How to Prepare for an Unprecedented Year

Could anyone have prepared for a year like 2020?

Better-performing community banks, over the long run, generally anchor their balance sheet management in a set of principles — not divination. They organize their principles into a coherent decision-making methodology, which requires them to constantly study the relative risk-reward profiles of various options, across multiple rate scenarios and industry conditions over time.

But far too many community bankers look through the wrong end of the kaleidoscope. Rather than anchoring themselves with principles, they drift among the currents of economic and interest rate forecasts. Where that drift takes them at any given moment dictates their narrowly focused reactions and strategies. If they are in a reward mindset, they’ll focus on near-term accounting income; if the mood of the day is risk-centered, their framework will be liquidity. At Performance Trust, we have long argued that following this approach accumulates less reward, and more risk, than its practitioners ever expect.

Against this backdrop, we offer five decision-making principles that have helped many banks prepare for the hectic year that just closed, and can ensure that they are prepared for any hectic or challenging ones ahead.

  • Know where you are before deciding where to go. Net Interest Income and Economic Value of Equity simulations, when viewed in isolation, can present incomplete and often conflicting portrayals of a bank’s financial risk and reward profile. To know where you are, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both net income to a horizon and overall economic value at that horizon. Multiple-scenario total return analysis isn’t about predicting the future. Rather, it allows you to see how your institution would perform in multiple possible futures.
  • Don’t decide based on interest rate expectations — in fact, don’t even have expectations. Plenty of wealth has been lost by reacting to predictions. Running an asset-sensitive balance sheet is nothing more than making a levered bet on rising rates. So, too, is sitting on excess liquidity waiting for higher rates. The massive erosion in net interest margin in 2020 supports our view that most community banks have been, intentionally or not, speculatively asset sensitive. Banks that take a principle-based approach currently hold sufficient call-protected, long-duration earning assets — not because they knew rates would fall, but because they knew they would need them if rates did fall. As a result, they are in a potentially better position to withstand a “low and flat” rate environment.
  • Maintaining sufficient liquidity is job No. 1. Job No. 2 is profitably deploying the very next penny after that. In this environment, cash is a nonaccrual asset. Banks with a principle-oriented approach have not treated every bit of unexpected “excess liquidity” inflow as a new “floor” to their idea of “required liquidity.” One approach is to “goal post” liquidity needs by running sensitivity cases on both net loan growth and deposit outflows, and tailoring deployment to non-cash assets with this in mind — for instance by tracking FHLB pledgeability and haircutting — and allowing for a mark-to-market collateral devaluation cushion. Liquidity is by no means limited to near-zero returns.
  • Don’t sell underpriced options. Banks sell options all day long, seldom considering their compensation. Far too often, banks offer loans without prepayment penalties because “everyone is doing it.” Less forgivably, they sell options too cheaply in their securities portfolio, in taking on putable advances or when pricing their servicing rates. The last two years were an era of very low option compensation, even by historical measures. Principle-based decision-makers are always mindful of the economics of selling an option; those who passed on underpriced opportunities leading into 2021 find their NIMs generally have more staying power as a result.
  • Evaluate all capital allocation decisions on a level playing field. Community banks, like all competitive enterprises, can allocate capital in just four ways: organic growth, acquisitions, dividends or share repurchases. Management teams strike the optimal balance between risk and reward of any capital allocation opportunity by examining each strategy alongside the others across multiple rate scenarios and over time. This approach also allows managers to harness the power of combinations — say, simultaneously executing a growth strategy and repurchasing stock — to seek to enhance the institution’s overall risk/return profile.

So what about 2021 and beyond? This same discipline, these same principles, are timeless. Those who have woven them into their organizational fabric will continue to benefit whatever comes their way. Those encountering them for the first time and commit to them in earnest can enjoy the same.

Balance Sheet Opportunities Create Path to Outperformance

How important is net interest margin (NIM) to your institution?

In 2019, banks nationally were 87% dependent on net interest income. With the lion’s share of earnings coming from NIM, implementing a disciplined approach around margin management will mean the difference between underperforming institutions and outperforming ones. (To see how your institution ranks versus national and in-state peers, click here.)

Anticipating the next steps a bank should take to protect or improve its profitability will become increasingly difficult as they manage balance sheet risks and margin pressure. Cash positions are growing with record deposit inflows, pricing on meager loan demand is ultra-competitive and many institutions are experiencing accelerated cash flows from investment portfolios.

It is also important to remember that stress testing the balance sheet is no longer an academic exercise. Beyond the risk management, stressing the durability of capital and resiliency of liquidity can give your institution the confidence necessary to execute on strategies to improve performance and to stay ahead of peers. It is of heightened importance to maintain focus on the four major balance sheet position discussed below.

Capital Assessment, Position
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses and providing resources to seize opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown.

