How CECL Impacts Acquisitive Banks


CECL-7-30-19.pngBank buyers preparing to review a potential transaction or close a purchase may encounter unexpected challenges.

For public and private financial institutions, the impending accounting standard called the current expected credit loss or CECL will change how they will account for acquired receivables. It is imperative that buyers use careful planning and consideration to avoid CECL headaches.

Moving to CECL will change the name and definitions for acquired loans. The existing accounting guidance classifies loans into two categories: purchased-credit impaired (PCI) loans and purchased performing loans. Under CECL, the categories will change to purchased credit deteriorated (PCD) loans and non-PCD loans.

PCI loans are loans that have experienced deterioration in credit quality after origination. It is probable that the acquiring institution will be unable to collect all the contractually obligated payments from the borrower for these loans. In comparison, PCD loans are purchased financial assets that have experienced a more-than-insignificant amount of credit deterioration since origination. CECL will give financial institutions broader latitude for considering which of their acquired loans have impairments.

Under existing guidance for PCI loans, management teams must establish what contractual cash flows they expect to receive, as well as the cash flows they do not expect to receive. The yield on these loans can change with expected cash flows assessments following the close of a deal. In contrast, changes in the expected credit losses on PCD loans will impact provisions for loan losses following a deal, similar to changes in expectations on originated loans.

CECL will significantly change how banks treat existing purchased performing loans. Right now, accounting for purchased performing loans is straightforward: banks record loans at fair value, with no allowance recorded on Day One.

Under CECL, acquired assets that have only insignificant credit deterioration (non-PCD loans) will be treated similarly to originated assets. This requires a bank to record an allowance at acquisition, with an offset to the income statement.

The key difference with the CECL standard for these loans is that it is not appropriate for a financial institution to offset the need for an allowance with a purchase discount that is accreted into income. To take it a step further: a bank will need to record an appropriate allowance for all purchased performing loans from past mergers and acquisitions that it has on the balance sheet, even if the remaining purchase discounts resulted in no allowance under today’s standards.

Management teams should understand how CECL impacts accounting for acquired loans as they model potential transactions. The most substantial change relates to how banks account for acquired non-PCD loans. These loans first need to be adjusted to fair value under the requirements of accounting standards codification 805, Business Combinations, and then require a Day One reserve as discussed above. This new accounting could further dilute capital during an acquisition and increase the amount of time it takes a bank to earn back its tangible book value.

Banks should work with their advisors to model the impact of these changes and consider whether they should adjust pricing or deal structure in response. Executives who are considering transactions that will close near their bank’s CECL adoption date not only will need to model the impact on the acquired loans but also the impact on their own loan portfolio. This preparation is imperative, so they can accurately estimate the impact on regulatory capital.

77 Percent of Bank Boards Approve Loans. Is That a Mistake?


loans-5-17-19.pngBank directors face a myriad of expectations from regulators to ensure that their institutions are safe and sound. But there’s one thing directors do that regulators don’t actually ask them to do.

“There’s no requirement or even suggestion, that I’m aware of, from any regulators that says, ‘Hey, we want the board involved at the loan-approval level,’” says Patrick Hanchey, a partner at the law firm Alston & Bird. The one exception is Regulation O, which requires boards to review and approve insider loans.

Instead, the board is tasked with implementing policies and procedures for the bank, and hiring a management team to execute on that strategy, Hanchey explains.

“If all that’s done, then you’re making good loans, and there’s no issue.”

Yet, 77 percent of executives and directors say their board or a board-level loan committee plays a role in approving credits, according to Bank Director’s 2019 Risk Survey.

Boards at smaller banks are more likely to approve loans than their larger peers. This is despite the spate of loan-related lawsuits filed by the Federal Deposit Insurance Corp. against directors in the wake of the recent financial crisis.

Loans-chart.png

The board at Mayfield, Kentucky-based First Kentucky Bank approves five to seven loans a month, says Ann Hale Mills, who serves on the board. These are either large loans or loans extended to businesses or individuals who already have a large line of credit at the bank, which is the $442 million asset subsidiary of Exchange Bancshares.

