A Timely Reminder About the Importance of Capital Allocation


capital-7-6-18.pngCapital allocation may not be something bank executives and directors spend a lot of time thinking about—but they should. To fully maximize performance, a bank must both earn big profits and allocate those profits wisely.

This is why the annual stress tests administered each year by the Federal Reserve are important, even for the 5,570 banks and savings institutions that don’t qualify as systemically important financial institutions, or SIFIs, and are spared the ritual. The widely publicized release of the results is an opportunity for all banks to reassess whether their capital allocation strategies are creating value.

There are two phases to the stress tests. In the first phase, the results of which were released on June 21, the Fed projects the impact of an acute economic downturn on the participating banks’ balance sheets. This is known as the Dodd-Frank Act stress test, or DFAST. So long as a bank’s capital ratios remain above the regulatory minimum through the nine-quarter scenario, then it passes this phase, as was the case with all 35 banks that completed DFAST this year.

The second phase is the Comprehensive Capital Analysis and Review, or CCAR. In this phase, banks request permission from the Fed to increase the amount of capital they return to shareholders by way of dividends and share buybacks. So long as a bank’s proposed capital actions don’t cause its capital ratios from the first phase to dip below the regulatory minimum, and assuming no other deficiencies in the capital-planning process are uncovered by the Fed during CCAR, then the bank’s request will, presumably, be approved.

There’s reason to believe the participating banks in this year’s stress tests will seek permission to release an increasingly large wave of capital. Banks have more capital than they know what to do with right now, which causes consternation because it suppresses return on equity—a ratio of earnings over equity. And last year’s corporate income tax cut will only further fuel the buildup going forward, as profits throughout the industry are expected to climb by as much as 20 percent.

We probably won’t know exactly how much capital the SIFIs as a group plan to return over the next 12 months until, at the soonest, second-quarter earnings are reported in July. But early indications suggest a windfall from most banks. Immediately after CCAR results were released on June 28, for example, Bank of America Corp. said it will increase its dividend by 25 percent and repurchase $20.6 billion worth of stock over the next four quarters, nearly double its repurchase request over last year.

The importance of capital allocation can’t be overstated. It’s one of the most effective ways for a bank to differentiate its performance. Running a prudent and efficient operation is necessary to maximize profits, but if a bank wants to maximize total shareholder return as well, it must also allocate those profits in a way that creates shareholder value.

One way to do so is to repurchase stock at no more than a modest premium to book value. This is easier said than done, however. The only time banks tend to trade for sufficiently low multiples to book value is when the industry is experiencing a crisis, which also happens to be when banks prefer to hoard capital instead of return it to shareholders.

As a result, the best way to add value through capital allocation is generally to use excess capital to make acquisitions. And not just any ole’ acquisition will do. For an acquisition to create value, it must be accretive to a bank’s earnings per share, book value per share or both, either immediately or over a relatively brief period of time.

If you look at the two best-performing publicly traded banks since 1980, measured by total shareholder return, this is the strategy they have followed. M&T Bank, a $119 billion asset bank based in Buffalo, New York, has made 23 acquisitions since then, typically doing so at a discount to prevailing valuations. And Glacier Bancorp, a $12 billion asset bank based in Kalispell, Montana, has bolstered its returns with two dozen bank acquisitions throughout the Rocky Mountain region.

The point is that capital allocation shouldn’t be an afterthought. If you want to earn superior returns, the process of allocating capital must be approached with the same seriousness as the two other pillars of extraordinary performance—prudence and efficiency.

The Deregulation Promise Beginning to Bear Fruit


regulation-5-14-18.pngEd Mills, a Washington policy analyst at Raymond James, answers some of the most frequent questions swirling around the deregulation discussion working its way through Congress, the changing face of the Fed and other hot-button issues within the banking industry.

Q: You see the policy stars aligning for financials – what do you mean?
The bank deregulatory process anticipated following the 2016 election is underway. The key personnel atop the federal banking regulators are being replaced, the Board of Governors at the Federal Reserve is undergoing a near total transformation, and Congress is set to make the most significant changes to the Dodd-Frank Wall Street Reform Act since its passage. This deregulatory push, combined with the recently enacted tax changes, will likely result in increased profitability, capital return, and M&A activity for many financial services companies.

Perhaps no regulator has been more impactful on the implementation of the post-crisis regulatory infrastructure than the Federal Reserve. As six of seven seats on the board of governors change hands, this represents a sea change for bank regulation.

