Slow loan demand continues to plague many community and regional banks across the country, as they continue to search for ways to grow their loan portfolios. Bob Newmarker of Zurich Insurance offers some insight into how banks can look toward an environmental insurance portfolio program as an alternative way to manage their risks and create a competitive advantage.
With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.
How will the new Basel III capital requirements impact the banking industry in the U.S.?
Basel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.
—Luigi L. De Ghenghi, Partner, Davis Polk
If adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes. Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry. For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010. Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.
—Greg Lyons, Debevoise & Plimpton
The impact will be positive in the long term. Basel III’s higher capital requirements will be phased in over a number of years. While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources. The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability.
—Mark Nuccio, Ropes & Gray
The real impact will be the change on Main Street. The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.
This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.
—Jonathan Hightower, Bryan Cave
The implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.
We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.
—Rob Fleetwood, Barack Ferrazzano
Basel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking. Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting. Yet, the Basel accord now mandates it for the securities portfolio. The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans. Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions. Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.
In the wake of over 400 bank failures since the beginning of 2008, the Federal Deposit Insurance Corp. is well underway with its process of seeking recoveries from directors and officers of failed banks who the FDIC believes breached their duties in the course of managing those institutions. As of mid-May 2012, the FDIC had filed lawsuits against almost 30 groups of directors and officers alleging negligence, gross negligence and/or breaches of fiduciary duties. While the litigation filed by the FDIC tends to sensationalize certain actions of the directors and officers in order to better the FDIC’s case, there are lessons to be learned.
Some of the take-aways from the FDIC lawsuits are fairly mechanical: carefully underwrite loans, avoid excessive concentrations and manage your bank’s transactions with insiders. However, there are two major themes that are more nuanced and which are present in almost all of the lawsuits. Those themes relate to the loan approval process and director education.
Develop a thoughtful loan approval process. As evidenced by the recent piece published on BankDirector.com, a spirited debate among industry advisors is currently taking place with respect to whether directors should approve loans or not. On the one hand, many attorneys believe directors have a duty to consider and approve (or decline to approve) certain credits that are or would be material to their banks. Regulation O requires approval of certain credits, the laws of some states require approval of some loans, and there is a general feeling among many bank directors that they should be directly involved in the credit approval process. In addition, many bank management teams believe that directors should “buy in” with them to material credit transactions.
On the other hand, the FDIC litigation clearly focuses on loan committee members who approved individual loans that did not perform. This should give pause to directors in general and loan committee members in particular. It is now the belief of many legal practitioners that the practice of approving individual loans when the loans are not otherwise required to be approved by the directors paints a target on the backs of the loan committee members. The FDIC may be able to target directors who participated in the underwriting of a credit (or were deemed to have done so given their involvement in the approval process) when they did not have the expertise necessary to do so. Some practitioners argue that the directors should instead focus on the development and approval of loan policies that place appropriate limits on the types of loans—and the amounts—that the bank is willing to make. This policy would be consistent not only with safe and sound banking principles but also with the board’s risk tolerance, and it would be appropriate to seek guidance from management and outside advisors on the development of the policy. The idea is that it is much more difficult to criticize a policy than an individual credit decision with the benefit of hindsight.
No matter the approach that your board chooses, the common theme is that the board and the loan committee should expect and receive all relevant information from management about material credits. If directors are actually approving loans, they should get detailed information in a timely fashion that allows them to review and approve the underwriting of the credit. If the directors aren’t approving loans, they should still get information that confirms that the loans conform to the bank’s loan policy and the board’s risk appetite.
Directors should be educated and informed. Above all else, the FDIC lawsuits make clear that the bank board is certainly no longer a social club. Bank directors are charged with very real responsibilities and face the very real prospect of personal liability if their banks are not successful. Indeed, being a bank director is a job.
Because the bank’s shareholders and regulators demand that the directors do a job for the bank, the bank should offer appropriate training to do that job well. Bank directors should be offered the opportunity to engage outside consultants to provide training for the directors to develop the skills they need, particularly at the committee level. In addition, directors should attend conferences that allow them to familiarize themselves with industry trends and best practices. We suggest that there is no better expense for the bank than ensuring that its directors are equipped with the education and tools they need to fulfill their duties.
In addition to more general training, the FDIC lawsuits bring focus to the fact that some directors simply did not understand the material risks to their banks. We have encountered directors who do not fully understand the material risks their institutions face, even at high performing banks. As a result, we recommend that at least annually the directors have a special session to focus on enterprise risk management and discuss the key risks that face the institution. These sessions can be conducted by the chief risk officer or, at smaller banks, by an outside consultant who has helped to manage the enterprise risk management process. This understanding of material risks should better inform the decision making of the board.
While the FDIC lawsuits paint a picture of inattentive, runaway directors and officers, a number of the practices that the FDIC found objectionable could be found at many healthy institutions. By learning from the situations that led to many of these lawsuits, even the best performing banks can enhance the performance of their boards, which will ultimately result in greater value to the shareholders of the bank.