Yet, the fact that directors often lack formal credit expertise leads some to question whether they should be directly involved in the process.

“Inserting themselves into that decision-making process is putting [directors] in a place that they’re not necessarily trained to be in,” says James Stevens, a partner at the law firm Troutman Sanders.

What’s more, focusing on loan approvals may take directors’ eyes off the big picture, says David Ruffin, a director at the accounting firm Dixon Hughes Goodman LLP.

“It, primarily, deflects them from the more important role of understanding and overseeing the macro performance of the credit portfolio,” he says. “[Regulators would] much rather have directors focused on the macro performance of the credit portfolio, and understanding the risk tolerances and risk appetite.”

Ruffin believes that boards should focus instead on getting the right information about the bank’s loan portfolio, including trend analyses around loan concentrations.

“That’s where a good board member should be highly sensitized and, frankly, treat that as their priority—not individual loan approvals,” says Ruffin.

It all boils down to effective risk management.

“That’s one of [the board’s] main jobs, in my mind. Is the institution taking the right risk, and is the institution taking enough risk, and then how is that risk allocated across capital lines?” says Chris Nichols, the chief strategy officer at Winter Haven, Florida-based CenterState Bank Corp. CenterState has $12.6 billion in assets, which includes a national correspondent banking division. “That’s exactly where the board should be: [Defining] ‘this is the risk we want to take’ and looking at the process to make sure they’re taking the right risk.”

Directors can still contribute their expertise without taking on the liability of approving individual loans, adds Stevens.

“[Directors] have information to contribute to loan decisions, and there’s nothing that says that they can’t attend officer loan committee meetings or share what they know about borrowers or credits that are being considered,” he says.

But Mills disagrees, as do many community bank directors. She believes the board has a vital role to play in approving loans.

First Kentucky Bank’s board examines quantitative metrics—including credit history, repayment terms and the loan-to-value ratio—and qualitative factors, such as the customer’s relationship with the bank and how changes in the local economy could impact repayment.

“We are very well informed with data, local economic insight and competitive dynamics when we approve a loan,” she says.

And community bank directors and executives are looking at the bigger picture for their community, beyond the bank’s credit portfolio.

“We are more likely to accept risk for loans we see in the best interest of the overall community … an external effect that is hard to quantify using only traditional credit metrics,” she says.

Regardless of how a particular bank approaches this process, however, the one thing most people can agree on is that the value of such bespoke expertise diminishes as a bank grows and expands into far-flung markets.

“You could argue that in a very small bank, that the directors are often seasoned business men and women who understand how to run a business, and do have an intuitive credit sense about them, and they do add value,” says Ruffin. “Where it loses its efficacy, in my opinion, is where you start adding markets that they have no understanding of or awareness of the key personalities—that’s where it starts breaking apart.”

Avoiding Hot Water: Complying with Regulation O


regulation-3-14-18.pngIf a director wants to get into hot water—and their financial institution as well—violating Regulation O is a good place to start. It’s “one of the three things that makes bank examiners see red,” says Sanford Brown, a partner at the law firm Alston & Bird (the other two being the violation of lending limits and noncompliance with Regulation W, which governs transactions between a member bank and its affiliates). Designed to prevent insider abuse and ensure the safety and soundness of the bank through good lending practices, it’s a violation that examiners have zero tolerance for, and often results in a civil money penalty, adds Brown. It’s no wonder that bank directors often err on the side of caution when it comes to compliance with the rule.

Regulation O “governs any extension of credit made by a member bank to an executive officer, director or principal shareholder of the member bank, of any company of which the member bank is a subsidiary, and of any other subsidiary of that company.” Loans made to covered individuals, or businesses that these individuals have an interest in, must be made on par with what any other bank customer would receive, with the same terms and underwriting standards. The covered loans are subject to the bank’s legal lending limits, and the aggregate credit for all covered parties cannot exceed the bank’s unimpaired capital and unimpaired surplus. The extension of credit must be approved by the majority of the board, with the affected person abstaining from the discussion. Executive officers are limited further and may only receive credit to finance their child’s education, and to purchase or refinance a primary residence.