We are also anticipating action on a bipartisan Senate legislation to increase the threshold that determines if an institution is systemically important – or a SIFI institution – on bank holding companies from $50 billion to $250 billion, among other reforms.

Q: Can you expand on why Congress is changing these rules?
Under existing law, banks are subject to escalating levels of regulation based upon their asset size. Key thresholds include banks at $1 billion, $10 billion, $50 billion and $250 billion in assets. These asset sizes may seem like really large numbers, but are only a fraction of the $1 trillion-plus held by top banks. There have been concerns in recent years that these thresholds are too low and have held back community and regional banks from lending to small businesses, and have slowed economic growth.

Responding to these concerns, a bipartisan group in the Senate is advocating a bill that would raise the threshold for when a bank is considered systemically important and subjected to increased regulations. The hope among the bill’s advocates is that community and regional banks would see a reduction in regulatory cost, greater flexibility on business activity, increased lending, and a boost to economic growth.

The bill recently cleared the Senate on a 67-31 vote, and is now waiting for the House to pass the bill and the two chambers to then strike a deal that sends it to the president’s desk.

Q: What changes do you expect on the regulatory side with leadership transitions?
In the coming year, we expect continued changes to the stress testing process for the largest banks (Comprehensive Capital Analysis and Review, known as CCAR), greater ability for banks to increase dividends, and changes to capital, leverage and liquidity rules.

We expect the Fed will shift away from regulation to normalization of the fed funds rate. This could represent a multi-pronged win for the banking industry: normalized interest rates, expanded regulatory relief, increased business activity and lower regulatory expenses.

Another key regulator we’re watching is the CFPB (Consumer Financial Protection Bureau), which under Director Richard Cordray pursued an aggressive regulatory agenda for banks. With White House Office of Management and Budget Director Mick Mulvaney assuming interim leadership, the bureau is re-evaluating its enforcement mechanisms. Additionally, Dodd-Frank requires review of all major rules within five years of their effective dates, providing an opportunity for the Trump-appointed director to make major revisions.

Q: We often hear concerns that the rollback of financial regulations put in place to prevent a repeat of one financial crisis will lead to the next. Are we sowing the seeds of the next collapse?
There is little doubt the lack of proper regulation and enforcement played a strong role in the financial crisis. The regulatory infrastructure put in place post-crisis has undoubtedly made the banking industry sounder. Fed Chairman Jerome Powell recently testified before Congress that the deregulatory bill being considered will not impact that soundness.

Q: In your view, what kind of political developments will have effects on markets?
We are keeping our eyes on the results of the increase in trade-related actions and the November midterms. The recent announcement on tariffs raises concerns of a trade war and presents a potentially significant headwind for the economy. The market may grow nervous over a potential changeover in the House and or Senate majorities, but it could also sow optimism on the ability to see a breakthrough on other legislative priorities.

Fed Raises Red Flag in Wells Action


governance-4-17-18.pngIn February of this year, in response to widespread consumer abuses and breakdowns in compliance, the Board of Governors of the Federal Reserve System issued an unprecedented enforcement order against Wells Fargo & Co. that, among other things, requires Wells to submit to the Federal Reserve a written plan to enhance the effectiveness of its board of directors in carrying out its oversight and governance responsibilities, and further restricts Wells’ growth—an action that is typically only imposed on troubled institutions.

In the consent order, Wells agreed to fully cooperate with the Fed in further investigations as to whether separate enforcement actions should be taken against individuals involved in the conduct cited in the order. In connection with entering into the consent order, Wells agreed to replace four directors, three by April and the other by the end of 2018. In addition, on the same date, the Fed publicly released letters of reprimand that it issued to the board of directors of Wells as well as to the company’s past lead director and chairman. These types of supervisory letters usually remain confidential.

While the Federal Reserve’s action was clearly intended to address an egregious situation that involved a breakdown of Wells’ risk management system and resulted in widespread consumer abuses, bank board members and executive management should take note of its statements in the letters of reprimand as they relate to the responsibilities of a board and its leadership, particularly when they become aware of serious matters at the bank, whether related to misconduct, compliance, operations or other areas.

Here are the key governance and oversight considerations noted by the Federal Reserve.

Responsibility of the Board
In its letter of reprimand to the Wells board, the Fed noted that it was incumbent upon the board to “carefully evaluate” the company’s risk management capacity and “to oversee” the implementation by management of an adequate risk management framework for the entire company. The Federal Reserve found that the Wells board failed to take sufficient steps to ensure that the bank’s executive management team had established and was maintaining an effective risk management structure. It also found that reporting by management to the board lacked sufficient detail and failed to include concrete plans to address the serious consumer compliance issues Wells was facing.