The rapid changes occurring within the economy are not wholly cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to the ‘next normal.’ Knowing the breaking points for your capital base — in terms of growth, credit deterioration and a combination of these factors — will serve your institution well.

Liquidity Assessment, Position
Asset quality deterioration leads to capital erosion, which leads to liquidity evaporation. With institutions reporting record deposit growth and swelling cash balances, understanding how access to a variety of funding sources can change, given asset quality deterioration or capital pressure, is critical to evaluating the adequacy of your comprehensive liquidity position.

Interest Rate Risk Assessment, Position
In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive; significant asset sensitivity represents an opportunity cost as the central bank forecasts a low-rate environment for the foreseeable future. Focus on adjusting your asset mix — not only to improve your earnings today, but to sustain it with higher, stable-earning asset yields over time.

Additionally, revisit critical model assumptions to ensure that your assumptions are reflective of actual pricing behaviors, including new volume rate floors and deposit betas, as they may be too high for certain categories.

Investment Assessment, Position
Strategies for investment portfolios including cash can make a meaningful contribution to your institution’s overall interest income. Some key considerations to help guide the investment process in today’s challenging environment include:

  • Cost of carrying excess cash has increased: Most institutions are now earning 0.1% or less on their overnight funds, but there are alternatives to increasing income on short-term liquidity.
  • Consider pre-investing: Many institutions have been very busy with Paycheck Protection Program loans, and we anticipate this will have a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.

Taylor Advisors’ Take:
Moving into 2021, liquidity and capital are taking center stage in most community banks’ asset-liability committee discussions. Moving away from regulatory appeasement and towards proactive planning and decision-making are of paramount importance. This can start with upgrading your bank’s tools and policies, improving your ability to interpret and communicate the results and implementing actionable strategies.

Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. You must know where you are to know where you want to go. Start by studying your latest quarterly data. Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform; anything less will lead to sub-optimal results.

New Pandemic Safety and Soundness Standards for Banks

In June, financial regulators jointly issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions.” In addition to existing rating systems such as CAMELS, examiners will also assess management’s responsiveness to Covid-19 stresses. With this in mind, CLA is offering financial institutions our interpretation of, and key takeaways from, the guidance.

Asset quality
Asset quality will be a primary focus for all examiners. Safety and soundness exam standards have not changed despite the impacts of Covid-19. Assess and document the changing risk in your loan portfolio and appropriately respond with necessary changes to policies, procedures and programs that help customers, borrowers and communities.

Credit classification and credit risk review
The rise in credit risk due to the pandemic is widespread; no community or financial institution is untouched. As such, the June guidance emphasizes that you should reevaluate assigned credit ratings on the regulatory credit risk rating scale to assess if a change is necessary due to coronavirus-related challenges.

An objective credit risk review will help validate assigned ratings and eliminate “surprises” that could occur during your regulatory examination. In May, regulators released the “Interagency Guidance on Credit Risk Review Systems” and re-emphasized the fundamental concept of an independent credit risk review, which echoes the significance of the process at a critical time.

Credit modifications
Regulators continue to emphasize their support for banks working prudently with borrowers through the pandemic. In August, the Federal Financial Institutions Examination Council explored the need for additional accommodations for certain borrowers via loan modifications. While working with borrowers, banks should obtain current financial information to assess the viability of additional accommodations. Establishing and documenting a systematic approach to loan modifications is prudent and shows what, if any, considerations are being made to the credit risk rating as multiple modifications continue.

Earnings
Despite strong earnings in recent years, the guidance clearly communicates a distinct possibility that bank core earnings could be reduced by the pandemic. Analyze the pandemic’s impact on your current year earnings, how it will detract or enhance your earnings potential, and document accordingly.

Capital
Strong capital and a well-developed plan lead to enhanced viability. Loan growth, deposit growth, and inflows from government stimulus have happened quickly, without an opportunity to fully assess the capital impact. Regulators have even encouraged the use of capital buffers to promote lending activities. Given the pandemic-related changes, updating your capital plan and previously established limits and triggers is essential. Additionally, a current assessment of your overall risk profile and forecasted risks allows you to develop relevant strategies that address risk in your capital.

Liquidity
Most financial institutions have been liquid since the last recession, with less dependency on third parties for funding. Also, as happened during the last recession, there has been an inflow of funds from consumer savings due to economic uncertainty. The guidance readily admits liquidity profiles for financial institutions remain uncertain due to the coronavirus; yet, amid the uncertainty, expectations to employ smart strategies remain — which only places greater emphasis on your overall funding strategy and contingency plans.

Sensitivity to market risk
Earnings and capital evaluations require an assessment of sensitivity to market risk, primarily in the form of interest rate risk. Reassess your asset liability management (ALM) policies and related models to address changes that have occurred to your interest rate risk profile. Decipher between risks that are temporary and risks that will have longer-term effects.

