Trust in the banking system: How should banks respond to Occupy Wall Street?

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occupy-sign2.jpg“The corporations get what they want and the people don’t get anything,’’ says Elizabeth Johnson, with two pieces of duct tape stuck to her shirt with the words “Occupy Nashville” written on them.

She is taking part in Nashville’s version of Occupy Wall Street, where a loose group of protestors hang out on War Memorial Plaza playing the guitar, holding signs, and conducting organizational meetings to plan their marches and policies: keep the plaza clean, be respectful, don’t destroy property.

Johnson says she was originally in favor of the $700 billion rescue of the financial system until she realized the banks “kept that money for themselves.”

Other protestors include a call center worker who says she is disappointed her $100,000 in student loans for a master’s degree in communications landed her in call center doing customer service; a financial planner who says he is concerned about the future of Social Security, low wages and the loss of American jobs to developing countries; and a machinist who disagrees with the Federal Reserve’s control over monetary policy.

Occupy Wall Street’s protests in cities across the world over the weekend unveiled a groundswell of frustration against corporations, political systems, the global economy and the banking system, all rolled into one. Should the banking industry care? If so, what should be done about it?

After all, there doesn’t seem to be a lot of evidence that angry consumers are voting with their feet. The biggest banks in the country control most of the deposits. Account balances in checking and savings accounts are growing, not declining.

Bank of America just reported Tuesday deposits at the bank grew by $3 billion in the third quarter to $1.04 trillion. JP Morgan Chase & Co. reported deposits grew by $44 billion in the quarter to $1.09 trillion.

Still, many people think a bad image for banking isn’t good for business.

In June, GfK Custom Research North America, a division of market research company GfK Group, reported an online survey of 1,000 Americans where the financial services industry ranked third lowest for trustworthiness, ranking above only state and federal governments.

Only 35 percent found financial companies trustworthy. (Retail companies and packaged food manufacturers got the highest marks—71 percent and 65 percent, respectively—out of the 12 public and private sectors in the survey.)

“The fact is that the vast majority of financial services companies still generate substantial profits by fooling customers, or by capitalizing on their mistakes, or by taking advantage of them when they simply aren’t paying attention,’’ says a new report from the management consulting firm Peppers & Rogers Group. The group recommends increased transparency and practices that keep the customers’ best interests in mind, as a way to survive a future where customers can increasingly publicize their frustrations and bad experiences on everything from Facebook to Twitter.

In fact, making consumers happier could do something to push back the tidal wave of increased regulation of the banking industry, some think. Where did the Credit Card Act of 2009 come from, if not consumer frustration?

Plus, the volatile stock market, crashing home values, low wages and high unemployment set the stage for people to be angry at banks, says Gregg Poryzees, vice president, Consulting – GfK Financial Services.

“When the economy takes a hit, people are now unhappier with the financial firms they deal with,” Poryzees says. “This really is an opportunity to rise to the occasion. This is a great time to say ‘What can we do in terms of communication with our customers and designing innovative products, with brand positioning, managing the brand in a volatile market and a volatile consumer market?’”

Another GfK survey in July found that 88 percent of respondents strongly agree or moderately agree that consumers need an agency such as the Consumer Financial Protection Bureau to oversee the practices of banks and other financial institutions.

Waiting for new regulation from the Consumer Financial Protection Bureau is not a plan, Poryzees says. Getting ahead of regulation with consumer-friendly changes is a solution.

 “The implications are that the banking industry can turn this frustration into an opportunity, not so much different fees, but innovations that are more customer focused,’’ he says.

One can only wonder if the recent decisions of some large banks, including Bank of America and JP Morgan Chase to offset new restrictions on debit card interchange fees by charging customers a monthly fee, has further tarnished the industry’s image.

William Mills III, the CEO of Atlanta-based financial public relations firm the William Mills Agency, says bankers should think about how they will respond to the concerns of Occupy Wall Street and others. Community bankers in particular may have an opportunity to differentiate themselves from the bigger banks because they didn’t participate in the marketing and sale of risky bonds, equities and subprime mortgages.

“I hope bankers are thinking about how they would respond if a member of the media calls or a customer asks about it,’’ he says.

