When Directors Should Talk to Investors

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Company boards have long spoken to investors in indirect ways, through their votes and organizational performance. But as powers shift to large investors and governance norms have changed, investor groups have demanded more one-on-one conversations with bank directors.

Allowing directors to speak to investors comes with risk, and not just due to the potential for legal missteps. The director becomes a public representative of the bank and anything he or she says will be scrutinized, resulting in possible backfire.

“You can’t really say you’re not speaking for the company,” says Peter Weinstock, a partner at the global law firm Hunton Andrews Kurth. “You’re speaking for the company.”

But in an age where activist shareholders have an increased presence and institutional investors such as Blackrock and State Street Corp. have greater power, organizations find that some investors expect this one-to-one interface with directors. When done right, it can ease tension among the investor base, allowing management to maneuver more freely. When done wrong, however, it can result in proxy fights and changes to the board and management.

The topics that investors care about impact the moves that directors and boards make. Board discussions on compensation, for example, are becoming more important. Last year saw the lowest level of shareholder support for executive pay — only 87.4% of S&P 500 companies received shareholder approval in advisory voting during proxy season, according to PwC. That indicates a higher bar for boards to get shareholder buy-in for executive compensation.

Companies also must deal with an increasing amount of activist shareholder proposals. PwC reports there was a 17% increase in shareholder proposals last year. Out of 288 proposals related to environmental, social and governance (ESG) matters, a popular topic last year, 41 proposals passed.

One way to provide context for the company’s efforts on those matters: director conversations.
Institutional investors and shareholder analysis groups have turned their focus to three big concerns – audit, governance and compensation – all of which reside at the board level. With questions surrounding those specific concerns coming from many different groups, banks have turned to so-called “roadshows.” In those organized conversations, directors speak to shareholders or investor services groups about specific governance or audit topics. During those roadshows, board members stick to a prewritten script.

“The advent of the one-way listening session allayed director fear,” says Lex Suvanto, global CEO at the public relations firm Edelman Smithfield. “There isn’t much risk in what they shouldn’t say.”

Certain concerns may require more direct conversations with a specific investment group. When entering those conversations, it’s important to remember what information the shareholders want to glean. “Understand who you are speaking to and what they are all about,” says Tom Germinario, senior managing director at the financial communication firm D.F. King & Co. “Is it a governance department or a portfolio manager, because there’s a difference?”

Each investor will come to the conversation with different goals, investment criteria and questions they want addressed. It’s on the company to prepare the director for what types of questions each investor may need answered.

During those different calls, banks should ask to receive the questions ahead of time. Many investors will provide this, since they understand that the director cannot run afoul of fair disclosure rules, a set of parameters that prevent insider trading. But not all investors will provide those insights upfront.

To head off such concerns, the bank’s communications or investor relations team should run a rehearsal or prepare the director with possible questions, based on the reason for the meeting.

The investors will look for anything that might give them insight. Directors that veer off script could run afoul of what they can legally disclose. Plus, the tenor of the answers must match what the CEO has said publicly about the company. Without practice, the conversation can unwittingly turn awry.

“If a director is on the phone with an investor and something is asked that the company hasn’t disclosed, the director can table that part of the discussion,” says Weinstock. “The company can then make a Regulation Fair Disclosure filing before following up with the investor on a subsequent call. That’s an option if the company wants to release the information.”

It’s important to remember the practice will also protect you, since you will have a significant amount riding on the conversation as well. “Directors may reveal that they’re not in touch with important investor priorities,” says Suvanto. “Directors need to understand and be fully prepared to represent the values and behaviors [of the company].”

Suvanto adds that many directors would have been better not to speak at all than to go into a room with a large institutional investor, unprepared. In a public bank, such a misstep can lead to a proxy battle, which may result in the director (or many directors) being replaced by members the investors view as more favorable or knowledgeable.

The conversation also works differently, depending on the size of the bank and whether it’s a private or public institution. Institutional investors likely will focus on larger banks. Small banks may not account for an oversized spot in the institutional investor’s portfolios. Instead, for smaller companies, it’s often about getting the CEO and chief financial officer in front of investors to encourage investment. Often, this does not need a director’s voice.

For private banks, however, there are certain moments where directors may be asked to step in. If, say, an organization has questions about its auditing practices. Or what if a competitor bank has major governance violations? To address questions from investors concerning those issues, it may be advisable to have the committee head for the specific concern speak to investors about the bank’s practices.