These points will impact assumptions and data incorporated in ALM models, including the impact of loan modifications, payment timing and deposit growth. Additionally, stress testing models are important tools during the pandemic. Incorporate stress scenarios such as fluctuations in unemployment and the impact of possible future shutdowns to manage your risk. Like credit review, banks should strongly consider engaging independent verification of these models to confirm integrity, accuracy and reasonableness.

Management
Management should serve as the driving navigational force during this time of uncertainty. The guidance specifically states examiners will evaluate management’s actions in response to the pandemic. Management can demonstrate responsiveness by fostering open lines of internal communication on a day-to-day basis, and by engaging with the board of directors to obtain a different perspective that could enhance your risk assessment process. Prioritize documentation, which includes an assessment of what policies, procedures and risk assessments need to be revised based on decisions made in response to the pandemic.

The CARES Act: What Banks Need to Know

Banks will play a critical role in providing capital and liquidity to American businesses and consumers, and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) includes several provisions that benefit depository institutions. The implications for bank directors and officers are significant; they may need to make major decisions quickly.

Expanded SBA Lending
The CARES Act appropriates $349 billion for “paycheck protection loans” to be made primarily by banks that will be 100% guaranteed by the Small Business Administration (SBA) through its 7(a) Loan Guaranty Program. The SBA issued an interim final rule on the program on April 2 and has issued additional formal and informal guidance since that date. Application submissions began on April 3. Banks and borrowers will want to move quickly, due to the limited funds available for the program.

Provisions Benefitting Depository Institutions Directly

Troubled Debt Restructuring Relief. A financial institution may elect to suspend the requirements under generally accepted accounting principles and federal banking regulations to treat loan modifications related to the COVID-19 pandemic as troubled debt restructurings. The relief runs through the earlier of Dec. 31 or 60 days after the termination date of the national emergency, and does not apply to any adverse impact on the credit of a borrower that is not related to the COVID-19 pandemic.

CECL Delay. Financial institutions are not required to comply with the current expected credit losses methodology (CECL) until the earlier of the end of the national emergency or Dec. 31.

Reduction of the Community Bank Leverage Ratio. Currently, a qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio of greater than 9% will be considered to have met all regulatory capital requirements. The CARES Act reduces the community bank leverage ratio from 9% to 8% until the earlier of the end of the national emergency or Dec. 31. In response to the CARES Act, federal banking regulators set the community bank leverage ratio at 8% for the remainder of 2020, 8.5% for 2021 and 9% thereafter.

Revival of Bank Debt Guarantee Program. The CARES Act provides the Federal Deposit Insurance Corp. with the authority to guarantee bank-issued debt and noninterest-bearing transaction accounts that exceed the existing $250,000 limit through Dec. 31. The FDIC will determine whether and how to exercise this authority.

Removal of Limits on Lending to Nonbank Financial Firms. The Comptroller of the Currency is authorized to exempt transactions between a national bank or federal savings association and nonbank financial companies from limits on loans or other extensions of credit — commonly referred to as “loan-to-one borrower” limits — upon a finding by the Comptroller that such exemption is in the public interest.

Provisions Related to Mortgage Forbearance and Credit Reporting

The CARES Act codifies in part recent guidance from state and federal regulators and government-sponsored enterprises, including the 60-day suspension of foreclosures on federally-backed mortgages and requirements that servicers grant forbearance to borrowers affected by COVID-19.

Foreclosure and Forbearance on Residential Mortgages. Companies servicing loans insured or guaranteed by a federal government agency, or purchased or securitized by Fannie Mae or Freddie Mac, must grant up to 180 days of forbearance to borrowers who request and affirm financial hardship due to COVID-19 through the period ending on the later of July 25, or the end of the national emergency.

Servicers are not required to document the borrower’s hardship. The initial 180-day forbearance period must be extended up to an additional 180 days at the borrower’s request., Servicers of federally backed mortgage loans may not assess fees, penalties, or interest beyond the amounts scheduled or calculated during this forbearance period, as if the borrower made all contractual payments on time and in full under the terms of the mortgage contract. The law also imposes a foreclosure moratorium on federally backed mortgage loans of at least 60 days, beginning on March 18.

Forbearance on Multi-Family Mortgages. Multifamily borrowers with a federally backed multifamily mortgage loan that was current on its payments on Feb. 1, may request forbearance for a 30-day period with up to two 30-day extensions, during the covered period. Servicers are required to document borrower’s hardship. Borrowers must provide tenant protections, including prohibitions on evictions for non-payment and late payment fees, in order to qualify for the forbearance, and servicers are required to document the borrower’s hardship.