Scott Talbott, the senior vice president of government affairs at The Financial Services Roundtable, which represents 100 of the largest financial institutions in the country, says the industry understands the anger reflected in the Occupy Wall Street protests. The financial industry is carrying more capital, is safer, and has eliminated a lot of risky practices, such as subprime lending.

“We are working hard to restore the economy and trust in the banking system,’’ he says.

But the problem lies deeper than trust.

“What am I supposed to tell my children about what their goals should be?’’ says Felisha Cannon, the 33-year-old call center worker, saying she’s not sure there’s a better future for them.  “I can’t tell them to buy a house, because it might not be worth anything. What should they be working for? Should they go to (college) and have $200,000 in debt?”

Opportunity knocks, but there are drawbacks

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The mess in banking isn’t over yet.That means hundreds of banks, most of them small, community organizations, likely will fail in the years to come. The flip side of all that carnage is an opportunity for bankers to buy troubled institutions, grow balance sheets during tough economic times and let the Federal Deposit Insurance Corp. take most of the bad assets of the failed bank.
 
The investment bankers and attorneys who attended Bank Director’s May 2nd conference in Chicago agreed on one theme: There are still plenty of deals to be had for banks looking to buy failed institutions from the FDIC, as long as they work hard, fast and smart to do the deals right. 
 
“There is ample opportunity,’’ said Jeffrey Brand, managing director at investment bank Keefe, Bruyette & Woods. “The FDIC will allow you to bid as many times as you like and they will let you be as creative as you like.”
 
There were more than 523 banks with $318.3 billion in assets at the end of last year that had Texas ratios topping 100 percent, said Brand, using SNL Financial data. The Texas ratio is commonly used to predict bank failure, and is the amount of non-performing assets and loans, plus loans delinquent for more than 90 days, divided by tangible equity capital and loan loss reserves. If it’s more than 100 percent, that’s trouble.
 
The number of troubled banks also appears to be increasing. The number of banks with Texas ratios above 100 percent increased 4.5 percent from the third quarter.
 
The FDIC’s “problem” bank list also appears to be growing. It reached a record high for this cycle of 884 banks at the end of last year, more than 10 percent of the total banking system. That number was up from 860 the quarter before.

Louis Dubin, president of Resolution Asset Management Co., said the states with the most number of troubled banks are Georgia, Florida, Illinois and Minnesota.

Troubled Bank Map: 2010 Q4

fdic-failedmap.jpg

TOTAL BANKS: 417
CRITERIA: Texas ratio > 100%, Leverage ratio <9%

Picking up failed banks from the FDIC offers some benefits: the FDIC can take on as much as 80 percent of the failed bank’s losses, using a tranche system based on the size of the losses. Plus, the acquiring bank can cherry pick the assets, locations and employees it wants. The failed bank’s pre-existing contracts are automatically voided on the sale.

And bankers can get creative in terms of how they structure deals. Brand recommended making several bids, including one that follows traditional FDIC deals and one that doesn’t. For instance, banks can price bids to take into account future risk, instead of using a loss share agreement, avoiding the hassles of regular audits from the FDIC to make sure they comply with the loss-share agreement.

“The FDIC is discovering the costs of auditing all these banks to see what their losses are,’’ Brand said. “Now they’re doing deals without loss share (agreements). You don’t need that expensive accounting system. But they are taking away that safety net, too. If losses are worse than estimated, that’s 100 percent coming out of your pocket.”  

One of the drawbacks of FDIC deals is the possibility that the government could change the rules at any time. The loss share agreement lasts a decade for single-family housing assets; five years for commercial properties.

Buyers also don’t have much time to do due diligence. The entire process, from expressing an interest in acquiring a bank, to closing, can take about 90 days, less if the failed bank’s situation is dire.

“They don’t let you wander around the bank talking to all the lending officers,’’ said James McAlpin, an attorney and partner at Bryan Cave in Atlanta.

Bank employees will have to work quickly to make a bid and conduct due diligence. Plus, they must be able to reopen the bank on the Monday after the bank’s Friday closure, and follow timelines to transition the acquired bank and dispose of its assets.

“It is a tremendous strain on your organization,’’ Brand said.

TARP Legacy: Hidden Costs

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The U.S. Treasury reported this week that taxpayers will make a $20 billion profit from the Troubled Asset Relief Program for banks, the government’s emergency support during the financial crisis.