The Federal Reserve also emphasized that it was the board’s responsibility to ensure that the company’s performance management and compensation programs were consistent with sound risk management objectives and complied with laws and regulations. The letter stated that the lack of effective oversight and control of compliance and operational risks were material factors in the substantial harm suffered by Wells customers.

Responsibility of the Board Chair
The letter of reprimand to former Chairman and CEO John Stumpf stated that it was the responsibility of the chairman “to ensure that business strategies approved by the board were consistent with the risk management capabilities” of Wells. It further noted that it was incumbent on the chairman to ensure that the full board had sufficient information to fulfill its responsibilities. The Federal Reserve found that Stumpf failed to take appropriate and timely action to address the compliance issues and improper conduct by Wells employees. Also noted were his actions in continuing to support those senior executives most responsible for the failures and in resisting attempts by other directors to hold the executives accountable.

Responsibility of the Lead Director
For financial institutions that have lead directors, the Fed’s letter of reprimand is insightful as to its view of the lead director’s role. The letter stated that former lead director Stephen Sanger “had a responsibility to lead other non-executive directors in forming and providing an independent view of the state of the firm and its management.” The letter noted the failure of the lead director to initiate any serious, robust investigation into the widespread consumer compliance issues that were raised as well as the failure to press management for more information or action after being made aware of the seriousness of the issues. The Fed also noted that Sanger did not perform in a manner consistent with the duties and responsibilities of the lead director that were set forth in Wells’ corporate governance guidelines.

Is Congress Sowing the Seeds of the Next Banking Crisis?


regulation-4-4-18.pngThree weeks ago today, the U.S. Senate passed a bank deregulation bill that either provides modest relief to one of the country’s most heavily regulated and scrutinized industries—or sows the seeds of our next great banking crisis.

Sponsored by Sen. Mike Crapo (R-Idaho), who chairs the Senate Banking Committee, the measure passed by a 67-31 vote that included 15 Democrats and Sen. Angus King, an independent from Maine. The Crapo bill has often been described in the media as a “roll back” of the landmark Dodd-Frank Act of 2010. Passed after the financial crisis—which is approaching its 10-year anniversary, if one considers the Sept. 15, 2008 bankruptcy filing by the investment bank Lehman Brothers to mark the beginning of the crisis—Dodd-Frank imposed a number of new regulatory restrictions and requirements on the entire banking industry, particularly big banks.

The Crapo bill is hardly the full-throated repudiation of Dodd-Frank that some of its harshest critics would suggest. It’s most significant provision raises the designation threshold for Systemically Important Financial Institutions, or SIFIs as they are usually called, from $50 billion to $250 billion. Banks below the $250 billion threshold would no longer be subject to the same level of heightened supervision by the Federal Reserve that would remain in effect for banks above the $250 billion threshold, although the Federal Reserve would have the authority to designate any bank a SIFI if it believes that is warranted.

The bill would also exempt banks with $10 billion in assets or less from Dodd-Frank’s restrictions on proprietary trading (through the so-called Volcker Rule), which was aimed primarily at the practices of the big banks. The complicated capital framework for community banks would be replaced by a simplified leverage ratio that would still leave them well capitalized. And the bill eases a number of residential mortgage loan requirements that have made it difficult for smaller banks to compete in that market.

These changes are hardly an evisceration of Dodd-Frank—particularly when compared to a more ambitious bank deregulation bill that passed in the House of Representatives last year, but has found little bipartisan support in the Senate. Still, progressive Democrats like Sen. Elizabeth Warren (D-Massachusetts) and consumer advocacy groups like Public Citizen would have you believe that the next banking crisis is lurking around the corner if the Crapo bill ever becomes law.

Warren, a strident critic of big banks, says none of her constituents are clamoring for bank deregulation. “[N]ot one single person at any of my town halls, or meetings … or picking up pizza at Armando’s, asked for Congress to work on rolling back the rules on some of the biggest banks in the country so they’ll have a chance to crash the economy again,” she said in an interview with the website Politico. Public Citizen sent Crapo a letter in November of last year that laid out its broad objections to his bill, saying it would “take us in the wrong direction by removing important safeguards that protect the markets and consumers from some of the nation’s largest banks.”

