processing providers will often attempt to recoup any past credits or rebates through the termination fee formula. Understanding and negotiating these termination provisions on the front end can save millions of dollars for the acquiring bank, and ultimately increase returns for the bank’s shareholders.

If your bank is considering a new data processing vendor, or reaching the expiration of your current term and considering renewing with your old vendor, you should work through your regulatory vendor risk management and due diligence checklists before entering into a new contract. We further encourage you to identify a dedicated team, with access to bank counsel, to review and negotiate any proposed agreement. If your institution is considering a future sale or other business combination transaction, then negotiating your data processing contract is of paramount concern. Ultimately, an ignored termination provision in your core processing agreement has the potential to undermine a potential merger or materially impair shareholder returns.

Time to Develop an M&A Survival Strategy


Thirty years ago there were a record high 18,000+ banks in the United States. We’re now down to around 6,700 with all indications pointing to further consolidation. Meanwhile, new bank charters have dwindled to near non-existence with one new bank opened between the end of 2010 and 2013.

  20 years ago 10 years ago Today
 Total number of institutions 12,644 9,129 6,739
 Total number of banks $1 – $50B in assets 554 553 642
 Total number of banks $50B+ in assets 8 27 37
 Total number of banks less than $500MM in assets 11,688 8,022 5,382

Between the number of industry disrupters trying to win a slice of the traditional banking business and the plethora of investment opportunities in other industries with less regulation, it’s easy to imagine the number of banks falling by a full 50 percent in the next 20 years.

For better or worse, banking has become a scale business. The costs of regulatory compliance, necessary investments in new technology, physical and digital channels, and thinning industry margins mean banks will either need to be of a certain size or have a defensible niche built on knowledge rather than transactions.

For the better part of the past decade, the folks at Cornerstone have touted the $1 billion asset threshold as a marker of scale. Because of our friends in Washington and the dizzying pace with which technology has changed our industry, I think the new threshold to reach in the next five to seven years is more in the $5 billion asset neighborhood. If my prediction bears out, the vast majority of M&A activity and consolidation will take place in the midsize bank space ($1 – $50 billion), either with smaller midsize banks buying community banks or banks at the upper end acquiring $5 and $8 billion banks.

I have always been a proponent of having a solid organic growth strategy, but midsize banks will need to develop AND execute upon a solid M&A strategy to survive. Most banks lamely describe their M&A strategy as “opportunistic,” which is code word for: “waiting for the investment banker to call with a proposed deal.” This simply won’t cut it in the fast-consolidating, commoditized industry we call banking today. Here are some key areas your M&A strategy should address.

  • Define Your Value Proposition. Define in financial AND human terms what makes you an attractive acquirer. The list of possibilities are endless: opportunities for stock value gains, opportunities for employee growth at a larger bank, track record of performance, a willingness to negotiate system choices, or a holding company type business model that allows the acquired bank to maintain its brand and management team.
  • Identify M&A Partners. Define filters to narrow down what targets make the list including qualities like geography, asset size, branch network, balance sheet mix, capital levels and niche businesses. Tools like the Federal Deposit Insurance Corp. website or SNL Financial can easily help you produce your target list. Stack rank your target list starting with the most attractive to the least by assigning weighted values to your filters.
  • Cultivate the Courtship. If you are the acquirer, you need an active outreach program that includes management, directors and shareholders, with the mix changing depending on the target. Your outreach program needs to involve a consistent manner of communicating your value to your targets. Get creative. Courtship could involve providing shared services for a common core platform, inviting select management and directors to your strategic planning session, or offering to outsource from your niche expertise like trust and wealth management platforms.
  • Define the Merger Value. Once you find a receptive bank, you will need to paint a clear picture of the value a merger will bring to shareholders and management of the target bank that goes beyond the pro forma financial model. The target bank will want to know about management team composition, board seats, branch closures, surviving systems and products, efficiency targets, headcount reductions, and branding, to name a few.
  • Conduct Due Diligence and Begin Negotiations. If you’ve made it this far, the M&A strategy and framework you have laid out is obviously working. Now, the formal process begins.