But even a private bank cannot ignore concerns about releasing information that’s meant to stay within the board room. “It’s important to realize that information does not belong to a director,” says Weinstock. “It’s also important to realize that private companies could have insider trading violations.”

What else could go wrong? A director could overpromise when the company isn’t ready to address the issue. This can happen in the environmental, social and governance (ESG) space with regards to addressing social concerns, for example. If a director commits to social commitments that the company cannot yet adopt, it can pit the director against the board or management. Either the company will decide to adopt the promised measures, or the director will have misled the investor.

“A director should never get on the phone alone,” says Germinario. “You never want an investor to misconstrue a promise.”

Before Digital Banking Was Cool, There Was Live Oak

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As James “Chip” Mahan III tells it, Live Oak Bancshares was everything a regulator would hate when it started up in 2008. The Wilmington, North Carolina-based banking company would go branchless, lend on a national scale to only one industry, and raise deposits by paying top rates.  “They fundamentally hated all that,” Mahan, one of the founders, says.

Nowadays, Mahan and his team say the $8.2 billion banking company’s relationship with the regulators has improved. On top of that, niche lending on a national platform isn’t a new concept anymore. Investors, in particular, seem drawn to the bank lately. As of Sept. 22, Live Oak was trading at 385% of tangible book value and 22.8 times price to forward earnings, according to S&P Capital IQ.

Why?

The market views Live Oak as a successful cultivator of technology companies, with a venture capital arm currently invested in growth companies such as digital banking platform Greenlight and core provider Finxact, says Christopher Donat, an analyst and managing director at Piper Sandler & Co.

There may be other reasons, too. Investors think Live Oak is a niche bank like a SVB Financial Group or First Republic Bank, both based in California, says Jennifer Demba, managing director at Truist Securities, who follows the bank. “Niche banks growing faster than their peers tend to trade at premiums,” she says. And growing it is. Live Oak’s compound annual growth rate for noninterest and interest income from 2011 to 2020 was 25.9%, according to its 2020 annual report.

The Live Oak team’s journey to niche, digital bank started out with a simple enough concept. Vice Chairman Lee Williams III and Mahan had previous experience with Small Business Administration lending and banking, and wanted to start a bank focused on it. They worked with a company in Cleveland called Government Loan Solutions, which gathered loan performance data from the SBA by filing public records requests. Live Oak scoured this data to find out which industries had the best loan performance. Guess who did? Veterinarians. Not only did they have love animals, but they loved paying their loans on time.

As Live Oak grew, it expanded to more small businesses the team felt were overlooked by banks: smaller businesses that many banks didn’t focus on, usually with less than $5 million in annual revenues. Live Oak created a digital lending platform that would deliver those customers a decision on their loan approval quicker.

Live Oak eventually bought Government Loan Solutions, but it’s not only focused on technology. It’s also focused on talent, recruiting top SBA lenders from other banks. While other banks tend to offer SBA lenders complicated compensation structures based on commission, Live Oak doesn’t pay commissions. Instead, it offers lenders their total pay at their current jobs as a base pay, plus 100% coverage of family health care costs. “They are the bank of choice for an SBA lender to work at,” Demba says.

Among banks in the SBA’s signature 7(a) program for fiscal year 2021, Live Oak was the No. 1 lender in terms of dollar volume. When the coronavirus pandemic hit, Live Oak was vulnerable to risky sectors of the economy, including restaurants, hotels and entertainment businesses, says Donat. The bank took $19.4 million in net charge offs in 2020 related to the pandemic and hotel loans it chose to sell, according to its 2020 annual report. Its profitability also took a hit in 2019 and 2020 as it transitions to holding more SBA loans on its balance sheet; previously it had generated fees selling SBA loans, according to Demba. Moving forward, that may make Live Oak’s profitability less volatile.

Despite the pandemic, the bank’s credit quality has been good and its opportunities to grow are numerous, Demba says. It could improve future profitability by generating more noninterest bearing deposits through more attractive deposit products for small businesses. Mahan describes a future where the bank is “embedded” in small business operations, from payroll to cash management to accounting software. “We’re going to create, in every industry that we lend to, everything that that business needs to operate,” Mahan says. That’s part of the reason why investors are willing to make their bets on Live Oak.