I don’t think there is any question that the banking industry today is stronger than before the crisis. Banks are more highly capitalized, and while the Senate bill would relax oversight for banks that would no longer be designated as SIFIs, it is indisputable that the entire industry is more closely supervised than prior to the crisis. And this is important: The federal banking regulators retain their full authority to crack down on any bank they believe is operating in an unsafe or unsound manner. I think most of the Crapo bill’s changes make sense and won’t lead to a weakening of the industry’s safety and soundness.

Some of the fierce opposition from progressives like Warren is also a sign that even after nearly a decade the financial crisis still has a firm grip on our politics. “We continue to live in a very populist environment—there’s populism on the right and populism on the left,” says Brian Gardner, the director of Washington research at the investment bank Keefe Bruyette & Woods. “I think some of the lawmakers [like Warren] are playing to their base. I think it’s very good politics for them.”

Indeed, many of the Democrats who voted for the Senate bill are running for reelection this fall in states won by President Donald Trump in 2016, so maybe they were playing to their base as well.

Still, I’m not convinced that Warren, who is probably the banking industry’s harshest critic in Congress, is merely being political. Right or wrong, I think she truly believes that big banks pose a deadly threat to the economy and any loosening of their oversight will sow the seeds of another crisis. For Warren, nearly 10 years later, it’s still a matter of principle more than politics.

Navigating Your Bank Through Rising Rates


interest-rates-4-2-18.pngBanks have been lamenting low interest rates for almost a decade. In boardrooms and on earnings calls, low rates have been blamed for shrinking margins, tepid deposit growth and intense loan competition.

With rates now up more than 100 basis points from their lows, we’re about to find out where that was true, and where interest rates were just a convenient scapegoat. Management teams and boards now face a few strategic questions. Among them: How is lending typically impacted by higher rates, and what strategies should my institution consider as rates continue to rise?

First, as the Federal Reserve’s Federal Open Market Committee puts upward pressure on overnight rates, there is typically a follow-on effect further out on the curve. But, these effects are rarely 1:1, resulting in a flattening yield curve. Bear flatteners, in which short-term interest rates increase more quickly than long-term rates, differ in severity, but if this one is anything like the period following the last Fed tightening cycle—from June 2004 through August 2006, as shown in the chart below—banks could be in for some pain.

Second, as rates start to quickly rise, nominal loan yields lag, resulting in declining credit spreads. It takes time for borrowers to adjust to the new reality, and competing banks can be expected to play a game of chicken, waiting to see which will blink first on higher loan rates and face a potential loss of market share.

Taken together, these two phenomena can put intense pressure on loan profitability. Banks are now enjoying an increase in net interest margins, but this comes on the back of rising yields on floating rate loans funded with deposits that have not yet become more expensive. Deposit costs will soon start moving, and once they do, they can move quickly.

This is a time when a rising tide no longer lifts all boats, and the banks that properly navigate the asset side of their balance sheet will start to separate themselves from everyone else. So, what does “proper navigation” look like? It’s not timing the market or outguessing the competition. Instead, winning during pivots in interest rates is all about adhering to a disciplined pricing process.

Trust the Yield Curve
The top performing banks let the yield curve guide pricing. We see evidence of this discipline in the mix between floating and fixed-rate structures. When rates were low, and the yield curve was steep, many banks were tempted to move out on the curve. They instituted arbitrary minimum starting rates on floating structures and saw their share of fixed-rate loans reach record highs. Now that rates are starting rise, these banks fear the exposure those fixed rates created, so they are desperately trying to correct the mix.

Disciplined banks ended up with the opposite scenario. With a steep curve, they found the lower floating-rate structures to be popular with borrowers. Now that the curve is flattening, borrowers are choosing more fixed-rate structures. These banks have large blocks of floating-rate loans that are now repricing higher, and that mix will naturally shift to fixed as rates move higher and the curve flattens, protecting them from dropping yields when the cycle eventually turns again. These banks let the yield curve help them manage their exposure, working in sync with borrower demand instead of against it.

Supercharge Cross-Sell Efforts
We also see top performing banks paying more attention than ever to their cross-selling efforts. In a rising rate environment, low cost deposits become much more valuable. Banks that already have deposit gathering built into their lending function are taking advantage, as their relationship managers can offer more aggressive loan pricing when the deals are accompanied by net new deposits. These banks have well-established processes for measuring the value of these deposits, tracking the delivery of promised new business and properly incentivizing their relationship managers to chase the right kind of new accounts.

