ESG Factors Come to Play in M&A

As investors increase their focus on environmental, social and governance matters — otherwise known as ESG — the acronym is also making waves when it comes to M&A due diligence, according to Bank Director’s 2022 Bank M&A Survey, sponsored by Crowe LLP. But while the ESG acronym may be a newer one to the industry, many of the issues under the broad ESG umbrella are familiar to bankers.

Numerous areas fall under ESG. These include climate risk, energy and water use, and green-focused products and investments (environmental); organizational diversity, and employee and community engagement (social); and board composition and independence, shareholder rights, and ethics and compliance (governance). Cybersecurity and data privacy are also key elements, sometimes classified as social and sometimes as governance.

A typical bank M&A announcement tends to mention cultural alignment, and many ESG elements — particularly under the social and governance umbrellas — are strongly informed by an entity’s culture. Culture frequently comes up in the annual survey; this year, 64% of responding directors and executives identify a complementary culture as a top-five attribute in a seller. When asked about assessing the strategic fit of a target, 89% of respondents overall say they’d evaluate cultural alignment.

“Anytime you talk about an acquisition from the acquirer’s perspective, culture’s a big concern,” says Patrick Vernon, a senior manager at Crowe. “Culture [and] social and governance [factors] go hand in hand.”

For the acquirer, these considerations include cultural fit, employee integration and appropriate compensation to retain talent. For example, a seller where lenders work only on commission might not be a good fit for a buyer that where commission pay may be lower or nonexistent. Understanding those elements often calls for a qualitative assessment.

“If it’s a public company, I’d want to look at the human capital management disclosure in the 10K,” says Gayle Appelbaum, a partner in the regional and community banking consulting practice at McLagan. “What are some of the highlights, features, programs, results [and] areas for focus that the seller has been involved in?”

Effective Nov. 9, 2020, the Securities and Exchange Commission requires companies to disclose “any human capital measures or objectives that the registrant focuses on in managing the business,” which would include attracting, developing and retaining talent. The SEC didn’t provide further specific guidance, and an analysis conducted by the law firm Gibson Dunn finds a lack of uniformity in disclosures by S&P 500 companies. Most of these firms include diversity & inclusion statements in the disclosure, but fewer provide hard metrics about the company’s efforts. Most disclose talent development efforts, and more than half provide general statements around recruiting and retaining talent. Less than half disclose employee engagement efforts.

Human capital management disclosures can yield clues about the quality of talent as well as their expectations around compensation, benefits and development. Can the acquiring bank effectively support the acquired employees? Can the acquirer adopt some attributes from the seller to better manage talent in their own organization?

Companies that value diversity, equity and inclusion (DE&I) may also look at the target’s progress in these areas. Bank Director’s 2021 Compensation Survey, conducted earlier this year, found 37% of respondents reporting that their banks focused more on DE&I initiatives in 2020 compared to 2019. However, 42% lack a formal program — especially banks below $1 billion in assets. Those that do track progress primarily focus on the percentage of women and minorities at different levels of the organization.

Daniela Arias, a senior audit manager at Crowe, leads the firm’s ESG services in the U.S. and has been consulting banks on these issues; she also works with private equity firms. She’s increasingly seeing ESG considered in due diligence, along with operational and financial matters. That includes DE&I. “What policies are there in place for diversity?” she says. “What are they doing to track the data of who’s making it to leadership? Do they have development programs in place to help move the needle on diversity?”

Governance —including board composition and practices — is also critically important, says Appelbaum. “Are there problems?” she asks. Is governance strong at the target? What are the weaknesses? For sellers, she suggests asking, “Do you want to align with a company that doesn’t do things well?”

Compliance gaps can help acquirers identify red flags in a target, adds Arias. “If an organization does not have the critical, basic compliance issues down, that is already indicative that there are so many other areas that are not being thought about.”

Vernon points out that there are still a lot of unknowns in the ESG space, especially relative to examining climate risk. “It’s been a lot of wait and see,” says Vernon. “We’re not quite sure, from a regulatory standpoint, what requirements are actually going to be there in the banking space.”

Acquisitions can add strength to an organization, from new business lines and markets to talent. From an ESG perspective, the post-deal bank could emerge stronger. “For some, combining two organizations enhances the ESG picture,” says Appelbaum. One organization may have strengths when it comes to data security; the other may have a great training program.

While ESG won’t drive the selection of a target, an acquirer should understand the progress the seller has made — and whether there will be any issues. Appelbaum recommends starting with the target’s ESG policy and determining whether it’s aligned with the buyer. Also, look for feedback the seller has received from large investors and other stakeholders on ESG. “What’s been done to make headway with those institutional investors?” she says.

Arias helps companies consider their ESG roadmap, identifying where they are and where they want to go. “There are so many existing processes [and] operations that are ESG-related and … need to be brought together into one cohesive structure,” she says. Companies need to understand where they’re strong on ESG and where they need to improve. Once they have that picture, they can then ask, “Where do we need to be for organizations of our size within our industry?”

The banking industry may be in the early stages on ESG, but a strong program could become a competitive advantage. “From a seller’s perspective, in my opinion, the best way to execute a good deal and get that good price is to figure out what your competitive advantage is,” says Vernon. A seller could also be swayed by an acquirer with a strong ESG reputation that will have a positive impact on the seller’s community and employees. “On a go-forward basis, you could have a competitive advantage in ESG,” he adds.