That’s because banks have been paying dividends to the government on what was essentially borrowed capital and now 99 percent of the funds have been paid back.
 
The latest banks to pay back TARP, as announced this week, were Cincinnati’s Fifth Third Bancorp; Boyertown, Pa.’s National Penn Bancshares; Rapid City, South Dakota’s Stockmens Financial Corp.; San Jose, California’s Bridge Capital Holdings; and Norfolk, Virginia’s Heritage Bankshares.

Separately, the Congressional Budget Office has brought down its estimate of the total cost of TARP to taxpayers, which included investments in automobile manufacturers and insurer AIG, down to $25 billion, must less than the $356 billion the budget office previously estimated.

Winding down its work this week, the Congressional Oversight Panel for TARP released its final report on the program, saying TARP helped avert an even worse financial meltdown, which has become a pretty standard line for economists on both sides of the political aisle.

The Congressional Oversight Panel said: “The TARP does not deserve full credit for this outcome, but it provided critical support to markets at a moment of profound uncertainty. It achieved this effect in part by providing capital to banks but, more significantly, by demonstrating that the United States would take any action necessary to prevent the collapse of its financial system.”

The report goes on to criticize TARP as well, saying part of the reason the program has cost so little is because some of it didn’t work. For instance, the home affordable modification program (HAMP) was designed to lose money and benefit three to four million homeowners, but the U.S. Treasury hastily crafted it, and relied on voluntary participation from mortgage servicers.

“The program now appears on track to help only 700,000 to 800,000 homeowners,’’ the Congressional Oversight report says.

Also, TARP probably cost less than expected because of other government aid to the economy, the report says.

Plus, TARP leaves an even bigger problem on the table: the problem of moral hazard, the report says.

“By protecting very large banks from insolvency and collapse, the TARP also created moral hazard: very large financial institutions may now rationally decide to take inflated risks because they expect that, if their gamble fails, taxpayers will bear the loss. Ironically, these inflated risks may create even greater systemic risk and increase the likelihood of future crises and bailouts.”

The Congressional Oversight Panel is not the only one to bring up this problem. Many economists have been calling attention to the same issue. Whether the topic will resonate with the American public, still reeling from high unemployment, remains to be seen.

Pros & Cons of Traditional M&A vs. FDIC-Assisted Transactions

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handshake.jpgWith the financial industry cautiously anticipating a recovery from the dramatic economic crisis that resulted in increased regulations and scrutiny for banks of all sizes, many are hoping to see increased activity from traditional M&A transactions. Although the number and size of bank failures is slowing down, FDIC-Assisted deals should not be discounted as a viable growth opportunity in 2011.

As part of our Inside the Boardroom interview series, Rick Childs, a director in Crowe Horwath LLP’s financial advisory services group, outlines below the pros and cons of traditional M&A vs. FDIC-Assisted transactions, and what today’s boards should know before considering these two options.

What are the pros & cons of traditional M&A vs. FDIC-Assisted deals?

TRADITIONAL M&A

PROS:

  • There is more time to perform due diligence and to understand how the organization fits your culture and business plan.
  • Traditional M&A deals are usually negotiated with a single buyer. If a potential acquirer can negotiate and improve its chances of winning the transaction. In an FDIC-assisted transaction, the agency is required by law to select the bid that entails the lowest cost to the FDIC insurance fund. As a result, competition for the bid can decrease the odds of the bidders being successful.
  • In 2010, there were still a number of deals where the target’s earnings were positive. In approximately 42 percent of the traditional M&A deals the target had positive earnings and approximately 26 percent had ROAs in excess of 50 percent. Institutions with positive earnings provide growth opportunities at attractive prices.

CONS:

  • The level of non-performing assets in some of the deals may still make the transaction prohibitive without FDIC loss protection. While bidders for FDIC-assisted deals are able to bid the assets acquired at a discount, the traditional M&A buyers cannot bid less than $0. Or, to put it another way, the sellers of whole institutions are not in a position to pay the buyer to take over the institution while the FDIC-assisted transaction is able to absorb the negative bids.
  • With prices for healthy institutions still depressed, there are fewer healthy sellers. Likely these institutions are waiting for prices to return to historical—which is to say higher-levels, although it’s unclear whether that will every happen.