When it comes to surviving—and thriving—in a rising rate environment, there is no magic bullet or secret shortcut. Instead, the answer lies in continuing to do what you should have been doing all along: Trusting the process you’ve built, staying disciplined and ignoring all the noise around you in the market.

And if you don’t have a process—a true north that you can use to guide your commercial bank’s pricing strategy—then get one right now. Rough seas may well lie ahead.

Do You Really Need a Bank Holding Company?


holding-company-2-23-18.pngThe boards of directors at three, multibillion-dollar, publicly traded banks recently chose to get rid of their holding companies. Bank of the Ozarks, BancorpSouth and Zions Bank, N.A. are now or soon will be stand-alone, publicly traded banks. For years, Republic Bank and Signature Bank have also operated as publicly traded banks without a holding company.

According to the public filings of Ozarks and BancorpSouth, the boards of those two organizations decided that having a holding company on top of their bank was way more trouble than it was worth in terms of dollars and time. The Zions board concluded that subject to regulatory approval, the bank would no longer be “systemically important” if it did not have a financial holding company structure. In the process, all three banks eliminated at least two regulators—the Federal Reserve, which oversees bank holding companies, and the Securities and Exchange Commission (SEC). None of the former holding companies were engaged in any significant nonbanking activities that couldn’t be conducted by the bank, either directly or through a subsidiary. For banks, the federal securities laws are administered by the bank’s primary federal banking regulator, rather than the SEC.

Life is a series of trade-offs, and none us can predict the future, but the increase in efficiencies for these organizations seems to have been worth giving up the flexibility afforded by operating in a bank holding company structure. For most banks that aren’t actively using their holding companies to engage in those non-bank activities that may only be performed under a holding company structure, the cost of eliminating the holding company is quickly recovered. If it turns out that eliminating the holding company was a bad idea, the Federal Reserve seems receptive to accepting and approving applications to form bank holding companies from many organizations, including those that had previously eliminated them.

Ozarks and BancorpSouth, like Signature and Republic before them, file their periodic reports under the Securities and Exchange Act of 1934 with the Federal Deposit Insurance Corp. Zions, which operates under a national charter, will make those filings with the Office of the Comptroller of the Currency. The shares of the banks are still listed on Nasdaq or the New York Stock Exchange.

Shareholders and analysts don’t seem to care that the banks’ filings are no longer available on EDGAR, an electronic filing system maintained by the SEC that investors can access. One can argue that bank holding companies that have over $1 billion in consolidated assets and thus are not eligible for the Fed’s Small One Bank Holding Company Policy Statement should consider whether their enterprise is getting its money’s worth from having a holding company—some are, and some aren’t. But remaining in a holding company structure simply because that is the way you’ve always done it is not sufficient analysis to withstand even polite questions from your shareholders.

The process of becoming a stand-alone bank is not intimidating for folks who know their way around the corporate and regulatory world in which banking organizations operate, but there are a number of important questions that bank boards need to consider, including: “Can we execute our business plan without a holding company?” Also, “Are the corporate laws applicable to banks chartered in our state as flexible as the laws applicable to our holding company?”

Three prominent banking organizations making a move like this in a six-month span might not signal a new trend, but it should cause directors at other banks to ask whether they really need a bank holding company.

Does Your Bank Have a Deposit Strategy?


strategy-1-22-18.pngMany banks lack a clear, written deposit strategy and funding plan. For the last several years, that’s been somewhat understandable. After all, deposits flowed into banks and have now reached historic highs, even though banks on average pay little or nothing in interest on the vast majority of those deposits.

Now that’s changing. Deposits are an increasingly important topic for bank boards. We are on the front end of an environment bankers have not seen in almost a decade. The Federal Reserve raised the fed funds target rate by 75 basis points last year, and three more rate increases are expected this year.

Banks already are seeing deposit competition heat up. Close to 64 percent of bankers said that deposit competition had increased in the last year, and 77 percent expected it to increase during the subsequent 12 months, according to Promontory Interfinancial Network’s Bank Executive Business Outlook Survey in the third quarter of 2017. Although in the past banks have had to compete in rising rate environments, we’ve never seen a point in history quite like this one, and it would be wise to assume rising rates will impact deposits, as well as your bank’s funding mix and profit margins.