Essentially, Regulation O ensures that directors, officers and principal shareholders aren’t treating the institution like their own personal piggy bank. But directors also want to drive business to their bank. “Most directors want to know where [the] line is and stay away from it, but some believe that their job is to drive all the business they can to the bank, and that’s one of the things that great directors do,” says Brown. “But do it right.” Here are a few things to keep in mind to avoid compliance gaps in Regulation O.

Know Who All Are Affected
“With all the various corporate structures that banks can have, having a strong process for the identification of covered individuals is the No. 1 thing a bank can do to help the compliance process,” says Asaad Faquir, a director at RSK Compliance Solutions, a regulatory compliance consultant.

Under Regulation O, “executive officers” are defined as bank employees that participate, or are authorized to participate, in major policymaking functions—regardless of that person’s title within the organization. This generally includes the president, chairman of the board, cashier, secretary, treasurer and vice presidents. There can be some grey area as to which officers are covered under Regulation O, and some banks provide a broader definition than the rule requires to ensure compliance.

Principal shareholders are defined as those that own more than 10 percent of the organization. The definition of director, as a general rule, doesn’t include advisory directors.

An ill-defined population for Regulation O can raise the risk of noncompliance with the rule, says Tim Kosiek, a partner with the accounting and advisory firm Baker Tilly. The law is relatively black-and-white, as legislation goes, but the holdings of bank directors and principal shareholders can be complex, which heightens the compliance challenge. Banks should not only identify the officers, directors and principal shareholders covered by the law, but also family and business interests. The bank’s governing policy should define that process, and indicate how often it will be reviewed, he says.

Covered individuals are required to prepare an annual statement of related interests, and Brown says this is an area where a well-meaning director can easily trip up. “Full disclosure of every business relationship that the director has is critical. And it’s a pain—some of these people really do have their fingers in lots of pies,” he says. These interests should be communicated throughout the organization, to ensure that a loan officer doesn’t unintentionally conduct business as usual with a company that has a relationship with a covered individual.

If the terms of a covered loan are modified, the modification should go back through the bank’s Regulation O process, says Kosiek. And if a director acquires an interest in a company with a preexisting credit relationship with the bank, that should also be reviewed due to the director’s involvement.

Document Everything
A director, officer or principal shareholder must ensure that he or she is seen as having no influence on the process for the approval of a loan in which the covered individual has any interest. It’s a good practice for the affected director to just leave the boardroom before the related loan is discussed, says Faquir. “It protects the directors themselves, it protects the institution, and it’s a cleaner process.” He provides one example where a director explained to the board his own involvement in a loan, and then recused himself—with the good intention of being transparent about the process. From the point of view of the bank’s regulator, however, this was perceived as influencing the board in the loan’s approval. It’s best for the recusal to be immediate, so the regulators, upon reviewing the documentation, find no cause to believe that there was undue influence.

The law requires that each bank maintain records that identify covered parties, and document all extensions of credit to directors, principal shareholders and executive officers, to prove that the bank followed the letter of the law. “If you are to demonstrate compliance with the regulation, you have to make sure that your minutes reflect, No. 1, that the individual did not participate in the discussion” and that the rate and terms offered are the same as what would be offered to any other bank customer, says Scott Coleman, a partner at the law firm Ballard Spahr. Document the credit analysis to ensure the loan received the appropriate terms and underwriting standards. The board should also deliberate annually on who is covered by Regulation O, particularly which officers are involved in policymaking. Recordkeeping in this case can help address questions that come up in an exam, says Coleman.