FDIC-ASSISTED TRANSACTIONS

PROS:

  • The protection afforded from loss sharing has been a catalyst for getting bidders to participate in the bidding process and makes the transaction palatable on a prospective basis as the future losses are covered by loss sharing.
  • For many acquirers, it has offered a unique growth opportunity and there have been a number of serial FDIC-assisted transaction acquirers who have been able to raise capital and build long-term franchise value.
  • Buyers have been able to acquire assets and liabilities but leave behind unfavorable contracts and any potential litigation risks that would be associated with a failed institution.
  • The potential for bargain purchase gains can provide capital for the acquiring institution. However, those institutions should expect the regulatory agencies to exclude capital arising from a bargain purchase until the valuations have been finalized and then validated through examination or external audit.

CONS:

  • The loss sharing contract requirements can be time consuming and expensive to comply with, including reporting, systems and the required loan modification commitments.
  • Limited due diligence and a compressed time frame for the transaction translate into the bidder needing to make a significant number of material estimates to arrive at the bid with limited information. This can lead to unexpected results post transaction.

What is the outlook for both types of deals?

Trends in acquisitions of both types of deals increased in 2010 compared to 2009. On September 30, 2010, the FDIC reported 860 troubled institutions, up from 720 at December 31, 2009. If only 10 percent of those institutions ultimately fail, then 2011 will still see a significant number of transactions.

The total assets of troubled institutions are actually lower than at December 31, 2009, so the transactions likely will be of smaller sized institutions. Traditional M&A transactions also appear to be ready for an increase in activity in 2011, although still tempered compared to more recent history before the current financial crisis.

Are the FDIC-Assisted deals still attractive, or have they lost their allure since the FDIC is providing less loss protection?

The deals are still attractive and what the bidders appear to be doing is considering the level of expected losses including the revised coverage into their bids. In the 4th quarter of 2010 the asset discount on the deals with loss sharing increased over the prior quarters. Further, about 15 percent of transactions in 2010 didn’t include a loss sharing agreement, and in those transactions the asset discount was approximately twice as much as the loss sharing transactions. Our experience with bidders has been that they adjust to the changes in the FDIC structures.

Is this change in loss protection making traditional deals more competitive?

The changes in the loss sharing agreements do not appear to be changing the landscape. Bidders adjust their bids to encompass the expectations of losses. At the same time, buyers in traditional deals are including contingent payments, escrows and other holdbacks tied to credit performance as ways of providing some protection against future losses.

What are the impediments to getting traditional M&A deals done?

Capital is clearly an issue for many acquirers in traditional deals, and because the discounts on traditional deals are limited by the level of capital, some deals actually produce goodwill once the purchase accounting adjustments are all recorded. Regulators are expecting higher levels of capital and as a result the available buyer pool may be limited. Additionally, many potential sellers may be waiting until prices rebound and the returns to shareholders are maximized.

Potential acquirers are also weighing the ongoing costs of acquiring an institution with significant credit problems. The time and expense related to working out a significant number of problem credits can be prohibitive for some institutions. Finally, activity in certain states has been nominal in the last several years, so for buyers in those states, a potential transaction may be well outside their market area and that can be an impediment.

Navigating the Sea of Financial Reform

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navigate.jpgRecently, Bank Director and the American Banker presented the 2nd annual America’s Bank Board Symposium tailored to provide bank boards with the knowledge to develop, implement, and monitor strategies for their institutions. Several key industry speakers joined CEOs, board members and experienced financial leaders in Dallas to help navigate the sea of challenges facing bank directors today.

On the heels this event, I had the chance to catch up with one of the presenters, Susan O’Donnell, Managing Director with Pearl Meyer & Partners, an independent compensation consulting firm, to further explore her insights on what she believes are the top three issues concerning directors. Below is what she shared with me via email:

1. Responding to a Rapidly Changing Regulatory Environment
New regulations and requirements are coming at bank directors at an unprecedented pace, particularly in the last decade. Whether Sarbanes Oxley, recent banking regulatory agency guidance on risk assessment of incentive compensation practices, or new proxy disclosure requirements under the Dodd-Frank Act – there is a much greater need for board members to keep up with the rapid and constantly changing regulatory environment. This is particularly true of public banks that now have to meet even more disclosure requirements.