There are a couple of reasons why the environment has changed. Historically, big banks ignored the rate wars for deposits, a game that was left to community banks. But this time, the new liquidity coverage ratio requirement that came out of the Basel III accords could encourage big banks to get more competitive on deposit rates. The ratio, finalized in the U.S. in 2014, requires banks with more than $250 billion in assets to keep a ratio of 100 percent high-quality liquid assets, such as Treasury bonds, relative to potentially volatile funds. Banks that move toward more retail deposits will have a lower expected level of volatile funds.

Also, banks have a majority of their deposits in liquid accounts while term deposits, such as CDs, are at historic lows. There’s no hard-and-fast rule to know how much of those non-term deposits will leave your bank as rates rise.

As the economy has improved, surging loan growth has put more pressure on the need to grow deposits. Loan-to-deposit ratios are rising, and as banks need to fund further growth, demand for deposits will rise. What this will do to competition for deposits and, therefore, deposit rates, is unclear. We have found that many banks aren’t raising rates on their loans, and the best borrowers can easily shop around to get the best rates. This will put pressure on margins if banks don’t raise rates on loans as interest rates rise.

Still another factor is that people have had a decade since the financial crisis to get comfortable with the benefits of online and mobile banking. Online banks, not incurring costs associated with physical branches, often offer higher interest rates on deposits than traditional banks.

One of the best ways to prepare for the changing environment is to make sure your bank has a written, well-prepared deposit strategy. We’re not talking about a 100-page document. In fact, the asset/liability committee (ALCO) of the bank may need a five- to 10-page report highlighting the rate environment, the bank’s deposit strategy, and alternative funding plans and projections. The bank’s full board may just need a three- to four-page summary of the bank’s deposit strategy, making sure that management is able to address key questions:

  1. Who are your bank’s top 10 competitors, and what are they doing with rates? What new products are they offering?
  2. How will the Federal Reserve’s expected moves in the coming year impact our rates, our margins and our annual net income?
  3. What is our bank’s strategy for contacting our largest depositors and determining their needs?
  4. What new deposit products do we plan to offer, and how will we offer them only to our best customers? Not all customers or deposits have equal value to the bank.
  5. What is our funding plan? In other words, what are our alternatives if we need deposits to grow, and what will they cost? This is perhaps the most difficult question to answer.

While it’s important not to be caught off guard in a rising-rate environment, rising rates can be a good thing for a bank with a solid deposit strategy in place. For the first time in a long time, the wind will be in the sails of bankers. They just need a plan for navigating the changing environment ahead.

Changing the Regulatory Landscape


regulation-12-8-17.pngThere is perhaps no other area of the federal government where personnel have a greater influence on policy than bank regulation. By picking the right regulators, the president can have a meaningful impact on the banking sector and the economy at large.

Banking has long been a bastion of static thinking on the regulatory front, and it needs a shot of dynamism. With recent confirmations at the Federal Reserve and the Office of the Comptroller of the Currency, and the nomination of a new chair of the Federal Deposit Insurance Corp., the administration is on the cusp of an overhaul of regulators that will have potentially far-reaching consequences. A new director—and new thinking—at the Consumer Financial Protection Bureau would also have a positive impact on the regulatory culture under which banks are operating.

The president’s new team of regulators can make an impact without any changes in the law or regulation in three key areas.

First, these regulators can approve new banks. Only six new banks have been chartered since 2010, and more than 2,000 have gone away. The attendant lack of dynamism and entrepreneurial disruption is palpable. Community banks are losing critical funding and payment market share to large banks and fintech companies. Traditional banks are crowding around discrete areas of the American wallet: middle-market commercial loans, owner-occupied commercial real estate and small business lending. Mortgage and consumer lending are increasingly offered by big companies that can afford to comply with costly rules. Customer contact and loan pricing is increasingly automated and regulated. New bank founders need the flexibility to build diversified portfolios, certainty around the capital required to implement a given business plan and certainty around the timeliness of the approval process. Greater transparency in these areas would contribute far more to stimulating new charter development than revising handbooks and holding conferences. Agency leaders can give that clarity right now, and they should.

Second, the burden of onsite bank exams is a continual concern. Most of these complaints are from banks so small that if any 200 of them were to fail tomorrow, it would hardly make a dent in the FDIC’s reserves. Banks divulge massive amounts of information to regulators on a quarterly basis. Couldn’t regulators perform remote exams of these small banks, with onsite spot checks as needed? Further, the rigid application of compliance regulations are eliminating small dollar lending programs at many community banks—to the detriment of the very customers these rules are supposed to be protecting. Wouldn’t community banks be better off if they could diversify their loan portfolios by offering products needed by their communities? Wouldn’t the industry be better served if examiners’ efforts were focused on large banks, where the customer experience needs improvement, and the consequences of failure are more severe?