Moratorium on Negative Credit Reporting. Any furnisher of credit information that agrees to defer payments, forbear on any delinquent credit or account, or provide any other relief to consumers affected by the COVID-19 pandemic must report the credit obligation or account as current if the credit obligation or account was current before the accommodation.

Whipsawed by Interest Rates

One of the things that bankers hate most is uncertainty and abrupt changes in the underlying economics of their business, and the emerging global crisis caused by the COVID-19 pandemic is confronting them with the perfect storm.

You can blame it all on the Federal Reserve.

Indeed, the higher rates that the Fed gave in 2018, it is now taken away — and that is creating a big challenge for banks as they scramble to adapt to a very different interest rate scenario from what they were dealing with just 15 months ago.

On March 3, as the economic impact of the coronavirus both globally and in the United States was becoming more apparent and fears about a possible recession were mounting, the Fed made an emergency 50 basis-point cut in interest rates, to a range of 1% to 1.25%. The Fed’s action was dramatic not only because of the size of the reduction, but also because this action was taken “off cycle” — which is to say two weeks prior to the next scheduled meeting of the Federal Open Market Committee, which is the Fed’s rate-setting body.

And as this article was being posted, many market observers were expecting that the Fed would follow with another rate cut at its March 17-18 meeting, which would drive down rates to their lowest levels since the financial crisis 12 years ago. Needless to say, banks have been whipsawed by these abrupt shifts in monetary policy. The Fed increased rates four times in 2018, to a range of 2.25% to 2.50%, then lowered rates three times in 2019 when the U.S. economy seemed to be softening, to a range of 1.50% to 1.75%.    

Now, it appears that interest rates might go even lower.

What should bank management teams do to deal with this unexpected shift in interest rates? To gain some insight into that question, I reached out to Matt Pieniazek, president of the Darling Consulting Group in Newburyport, Massachusetts. I’ve known Pieniazek for several years and interviewed him on numerous occasions, and consider him to be one of the industry’s leading experts on asset/liability management. Pieniazek says he has been swamped by community banks looking for advice about how to navigate this new rate environment.

One of Pieniazek’s first comments was to lament that many banks didn’t act sooner when the Fed cut rates last year. “It’s just disappointing that too many banks let their own biases get in the way, rather than listen to their balance sheets,” he says. “There are a lot of things that could’ve been done. Now everyone’s in a panic, and they’re willing to talk about doing things today when the dynamics of it are not very encouraging. Risk return or the cost benefit are just nowhere near the same as what they were just six months ago, let alone a year, year and a half ago.”

So, what’s to be done?

Pieniazek’s first suggestion is to dramatically lower funding costs. “No matter how low their funding costs are, very few banks are going to be able to outrun this on the asset side,” he says. “They’ve got to be able to [be] diligent and disciplined and formalized in their approach to driving down deposit costs.”

“In doing so, they have to acknowledge that there could be some risk of loss of balances,” Pieniazek continues. “As a result, they need to really revisit their contingency liquidity planning. They have to also revisit with management and the board the extent to which they truly are willing to utilize wholesale funding. The more you’re willing to do that, the more you would be willing to test the water on lowering deposits. I think there is a correlation to comfort level and challenging yourself to lower deposits and well thought out contingency planning that incorporates the willingness and ability to prudently use the wholesale market. Aggressively attacking deposit costs has to be accompanied by a real hard, fresh look at contingency liquidity planning and the bank’s philosophy toward wholesale markets.”

This strategy of driving down funding costs might be a hard sell in a market where competitors are still paying relatively high rates on deposits. “Well, you know what?” Pieniazek says. “You’ve got two choices. You either let village idiots drive your business, or you do what makes sense for your organization.”

Most banks will also feel pressure on the asset side of their balance sheets as rates decline. Banks that have a large percentage of floating rate loans may not have enough funding to offset them. As those loans reprice in a falling rate environment, banks will feel pressure to correspondingly lower their funding costs to protect their net interest margins as much as possible. And while community banks typically don’t have a lot of floating rate loans, they do have high percentages of commercial real estate loans, which Pieniazek estimates have an average life span of two and a half years. The only alternative to lowering deposit costs to protect the margin would be to dramatically grow the loan portfolio during a time of great economic uncertainty. But as Pieniazek puts it, “There’s not enough growth out there at [attractive] yield levels to allow people to head off that margin compression.”

Pieniazek’s second suggestion is to review your loan documents. “While I’m not suggesting [interest] rates are going to go negative, most banks do not have loan docs which prevent rates from going negative,” he says. “They need to revisit their loan docs and make sure that there’s lifetime floors on all of their loans that will not enable the actual note rate to go zero. They could always negotiate lower if they want. They can’t negotiate up.”