And Arias advises that banks shouldn’t focus on specific metrics.  “Presenting your value from an ESG perspective is not about hitting the metrics,” she says. “It’s about showing progress, transparency, showing where you are, where you intend to go, and what are the steps that you’re going to take to get there.”

For a primer on getting started with ESG, view the video “Starting Your ESG Journey,” part of the Online Training Series. You may also consider reading “ESG: Walk Before You Run” for more considerations on where to start, or “Why ESG Will Include Consumer Metrics” to explore why your ESG program should include customer financial health. For questions boards should consider asking about climate change, read “The Topic That’s Missing From Strategic Discussions” and “Confronting Climate Change” from the third quarter 2021 issue of Bank Director magazine.

Bank Director’s 2022 Bank M&A Survey, sponsored by Crowe LLP, surveyed 229 independent directors, CEOs, CFOs and other senior executives of U.S. banks below $600 billion in assets to understand current growth strategies, particularly M&A. The survey was conducted in September 2021.

Bank Director’s 2021 Compensation Survey, sponsored by Newcleus Compensation Advisors, surveyed 282 independent directors, chief executive officers, human resources officers and other senior executives of U.S. banks below $50 billion in assets to understand talent trends, cultural shifts, CEO performance and pay, and director compensation. The survey was conducted in March and April 2021.

Bank Director’s 2021 Risk Survey, sponsored by Moss Adams LLP, received responses from 188 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $50 billion in assets. The survey was conducted in January 2021, and focuses on the key risks facing the industry today and how banks will emerge from the pandemic environment.

Laying Down a Foundation for Bank Boards Through Assessment, Alignment

There are few things in life that remain unchanged for their entirety, and that is certainly true of corporate boards of directors. A board’s ability to plan ahead for retirements, unexpected departures and shifts in business scale is imperative in maintaining a successful franchise.

As the cornerstone of leadership, the board’s composition plays a critical role in a corporation’s performance. In the banking sector, the board’s commitment encompasses the shareholders, to whom it has a fiduciary obligation, and to its management team, for which it has oversight responsibility. The board’s collective experience and knowledge of its members provides tremendous value, empowering the trajectory of the bank’s strategy.

But without the proper strategies in place, even the most robust board rooms are vulnerable to unexpected changes in the industry. An estimated 50% of all boards are operating without a strong succession plan. The absence of sufficient forethought poses incredible risk to a bank’s present and future stability. In contrast, establishing a foundation for preparedness through a board assessment process can help ensure the board is aligned to the strategic direction of the bank, and is prepared to address an ever-evolving business landscape.

The ideal board assessment approach allows for a standardized, yet customizable process. With careful attention to the uniqueness of every institution, the right steps will allow directors to examine their board’s strategic alignment to the functional and industry expertise needed to support the bank’s growth. A thorough assessment generates a “road map” of future director needs, along with updated governance framework. The assessment process can be led by the governance committee, the lead independent director, the chairman or a third-party firm. Here is the process we recommend:

Intake Session
Having conversations with board stakeholders that are focused on the bank’s long-term vision and short-term objectives will shape the strategy of the organization. This should also take into account the unique culture of the bank’s management team, coupled with any shareholder dynamics that can help guide the framework output and objectives.

Board Assessment
Develop a list of director questions and conduct one-on-one interviews with each director. Some categories of questions to ask include director professional background, contributions and engagement, director aspiration and a deep dive on director profile and skills. We also recommend developing a skills matrix as an effective tool to assess directors.

Future Board Framework
A healthy director composition analysis requires that the board compiling a thorough report that includes the findings of the board interviews and member assessments. . Directors should have candid discussions about the skills and expertise the board needs to fill identified gaps and needed changes. Directors should revisit all governance elements such as terms and limits, size of board, committee structures, election process and succession issues, among others. We recommend that bank directors develop a final three-year board framework plan to implement the identified changes.

Refreshment
Boards should follow this plan to refresh overall board governance, implementing new processes over time as to not dispute important social and cultural matters. Boards should also use a director refreshment plan to bring on new directors that fill experience and skills gaps identified as part of the board assessment process.

Often, a third-party firm is brought in to lead the overall assessment and refreshment process, working closely with the chairman or the board’s governance and nominating committee. Given the complexities of crafting and gauging a board’s optimal composition, a firm can be helpful with managing that assessment process from beginning to end. Additionally, a third party can help recruit a strategic director with the needed industry and functional expertise, with the added benefit of bringing forward a more diverse candidate pool to consider.

Strong bank boards continue to adapt to strategic objectives and maximize shareholder returns. Time and time again, companies that thrive consistently focus on going deeper with corporate board best practices. For emerging institutions, going through the assessment process for the first time is typically challenging; this process inherently implies impending change. Boards that regularly engage in director assessment and revisit their overall governance framework tend to produce better shareholder returns. Is your board focused on how to elevate the oversight function for the organization?

Can Boards Be a Technology Resource for Their Bank?

Just 29% of chief executives, and 17% of chief information and chief technology officers, say they rely on members of their board for information about technology’s impact on their institution, according to Bank Director’s 2021 Technology Survey. But what if a bank could leverage their board as a resource on this issue, helping to connect the dots between technology and its overall strategy?