“It’s a unique company, and they are very forward thinking, and I think they are more nimble than their traditional bank peers,” Demba says.

Why Regulation Should be Part of Cryptocurrencies’ Future

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Despite a recent embrace by the capital markets and financial corporations, digital assets and cryptocurrencies are still not at the point of widespread, global adoption. To get there, lawmakers and financial agencies should implement rules and regulations to protect consumers and enable the space to develop further as an alternative financial system.

The evolution of digital assets like cryptocurrencies has a phenomenal potential to change the financial industry. However, it also creates challenges. Digital assets are decentralized and do not rely on either governmental authorities or financial institutions to create, transmit or determine the value of a cryptocurrency. Supply is determined by a computer code; prices can be extremely volatile. Over the past decade we have witnessed digital asset exchanges being closed down due to fraud, failure or security breaches.

Within the United States, there is no uniformity in the regulatory framework with respect to how businesses that deal in digital assets should conduct themselves. New York is one of the few states that has a functional regulatory regime through the New York State Department of Financial Services. Meeting compliance in New York has become a badge of legitimacy. However, there are also a significant number of companies that have chosen not to operate in New York due to these regulations. On the other hand, Wyoming has adopted a lighter regulatory framework and is widely considered the most crypto-friendly jurisdiction in the United States.

Congressional Developments
In April, the U.S. House of Representatives passed “The Eliminate Barriers to Innovation Act,” a bill that directs the Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission to establish a digital asset working group and open new regulatory frameworks for both digital assets and cryptocurrencies.

The bipartisan bill would initiate the commission of a specialized working group that would evaluate regulation of digital assets in the U.S. The joint working group would include the SEC and CFTC, in collaboration with financial technology firms, financial firms, academic institutions, small and medium businesses that leverage financial technology and investor protection groups, as well as business or non-profit entities that are working to support historically underserved businesses. The working group would draft recommendations to improve the current regulatory landscape in the U.S., which will then be extended internationally where possible. The working group will be given a year to evaluate and provide technical documentation on how these recommendations should be implemented through compliance frameworks.

Regulation Ensures Market Stability
While some people believe that cryptocurrencies should operate completely independently from any form of regulation, publicly accountable businesses are vigorously regulated in order to protect consumers and economic stability. Independent audits are similarly required to protect the interests of all stakeholders, ensure that the applicable laws and regulations are adhered to and that the financial statements are free from material misstatement, as well as fraud (to a certain extent).

Regulators around the world regularly warn crypto asset investors to be extremely cautious and vigilant, partially due to a lack of regulation, which creates an opportunity for fraudsters to prey on uninformed investors. Fraud and error can usually be mitigated by prevention, detection, and recourse. Introducing regulations to govern the cryptocurrency industry will mean preventative measures are in place to ensure fraud doesn’t occur and that there is appropriate legal recourse for victims. There is also a significant role for auditors in detecting possible instances of fraud or error, as well as assisting with the recourse process.

Digital Asset Outlook
Mazars will be keeping a close watch on the progress of the innovation bill. We believe positive regulatory changes are ahead. Gary Gensler, the recently confirmed head of the SEC, has a keen knowledge of, and appreciation for, the applicability of digital assets in the global financial services ecosystem. Gensler is the former head of the CFTC, as well as a professor at the MIT Sloan School of Management where he researched and taught blockchain technology, digital currencies and financial technology.

In a recent interview with CNBC, Chair Gensler said there needed to be authority for a regulator to oversee the crypto exchanges, similar to the equity and futures markets. He said many crypto coins were trading like assets and should fall under the purview of the SEC.

We welcome this level of engagement and improved regulation, which will be good for the industry, investors, consumers and society at large. Without regulation, cryptocurrencies are unlikely to become a standard part of investment portfolios due to the current high level of risk.

The information provided here is for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

nCino IPO

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nCino, a cloud-based technology and lending platform for banks, navigated the challenges of going public while working remotely. The firm’s success story speaks to the critical importance of digital transformations to the survival of any company, especially as the pandemic has changed consumer mindsets about delivery and the way banks approach their business.

nCino CEO Pierre Naudé virtually sat down with Bank Director CEO Al Dominick to share the lessons he took from the IPO experience and maintains the company culture now that it’s public. Banks can also hear about how nCino strengthened its board, and managed communications in the remote environment.