A final element of dynamism relates to the ability to exit. Banking is one of the few industries where the government approves the sale of the company—and takes months, if not years, to do so. Even the smallest transactions are subject to geographic competition tests normally seen when titans merge and make no sense in this age of digital banking. The list of incentives for regulators to say “no” is long and getting longer. Third-party protest groups have no direct skin in the game, yet have great influence over the process. Meanwhile, stakeholders, customers, employees and communities are all in limbo. Regulators could address these concerns by setting deadlines, actively brokering conversations between all parties and holding public hearings in a matter of days, not months. Restoring a timely process could make a big difference in resolving these issues.

None of these efforts require changing a law or a regulation. All of them would improve the transparency and timeliness of regulation. Unfortunately, few of the beltway types that frequently occupy regulatory chairs have a business executive’s skill and experience in gathering information and making timely decisions. These skills are badly needed now in the regulatory arena. As the new administration gets its team in place, the president should know he can make a significant difference in banking just by choosing the right people to occupy the regulatory chairs—and then letting them do their work.

When the Gloves Come Off


shareholder-12-1-17.pngShareholder lawsuits are relatively common for the banking industry, but the reverse—a bank suing one of its shareholders—is fairly unique. On October 31, 2017, Nashville, Tennessee-based CapStar Financial Holdings, with $1.3 billion in assets, sued its second-largest shareholder, Gaylon Lawrence Jr. The bank alleges that the investor and his holding company, The Lawrence Group, violated the Change in Bank Control Act, which requires written notice and approval from the Federal Reserve before owning more than 10 percent of a financial institution, as well as a related Tennessee law. CapStar also maintains that Lawrence violated the Securities Exchange Act of 1934 by failing to disclose plans to acquire additional CapStar stock.

Passing the 10 percent ownership mark without the proper approvals is more common than one might think, according to Jonathan Hightower, a partner at the law firm Bryan Cave LLP. And often the violators of these rules are directors who are simply enthusiastic about their bank’s stock and want more of it. “They’re interested in the bank. They may know of shares that are available in the community and buy them up without realizing they’ve crossed the threshold where they need regulatory approval,” says Hightower.

How the Fed interprets these regulations and the steps required of shareholders is a specialized area, adds Hightower. “Given that, the Fed’s approach, assuming there’s not an intentional violation, is more permissive than might be expected.” The Fed is unlikely to levy penalties against a shareholder acting in good faith.

Lawrence filed a motion to dismiss the lawsuit on November 13, 2017, and maintains that he has complied where necessary and that, as an individual investor, the Tennessee code requiring a bank holding company to acquire control of the bank isn’t relevant.

What’s unique in the CapStar case is that it’s the bank taking action against the investor, rather than the regulator. In a letter dated November 20, 2017, CapStar asked the Fed to reject Mr. Lawrence’s stake in the bank and require that Lawrence divest “all illegally acquired CapStar shares,” in addition to a request for a cease-and-desist order and the levying of civil money penalties against Lawrence.

Requiring Lawrence to divest will likely harm what is, in CapStar’s own words, a “thinly traded” stock, according to Stephen Scouten, a managing director at Sandler O’Neill + Partners. Without Lawrence’s acquisitions of large amounts of stock, “the stock would be appreciably lower than it is today,” says Scouten. The stock price rose 6.95 percent year-over-year as of November 27, 2017, and 17 percent in the three months in which Lawrence has been accumulating a sizeable number of shares.

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Filings by CapStar indicate that Lawrence attempted to acquire the bank in the summer of 2016. When that attempt was unsuccessful, CapStar alleges that Lawrence approached two of the bank’s largest stockholders to buy their combined 30 percent stake. That attempt also failed, and Lawrence began acquiring CapStar stock on the open market after the bank’s initial public offering last year. From August through October 2017, Lawrence rapidly increased his stake in CapStar from 6.2 to 10.2 percent, paying a total of $82.7 million for 4.6 million shares. CapStar alleges that Lawrence has “coveted control” of CapStar, and it’s easy to see how the bank arrived at that conclusion.