Coastal Financial Corp., based in Everett, Washington, has brought on board members over the past three years with experience working in and supporting the digital sector: Sadhana Akella-Mishra, chief risk officer at the core provider Finxact; Stephan Klee, chief financial officer at the venture capital firm Portage Ventures and former CFO of Zenbanx, a fintech acquired by SoFi in 2017; Rilla Delorier, a retired bank executive who until last year led digital transformation at Umpqua Bank; and Pamela Unger, a certified public accountant who created software to support her work with venture capital firms. That deep bench of technology expertise helps the bank evolve, according to CEO Eric Sprink, by better understanding opportunities and risks. The board can even help $2 billion Coastal identify and bring on staff.

“The board has always been entrepreneurial at its basis, and some of the core values that we developed as a board were, be flexible, be unbankey and live in the gray — and those are [our] board values,” Sprink says. “We’ve really worked hard to continually ask people to join our board that continue that evolution and entrepreneurial spirit with some specialty that they bring.”

Bank Director’s recent Technology Survey finds that roughly half of bank boards discuss technology at every board meeting; another 30% make sure it’s a quarterly agenda item. That’s been the picture for several years in our survey, given technology’s importance in an increasingly digital economy.

But for many community bank boards, the expertise reflected in the boardroom hasn’t caught up to today’s reality — just 49% of board members and executives representing a bank smaller than $10 billion in assets report that their board has a director with a background or expertise in technology. And these skills are even rarer for discrete areas affecting bank strategies and operations, from cybersecurity (25% say they have such an expert on their board) to digital transformation (20%) and data analytics (16%).

Bank boards would benefit greatly from this expertise — and many of them know it, says J. Scott Petty, a partner at the executive search firm Chartwell Partners. “When I interview boards and we go through an assessment process, it’s always the No. 1 thing they talk about,” he says. “There’s no one there [who] can really understand what their head of technology is talking about. So, whatever they say, they go, ‘OK, well, you’re the tech expert.’”

In Bank Director’s 2021 Governance Best Practices Survey conducted earlier this year, board members identify their two most vital functions: holding management accountable for achieving strategic goals in a safe and sound manner, and meeting the board’s fiduciary responsibilities to shareholders.

If board members can’t pose a credible challenge to management when it comes to discussions on technology — asking pointed questions about a rising budget item for the majority of banks, as our recent research finds — then they can’t effectively fulfill their two most important duties. And boards also will find themselves unable to contribute to the bank’s strategy in the way they could or should.

Directors with technology expertise can help boards provide effective oversight and link technology and strategy, says Petty. “That’s the No. 1 [thing] — that fiduciary responsibility to really understand how the bank [aligns] its business strategy with its technology strategy.”

Petty shares a comprehensive list that identifies how technology expertise in the boardroom can contribute to the board’s oversight and strategic functions. These include:

  • Linking technology to the overall business strategy
  • Asking incisive questions of the bank’s CIO and/or CTO, and holding them accountable for goals, deadlines and budgets
  • Providing effective oversight of information security as well as Bank Secrecy Act/anti-money laundering (BSA/AML) compliance
  • Offering input and guidance on the bank’s technology initiatives
  • Giving feedback on innovation, customer experience and acquisition, product development, digital integration, cross-selling opportunities and similar areas

Asking pointed questions and deliberating about these technology matters isn’t just a fiduciary responsibility — it makes banks better, points out Jeff Marsico, president of The Kafafian Group, a consulting firm. Technology use by the industry isn’t new, he notes, but community bank boardrooms are typically composed of older members who will be inherently less tapped into what’s going on in the digital banking space. As a result, “they don’t have enough base knowledge to be challenging to management and therefore management knows, ‘I’m not going to be particularly challenged here,’” Marsico says. “[Boards] need somebody with enough knowledge to be able to challenge management — because then management gets better.”

Marsico sees flaws in most boards’ often-informal nomination processes. Performance evaluations, he notes, aren’t adequately used by the industry to identify gaps in board composition, and board members are often reticent to leave. Bank Director’s governance research backs this up, finding that roughly half of boards representing banks between $1 billion and $10 billion in assets conduct an annual performance assessment; that drops to 23% of boards below $1 billion in assets. Fewer than 20% overall use that assessment to modify the board’s composition.

Finding technology skill sets may challenge community bank boards, but Petty recommends a few ways that nominating committees can expand their search. Banks aren’t alone in the digital evolution, which affects practically every sector of the economy. With that in mind, he suggests looking at other industries for prospective board members. “Take an industry-agnostic look to find technology experts from organizations that are larger than the current institution,” Petty says.

Colleges, universities or vocational schools may also provide a resource to tap into technology expertise. “They typically are also at the forefront of talking about digitization across industries,” Petty adds.

While boardrooms should benefit from recruiting members with expertise for the digital age, that doesn’t excuse directors from enhancing their own understanding of the topic.

The 2021 Technology Survey finds board members highly reliant on bank executives and staff (87%) for information about the technologies that could affect their institution — right behind articles and publications (96%) as directors’ top resources.

While input from the bank’s executive team is critical, it’s important that directors leverage their own backgrounds, in addition to taking advantage of ongoing training and informational resources, to ask the right questions of these executives.

Marsico recommends that boards focus on strategy in every board meeting, with regular quarterly updates on the bank’s progress on executing the strategy. Other sessions should provide opportunities to educate board members on what’s going on in the banking environment — and should include external points of view. These could include technology vendors or representatives from the various associations serving the banking community. Petty suggests bringing in a former technology executive of another, larger bank who could brief members on what they’re seeing in the marketplace.