2. Understanding Changing Executive Compensation Trends, Including the Role of Risk Management
Keeping informed of the emerging best practices has also become a major challenge, as boards today must ensure their executive compensation practices reflect sound risk management, pay-for-performance alignment and align with shareholder interests. Board members (particularly compensation committee members) need to adapt their institution’s compensation practices, where appropriate, to reflect the new regulations and emerging best practices, while continuing to support their unique compensation philosophy.

What was ‘acceptable’ practice several years ago might be considered inappropriate today. For example, incentive compensation programs that place significant (or sole) focus on profits and top line growth may be perceived as potentially diverting banks’ focus on safety and soundness. Regulators are reviewing incentive plans with a new “set of glasses” and board must also review their executive compensation programs through these new lenses.

Severance/change in control benefits are also changing in response to increased scrutiny and transparency. Provisions such as the gross-up payments to cover the taxes to the executive under certain situations used to be common several years ago, but are no longer considered appropriate. And companies that continue to put such provisions in place with new contracts will come under increased pressure from shareholders and shareholder advisory groups, potentially impacting future Say on Pay votes. Boards need to be aware of these changing perspectives and the potential reaction from regulators and shareholders.

As executive compensation is under increased pressure, boards need to be ready to respond to the new level of scrutiny. More importantly, they will need to articulate their own compensation philosophy and develop programs that address their own unique needs, rather than chase historical market practice, which in many cases is no longer applicable or appropriate.

3. Responding to Increased Transparency, Disclosure and Shareholder Influence
The new disclosure requirements, starting in 2006 and culminating with many new requirements enacted through the Dodd-Frank Act, are placing a greater spotlight on executive compensation (and governance) practices. With a brighter light comes increased scrutiny.

With Say on Pay, shareholders will have an opportunity to vote their approval (or disapproval) of bank compensation programs. While non-binding, the votes will be public information, subject to media scrutiny. As such, boards will need to listen and be prepared to adapt or change in response to the feedback they receive.  It is critical that boards today focus on ensuring their proxy disclosure effectively communicates their compensation philosophy, programs, decisions, rationale for decisions and pay –performance alignment.

Boards will also need to know and understand their shareholders better. Say on Pay, Proxy Access and the loss of the Broker vote will increase shareholders’ influence on compensation programs and banks should be prepared for this new level of transparency and disclosure.

The Characteristics of Success

With all the new regulations and increased scrutiny within the financial industry, I was curious to know what characteristics would separate the winning banks from the losing ones over the next five years. O’Donnell highlighted these top three traits that she recommends bankers will need to make it through this period of reform:

1. Adaptability: Bank boards will need to be responsive to all the changes going on in the industry, including the new economic, business and regulatory requirements.

2. Leadership: Boards that exercise strong leadership as they navigate the bank through challenging times will more than likely come out on the winning side.

3. Focused: Boards must have clearly defined goals and strategies, knowing what needs to be done to execute them effectively.

One thing I’ve learned very quickly since joining Bank Director is that these are without a doubt some of the most challenging times the U.S. banking industry has experienced in quite some time. But with knowledge, flexibility and effective execution, I am confident that smart bankers will continue to excel at growing their financial institutions.

The Crisis in Community Banking

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growth.jpgLost in all the Sturm und Drang surrounding the financial crisis of 2008 – when several large U.S. financial institutions either failed (Washington Mutual Inc.), sold themselves off to avoid failure (Wachovia Corp.), or were simply propped by the federal government (Citigroup) – is the very real crisis facing community banks throughout the country.

The nation’s largest banks – all of which received direct capital infusions from the U.S. government under the controversial Troubled Asset Relief Program (TARP) – are once again profitable, and many of them have long since paid back the money. On the other hand, a great many community banks are still struggling to regain their footing – and for them the long nightmare is not yet over. 

Haves vs. Have-Nots
 
The disparity in fortunes between the industry’s largest institutions and smaller regional banks is framed perfectly by two bank stock indexes published by Keefe Bruyette & Woods Inc. The KBW Bank Index (BKX), which is comprised of 24 U.S. money centers or super-regional banks, was up 17% on the year through late October, while the KBW Regional Banking Index (KRX) – which is comprised of 50 smaller regional banks – was up just 3% on the year. Clearly institutional investors like what they see in the BKX universe, and that has allowed large banks to raise capital at a reasonable cost and put their troubled past behind them. 
 