Banks Tap Capital Markets to Raise Pandemic Capital

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Capital markets are open — for now — and community banks have taken note.

The coronavirus pandemic and recession have created an attractive environment for banks to raise certain types of capital. Executives bracing for a potentially years-long recession are asking themselves how much capital their bank will need to guard against low earnings prospects, higher credit costs and unforeseen strategic opportunities. For a number of banks, their response has been to raise capital.

A number of banks are taking advantage of interested investors and relatively low pricing to pad existing capital levels with new funds. Other banks may want to consider striking the markets with their own offerings while the iron is hot. Most of the raises to-date have been subordinated debt or preferred equity, as executives try to avoid diluting shareholders and tangible book value with common equity raises while they can.

“I think a lot of this capital raising is done because they can: The markets are open, the pricing is attractive and investors are open to the concept, so do it,” says Christopher Marinac, director of research at Janney Montgomery Scott. “Banks are in survival mode right now. Having more capital is preferred over less. Hoarding capital is most likely going to be the norm — even if it’s not stated expressly — that’s de facto what they’re doing.”

Shore Bancshares’ CEO Lloyd “Scott” Beatty, Jr. said the bank is “cautiously optimistic” that credit issues will not be as dire as predicted. But because no one knows how the recession will play out, the bank decided to raise “safety capital” — $25 million in subordinated debt. The raise will grow the bank’s Tier 2 capital and boost overall risk-based capital from 14.1% to about 16%, according to analysts.

“If credit issues do not develop, we will be in a position to use this capital offensively in a number of ways to improve shareholder value,” Beatty said in the Aug. 8 release.

That mindset resonates with Rick Weiss, managing director at PNC’s Financial Institutions Group, who started his career as a regulator at the U.S. Securities and Exchange Commission.

“I’ve never seen capital I haven’t liked,” he says. “I feel safer [when banks have higher] capital — in addition to avoiding any regulatory problems, especially in a bad economy, it gives you more flexibility with M&A, expanding your business, developing new lines, paying dividends, doing buybacks. It allows you to keep the door open.”

Raising capital is especially important for banks with thinner cushions. Republic First Bancorp raised $50 million in convertible preferred equity on Aug. 27 — a move that Frank Schiraldi, managing director at Piper Sandler & Co., called a “positive, and necessary, development.” The bank had capital levels that were “well below peers” and was on a significant growth trajectory prior to the pandemic. This raise boosts tangible common equity and Tier 1 capital by 100 basis points, assuming the conversion.

Banks are also taking advantage of current investor interest to raise capital at attractive interest rates. At least three banks were able to raise $100 million or more in subordinated offers in August at rates under 5%.

Lower pricing can also mean refinancing opportunities for banks carrying higher-cost debt; effortlessly shaving off basis points of interest can translate into crucial cost savings at a time when all institutions are trying to control costs. Atlantic Capital Bancshares stands to recoup an extra $25 million after refinancing existing debt that was about to reset to a more-expensive rate, according to a note from Stephen Scouten, a managing director at Piper Sandler. The bank raised $75 million of sub debt that carried a fixed-to-floating rate of 5.5% on Aug. 20.

Selected Capital Raises in August

Name Location, size Date, Type Amount, Rate
WesBanco Wheeling, West Virginia $16.8 billion Aug. 4, 2020
Preferred equity		 $150 million 6.75%
Crazy Woman Creek  Bancorp Buffalo, Wyoming
$138 million		 Aug. 18, 2020 Subordinated debt $2 million 5% fixed to floating
Republic First Bancorp Philadelphia, Pennsylvania
$4.4 billion		 Aug. 19, 2020 Preferred equity $50 million 7% convertible
Atlantic Capital Bancshares Atlanta, Georgia
$2.9 billion		 Aug. 20, 2020 Subordinated debt $75 million 5.5% fixed to floating
CNB Financial Clearfield, Pennsylvania
$4.5 billion		 Aug. 20, 2020 Preferred equity $60.4 million* 7.125%
Park National Co.       Newark, Ohio
$9.7 billion		 Aug. 20, 2020 Subordinated debt $175 million 4.5% fixed to floating
Southern National Bancorp of Virginia McLean, Virginia
$3.1 billion 		 Aug. 25, 2020** Subordinated debt $60 million 5.4% fixed to floating
Shore Bancshares Easton, Maryland
$1.7 billion		 Aug. 25, 2020 Subordinated debt $25 million 5.375% fixed to floating
Citizens Community Bancorp Eau Claire, Wisconsin $1.6 billion Aug. 27, 2020 Subordinated debt $15 million 6% fixed to floating
FB Financial Nashville, Tennessee $7.3 billion Aug. 31, 2020 Subordinated debt $100 million 4.5% fixed to floating
Renasant Corp. Tupelo, Mississippi
$14.9 billion		 Aug. 31, 2020 Subordinated debt $100 million 4.5% fixed to floating