[Boards] can get an outsider’s perspective that breathes fresh air into what is the possible — because I don’t think they know what is the possible,” says Marsico.

Petty also points to increasing interest in forming board-level technology committees. Bank Director’s 2021 Compensation Survey, conducted earlier this year, found that 23% of banks use such a committee.

“Even the smaller banks will have a technology committee, because it’s such a major focus for any institution to drive the digitization of how they go to market, how they leverage the digital experience for the customer, how they leverage the digital product offerings, [and] how they use digital to acquire new customers and onboard new customers,” says Petty.

To understand the responsibilities of the technology committee, access our Board Structure Guideline on that topic. Recent Bank Director research reports examine “The Road Ahead for Digital Banking” and “Meeting Customer Demand for Bitcoin.” Bank Director’s membership program includes a board assessment tool and access to the FinXTech Connect platform, which helps bank leaders identify potential technology providers and solutions.

Bank Director’s 2021 Technology Survey, sponsored by CDW, surveyed more than 100 independent directors, CEOs, COOs and senior technology executives of U.S. banks below $100 billion in assets to understand how these institutions leverage technology in response to the competitive landscape. The survey was conducted in June and July 2021.

Bank Director’s 2021 Compensation Survey, sponsored by Newcleus Compensation Advisors, surveyed 282 independent directors, chief executive officers, human resources officers and other senior executives of U.S. banks below $50 billion in assets to understand talent trends, cultural shifts, CEO performance and pay, and director compensation. The survey was conducted in March and April 2021.

Bank Director’s 2021 Governance Best Practices Survey, sponsored by Bryan Cave Leighton Paisner LLP, surveyed 217 independent directors, chairs and chief executives of U.S. banks below $50 billion in assets. The survey was conducted in February and March 2021, and explores the fundamentals of board performance, including strategic planning, working with the management team and enhancing the board’s composition.

ESG Disclosure on the Horizon for Financial Institutions

Over the last several years, investors, regulators and other stakeholders have sought an increase of environmental, social and governance (ESG) disclosures by public companies.

The U.S. Securities and Exchange Commission (SEC) has taken a cautious approach to developing uniform ESG disclosure requirements, but made a series of public statements and took preliminary steps this year indicating that it may soon enhance its climate-related disclosure requirements for all public companies, including financial institutions. To that end, the SEC’s spring 2021 agenda included four ESG-related rulemakings in the proposed rule stage, noting October 2021 for a climate-related disclosure proposed rule. The SEC is also sifting through an array of comments on its March 15 solicitation of input on how the Commission should fashion new climate disclosure requirements.

Recent speeches by Chair Gary Gensler and Commissioners Allison Herren Lee and Elad Roisman highlight some of the key elements of disclosure likely under consideration by the staff, as well as their personal priorities in this area. Commissioner Lee has asserted that the SEC has full rulemaking authority to require any disclosures in the public interest and for the protection of investors. She noted that an issue also having a social or political concern or component does not foreclose its materiality. Commissioner Lee has also commented on the disclosure of gender and diversity data and on boards’ roles in considering ESG matters.

Commissioner Roisman has noted that standardized ESG disclosures are very difficult to craft and that some ESG data is inherently imprecise, relies on continually evolving assumptions and can be calculated in multiple different ways. Commissioner Roisman has advocated for the SEC to tailor disclosure requirements, and phase in and extend the implementation period for ESG disclosures. Meanwhile, Chair Gensler has also asked the SEC staff to look at potential requirements for registrants that have made forward-looking climate commitments, the factors that should underlie the claims of funds marketing themselves as “sustainable, green, or ‘ESG’” and fund-naming conventions, and enhancements to transparency to improve diversity and inclusion practices within the asset management industry.

Significance for Financial Institutions
In the financial services industry, the risks associated with climate change encompass more than merely operational risk. They can include physical risk, transition risk, enterprise risk, regulatory risk, internal control risk and valuation risk. Financial institutions will need to consider how their climate risk disclosures harmonize with their enterprise risk management, internal controls and valuation methodologies. Further, they will need to have internal controls around the gathering of such valuation inputs, data and assumptions. Financial institutions therefore should consider how changes to the ESG disclosure requirements affect, and are consistent with, other aspects of their overall corporate governance.

Likewise, financial institutions should also consider how human capital disclosures align with enterprise risk management. Registrants will not only need to ensure that the collection of quantitative diversity data results in accurate disclosure, but also how diversity disclosures might affect reputational risk and whether any corporate governance changes may be needed to mitigate those concerns.

We recommend that financial institutions consider the following:

  • Expect to include a risk factor addressing climate change risks, and for the robustness and scope of that risk factor to increase.
  • Consider disclosing how to achieve goals set by public pledges, as well as whether the mechanisms to measure progress against such goals are in place.
  • Expect ESG disclosure requirements to become more prescriptive and for quantitative ESG disclosures to become more sophisticated. Prepare to identify the appropriate sources of information in a manner subject to customary internal controls.
  • Establish a strong corporate governance framework to evaluate ESG risks throughout your organization, including how your board will engage with such risks.
  • Incorporate ESG disclosures into disclosure controls and procedures.
  • Consider whether and how to align executive compensation with relevant ESG metrics and other strategic goals.