His final suggestion is that community banks need to strongly consider the use of derivatives to hedge their interest rate exposure. “If you think in an environment like this that your customers are going to allow you to dictate the structure of your balance sheet, you better think again,” he says. “Everyone’s going to want to shorten up … What you’re going to find is retail customers are going to keep their money short. In times of uncertainty, what do people want to do? They want to keep their cash close to them, don’t they?”

Of course, while depositors are going to keep their money on a short leash, borrowers “are going to want to know what the 100-year loan rate is,” Pieniazek says. And this scenario creates the potential for disaster that has been seen time and again in banking — funding long-term assets with short-term deposits.

The only thing you can do is augment customer behavior through the use of derivatives,” Pieniazek says. “Interest rate caps are hugely invaluable here for banks to hedge against rising rates while allowing their funding costs to remain or cycle lower if rates go lower. In a world of pressure for long-term fixed rate assets, being able to do derivatives … allows banks to convert fixed-rate loans in their portfolio to floating for whatever time period they want, starting whenever they want.”

During times of uncertainty and volatility, Pieniazek says it’s crucial that bank management teams make sound judgments based on a clear understanding of their ramifications. “Don’t let panic and fear result in you changing your operating strategy,” he says. “The worst thing to do is make material changes because of fear and panic. Let common sense and a clear understanding of your balance sheet, your risk profile, drive your thought process. And don’t be afraid to take calculated risks.”

Generational Shift Complicates Shareholder Succession

A challenge facing many community banks this new decade has nothing to do with public policy, the yield curve, regulation or technology.

A growing number of banks face an aging shareholder base, concentrated ownership and limited liquidity. This can lead to shareholder succession impositions when large shareholders want to exit their ownership position or an estate settlement creates a liquidity need.

Community banks have always been owned by local centers of influence, passed down through generations and thought of as both a financial investment and philanthropic participation in the community. But the societal aspect of bank ownership is not the same as the current ownership cedes to the younger generation, many of whom have moved away from home and see banking as an increasingly more digital experience.

Banking and securities regulations do not make the situation easier. There are parameters around a bank’s ability to issue stock in the local community to attract new shareholders. Banks are cautious of giving unknown investors a seat at the table, particularly institutional or activist owners, as they may only hold the stock for a defined, shorter period before seeking liquidity themselves. The bank itself can sometimes be a source of liquidity to repurchase stock from shareholders, but regulatory capital ratios may limit that capacity. Some advice for banks struggling with these issues includes the following:

Treat shareholder succession as a business initiative: Identifying issues before they occur, or a capital need before it becomes urgent, increases a bank’s flexibility. Boards should discuss shareholder liquidity issues, as some large owners may be sitting around the board table.

Investor relations is not just for large and liquid banks: Local banks are often owned by members of the local community. The legacy of family ownership is emotional, and large owners often do not want to “upset the apple cart” and force the bank to sell. Many may not realize that how they treat their position could impact the bank’s future. Some may not be open to discussing the issue, but others might appreciate the opportunity.

Address long-term liquidity in strategic planning: Under what conditions would the bank consider listing on a more liquid exchange, commencing a traditional public offering, or raising subordinated debt as a way to address shareholder succession? The owners of many closely held banks are wary of incurring dilution to their ownership stake but want to remain independent, which limits their options. For smaller banks, even upgrading to a slightly more liquid trading medium such as OTC Market Group’s OTCQX Banks market, may open the doors to investors that understand smaller, less-liquid situations and have capital to put to work.

Plan for shareholder liquidity as you would for balance sheet liquidity: It is helpful that directors and executives understand the bank’s capacity to repurchase shares, as the bank itself is often the first line of defense for an immediate liquidity need. Small bank holding company regulation gives community banks flexibility to leverage their capital structure by issuing debt at the holding company, which can be injected into the bank subsidiary as common equity. Creating an employee stock ownership plan or dividend reinvestment plan may help to manage and retain capital and dividend policy can also be critical.

The right answer is usually a combination of all of the above: There is no silver bullet for addressing shareholder liquidity in a smaller, more closely held bank; all of the discussed initiatives will play a part. Many banks get caught flat-footed after the fact, either faced with an estate settlement or a family with a large position seeking liquidity. Dealing with an urgent liquidity need, often in tight timing, limits the bank’s flexibility and options.

If a merger or sale is the right alternative, control that dialog: Some shareholders looking to exit may find the premium in a sale attractive relative to the desire of others for independence. It’s a worthwhile exercise for boards and executives to understand the bank’s value in a sale, as well as likely partners, even if a sale is only a remote possibility. This allows your bank to identify preferred partners and ascertain their ability to pay a competitive valuation independent of any urging from shareholders. Highlight those strategic alternatives to the board on a regular basis. If an urgent shareholder need forces the bank to seek a partner, your bank has already begun addressing these issues and building those relationships.