With traditional bank lending, one of the credit risk red flags was always a lack of borrower diversity. How could a company risk having all its eggs in one basket? The extra pain extracted from highly correlated bank portfolios (i.e. both with real estate and geographic concentrations) in this crisis has brought that proverbial chicken home to roost in our own industry. Conceptually, we all now understand this; how do we practically affect this change?
Here’s a possible five-step plan for your bank to consider:
Step One: Adopt strategic plans that include alternative loan products, such as those tied to C&I (commercial & industrial) lending, or indirect / dealer automobile lending or even mortgage warehousing. Small Business Administration loans are another possibility. Recruit the talent that can implement these strategies for you.
Step Two: Disabuse yourselves of the following anti-C&I biases:
It’s become just a consumerized product. This is a byproduct of the underwriting laziness adopted by many, where a small business owner’s credit score was the primary driver for this loan product.
It’s tantamount to unsecured lending. Because it tends to focus on the top of the balance sheet, assets for collateral, lines of credit can be monitored effectively by procedures that use collateral such as stepped borrowing base agreements.
It’s asset-based lending. We’re not talking about factoring-like products (buying or funding a customer’s accounts receivable at a discount) that proliferated the ’90’s. They often failed because they were unwisely sold to banks as having primarily operational rather than credit risks at their heart.
Step Three: Ditch (or at least modify) the hunter-skinner delivery system for your bank’s loan officers. It doesn’t work. Some of the so-called efficiencies gained lend themselves better to the book and forget mindset that too often characterized our industry’s fixation on commercial real estate. This strategy also robs us of broad-based credit talent needed to fulfill the axiom: the market place rewards value-added.
Step Four: Train and re-train lenders and related lending staff (analysts, underwriters, credit officers) in the ways of cash flow and cash cycle analyses. Twenty years ago, most commercial bankers were experts in these classical credit tenets—and frankly treated real estate as a form of specialty lending. Over the past decade, commercial banks have been copying mortgage lending, abdicating too much of their core underwriting to third parties such as appraisers and credit rating agencies. The fundamentals of classic credit underwriting are not that intimidating—and like riding a bike, can come back to even the most dedicated commercial real estate devotees.
Step Five: Create the infrastructure needed to deliver and oversee this diversity investment. In addition to front-end underwriting, enhance:
Use of practical loan covenants and borrowing base certificates to justify lines of credit;
Portfolio servicing (post-booking checks of a borrower’s risk trends);
Probative risk management tools (looking at future risks);
Staff. Remember, the cost of one or two additional full-time equivalents pales in comparison to the bloodletting the industry has experienced, due in some part to bare-boned risk management infrastructures.
Lest one think these initiatives are designed to address only the risk component of lending, I would offer that they also help return the community banker back to the successful production role of lending to a diverse borrowing base: a win-win.
*Another version of this article was previously published in Carolina Banker in 2009.
One of the more depressing aspects of this long-running post-recession malaise has been the continued shrinkage of bank loan portfolios. Consumers and business aren’t asking for many loans, and many of the people who do ask aren’t getting any. That impacts the economy’s ability to grow, if businesses aren’t investing and consumers aren’t spending.
But loan growth seemed to turn a corner in the second quarter, and interestingly, small and mid-sized banks are leading the way, according to an analysis by investment bank Keefe, Bruyette & Woods, Inc.
Total loans and leases increased 0.9 percent in the second quarter, or by $64.4 billion, according to the Federal Deposit Insurance Corp. (FDIC), the first actual growth in three years. The government’s statistics include all FDIC-insured institutions, both public and private. Commercial and industrial loans (C&I)increased for the fourth consecutive quarter, by 2.8 percent, while auto loans rose 3.4 percent, the FDIC said. Credit card balances rose by 0.8 percent and first lien residential mortgages rose by 0.2 percent. Loans for construction fell for the 13th consecutive quarter, this time by 7 percent.
A deeper look from KBW of publicly traded banks shows that mid-cap banks had the largest growth in loan portfolios. Large-cap banks saw total loan balances decline by 0.2 percent during the second quarter, while mid-cap and small-cap banks grew their total loans by 5.9 percent and 0.7 percent, respectively.
The investment bank and research firm reported:
Among the loan categories at mid-cap banks, C&I loans posted the largest quarter–to–quarter increase, gaining 13.9 percent.
Large-cap banks posted quarter-to-quarter loan shrinkage across all loan categories except C&I, which increased 2.0 percent.
Only Puerto Rico and the Southwest saw aggregate quarter-to-quarter loan shrinkage. Total loans fell 4.9 percent sequentially for Puerto Rico, and 1.6 percent for the Southwest.
The Midwestern and Southeastern regions posted the strongest quarter-to-quarter loan growth as total loans increased 9.5 percent for the Midwest and 6.1 percent for the Southeast.
Loan portfolios still are down from a year ago. On a year-over-year basis, total loans (excluding consumer loans) have declined annually for seven consecutive quarters, most recently falling 0.5 percent in the second quarter, according to KBW.