At the end of the day, midsize banks have two choices: rely on a decades-old organic growth strategy combined with opportunistic M&A, or get in the game and execute upon a carefully defined M&A strategy. The risk of being left behind as other midsize banks scale up is not one I would want to take with my bank.

Doom Diligence: Don’t Let Your Due Diligence Hurt You


bank-auction-8-18-15.pngAs M&A activity continues to steam forward in 2015, we are seeing a growing number of banks being sold through true active auctions: multiple qualified and interested buyers all place bids with similar pricing, leaving the seller’s board of directors to look beyond the “sticker price” to choose a partner.

Beyond the more traditional non-financial considerations, an increasing number of sellers now focus on the buyer’s ability to move quickly from a letter of intent to an announced transaction.  These considerations include not only the legal negotiation of a definitive agreement but also the post-letter of intent due diligence that will be conducted by the proposed buyer. To that point, we are now seeing some sellers request a full due diligence list as part of a buyer’s final bid.

With the depth of due diligence becoming a competitive matter, how does a buyer balance the need to identify potential risks in a target with a need to win a competitive process? This question is important even for buyers who do not desire to participate in competitive auctions because a buyer’s reputation will follow it from deal to deal. Those buyers who are deemed to be efficient partners will have an advantage over those who are viewed as conducting time consuming, onerous processes.

The best buyers have a well defined set of financial parameters that they require to be met in each transaction. These parameters might be stated in terms of a required internal rate of return or a required level of accretion to earnings per share. These criteria typically become the “non-negotiables,” while the buyer may be more willing to be flexible with respect to other non-financial terms.

A similar philosophy can and should be applied to due diligence efforts. That is, there should be a well defined universe of risks that should be carefully examined as a priority in due diligence while the buyer can be more flexible with respect to other items. As an example, if a seller has a small mortgage operation that will not be retained, diligence could be limited to matters that could present go-forward risk even after the operation is shut down. On the other hand, if a seller has a mortgage operation that is a material part of the acquisition, detailed diligence would be necessary to ensure that it can be smoothly integrated into the business of the buyer.

Buyers make two common mistakes in this area that can be relatively easily remedied. The first is hurriedly requesting a “standard” due diligence list from an advisor without carefully thinking about whether the request fits with the goals of the acquisition and the risks presented by the target bank. Without a tailored and focused request list, there are likely material issues that are not being thoroughly explored and immaterial issues that are causing sellers angst for no benefit.

A second common mistake is the failure to communicate to the diligence team (including outside advisors) the transaction’s key drivers of value so that they can focus most on those issues. In addition, the diligence team should be aware of the “tone” of the negotiations. If the buyer has promised a highly flexible and efficient process, the diligence team should be similarly accommodating in the diligence process. The diligence team, after all, should portray the buyer in a manner that is consistent with management’s overall view toward the potential deal.

Through a thoughtful approach, the due diligence process can allow buyers to manage potential risks while also demonstrating flexibility. If key drivers of value and potential risks are identified and communicated early in the process, the diligence team can add value without drawing the ire of the would-be seller. In an M&A environment that only seems to be getting more and more competitive, focus in this area can yield real benefits when it comes to winning deals.

This article originally appeared in Bank Director digital magazine’s Growth issue. Download the digital magazine app here.

Saving Money as Part of Due Diligence


due-diligence-8-18-15.pngAs acquisitions continue to play a major role in financial institutions’ strategic growth plans, management teams and boards are under increasing pressure to deliver results—with minimal surprises. Though due diligence often is seen as a necessary evil to completing a transaction, it can help identify opportunities to drive profitability and assess integration hurdles so an acquirer effectively can plan for and mitigate the risk of an unsuccessful integration.

Cost savings often are touted as a primary driver of acquisitions in banking. Many public filings show that estimated cost savings of a target’s expense structure run north of 25 percent. Preliminary cost estimates that are provided by management or investment advisers often are based on high level analysis prior to a letter of intent (LOI) being signed. Once an LOI is signed, due diligence should be performed to verify the extent, timing, and operational effects of the proposed cost savings as these are critical to recognizing the value in many acquisitions. Cost saving estimates should be continually adjusted throughout the due diligence process as new facts come to light.