What Directors Think About Diversity, Independence and Credible Challenge

Building a diverse board —as defined by gender, race and ethnicity — is a controversial issue in many corporate boardrooms today, banks included. An increasing number of large institutional investors and stock exchanges like the Nasdaq Stock Market are pushing for it, and a small but growing number of states either mandate it or are instituting disclosure requirements.

But not everyone is convinced that greater diversity inherently leads to better governance, as illustrated by results of Bank Director’s 2021 Governance Best Practices Survey. Fifty-nine percent of the respondents agreed that diversity as defined by race, gender and ethnicity improves the performance of a corporate board. However, 36% agreed with statement but said the impact was overrated, and 5% disagreed that greater diversity improves performance.

James J. McAlpin Jr., a partner at Bryan Cave Leighton Paisner LLP and leader of the firm’s banking practice group, is a strong proponent of board room diversity. “I have experienced the power of diversity on a bank board of which I am a member,” he says. “We have gone from a board of eight men and one woman three years ago to now a majority female board. There is a difference resulting from that positive transformation. Our board is probably more risk averse that it used to be. We seem to be better prepared as a group for meetings. And as a group we ask more probing questions.”

Sponsored by Bryan Cave, the survey polled 217 directors and chief executives at banks under $50 billion in assets in February and March of 2021. The majority of the respondents were independent board members. Almost half of the participants represented banks with $1 billion to $10 billion in assets.

Diversity is just one of many issues covered in this year’s survey. The list includes the practice of credible challenge, the desire for collegiality versus the freedom to disagree, board assessments, the board’s role in strategic planning and CEO performance evaluations. The survey results have been divided into five modules: board practices, the board/management relationship, strategic planning, board refreshment and diversity, and the role of the independent director.

The white paper also includes the insights of two experienced directors who helped us interpret the results: David. L. Porteous, the lead director at Huntington Bancshares, a $175 billion asset bank headquartered in Columbus, Ohio; and C. Dallas Kayser, the independent chair at City Holding Co., a $5.9 billion bank located in Charleston, West Virginia.

Ninety-nine percent of the survey respondents said that personal integrity was the most important attribute of an independent director, followed by the ability to exercise sound judgment at 96% and accountability at 94%.

“Regardless the size of the bank, the role of the independent director is pretty much the same,” says Porteous, who has served on the Huntington board since 2003, and as lead director since 2007. “There has to be a level of commitment, and that commitment has to be to your fellow directors. It has to be to the leadership of the organization, it has to be to the shareholders, to the community and to the regulators. If there comes a time when you just can’t dedicate that level of commitment, you should probably step down.”

To read more about these critical board issues, read the white paper.

To view the full results of the survey, click here.

Tips to Navigate Top Risk Factors for Banks in 2021

Risk is always a prominent factor for banks. Their ability to strategically navigate change proved to be crucial in a year of unprecedented challenges caused by the Covid-19 pandemic.

Moss Adams partnered with Bank Director to conduct the 2021 Risk Survey that explored key risks facing the industry — and forecast how banks will emerge from the pandemic. Below is a summary of top insights from the survey, as well as considerations that bank leadership should keep front of mind as they go into the second half of the year.

Rising Credit Risk Concerns

Unsurprisingly, concerns around credit risk increased in 2020.

Two-thirds of bank respondents worry about concentrations in their loan portfolio, particularly around industries significantly strained during the pandemic, including commercial real estate and hospitality. Almost all respondents modified loans in second and third quarters of 2020 to aid their customers during the initial wave; some of these modifications extended into the fourth quarter.

Evaluation Metrics and Portfolio Concerns

Two separate metrics are now in play for regulators’ evaluations. As a result, it’s important to remember that just because your bank’s loan portfolio doesn’t receive a favorable rating doesn’t mean your bank or management won’t be evaluated favorably.

Regulators might downgrade a portfolio rating as some credits went into deferrals due to business shutdowns and borrowers being unable to make payments. However, bank management could receive a strong rating because of actions they took to keep the bank running and support customers.

While modifications reflect current realities, they don’t diminish the fact that portfolios are degrading from a stability standpoint. Forty-three percent of respondents tightened underwriting standards during the pandemic, while roughly half are unsure if they’ll adjust standards in 2021 and 2022.

Banks that have good governance will loosen their underwriting standards and will be strategic about to whom they lend money. In addition, they will assess which loans they’ll permit to be in delinquent status without taking action, and which they’ll defer.

Increases in Stress Testing

While annual stress tests are common for banks, 60% of respondents expanded the quantity or depth of economic scenarios in response to the pandemic. This is despite regulators’ previous increase of the asset cap threshold for required testing.

Most institutions focus not just on interest rate stress testing — they test the whole portfolio. This is driving more stress testing on the viability of collateral for loans and liquidity. Institutions know they’ll face increased allowance provisions and write-offs, so they’re stress testing the capital resiliency of their organization and see how they would shoulder that burden.

Looking forward, banks may want to focus on concentrated risks within the portfolio. They may also want to apply different, more specific stress testing criteria to various segments such as multifamily real estate, hospitality and mortgages, knowing certain areas may pose greater risk.