The commercial and industrial loan category, which accounts for 18 percent of total loans, is the only loan category to post both quarter–over–quarter and year–over–year loan growth of 2.7 percent and 4.6 percent, respectively.
Commercial and industrial loans to businesses clearly remain a source of strength, even as real estate is soft. The growth in loan portfolios among small and mid-sized banks is a welcome sign, even though large-cap banks account for 90 percent of aggregate loans, according to KBW. Banks have been giving investors something to be happy about: Higher profits, better loan credit qualityandeven some loan growth during the second quarter. But with the wild swings in the market and plummeting bank stocks lately, it may be that investors still are too worried about the economy to care.
Steve Trager is president and CEO of Republic Bancorp, Inc., a Louisville, Kentucky-based, $3.1 billion-asset publicly traded company with 43 bank branches in Kentucky, Florida, Indiana and Ohio. Despite the crummy economic environment, poor loan demand and high regulatory demands, Republic Bancorp has maintained high profitability; even with half its loans in residential mortgages, and most of the rest in commercial real estate, construction, business and consumer loans.
Republic Bancorp had the second and third highest return on average assets and return on average equity last year, and the fifth best performance overall in Bank Director magazine’s ranking of the top 150 banking companies in the nation.
To be sure, the bank has experienced problems, too.Its non-performing assets are 1.28 percent of total loans as of the second quarter, a decline from previous quarters, and it took a $2 million charge in second quarter earnings over a civil penalty from the Federal Deposit Insurance Corp. relating to its IRS tax refund anticipation loan service. (The company says it will contest the fine before an administrative law judge and will work to make sure its tax firm clients comply with applicable banking regulations).
Trager talked to Bank Director recently about how he’s handling the challenges of the current regulatory and economic environment.
Can you talk about what sort of lending you do?
The challenge for us in residential mortgages is we compete with a government product that is a 15- and 30-year fixed rate at 3.5 percent for 15 years and 30 years at 4.25 percent and only the government would make a 15- or 30-year fixed rate loan at those kind of rates, with that kind of interest-rate risk. We are proud to be able to offer that government product to our customers as well and we service that product as a competitive edge. Every single one of our products is delivered by a Republic Bank banker as opposed to a broker and that is competitive difference for us. We sell those (government-backed) loans on the secondary market so we don’t keep them on our books.
So what kind of residential mortgages do you keep in your portfolio?
There’s an expanding universe of people who aren’t able to comply with the government’s rigid requirements. Some of those requirements don’t reflect credit quality. Some folks are very capable with good debt service characteristics, low loan-to-value. They might want to buy a condo and the secondary market is very difficult for condos.
We would love to expand our offering to an even bigger group of customers who are very credit worthy, if we could get a little better pricing. The biggest risk today is regulatory risk. The mortgages we do, the rates we do, and whom we make them to, is just subject to so much scrutiny, that we can’t take a chance to expand our portfolio credit offering to those who need it.
Didn’t your $2.2 billion loan portfolio grow a little bit in the second quarter, by 2 percent?
Absolutely, (it grew) by about $50 million. That was a little bit more than half commercial and some residential. I think customers see Republic Bank and our financial health as a stable, long-term option.
We’re still in the market for residential mortgages because we have enough size and enough volume. The risks are so great that it has pushed a lot of other lenders out of the market. Any mortgage loan we make, we’ve got to gather tons of fields of demographic information, for thousands of loans per year. It frustrates customers.
Have you loosened your underwriting standards recently?
We have not. Our underwriting standards have remained relatively stable over the last five years. I do worry that in this market, where there is not much loan demand and a lot of banks in desperate need of loans that that’s a dynamic that might cause some to stretch their underwriting models. We’re never going to sacrifice the long-term viability of Republic Bank or our customers for short-term gain.
Your focus has been maintaining a highly profitable bank. You saw profits rise 50 percent in the first half of the year compared to the same time a year ago to $80 million. How?
I think it’s a combination of the stability that our core bank provides. We haven’t been haunted by credit quality. We have had good demand from both the deposit and loan side. It’s just trying to do the right thing over and over again for a long period of time, and having the right people do it. We’ve got 780 associates and they do a spectacular job.
We also have niche businesses that supplement our bottom line. We are the largest provider of electronic tax refunds in the country. We service folks like Jackson Hewitt, Liberty and other tax services around the country, processing electronic refunds for their customer base. A small percentage of the customers would like to get an advance on their refund within 24 or 36 hours. That represented about 700,000 of our four million tax refund customers in the first quarter. For the rest, when the IRS pays it, we make sure our customers get it quickly.
What advice do you have for other bankers in this difficult time to grow lending?
Go out and encourage and support a good lending staff. Get out and pound the pavement. Our lending staff is very incentivized to do that. Their incentives are tied to loan quality. Part of their annual bonus is determined by production and delinquency. We are fortunate enough to have had a lot of folks who have been with us for a long period of time, and that helps.