*Company specified this figure is gross and includes the full allotment exercised by the underwriters.
**Date offering closed
Source: company press releases

Why This 17-Year-Old Investor Prefers Community Banks

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Maya Peterson graduates from high school at the end of summer. She’s also the author of two books: “Early Bird: The Power of Investing Young” — which she wrote when she was just 13 years old — and “Lighthouse: Women Leading the Way in Finance,” which published in April.

To call her precocious may be an understatement: Peterson started investing when she was just 9 years old. At 10, most kids just want to play video games; instead, Peterson attended Berkshire Hathaway’s annual shareholders’ meeting to hear Warren Buffett speak and meet personal heroes like Lauren Templeton, the founder and president of Templeton & Phillips Capital Management. Templeton is one of the 20 women featured in “Lighthouse.”

Peterson researches every investment she makes, from the company’s financials to its competitive position in the marketplace and the state of its industry. “Investing is simple to understand: You put in your work, try to understand the business, and do your best to pick stocks; however, the world is unpredictable, and things do not always go as planned,” she writes in “Lighthouse.”

“Over the past seven years, I have developed an investing mindset of patience, frugality, nerdiness, humility and discipline.”  

In August, I interviewed Peterson about why she’s fascinated by women in finance and what she values in an investment. The transcript that follows has been edited for brevity and flow.

BD: As an investor, how do you view the banking sector?
MP: I stick to investing in what I know, so I started out buying [The] Procter & Gamble [Co.] and Johnson & Johnson. The big banks are complicated for outside investors, and I try to keep it simple. For smaller banks, I think new investors have a better chance to be able to analyze them, but there is still a lot of banking jargon to wade through. Overall, seeing how banks adapt to accommodate their customers over the long haul, the quality of their loans and how they serve their community is something that I look for. I find this much easier to see in smaller banks.

BD: You spent time with Robert and Patrick Gaughen of Hingham Institution for Savings, who explained to you how they built their bank. You own shares in Hingham. What did you learn from them?
MP: The biggest key to Hingham’s success has been its culture. They are really customer focused, and they do not overcomplicate their business model with growth for growth’s sake. Their loan quality over many years shows a clear focus on risk quality. There was a quote in [their] 2014 Annual Report, where Robert Gaughen summed it up as, “Balance sheet growth at Hingham must be safe and it must be profitable, in that order.”

[Editor’s Note: Bank Director also spoke with the Gaughens for our report on the Six Tenets of Extraordinary Banks.]

BD: You’re an experienced investor, particularly given your age. What do you value when you look at a company?
MP: I value social responsibility. I invest for the long haul, so the companies I am a shareholder of are ones I think will be around and successful in 20 years. These businesses realize that it is their future too. It is easy to fall into the trap of thinking that capitalism is a short-term game, but most great businesses are built by long-term thinkers. Our thinking has to grow beyond thoughts of, “What is cheapest now?”

[Investor] Jeremy Grantham said [at a 2018 MorningStar conference] that, “Capitalism also has a severe problem with the very long term … anything that happens to a corporation over 25 years out doesn’t [exist for] them. Therefore, grandchildren, I like to say, have no value. … We deforest the land, we degrade our soils, we pollute and overuse our water, and treat air like an open sewer. [We do it] all off balance sheet and off the income statement.”

Investing works over the long run, whether that is competitive advantage, fair prices or good management, and social responsibility is a long-term mindset as well. It focuses on how the business benefits society through diversity within the workplace, their environmental impact and so on.

[Socially responsible investing] brings these two long-term perspectives together.