Improved Plans for Continuity and Disaster Recovery

The pandemic placed a renewed focus on continuity and disaster recovery. While most organizations had a pandemic provision in their plans following guidance from the Federal Financial Institutions Examination Council (FFIEC), they had been considered only hypothetical exercises. When an actual pandemic hit, many organizations had to react quickly, focus and learn how to adapt during the experience. Most banks will enhance their business continuity plans as a result of the pandemic: 84% of respondents say they’ve made or plan to make changes to their plans.

Key improvement areas include plans to:

  • Formalize remote work procedures.
  • Educate and train employees.
  • Provide the right tools to staff.
  • Ensure the bank’s IT infrastructure can adapt in a crisis.

Cybersecurity and Remote Work Setups

Three-quarters of respondents plan for at least some employees to work remotely after the pandemic abates. This makes cybersecurity a significant concern that boards need to further explore and implement additional precautions around.

Previously, with employees working in one space, there was only one entry point of attack for cybercriminals. Suddenly, with employees working from potentially hundreds of different locations, hundreds of entry points could exist.

Factoring in employees’ mental states is also a crucial vulnerability. It’s easier for cybercriminals to take advantage of or deceive employees that are navigating the difficulties of working from home and the general stresses of the pandemic. Increased staff training, as well as technology improvements, can help better detect and deter cyberthreats and intrusions.

Looking Forward

Though many respondents noted the resilience of the industry, it’s important to not get complacent. Banks certainly weathered the hard times, but the biggest impacts of the past year likely won’t be fully visible until the pandemic subsides.

Once that occurs, some businesses will reopen but may need more capital. Others may still close permanently, leaving banks to determine which loans won’t get repaid, engage bankruptcy courts, take cents on the dollars for the loan and charge write-offs.

So while this past year has been a major learning experience, the lesson likely won’t be concluded until early 2022.

 

Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC.

ESG Principles at Work in Diversifying Governance

Before environmental, social, and governance (ESG) matters became commercially and culturally significant, the lack of diversity and inclusion within governance structures was noted by stakeholders but not scrutinized.

The shifting tides now means that organizations lacking diversity in their corporate leadership could be potentially subjected to shareholder lawsuits, increased regulation and directives by state laws, investment bank requirements, and potential industry edicts.

Board and management diversity is undoubtedly a high-priority issue in the banking and financial services sectors. Numerous reports establish minority groups have historically been denied access to capital, which is mirrored by the lack of minority representation on the boards of financial institutions.

Some progress has been made. For example, for the first time in its 107-year history, white men held fewer than half of the board seats at the Federal Reserve’s 12 regional outposts. This was part of an intentional effort, as Fed leaders believe a more representative body of leaders will better understand economic conditions and make better policy decisions. However, further analysis reflects such diversity predominantly among the two-thirds of directors who are not bankers, while the experienced banking directors are mainly white males.

Board Diversity Lawsuits
The current pending shareholder suits have been primarily filed by the same group of firms and targeted many companies listed by a recent Newsweek article as not having a Black director. None of these suits involve financial institutions, but it is not hard to foresee such cases coming in the future. The lawsuits generally assert that the defendants breached their fiduciary duties and made false or misleading public statements regarding a company’s commitment to diversity. The Courts have summarily dismissed at least two suits, but a legal victory may not even be the goal in some cases.

Recently, Google’s parent settled its #MeToo derivative litigation and agreed to create a $310 million diversity, equity, and inclusion fund to support global diversity and inclusion initiatives within Google over the next ten years. The fund will also support various ESG programs outside Google focused on the digital and technology industries.

Regulatory, Industry, and Shareholder Efforts
Federal and state regulatory efforts preceded these recent lawsuits. The U.S. Securities and Exchange Commission has issued compliance interpretations advising companies on the disclosure of diversity characteristics upon which they rely when nominating board members and is expected to push more disclosure in the future. Additionally, the U.S. House of Representatives considered a bill in November 2019 requiring issuers of securities to disclose the racial, ethnic, and gender composition of their boards of directors and executive officers and any plans to promote such diversity.

These efforts will likely filter into boardrooms and may spur additional board regulation at the state level. In 2019, California became the first state to require headquartered public companies to have a minimum number of female directors or face sanctions, increasing 2021. In June 2020, New York began requiring companies to report how many of their directors are women. As other states follow California’s lead regarding board composition, we can expect more claims to be filed across the country.

At the industry level, the Nasdaq stock exchange filed a proposal with the SEC to adopt regulations that would require most listed companies to elect at least one woman director and one director from an underrepresented minority or who identify as LGBTQ+. If adopted, the tiered requirements would force non-compliant companies to disclose such failures in the company’s annual meeting proxy statement or on its website.

In the private sector, institutional investors, such as BlackRock and Vanguard Group, have encouraged companies to pursue ESG goals and disclose their boards’ racial diversity, using proxy votes to advance such efforts. Separately, Institutional Shareholder Services and some non-profit organizations have either encouraged companies to disclose their diversity efforts or signed challenges and pledges to increase the diversity on their boards. Goldman Sachs Group has made clear it will only assist companies to go public if they have at least one diverse board member.