Lawrence is a long-term investor who appears to like what he sees in the Nashville market. He even recently purchased a home there. He’s certainly an experienced bank investor. He owns seven community banks, including two in the Nashville area: F&M Bank, with $1 billion in assets, and Tennessee Bank & Trust, formerly a division of $510 million asset Farmers Bank & Trust in Blytheville, Arkansas, which is also owned by Lawrence. “He’s got a lot of money to put to work, [and] he thinks banks are a good investment for his capital,” says Scouten. Right now, that looks to be as much as 15 percent of CapStar. Whether that turns into a full-fledged bid for the bank, as he sought in 2016, is anyone’s guess. Bank Director was unable to reach a representative of Gaylon Lawrence Jr., and CapStar CEO Claire Tucker declined to comment.

Bank boards frequently deal with active investors, and in most cases, Hightower recommends focusing on shareholder engagement and ensuring that large investors understand the broad strokes of the bank’s strategic plan. “More often than not, it’s people not understanding what they’ve invested in, and where it’s going,” he says.

Farewell to LIBOR


LIBOR-11-20-17.pngFive years ago, a small bank that almost no one had ever heard of launched an epic battle against three of the largest financial institutions in the world for their role in facilitating a crisis that began more than a thousand miles away. In 2012, Community Bank & Trust, of Sheboygan, WI, filed a class action suit against Bank of America Corp., Citigroup and JPMorgan Chase & Co. for their part in the manipulation of the London Interbank Offered Rate, or LIBOR—the benchmark rate for tens of thousands of financial contracts including commercial loans, home loans, student debt, mortgages and municipal debt. The lawsuit claimed that small financial institutions like Community Bank & Trust lost $300 million to $500 million a year due to LIBOR rigging, and that big banks were part of an ongoing criminal enterprise and guilty of violating the Racketeer Influenced and Corrupt Organizations (RICO) Act.

LIBOR is the average rate at which a group of large, global banks—including Bank of America, JPMorgan and Citi—estimate they’d be able to borrow funds from each other in five different currencies across seven time periods, submitted by a panel of lenders every morning. U.S. banks began their gradual transition to the metric in the 1990s because, unlike the Prime Rate that was widely used prior to that period, LIBOR changes daily and is—in theory—tagged to market conditions.

LIBOR has been called the “most important number in the world,” and even though most community banks rely on Prime and constant maturity treasuries for interest rate indices to set loan or deposit rates, LIBOR is still a critical index for community banks. In the case of smaller commercial lenders, even minor fluctuations in the LIBOR rate can have significant consequences. By manipulating the floating rate, large banks with greater borrowing power and cash reserves can artificially suppress the index, squeezing returns for smaller institutions.

“The defendant banks, sophisticated investors who understand that LIBOR is a key metric, knew that manipulating [the rate] downward would directly and proximately harm the small community banks in which the defendants compete for loan business by artificially depressing the interest rate paid to community banks on loans held by those banks,” the complaint asserted.

That litigation is still playing out in a federal appeals court in New York. Meanwhile, financial institutions around the world have shelled out more than $9 billion in fines and settlements since then to settle litigation related to the LIBOR scandal, and several bankers have faced criminal convictions. But LIBOR is now on its way out. On July 27, 2017, Andrew Bailey, chief executive of the U.K. Financial Conduct Authority, announced that LIBOR will officially be replaced as the key index for overnight loans. As a result, lenders will transition to alternative rates over the next four years.

This summer the Federal Reserve’s Alternative Reference Rates Committee (ARRC) identified a broad treasuries repo financing rate as its U.S. dollar-preferred LIBOR alternative. The new metric will be called the Secured Overnight Financing Rate (SOFR), and will include tri-party repo data from The Bank of New York Mellon Corp., and cleared bilateral and General Collateral Finance Repo data from The Depository Trust & Clearing Corp. (A repo transaction is the sale of a security or a portfolio of securities, combined with an agreement to repurchase the security or portfolio on a specified future date at a pre-arranged price).

While protocols for making the transition have not yet been finalized, it’s not too early to begin preparing. According to the Loan Syndications and Trading Association, while most credit agreements already include customary fallback language if there is a temporary disruption to LIBOR, it would be prudent for parties to review their existing credit agreements to understand those provisions and what, if any, amendment flexibility exists to address a discontinuation of LIBOR. And as new agreements are drafted, parties may want to consider the ability to amend the agreement with less than a 100 percent lender vote to avoid market disruption in the event that LIBOR is permanently discontinued.

To make informed decisions, it behooves all community banks, even those that do not directly use LIBOR, to consider how the replacement metrics may impact their own interest rates.