Shareholder succession issues can drive change and create uncertainty, risk and opportunity at community banks. Careful analysis and planning can help lead to a desired outcome for all involved.

Why Some Banks Purposefully Shun the Spotlight


strategy-8-9-19.pngFor as many banks that would love to be acquired, even more prefer to remain independent. Some within the second group have even taken steps to reduce their allure as acquisition targets.

I was reminded of this recently when I met with an executive at a mid-sized privately held community bank. We talked for a couple hours and then had lunch.

Ordinarily, I would go home after a conversation like that and write about the bank. In fact, that’s the expectation of most bank executives: If they’re going to give someone like me so much of their time, they expect something in return.

Most bank executives would welcome this type of attention as free advertising. It’s also a way to showcase a bank’s accomplishments to peers throughout the industry.

In this particular case, there was a lot to highlight. This is a well-run bank with talented executives, a unique culture, a growing balance sheet and a history of sound risk management.

But the executive specifically asked me not to write anything that could be used to identify the bank. The CEO and board believe that media attention — even if it’s laudatory — would serve as an invitation for unwanted offers to acquire the bank.

This bank in particular has a loan-to-deposit ratio that’s well below the average for its peer group. An acquiring bank could see that as a gold mine of liquidity that could be more profitably employed.

Because the board of this bank has no interest in selling, it also has no interest in fielding sufficiently lucrative offers that would make it hard for them to say “no.” This is why they avoid any unnecessary media exposure — thus the vague description.

This has come up for me on more than one occasion in the past few months. In each case, the bank executives aren’t worried about negative attention; it’s positive attention that worries them most.

The concern seems to stem from deeper, philosophical thoughts on banking.

In the case of the bank I recently visited, its executives and directors prioritize the bank’s customers over the other constituencies it serves. After that comes the bank’s communities, employees and regulators. Its shareholders, the biggest of which sit on the board, come last.

This is reflected in the bank’s loan-to-deposit ratio. If the bank focused on maximizing profits, it would lend out a larger share of deposits. But it wants to have liquidity when its customers and communities need it most – in times when credit is scarce.

Reading between the lines reveals an interesting way to gauge how a bank prioritizes between its customers and shareholders. One prioritization isn’t necessarily better than the other, as both constituencies must be appeased, but it’s indicative of an executive team’s philosophical approach to banking.

There are, of course, other ways to fend off unwanted acquisition attempts.

One is to run a highly efficient operation. That’s what Washington Federal does, as I wrote about in the latest issue of Bank Director magazine. In the two decades leading up to the financial crisis, it spent less than 20% of its revenue on expenses.

This may seem like it would make Washington Federal an attractive partner, given that efficiency tends to translate into profitability. From the perspective of a savvy acquirer, however, it means there are fewer cost saves that can be taken out to earn back any dilution.

Another way is to simply maintain a high concentration of ownership within the hands of a few shareholders. If a bank is closely held, the only way for it to sell is if its leading shareholders agree to do so. Widely dispersed ownership, on the other hand, can invite activists and proxy battles, bringing pressure to bear on the bank’s board of directors.

Other strategies are contractual in nature. “Poison pills” were in vogue during the hostile takeover frenzy of the 1980s. Change-of-control agreements for executives are another common approach. But neither of these are particularly savory ways to defend against unwanted acquisition offers. They’re a last line of defense; a shortcut in the face of a fait accompli.

Consequently, keeping a low media profile is one way that some top-performing banks choose to fend unwanted acquisition offers off at the proverbial pass.

While being acquired is certainly an attractive exit strategy for many banks, it isn’t for everyone. And for those banks that have earned their independence, there are things they can do to help sustain it.

Improving Shareholder Liquidity, Employee Performance through ESOPs


ESOP-6-18-19.pngMost banks face challenges to find, incentivize and retain their best employees in an increasing competitive market for talent. Often, smaller banks and banks structured as Subchapter S corporations have the added challenge of providing liquidity for their shareholders and founders. An employee stock ownership plan can be an excellent tool for addressing those issues.

An ESOP creates a buyer for the bank’s stock, generating liquidity for shareholders of private or thinly traded banks and providing market support for publicly traded ones. An ESOP’s buying activity can reduce shares outstanding and increase a bank’s earnings per share. It can also increase employee benefits and gives them a sense of ownership that can improve recruitment, retention and performance.

ESOPs are tax-qualified defined contribution retirement plans for employees that primarily invest in employer securities. ESOPs offer accounts to employees, similar to 401(k) retirement plans. But unlike a 401(k), employees do not contribute anything to the plan; instead, the bank makes the contribution on their behalf.