Following are three areas of significant cost saving estimates and examples of how thinking through integration objectives throughout the due diligence process will help eliminate surprises.

  1. Back Office Consolidation
    Significant cost savings can be realized through back office consolidation. Consolidating back office operations can get delayed, however, due to vendor backlogs for conversion or de-conversion of data. Product mapping issues also might delay moving from one core processor to another. Such delays can have significant impact on the returns analysis as the savings are delayed and two operating structures remain for extended periods of time. While it might not be possible to fully address all factors that can potentially affect the integration, reviewing product mapping and starting the system conversion timeline discussions during due diligence will provide insights into timing and possible roadblocks.
  2. Branch Rationalization
    Eliminating branch overlap or consolidating unprofitable locations can be a source of cost savings. A branch profitability analysis can identify the product usage, transaction activity, and relationship value and should be performed during due diligence. However, the costs associated with exiting facilities as well as operational drag must be considered. Acquisition accounting requires recognizing the assets and liabilities at fair value upon the change in control, and operational costs to exit or restructure a bank generally are represented through the acquirer’s income statement post-combination.
  3. Vendor Management
    While combining core processing systems are a given for cost savings, comprehensive vendor management cost savings often are overlooked in the initial transaction value proposition. Again, considering integration while performing due diligence can help executive teams concentrate vendors across the combined organization. Thinking in terms of pricing power, service level expectations, integration support, and breadth of service, acquisitions often set the stage for new conversations with vendors. Taking the time during due diligence to analyze the future stable of vendors to eliminate overlap or consolidate platforms can be a significant value driver. Analyzing vendors early on allows acquirers to execute formal vendor selection processes shortly after the transaction announcement and realize cost savings soon after legal closing.

Best Practices to Follow
Here are best practice recommendations for achieving targeted cost savings:

  • Each cost savings assumption should be championed or assigned to a cost savings owner.
  • The cost savings owner should help establish the initial savings estimate and timeline to recognize cost savings during due diligence.
  • The cost savings owner should be able to affect the integration plan to achieve the cost savings objective.
  • The integration vision should be defined during due diligence to accomplish the cost savings.
  • Cost savings estimates should be revisited throughout the due diligence process to adjust for one time costs identified and for revisions to the plan.

This article originally appeared in Bank Director digital magazine’s Growth issue. Download the digital magazine app here.

Mind These Gaps


5-13-15-Al.pngProbably one of the worst moments for a bank board and management team is to make an acquisition and find out it was a bad one. Over the past few years, it strikes me that three pitfalls typically upend deals that, on paper, looked promising:

  • Loss of key talent/integration problems;
  • Due diligence and regulatory minefields; and
  • Bad timing/market conditions.

While timing is everything, I thought to address the first two pitfalls here.

Losing Key Talent
A CEO with experience selling a bank tells me that number one on her list is to “personally reach out to top revenue generators ASAP and let them know they are going to have a great future in the combined company. It always amazes me how key leaders think they can wait on that while they talk to staff folks.”

But don’t stop there. If the merger is designed to significantly reduce costs and there is a lot of overlap, your staff will know that there are going to be significant job losses. “My advice, be honest,’’ the CEO says. “If you have a plan or process, tell them what it is. If you don’t tell them, you will let them know the second you do. Don’t sugar coat it. Call the key ones you know you will need with a retention offer ASAP.”

This advice had me seeking the counsel of Todd Leone, a principal with the management consulting firm of McLagan. Leone suggests those in key positions with change-in-control contracts usually stay as they are going to get paid.  Also, those in true key positions negotiate at the time of the deal to stay on after the merger. However, it can be complicated to retain the next level of staff.  As Todd says, “[It’s best to] negotiate at time of deal.”

Regulatory and Due Diligence Minefields
Now, as much as the drain of talent threatens the long-term success of a deal, there are other minefields to navigate. Bill Hickey, principal and co-head of the Investment Banking Group at Sandler O’Neill + Partners, cautions me that in today’s interest rate environment, significant loan pay-downs could be looming.

Another due diligence matter is an IT contract that requires large termination fees. Aaron Silva, the president and CEO of Paladin fs, says that banks need to implement terms and conditions into their agreements ahead of time that protect shareholders from unreasonable termination risk, separation expense and other obligations that may impact any M&A strategy.