BD: I decorated my room as a teenager with rock band posters, but you write in the introduction to “Lighthouse” that you wallpapered your room with the photos of 58 female CFOs to inspire you. As a young woman, why does finance appeal to you? Based on what you’ve learned, what are your thoughts now about possibly entering a male-dominated field?
MP: Hearing stories about Lauren Templeton’s childhood full of investing, I was excited to become a young shareholder, too. Those stories launched me into researching and discovering other women in investing and in finance, which was where I began seeking out stories of female CFOs. I think similar to other kids’ posters, these women were larger-than-life figures that taught me the importance of drive. They became my daily reminders to keep learning and asking questions. Once I ventured into investing, I saw the limitless potential to learn, and that is what made finance [appealing] to me. If I ran out of questions, then I couldn’t be thinking hard enough.

 

As a young woman, investing gave me the opportunity to make adult decisions at a young age without being judged by my age or gender. I had control over something in a way I had not yet had at such a young age. Investing felt like my window into the real, adult world.

 

BD: Finally, you’re in school now, but you’re obviously thinking ahead about your career. You come from a unique perspective compared to your peers, in that you really dug into companies and what makes them tick. And a lot of companies struggle to attract younger, skilled talent. With that in mind, what do you hope to see from a future employer?
MP: Emphasis on community. Right now, it is so critical that those who can give are giving to others in many ways. To me, this means having coworkers and employees that represent the customers they are serving, incentivizing and encouraging donating and volunteer work, companies allocating money to give to a good cause and being socially responsible from the inside out.

I think employers who want to attract the younger generation should have a longer-term outlook and ideas on how to make a positive impact on the future. There is no one size fits all — it is different for different types of businesses — but working to make a difference definitely matters in attracting younger employees.

Preparing for an Uncertain Future

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“By failing to prepare, you are preparing to fail.” — Benjamin Franklin

Mergers and acquisitions may be sidelined for the foreseeable future because of considerable economic and market uncertainty related to the coronavirus pandemic, but PNC’s Financial Institutions Group anticipates activity will likely reignite when market volatility eases, and asset quality can be confidently assessed.

Savvy bankers and investors recognize that the best deals generally occur when bank valuations are low, but the credit downturn may just be starting, so the timetable for a pickup in deal activity remains unclear. Not to mention, there may be many coronavirus-related issues to still sort out, so the possibility of future government-assisted deals cannot be ruled out.

Recent history supports this post-crisis resumption. Deal activity slowed measurably at the start of the Great Recession, dropping from 285 deals in 2007 to 174 in 2008, according to S&P Global Market Intelligence. It picked up again once potential buyers gained more clarity regarding both their own balance sheets as well as those of potential sellers.

Credit Quality is Key
The uncertain environment underlines that nothing is more significant to a bank’s capital and earnings than its credit quality. It is anticipated that credit costs will continue to climb and remain elevated for quite some time following the sudden and shocking increase to unemployment and government-mandated business closures. So, looking at balance sheets — not income statements — will provide the necessary clues to differentiate banks in a downward credit cycle. But these issues will eventually get resolved.

The uncertainty could give way to wider pricing disparity among community banks. Bank earnings for the quarter ending on March 31 were inconclusive, and eclipsed by coronavirus-related economic developments and stock market volatility. The vast majority of companies did not provide guidance, but the overall lower direction appears clear, as credit will likely be a major concern for the next several quarters.

Investors and analysts appear to have a wide range of opinions; high levels of market angst seem likely to persist into the foreseeable future. There will, however, be winners and losers among banks across the nation. This emerging pricing gap could lead to increased M&A activity as more deals make financial sense.

Cash, Capital Rule
Bank boards should consider all liquidity and capital options under various economic scenarios to construct stronger balance sheets as credit conditions start to deteriorate. This preparation holds true for all banks: potential buyers, sellers and those committed to independence.

Along with more dynamic trading strategies, there will be a need to vigorously assess capital-raising options, cash dividend payments and stock repurchase programs. To start, companies should seriously consider emphasizing internal “burn down” tangible book value models. We believe that sensitivity models tailored to individual banks can best identify additional capital needs and, if so, what form of capital is best suited for current and longer-term strategic plans.

Equity offerings carry their own pros and cons. They can strengthen bank balance sheets but dilute earnings per share. Given current market conditions, these issuances may be difficult to achieve and limited to high-quality institutions that can issue equity on financially attractive terms (including tangible book value accretion).