ESOPs are an excellent employee benefit and a recruitment, retention and performance tool. ESOPs do not pay taxes on an annual basis, so taxes are deferred while the stock remains in a plan. When the employee retires or takes a distribution from the plan, the value of the distribution is taxed as ordinary income. Employees also have the ability to roll over the distribution to an individual retirement account.

Employees at companies that offer an ESOP have, on average, 2.6 times more in retirement assets than employees working at companies that do not have an ESOP, according to the National Center for Employee Ownership. Additionally, companies with broad-based stock option plans experienced an increase in productivity of 20 percent to 33 percent above comparable firms after plans were implemented. Medium-sized companies saw gains at the higher end of the scale. Employee ownership is also associated with higher rates of employee retention. According to a survey by the Rutgers University’s NJ/NY Center for Employee Ownership, workers at employee-owned companies are less likely to look for other jobs and more likely to take action when co-workers are not working well.

There are a couple of different ways that banks can establish ESOPs. The simplest and most efficient is called a non-leveraged ESOP, where the bank or holding company makes a tax-deductible cash contribution. The contribution can be in stock or cash and is recorded as compensation expense. If the bank contributes cash, those funds can be used to purchase stock directly from shareholders and create liquidity and demand in the stock. However, it can take years for a non-leveraged ESOP to accumulate a significant enough position to make a meaningful difference to a bank.

The other method, called a leveraged ESOP, uses a bank’s holding company to lend money directly to the ownership plan. The holding company is required because banks are not permitted to lend directly to the ESOP or guarantee a loan made to the ESOP. The holding company can use cash on its balance sheet, borrow it from a third-party lender or guarantee a third-party loan made directly to the ESOP. The ESOP uses the funds to purchase a large block of non-issued shares from the holding company or directly from shareholders. Although leveraged ESOPs have higher costs and complexity, they can make an immediate, meaningful difference in liquidity and employee benefits. This approach also has the benefit of increasing earnings per share upfront, since the shares underlying the ESOP loan to make the purchase are not considered outstanding. However, the repurchased shares negatively impact tangible common equity and tangible book value.

An ESOP can help the right bank accomplish many of its goals and objectives. Banks should carefully review their goals and objectives with qualified professionals that know and understand both the ESOP and commercial bank industries.

A Better Way to Value Deposit-Driven Deals


deposits-4-1-19.pngThere’s no doubt that the focus these days on acquisitions centers around deposits. When surveyed at the 2019 Acquire or Be Acquired conference, 71 percent of attendees said that a target’s deposit base was the most important factor in making the decision to acquire. This suggests that targets with excess liquidity (low loan-to-deposit ratios) will be highly valued in the market going forward.

This strategic objective is out of whack with traditional deal valuation metrics.

The two primary traditional deal metrics are tangible book value (TBV) payback period and earnings per share (EPS) accretion. Investors expect every deal to meet the benchmarks of a low TBV payback period (ideally less than three years) and be accretive to EPS, according to a presentation from Keefe Bruyette & Woods President and CEO Tom Michaud.

These are earnings-based metrics, and targets with low loan-to-deposit ratios have lower earnings because they have larger securities portfolios relative to loans. Therefore, traditional consolidation modeling will undervalue those targets with longer payback periods and lower accretion. Potential acquirers will struggle to justify competitive prices for these highly valued targets.

Why are deals that clearly create shareholder value by strengthening the buyer’s deposit base not reflected by the deal metrics du jour? Because those metrics are flawed. How can you justify a deposit-driven deal to an investor base that is focused on TBV payback and EPS accretion? By abandoning traditional valuation methods and using forward-looking, common sense analytics that capture the true value of an acquisition.

Traditional consolidation methodology projects the buyer and seller independently, then combines them with some purchase accounting and cost savings adjustments. Maybe the analyst will increase consolidated loan growth generated from the excess deposits acquired. This methodology does not capture the true value of the acquired deposits.

The intelligent acquirer should first project its own financials under realistic scenarios, given current market trends. Industry deposit growth has already begun to slow, and the big banks are taking more and more market share. If the bank were to grow loans organically, it must be determined:

  • How much of the funding would come from core deposits and how much would require brokered deposits or other borrowings like Federal Home Loan Bank advances and repurchase agreements? This change in funding mix will drive up incremental interest expense.
  • How many of the bank’s existing depositors will shift their funds from low cost checking and savings accounts to higher cost CDs to capture higher market rates? This process will increase the bank’s existing cost of funds.
  • What will happen to my deposit rates when my competitors start advertising higher rates in a desperate play to attract deposits? This will put more pressure on the bank’s existing cost of funds.
  • How many of my existing loans will reprice at higher rates and help overcome increasing funding costs? Invictus’ BankGenome™ intelligence system suggests that, while the average fixed/floating mix for all banks in the US is 60/40, the percentage of floating rate loans actually repricing at higher rates in the next 12 months is much lower because the weighted average time between loan reset dates is more than six quarters.