Building on these talent and technology risks, John Dugan and Rusty Conner, both partners at the law firm of Covington & Burling, say that in today’s bank M&A market, “all of the historical issues related to pricing, diligence, and integration remain very relevant, but there are three issues that have taken on new prominence thereby impacting execution and certainty of closing.”  They are:

  • The reaction of the regulators to the proposed transaction—particularly if the acquiring institution is approaching a designated size threshold;
  • Protests by community groups—which can materially delay a transaction even if the complaint is without merit—especially [since] these groups are now targeting much smaller deals than ever before; and
  • Shareholder suits by the acquired institution’s shareholders—which are also increasingly making their way to smaller deals.

As Dugan opines, “parties need to anticipate and build into their pricing and timing the impact of these factors.”

Their views complement those of Curtis Carpenter, managing director of Sheshunoff & Co. He’s of the opinion that in today’s market, “regulatory and compliance matters have become critical components for both the seller and buyer. It is more important than ever for sellers to put in place generous pay-to-stay bonuses for key personnel who are in positions likely to be eliminated in the merger. The heightened regulatory scrutiny surrounding the merger process can result in long approval periods—sometimes many months.” 

Where most bank mergers fail isn’t in the transaction itself. No two deals are alike, but addressing these challenges is simply good business.

M&A 101 for the Board


Whether your financial institution is looking to buy or sell, the board of directors has several important responsibilities during an M&A transaction. In this video, Steve Kent of River Branch Capital LLC outlines the board’s role in the M&A process including negotiations, due diligence and after the deal is done.


Understanding M&A Accounting: What to Watch For


9-29-14-Crowe.pngOne of the worst things for an acquirer to find out after the fact is that the target wasn’t worth what the acquirer thought it was. That egg is on the board’s face and can cause significant headaches. The following are key trends and issues we have found recently in merger and acquisition (M&A) due diligence reviews.

Asset Quality
There is no better indicator of credit quality than a thorough loan review. We have seen a significant rise in collateral values in areas that were the hardest hit and modest recovery in others. Once-troubled institutions are recovering and finally are beginning to move other real estate owned and problem loans that sat unmarketable for several years. While the cleanup might not lead to a recapitalization of a bank for a variety of financial and legacy reasons, it has positioned many institutions as attractive acquisition targets at reasonable franchise values.

However, the not-so-happy news is that weak loan demand and the need to deploy capital efficiently have led to easing credit standards in commercial and industrial (C&I) and commercial real estate loans. It is important to check for deficiencies such as borrower base certificate compliance, waived or reset covenants, and lack of field audits. Also, current underwriting with extended amortizations and lower debt service requirements can present long-run risk to an acquirer. Additionally, we see institutions engaging in new loan products, which can present long-term risk if lender qualifications and track records have not been tested through a variety of economic cycles.

Quality of Earnings and Balance Sheet
Tangible book value (TBV), a common metric within the financial services industry, is used as an anchor for pricing a potential acquisition. Understanding the ways in which improper accounting or one-time income or expense items may skew this figure is important in arriving at a proper value for the bank. In the private company setting, we often find the rigor applied to interim accounting records does not match that applied to the annual audited financials. As management teams are more focused on normalizing yearly results, non-operating expense items might level out over the course of the year to not dramatically affect monthly results. We’ve observed a number of improperly capitalized items buried in other assets and underaccrued liabilities that can significantly distort the net book value of a bank. When establishing a fair purchase price based on a multiple of TBV, a $1 million interim balance sheet misstatement could mean a $1.5 million to $2 million purchase price adjustment.

Similarly, a $100,000 overstatement of core earnings could be a $1.6 million to $2 million purchase price adjustment using current multiples. We continue to see earnings supported by reserve releases, investment security salesA, and various other anomalies that have to be deciphered in order to get a true picture of normalized earnings. Determining a bank’s core earnings potential is more difficult in the current landscape because many acquisition targets have completed bank acquisitions of their own in the past few years. Both open-bank and failed-bank acquisitions come with accounting complexities related to recognition of interest income on the loans acquired. It’s imperative to understand the difference between the accounting yields and the cash income created from these acquired assets in order to avoid overestimating core earnings.