Smaller regionals have had a more torturous recovery – and many of them were actually quite grateful to receive their TARP funds because when that money was being doled out two years ago it was the only available source of capital for most banks. 
 

Overdosing on Real Estate

But most challenged by far are the thousands of small community institutions that are either privately owned or have thinly traded and highly illiquid stocks and haven’t been able to raise fresh capital to fuel their recovery. For the most part, their downfall has been the result of bad commercial real estate and real estate development loans, including loans tied to the grossly overbuilt housing market in such places as Florida, Nevada and Arizona. 
 
Although the U.S. housing bubble attracted lenders, investors and buyers like moths to a flame, there is a reason why so many community banks ended up being so overexposed to real estate. After 30-some years of disintermediation and conglomerization, there are only a limited number of ways that community banks can make money. Several large asset classes, including car loans, credit cards, mortgages and home equity loans, are now dominated by giant financial companies that have enormous marketing and efficiency advantages. 

Expanding Their Business Model

Many community banks focus on small and medium-sized businesses because it’s one market where their superior service gives them a competitive advantage over the big banks, but generally they lack the revenue diversification of their larger peers. So when the residential real estate market took off in the early 2000’s and local developers were looking for loans to finance their construction activities, many smaller banks saw that opportunity as manna sent down from heaven. 
 
As the U.S. economy improves and the real estate market gradually recovers, community banks will rebound as well. Unfortunately, their underlying weakness – the lack of revenue diversification – will remain. And the challenge for community bank CEOs and their directors will be to expand their business models to include a variety of fee-based activities that will make them less reliant on cyclical lending markets like real estate.
 
Otherwise, the community-banking sector will just be an accident waiting for the next recession to happen.

Bankers Are Starting to See the Glass Half Full

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Things are looking up. The tide of optimism has definitely turned since the first quarter of this year. In our recent survey of bank executives, 45% say they believe the U.S. economy will improve within the next six months. This demonstrates a sizeable increase from the 24% who were similarly optimistic in our first quarter 2010 survey. While the bulk of respondents are still in the camp that believe the economy will likely remain the same over the near term, (44%), we noted a drop by nearly half among those who believe that harder times are still ahead (11%, compared to 20% six months earlier).

Moreover, among those who were asked how well their local economies are faring, a similar strain of optimism is found. Thirty-five percent (compared to 22% in the first quarter) believe their local economy is poised to improve, and only 9% (compared to 18%) believe things will get worse within the next six months.

Compliance concerns remain high. Among the concerns that bank executives have over the next 12 months, regulatory concerns overwhelmingly stand out above the rest. Fully 87% of bank executives ranked regulatory burden as a major concern over the next 12 months—nearly 30 points higher than the next, most pressing concern: exposure to commercial real estate losses (58% ranked it as a major concern.) In third place, but much lower than either of the first two, was a concern over retaining quality talent (37% ranked as a major concern.)

Watch out for commercial real estate. The largest percentage of bank executives surveyed (35%) believe the shoe will drop on commercial real estate values sometime within the next 12 months, but that opinion is far from unanimous. Another quarter of the surveyed group (25%) believes commercial real estate values already have bottomed out; and another 24% believe it will happen in the next six months. Not surprisingly, perspectives on this question have a lot to do with one’s region. Forty-two percent of the central region think their values have already bottomed out, compared to only 10% of bankers in the southern region and 18% of those in the western region who think so.

Who is raising capital? With the regulatory scrutiny placed on capital standards in the wake of the financial crisis, we asked bank executives to tell us their anticipated plans with regard to capital raises in the next 12 months. Less than a quarter of the total surveyed (22%) say it is very likely they’ll go to the market to raise capital, but a higher percentage of those from the still-troubled Southeast (37%) say they’ll do so. The majority (67%) say such action is not likely in the next 12 months. Finally, a small group (11%) said they had already successfully undergone a capital raise.

For the complete survey results and graphic analysis, watch for Bank Director’s third quarter issue mailing later this month.