Standalone projections for the buyer must adequately reflect the risks inherent in the current operating environment. These risks will affect a bank’s bottom line and, therefore, shareholder value. This process will create a true baseline against which to measure the impact of the acquisition. Management must educate its investors on the flaws in legacy analytics, so they can understand a deal’s true value.

In the acquisition scenario, the bank is acquiring loan growth with existing core deposit funding attached. And if the target has excess deposits, the acquirer can deploy those funds into additional loans grown organically without the funding risks due to current market trends. The cost differential between the organic growth and acquisition scenarios creates real, tangible savings. These savings translate to higher incremental earnings from the acquisition, which alleviate TBV payback periods and EPS accretion issues. Traditional deal metrics may be used as guideposts in evaluating an acquisition, but a misguided reliance on them can obscure the true strategic and financial shareholder value created in a transaction.

Every target should be analyzed in depth, with prices customized to the acquirer’s unique balance sheet and footprint. Don’t pass on a great deal because of flawed traditional methodologies.

Rodge Cohen: Are We Preparing to Fight the Last War?


risk-3-1-19.pngHis name might not command the same recognition on the world stage as the mononymous Irish singer and song-writer known simply as Bono, but in banking and financial services just about everyone knows who “Rodge” is.

H. Rodgin Cohen–referred to simply as Rodge—is the unrivaled dean of U.S. bank attorneys. At 75, Cohen, who is the senior chairman at the New York City law firm Sullivan & Cromwell, is still actively involved in the industry, having recently advised SunTrust Banks on its pending merger with BB&T Corp.

Cohen has long been considered a valued advisor within the industry.

In the financial crisis a decade ago, he represented corporate clients like Lehman Brothers and worked closely with the federal government’s principal players, including Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke. His character even made an appearance in the movie “Too Big To Fail,” based on a popular book about the crisis by Andrew Ross Sorkin.

Eleven years later, Cohen says the risk to the banking industry is no longer excessive leverage or insufficient liquidity—major contributing factors to the last crisis.

The Dodd-Frank Act of 2010, passed nearly a decade ago, raised bank capitalization levels substantially compared to pre-crisis levels. In fact, bank capitalization levels have been rising for 40 years, going back to the thrift crisis in the late 1980s. Dodd-Frank also requires large banks to hold a higher percentage of their assets in cash to insure they have enough liquidity to weather another financial storm.

The lesson from the last crisis, says Cohen, revolves around the importance of having a fortress balance sheet. “I think that was the lesson which has been thoroughly learned not merely by the regulators, but by the banks themselves, so that banks today have exponentially more capital, and the differential is even greater in terms of having more liquidity,” says Cohen.

But does anyone know if these changes will be enough to help banks survive the next crisis?

“I don’t think it is possible to calculate this precisely, but if you look at the banks that did get into trouble, none of them had anywhere near the level of capital and liquidity that is required now,” says Cohen. “Although you can’t say with certainty that this is enough, because it’s almost unprovable, there’s enough evidence that suggests that we are at levels where no more is required.”

It is often said that generals have a tendency to fight the last war even though advances in weaponry—driven by technology—can render that war’s tactics and strategies obsolete. Think of the English cavalry on horseback in World War I charging into German machine guns.

It can be argued that regulators, policymakers and even customers in the United States still bear the emotional scars of the last financial crisis, so we all find comfort in the fact that banks are less leveraged today than they have been in recent history, particularly in the lead up to the last crisis.

But what if a strong balance sheet isn’t enough to fight the next war?

“I think the biggest risk in the [financial] system today is a successful cyberattack,” says Cohen. While a lot of attention is paid to the dangers of a broad attack on critical infrastructure that poses a systemic risk, Cohen worries about something different.

“That is a very serious risk, but I think the more likely [danger] is that a single bank—or a group of banks—are hit with a massive denial of service for a period of time, or a massive scrambling of records,” he says. This contagion could destabilize the financial system if depositors begin to worry about the safety of their money.

Cohen believes that financial contagion, where risk spreads from one bank to another like an infectious disease, played a bigger role in the financial crisis than most people appreciate. And he worries that the same scenario could play out in a crippling cyberattack on a major bank.

“Until we really understand what role contagion played in 2008, I don’t think we’re going to appreciate fully the risk of contagion with cyber,” he says. “But to me, that is clearly the principal risk.”

And herein lays the irony of the industry’s higher capital and liquidity requirements. They were designed to protect against the risk of credit bubbles, such as the one that precipitated the last crisis, but they will do little to protect against the bigger risk faced by banks today: a crippling cyberattack.

“That’s why I regard [cyber] as the greatest threat,” says Cohen, “because a fortress balance sheet won’t necessarily help.”