If a target bank has completed a failed-bank acquisition with loss-share agreements in place, significant consideration should be given to the accounting and record keeping of the loss-share arrangement. Acquirers should focus on understanding the remaining terms of any loss sharing, the ability to collect under the loss-share terms, and the potential hole that might be created from overstatement of the indemnification asset. Many of these arrangements may not be completely settled with the Federal Deposit Insurance Corp. (FDIC) for several more years, and many agreements contain a “true-up” provision whereby the FDIC could be owed significant sums of money if the loans perform better than expected. Each loss-share contract is unique, and potential acquirers need to fully understand the complexities associated with these agreements during the due diligence phase.

The issues highlighted here are just a few of the more common issues we’re seeing in current due diligence findings. Execution of a well-conceived due diligence plan can help eliminate surprises from an accounting, operational and credit perspective and lead to a successful transaction.

How to Handle Loan Portfolio Valuation and Avoid Trouble Later


12-23-13-Crowe.pngIn most acquisitions, the selling bank’s loan portfolio generally is the largest asset. Valuing it often consumes the majority of the valuation team’s effort. Achieving consensus on fair value can be challenging, as there typically isn’t an observable market price for most bank loan portfolios. In fact, the acquirers’ management often is surprised by the difference between its pro forma balance sheet projections and the final independent, third-party valuations. These unexpected changes in valuation could have a significant impact on the acquiring institution’s regulatory capital requirements and future earnings potential.

In most acquisitions, the valuation of the loan portfolio primarily is performed using a discounted cash flow method and various assumptions such as probability of default, loss given default, prepayment speeds, and required market rates of return on the projected loan cash flows.

What should management teams think about as they approach acquisitions and determine pricing and purchase price allocations? Here are a few considerations:

  1. To achieve a result that can be managed on an ongoing basis, loan valuations require a balance between the acquiring bank’s various internal management teams. For example, in many cases, finance teams significantly rely on the credit review due diligence team to assign the fair value marks on the loan portfolio. Note that the credit review team must provide its input for the results to be consistent with how the credits will be managed post-acquisition. An issue sometimes arises because most credit review teams typically provide identified loss ranges that are more applicable to an allowance for loan loss method. Alternatively, consider a range of life-to-date loss projections that can be presented to the board and management as best-case/worst-case scenarios to evaluate the overall merits of the transaction.
  2. The absolute credit mark might be fine for due diligence, but to be in compliance with U.S. generally accepted accounting principles (GAAP) and Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805, “Business Combinations,” the timing and amount of expected loan cash flows need to be projected, and the market-required rates of return on the cash flows must be considered. Both the credit review and finance teams need to keep this distinction in mind, because incorporating both the timing and amount of loan cash flows and market-required returns often will decrease the values from the basic credit marks.

    Consider market factors other than credit, timing, and market pricing in the analysis. ASC 805 and the fair value standard ASC 820, “Fair Value Measurement,” require acquirers to value loans using an “exit pricing” method, which loosely translates to what a willing buyer would pay a willing seller for that loan. This differs from other methods such as asset/liability fair values that often use a bank’s own new loan rates as the basis for discounting the cash flows. Under GAAP, using the current interest rate for the institution to make a loan is labeled as an entrance price, while acquisition accounting GAAP requires an exit price, or the price to sell the asset or assume the liability.

  3. One of the primary market factors to consider in addition to the basic valuation inputs (such as discount rate, credit loss factors, prepayments and the contractual loan principal and interest payments) is the liquidity discount applied to each loan. It takes time and effort to sell a loan or a loan portfolio, and that time affects pricing. The more difficult a loan portfolio is to sell, the higher the liquidity discount that is factored into the required rate of return. Additionally, market perception is a factor that affects pricing no matter the credit quality. For example, loan portfolios with heavy concentrations of home equity or construction loans are discounted regardless of credit quality because of the market’s negative perception of this lending type.
  4. Plan for the post-acquisition accounting processes in advance of due diligence and deal completion. Accounting for loans in an acquisition after the deal is closed is complicated and requires systems, processes and coordination with the various teams within the bank. For credit impaired loans, the teams working on those loans must provide feedback to the accounting team on the timing of cash flows and the ultimate values that might be realized for each loan.