Handle Violations Proactively
Mistakes can happen, so pay attention to quarterly loan reports. A director may find that a business she is involved in but doesn’t run daily received a loan from the bank. Own the error and make it right by disposing of the loan. Assuming it’s a good loan—which it should be—pay it off in full, at no loss to the bank, and move it to another (unconnected) bank. “That’s the easiest way to remedy it, and to show that there were systems in place to prevent these sorts of things from happening, [and] it just was an honest mistake,” says Brown.

Coleman recommends that banks self-report inadvertent infractions, as the penalties are likely to be less severe. “Contact [the regulator], indicate what was discovered, how the error was made, how the error was corrected and what the bank intends to do in the future to monitor Reg O,” he says.

More serious Regulation O violations can suggest to regulators that other abuses are occurring, and they may go looking for larger problems, adds Coleman. And a violation will almost certainly result in civil money penalties, for the covered individual as well as the board that approved the loan or the loan officer responsible for underwriting the loan. In extreme cases where a violation was seen as intentional, there can be criminal implications in addition to the fine, says Coleman, and regulators could seek the removal of that officer.

Brown believes that regulators under the current administration will focus more on safety and soundness and less on social issues, like consumer risk. “I think the current policymakers are going to focus on where banks make money and where banks lose money, and the real risk in the balance sheet is the loan portfolio,” he says. Banks tend to fail due to bad loans or fraud, so that could mean a heightened focus on Regulation O.

Back to the Future: The Allowance for Loan and Lease Losses


5-18-15-CRM.pngOne of the most important figures on a bank’s balance sheet is the allowance for loan and lease losses (ALLL), as it provides an estimate for future credit losses. More than a decade ago, the “unallocated” ALLL was the subjective component of the allowance, which was often criticized for being poorly supported. Regulatory guidance issued in December of 2006 attempted to provide a framework to support this portion of the reserve through the use of a Qualitative & Environmental (Q&E) adjustment. However, the financial crisis soon hit and the resultant high historical loss rates lessened the impact of the Q&E adjustment. Now, we are “back to the future;” the industry-wide ALLL was 1.5 percent at the end of 2014 while annual charge-off rates accounted for only one-third of that total. As the Q&E component of the ALLL has grown, the scrutiny over the Q&E from regulators and external auditors has increased proportionately.

Background
Today’s primary regulatory guidance on ALLL is the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. In the section covering the general reserve (Formerly FAS 5, now ASC 450-20), it indicates that while historical loss experience provides a reasonable starting point for the institution’s analysis, management “should consider” those qualitative or environmental factors that are likely to cause the estimated credit losses to differ from historical loss experience. Nine factors are listed and are summarized as 1) lending policies and procedures, 2) economic conditions, 3) nature/volume of portfolio, 4) lending/credit staffing, 5) asset quality, 6) loan review system, 7) collateral valuation, 8) loan concentrations, and 9) other external factors.

Balanced Approach
Q&E methodologies used today range from formulaic approaches to subjective determinations. The regulatory guidance suggests that “management must exercise significant judgment when evaluating the effect of qualitative factors on the amount of the ALLL.”  However, at the subjective end of the spectrum, we begin to resemble the old “unallocated reserve” method which is frequently criticized in today’s Q&E world. Community banks may want to consider a balanced approach, which can be accomplished in five simple steps.