Concrete Plans Can Decrease Director Risk
Successful institutions know their diversity commitment cannot be rhetorical and is measured by the number of their diverse board and management leaders. As pending lawsuits and legislation leverage diversity statements to form the basis of liability or regulatory culpability, financial institutions should ensure that their actions fully support their diversity proclamations. Among other things, boards should:

  • Take the lead from public and private efforts and review and, if necessary, reform board composition to open or create seats for diverse directors.
  • When recruiting new board members, identify and prioritize salient diversity characteristics; if necessary, utilize a diversity-focused search consultant to ensure a diverse pool of candidates.
  • Develop a quantifiable plan for diversity issues by reviewing and augmenting governance guidelines, board committee efforts, and executive compensation criteria.
  • Create and promote diversity and inclusion goals and incorporate training at the board and management levels.
  • Require quarterly board reporting on diversity and inclusion programs to reveal trends and progress towards stated goals.

As companies express their commitment to the board and C-level diversity and other ESG efforts, they should create and follow concrete plans with defined goals and meticulously measure their progress.

2021 Governance Best Practices Survey Results: Who’s Driving Bank Strategy?

The best banks balance short-term thinking with long-term strategy.

“Long-term performance is always our paramount objective,” Bank OZK Chair and CEO George Gleason told Bank Director at its recent Inspired by Acquire or Be Acquired virtual event. The $27 billion bank topped Bank Director’s 2021 RankingBanking study. “If short-term results suffer because of our focus on long-term objectives, then that’s just part of it.”

Strategic discipline starts with a bank’s leadership team — and the board should play an important role in developing the strategy and monitoring its execution. But that’s not always the case, according to the results of the 2021 Governance Best Practices Survey, sponsored by Bryan Cave Leighton Paisner LLP.

The survey explores the board’s approach to strategic planning, as well as governance practices, board composition and the relationship between executives and the board. The results find that most boards don’t drive strategic planning at their institutions: Just 20% say the board drives this process and collaborates with management to develop the strategic plan. Most — 56% — say their board establishes the risk appetite but relies on management to develop the strategy.

The vast majority believe their strategic planning process is effective. But of the 11% who believe their process to be ineffective, some express regret over the lack of input from their board. One respondent believes their bank’s strategic plan to be “too in the weeds,” while another holds the opposite concern. “It flies at 30,000 feet for [the] most part,” says one independent chair. “[We] need to get a little closer to the ground with metrics and clear paths for management to build.”

Most — 84% — reviewed their strategic plan during the pandemic, but few shortened the time horizon of their strategy. This may seem surprising, given previous indicators that Covid-19 accelerated bank strategy in some areas, particularly around the implementation of digital technology. Perhaps this indicates that, for most bank leadership teams, balancing short-term results and long-term strategy remains top of mind.

Key Findings

Strategic Review
Three-quarters of respondents say their board reviews the strategic plan annually. Roughly two-thirds bring in an outside advisor or consultant to assist in developing the strategic plan — but not generally every year.

Board Responsibilities
When asked to identify the board’s most important functions, the majority of respondents point to holding management accountable for achieving goals in a safe and sound manner (61%) and meeting its fiduciary responsibilities to shareholders (60%). Just 34% say that setting strategy is a key board responsibility.

Competitive Pressures
Respondents say that pressure on net interest margins (52%), the ability to grow organically in their markets (44%) and meeting customer demands for digital options (37%) threaten the long-term viability of their bank.

Interacting With Management
The vast majority of independent directors, chairs and lead directors believe they’re getting the right level of information from bank executives. Almost all interact at least quarterly with the bank’s CEO (98%), CFO (94%) and chief risk officer (85%).

Credible Challenge
Three-quarters say their board has several directors willing to ask tough questions when warranted; 92% find their management team receptive to feedback.

Needle Moving on Board Diversity
Almost 60% believe that fostering diversity in the boardroom improves corporate performance. Thirty-nine percent have three or more board members who bring diverse characteristics to the board, based on gender, race or ethnicity.

Assessing Performance
Less than half conduct an annual evaluation of their board’s performance, which most use to assess the effectiveness of the board as a whole (84%), improve governance processes (60%), identify training needs for the board (59%) or assess committee performance (58%).

To view the full results of the survey, click here.

Why ESG Will Include Consumer Metrics

Imagine a local manufacturer, beloved as an employer and a pillar of the community. The company uses 100% renewable energy and carefully manages its supply chain to be environmentally conscious. The manufacturer has a diverse group of employees, upper managers and board. It pays well and provides health benefits. It might be considered a star when it comes to environmental, social and governance (ESG) parameters.

Now imagine news breaks: Its product causes some customers to develop cancer, an outcome the company ignored for years. How did a good corporate citizen not care about this? You could say this was a governance failure. Everyone would agree that it was a trust-busting event for customers.

ESG, at its root, is about looking at the overall impact of a company. The most profound impact of banks is the impact of banking products. Most bank products are built for use in a perfect world with perfect compliance, but perfect compliance is hard for some people. Noncompliance disproportionately affects the most vulnerable customers ⎯ people living paycheck-to-paycheck and managing their money with little margin to spare. That isn’t to say that these individuals are all under or near the poverty line: Fully 18% of people who earn more than $100,000 say they live paycheck to paycheck, according to a survey of 8,000 U.S. workers by global advisory firm Willis Towers Watson. There is growing recognition that bank products need to reflect the realities of more and more Americans.

Years ago, Columbus, Ohio-based Huntington Bancshares started working on better overdraft solutions for customers whose financial lives were far from perfect. Currently, the $123 billion regional bank will not charge for overdrafts under $50 if a customer automatically deposits their paycheck. If the customer overdrafts $50 or more, the bank sends them an alert to correct it within 24 hours.