The benefits from an equity capital raise include, but are not limited to: the ability to grow organically above the sustainable growth rate; stronger capital ratios and a bigger cushion to withstand the credit downturn; greater liquidity and visibility from institutional investors; and providing support for M&A opportunities, which may be abundant in the post-coronavirus landscape.

Some institutions may find issuing subordinated debt (“sub debt”) to be a better alternative than raising additional equity capital. Debt remains relatively inexpensive due to attractive interest rates and favorable tax treatment. The market for sub debt became more stable by early June, which has facilitated several issuances at favorable pricing levels.

The question for bank directors and management going forward is how to properly value capital raising and any M&A initiatives. They will need to take a hard look at financial models to determine required rates of return and sustainable growth rates along with regulatory needs. Efficient capital management that optimizes long-term shareholder value should always be the primary goal of directors in good markets, bad markets and those in-between.

The views expressed in this article are the views of PNC FIG Advisory, PNC’s investment banking practice for community and regional banks.

Can the Industry Handle the Truth on Credit Quality?

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Maybe Jack Nicholson was right: “You can’t handle the truth!”

The actor’s famous line from the 1992 movie “A Few Good Men” echoes our concern on bank credit quality in fall 2019 and heading into early 2020.

Investors have been blessed with record lows in credit quality: The median ratio of nonperforming assets (NPA) is nearly 1%, accounting for nonperforming loans and foreclosed properties, a figure that modestly improved in the first half of 2019. Most credit indicators are rosy, with limited issues across both private and public financial institutions.

However, we are fairly certain this good news will not last and expect some normalization to occur. How should investors react when the pristine credit data reverts to a higher and more-normalized level?

The median NPA ratio between 2004 and 2019 peaked at 3.5% in 2011 and hit a record low of 60 basis points in 2004, according to credit data from the Federal Deposit Insurance Corp. on more than 1,500 institutions with more than $500 million in assets. It declined to near 1% in mid-2019. Median NPAs were 2.9% of loans over this 15-year timeframe. The reversion to the mean implies over 2.5 times worse credit quality than currently exists. Will investors be able to accept a headline that credit problems have increased 250%, even if it’s simply a return to normal NPA levels?

Common sense tells us that investors are already discounting this potential future outcome via lower stock prices and valuation multiples for banks. This is one of many reasons that public bank stocks have struggled since late August 2018 and frequently underperform their benchmarks.

It is impressive what banks have accomplished. Bank capital levels are 9.5%, 200 basis points higher than 2007 levels. Concentrations in construction and commercial real estate are vastly different, and few banks have more than 100% of total capital in any one loan category. Greater balance within loan portfolios is the standard today, often a mix of some commercial and industrial loans, modest consumer exposure, and lower CRE and construction loans.

Median C&I problem loans at banks that have at least 10% of total loans in the commercial category — more than 60% of all FDIC charters — showed similar trends to total NPAs. The median C&I problem loan levels peaked at 4% in late 2009 and again in 2010; it had retreated to 1.5%, as of fall 2019. The longer-term mean is greater due to the “hockey stick” growth of commercial nonaccrual loans during the crisis years spanning 2008 to 2011, as well as the sharp decline in C&I problem loans in 2014. Over time, we feel C&I NPAs will revert upward, to a new normal between 2% to 2.25%.

Public banks provide a plethora of risk-grade ratings on their portfolios in quarterly and annual filings, following strong encouragement from the Securities and Exchange Commission to provide better credit disclosures. The nine-point credit scale consists of “pass” (levels 1 to 4), “special mention/watch” (5), “substandard” (6), “nonperforming” (7), “doubtful” (8) and “loss” (9, the worst rating).

They define a financial institution’s criticized assets, which are loans not rated “pass,” indicating “special mention/watch” or worse, as well as classified assets, which are rated “substandard” or worse. The classified assets show the same pattern as total NPAs and C&I problem loans: low levels with very few signs of deterioration.

The median substandard/classified loan ratio at over 300 public banks was 1.14% through August 2019. That compared to 1.6% in fall 2016 and 3.4% in early 2013. We prefer looking at substandard credit data as a way to get a deeper cut at banks’ credit risk — and it too flashes positive signals at present.