Because loan valuations are complex, it is crucial that banks coordinate between their internal teams and external resources. Proper planning and process development can result in due diligence expectations that are consistent with post-completion valuations.

M&A: Avoiding Compliance Sinkholes


11-11-13-Moss-Adams.pngWith interest rates on loans at an all-time low and fee income significantly diminished as a result of a new focus on consumer protections, many banks, credit unions and other financial services companies are looking to acquisitions to supply needed growth in balance sheets and income sources. But along with acquisitions come many potential regulatory pitfalls, including consumer protection risks.

Without appropriate levels of due diligence, your bank could end up with a number of hidden compliance nightmares, such as violations of the Truth in Lending Act, Real Estate Settlement Procedures Act, or flood insurance rules that result in consumer restitution, fines or civil monetary penalty assessments from your banking regulator.

Here are a few key compliance considerations to keep in mind during your preliminary evaluation of an acquisition target. Think about these things well before seeking approval of the acquisition from regulators and shareholders.

Institutional History

Has the acquisition target historically had regulatory issues? Be sure to check for published enforcement actions regarding products, services or practices that may affect the combined institution’s compliance and reputational profile. Don’t forget to use simple Internet searches, including social media outlets, through readily available search engines. You might be surprised by the results of your searches.

Compliance Management

Does the acquisition target have a well-run compliance management system? Include an evaluation of key compliance management components in your due diligence. Always consider risk assessments, policies, monitoring schedules, training, and complaint-management practices. Is the institution’s program comprehensive? Is reporting to the board regarding program activities concise and detailed? Are issues reported and resolved in a timely manner?

Third-Party Service Providers

Does the acquisition target offer a large inventory of consumer products, and does it use third-party service providers to sell and deliver some or all of those products? With consumer products come a variety of laws, rules and regulatory expectations regarding consumer protection. Significant levels of risk may reside in third-party relationships the institution has developed to sell and service consumer products.

Evaluate management’s assessment of risks associated with service providers and the strength of the institution’s vendor management program as well as key provisions of contracts, including recourse related to noncompliance. Allocating time in this area could help prevent significant issues after a transaction has been completed.

Product Sets and Features

Does the target institution have multiple deposit and lending products with complex features? Conversion of products is a significant risk factor related to consumer compliance. The more complex features become, the more challenging converting accounts and providing accurate disclosures will be.

Stories of failed customer account conversions and public relations disasters are all too common. Address details regarding conversion of products as early as possible in acquisition planning. Include consideration of required timing of consumer disclosures and alternatives for accommodating customers when eliminating or adding key products and services.

Post-Conversion Compliance Activities

How will the acquisition affect your current compliance management activities? How will your institution ensure appropriate staffing is maintained in the compliance function after the merger is complete?

Compliance management activities change considerably in the months following an acquisition or merger. Besides the fact the merged institution will have an expanded customer and employee base, there are a number of factors that affect the personnel requirements after a merger, including heightened customer service activities, monitoring new employees and changes in procedures and processes.

Budget significant time for your compliance department to review consumer disclosures, particularly periodic statements, after conversion of the acquired institution’s accounts. For example, are interest accruals correct and in accordance with the contractual requirements of the loan or deposit account agreement? Are payments being applied as originally disclosed and properly allocated between interest and principal? Are Web sites and mobile applications functioning as planned and are consumer disclosures accurate?

Also plan an increased budget for compliance training. It should be tailored and conducted in person with new staff regarding key regulatory requirements and your institution’s procedures regarding handling of customer inquiries, complaints and other important aspects of your compliance program.

Conclusion

In the push for new revenue, it can be easy to see acquisitions as the path of least resistance, especially as other financial levers (fees and loan interest rates) cease to be as powerful as they once were. But clearly, for those who haven’t taken the time and care to evaluate the details well ahead of time, taking the plunge with another institution is fraught with risk. Only by performing sure-eyed due diligence can you hope to make the combination a happy marriage.