Likewise, Pittsburgh-based PNC Financial Services Group recently announced a new feature that gives PNC Virtual Wallet customers 24 hours to cure an overdraft without having to pay a fee.  If not corrected, an overdraft amounts to a maximum of $36 per day.

“With this new tool, we’re able to shift away from the industry’s widely used overdraft approach, which we believe is unsustainable,” said William Demchak, chairman and CEO of the $474 billion bank, in a statement. The statement alone reframes what sustainability means for banking.

The banks that become ESG leaders will create products that improve the long-term financial health of their retail and small businesses customers. To do so, some financial institutions are asking their customers to measure their current financial realities in order to provide better solutions.

For example, Credit Human, a $3.2 billion credit union in San Antonio, is putting financial health front and center both in their branches and digitally. Their onboarding process directs individuals to a financial health analysis supported by FinHealthCheck, a data tool that helps banks and credit unions measure the financial health of customers and the potential outcomes of the products they offer. The goal of Credit Human is to improve the financial health of their customers and eventually make it a part of the overall measurement of the product’s performance.

Measurement alone will not build better bank products. But it will provide banks and credit union executives with critical information to align their products with customer well being. With the implementation of overdraft avoidance programs such as PNC’s Low Cash Mode, the bank expects to help its customers avoid approximately $125 million to $150 million in overdraft fees annually. PNC benefits its bottom line by driving more customers to its Virtual Wallet, nabbing merchant fee income and creating customer loyalty in the process. PNC’s move makes it clear that they believe promoting the long-term financial health of their customers promotes the long-term financial health of the company.

Banks need to avoid appearing to care about ESG, while failing to care about customers. The banks that include customer financial health in their ESG measurement will survive, thrive and become the true ESG stars.

ESG: Walk Before You Run

Covid-19 and last year’s protests over racial injustice added to the mounting pressure corporations face to make progress on environmental, social and governance (ESG) issues — but banks may be further ahead than they believe.

“ESG took on a life of its own in 2020,” says Gayle Appelbaum, a partner at the consulting firm McLagan. Institutional investors have slowly turned up the heat on corporate America, along with community groups, proxy firms and ratings agencies, and regulators such as the Securities and Exchange Commission, which now mandates a human capital management disclosure in annual reports. Customers want to know where companies stand. Prospective employees want to know if a company shares their values. And President Joe Biden’s administration promises to focus more on social and environmental issues.

Big banks like Bank of America Corp. and JPMorgan Chase & Co. have been responding to these pressures, but now ESG is trending down through the industry. With the right approach, banks may find that these practices actually improve their operations. However, smaller community and regional banks can’t — and probably shouldn’t — merely copy the ESG practices of their larger brethren. “People have to think about what’s appropriate for their bank, given [its] size and location,” says Appelbaum. “What are they already doing that they could expand and beef up?”

That means banks shouldn’t feel pressured to go big or go home when it comes to ESG. Begin with the basics: Has your bank reduced waste by encouraging paperless statements? How many hours do employees spend volunteering in the community? “When you sit down and talk to bankers about this, it’s interesting to see [their] eyes open,” says Brandon Koeser, senior manager and financial services senior analyst at the consulting firm RSM. The pandemic shed light on how banks support their employees and communities. “The reality is, so much of what they’re doing is part of ESG.”

Robin Ferracone, CEO of the consultancy Farient Advisors, tells companies to think of ESG as a journey, one that keeps strategy at its core. “You need to walk before you run. If you try to bite [it] all off at once, you can get overwhelmed,” she says. Organizations should prioritize what’s important to their strategy and stakeholders. ESG objectives should be monitored, revisited and adjusted along the way.

Stakeholders are watching. Glacier Bancorp CEO Randall Chesler was surprised to learn just how closely in a conversation with one of the bank’s large investors two years ago.

“One of our investors asked us, ‘Have you looked at this? We see your score isn’t very good; are you aware of that? What are you going to do about it?’ And that was the first time that we started to dig into it and realized that we were being scored by ISS,” says Chesler. (Institutional Shareholder Services provides an ESG rating on companies, countries and bonds to inform investors.)

It turned out that $18.5 billion Glacier was doing a lot, particularly around the social and governance aspects of ESG. The Kalispell, Montana-based bank just wasn’t telling its story. This is a common ESG gap for community and regional banks.

Glacier worked with consultants to develop a program and put together a community and social responsibility report, which is available in the investor relations section of its website, along with other governance documents such as its code of ethics. This provided the right level of information to lift Glacier’s score. “Our benchmark was, we want to be at our peer-level scoring on ESG,” says Chesler. “[We] ended up actually better. And we continue to watch our scores.”

“Community banks have the social and governance aspects covered better than many industries because [banks are] heavily regulated,” says Joe Scott, a managing director at Kroll Bond Rating Agency. Where they likely lag, he says, is around the environment; most are just beginning to assess these risks to their business. And it’s important that banks get this right as stakeholders increasingly focus on ESG. “We’re hearing that, beyond equity and debt investors, larger depositors — particularly corporate depositors, institutional depositors, state treasurers’ officers [and] others like that — are incorporating ESG into their considerations on who they place large deposits with. That could be a theme over time— other kinds of stakeholders factoring in ESG more and more.”