The challenge we envision is that investors, bankers and reporters have been spoiled by good credit news. Reversions to the mean are a mathematical truth in statistics. We ultimately expect today’s good credit data to revert back to higher, but normalized, levels of NPAs and classified loans. A doubling of problem credit ratios would actually just be returning to the historical mean. Can investors accept that 2019’s credit quality is unsustainably low?

We believe higher credit problems will eventually emerge from an extremely low base. The key is handling the truth: An increase in NPAs and classified loans is healthy, and not a signal of pending danger and doom.

As the saying goes: “Keep Calm and Carry On.”

This Is a Red Flag for Banks

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yield-curve-7-5-19.pngThe yield curve has been in the news because its recent gyrations are seen as a harbinger of a coming recession.

The yield curve is the difference between short- and long-term bond yields. In a healthy economy, long-term bond yields are normally higher than short-term yields because investors take more risk with the longer duration.

In late June, however, the spread between the yield on the three-month Treasury bill and the 10-year Treasury note inverted—which is to say the 10-year yield was lower than the three-month yield.

Inverted Yield Curve.png

An inverted yield curve doesn’t cause a recession, but it signals a set of economic factors that are likely to result in one. It is a sign that investors lack confidence in the future of the economy. Or to put it another way, they have greater confidence in the economy’s long-term prospects than in its near-term outlook.

Long-term yields drop because investors want to lock in a higher return. This heightened demand for long-dated bonds allows the U.S. Department of the Treasury to offer lower yields. The historical average length of recessions is about 18 months, so a 10-year Treasury note takes investors well beyond that point.

Short-terms Treasury yields rise because investors are skittish about the economy’s near-term prospects, which requires the Treasury Department to entice them with higher yields.

It turns out that inverted yield curves have a pretty good track record of predicting recessions within the next 12 months. The last six recessions were preceded by inverted yield curves, although economists point out that inversions in 1995 and 1998 were not followed by subsequent downturns. And more than two years passed between an inversion in December 2005 and the onset of the 2008 financial crisis.

Still, an inverted yield curve is an economic red flag for banks. The industry’s performance inevitably suffers in a recession, and even the most conservative institutions will experience higher loan losses when the credit cycle turns.

An inversion is a warning that banks should tighten their credit standards and rein in their competitive impulses. Some of the worst commercial loans are made 12 to 18 months prior to an economic downturn, and they are often the first loans to go bad.

Ironically, if banks tighten up too much, they risk contributing to a recession by cutting off the funding that businesses need to grow. Banks make these decisions individually, of course, but the industry’s herd instinct is alive and well.

It’s possible that the most recent inversion presages a recession in 2020. In its June survey, the National Association of Business Economics forecast the U.S. economy to grow 2.6 percent this year, with only a 15 percent chance of a recession. But they see slower growth in 2020, with the risk of a recession by year-end rising to 60 percent.

This has been an unprecedented time for the U.S. economy and we seem to be sailing through uncharted waters. On July 1, the economy’s current expansion became the longest on record, and gross domestic product grew at a 3.1 percent annualized rate in the first quarter. Unemployment was just 3.6 percent in May—the lowest in 49 years—while inflation, which often rises when the economy reaches full employment because employers are forced to pay higher salaries to attract workers, remained under firm control.

These are historic anomalies, so maybe the old rules have changed.

The Federal Open Market Committee is widely expected to cut the fed funds rate in late July after raising it four times in 2018. That could both help and hurt bankers.

A rate cut helps if it keeps the economic expansion going. It hurts if it makes it more difficult for banks to charge higher rates for their loans. Many banks prospered last year because they were able raise their loan rates faster than their deposit rates, which helped expand their net interest margins. They may not benefit as much from repricing this year if the Fed ends up cutting interest rates.

Is an inverted yield curve a harbinger of a recession in 2020? This economy seems to shrug off all such concerns, but history says yes.

Creating Liquidity: Alternatives To Selling The Bank

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Executives and boards of private banks have to think outside the box if they want to create a path to liquidity for shareholders that doesn’t require selling the bank. In this video, Eric Corrigan of Commerce Street Capital outlines three liquidity alternatives to consider, and shares why a proactive approach can help a bank control its own destiny.

  • Challenges in Creating Liquidity
  • Three Liquidity Alternatives
  • Benefits and Drawbacks to Each Solution
  • Questions Boards Should Be Asking