  1. Factor Selection
    This one is easy. Use the nine factors listed in the interagency guidance. You are free to select additional factors if it is relevant to your portfolio, but you should not ignore any of the nine factors.
  2. Data Gathering
    For each of the nine factors, gather the appropriate data. The data should include not only current data, but also trend data that covers a considerable period of time and certainly spans the historical loss period utilized in calculation of the bank’s historical loss rates. Provide data in graph form whenever possible as it facilitates the review and analysis process. Data can come from a variety of sources including the government (federal, state and local), other publicly available data sources, as well as bank and bank peer group data.
  3. Factor Analysis
    The information gathered for each of the nine factors should be analyzed and summarized with an overall assessment of how this factor has changed from the periods covered by the historical loss rates to current conditions. It is also helpful to identify specific loan segments within the portfolio that may deviate positively or negatively from the overall assessment. The overall assessment can be summarized by a letter grade or rating on a numeric scale but other approaches to capturing an overall assessment may be preferable, depending on circumstances.
  4. Q&E Adjustment Setting
    The critical decision is how to best translate the nine-factor assessment into a basis point adjustment for each of the loan categories. One approach is to develop certain adjustment scales for each of the nine factors to be applied to each loan segment. A less formulaic approach would combine the nine-factor assessment with quantitative information regarding each loan segment, such as 1) unadjusted loss rate, 2) historical loss rates for bank and peer group over different time horizons, and 3) sensitivity loss rates informed by adverse case scenarios. This holistic approach would allow management to determine the overall effect of the Q&E factors for each loan segment while being informed by quantified impacts under differing scenarios.
  5. Trend Analysis
    This step is often overlooked as management is just glad to have finished the Q&E adjustment process. The interagency guidance indicates that documentation should include management’s analysis of how each factor has changed over time.  A summary table that captures the trends in the nine-factor assessment and compares it with the trends in the Q&E adjustment by loan category, along with a narrative, could serve as documented support for the directional consistency of the adjustments with the underlying trend information.

While it may seem like a “back to the future,” approach, properly assessing your bank’s Q&E can be accomplished through a structured, consistent, and well-informed method that doesn’t involve rocket science.

Partnering with the Enemy?


3-30-15-Naomi.pngSugar River Bank has a growth problem. Serving a rural area, the $268 million asset bank in Newport, New Hampshire, sits in a town with a population of about 6,500 people. The bank’s management team would like to diversify and do more consumer loans, but there are only so many potential borrowers in the market. So the bank is turning to the Lending Club, a San Francisco-based online marketplace, which is positioning itself both as a partner with and an alternative to traditional banks. Sugar River Bank wants to buy consumer loans generated from Lending Club’s online platform. But are banks such as Sugar River too friendly with the competition?

A Federal Reserve survey found that 20 percent of small businesses applying for credit in the first half of 2014 reported they applied through an online lender. “Things are changing so greatly, I don’t understand [bankers] who don’t want to do partnerships,’’ says Mark Pitkin, Sugar River’s president and CEO.

Sugar River is a member of BancAlliance, a membership organization with more than 200 community banks, which recently signed a deal with Lending Club, giving the banks an opportunity to buy loans or portions of loans nationwide, as well as a chance to co-brand a marketing campaign where Lending Club will underwrite and solicit the banks’ own customers for a loan. Prosper Marketplace, another San Francisco-based online lender, signed a similar deal with Western Independent Bankers, giving the association’s roughly 160 members access to the Prosper Marketplace.

Both deals are for unsecured, fixed-rate installment consumer loans, which are billed as less expensive for the consumer than traditional credit card loans, with rates as low as 6.5 percent for the best borrowers. (Lending Club also offers small business loans, but for now, that’s not a part of the BancAlliance deal.)

Community banks in large part have lost market share for consumer loans to bigger banks during the last few decades, as they can’t compete with the efficiencies enjoyed by the bigger banks. Steven Museles, the general counsel and head of client business for Alliance Partners, the Chevy Chase, Maryland-based asset manager that runs BancAlliance, says the average community bank would have to invest tens if not hundreds of thousands of dollars to scale up a consumer lending business. “We think it’s a significant opportunity for our members,’’ he says. “Many of them would have difficulty putting in place a consumer lending program that could get to any scale.”

According to Ron Suber, president of Prosper, banks don’t want to turn their customers away for consumer loans, and they don’t want to push them into high-interest credit card debt. Partnering with Prosper offers a better alternative for the bank, which receives a 4 percent yield. Borrowers also pay about 4 percent as an origination fee to Prosper and the bank pays Prosper 1 percent of the outstanding balance to service the loan, usually with a three-year term. Customers can apply for a loan from their mobile devices or laptops, or while sitting in a bank’s office. The bank can specify the investment grade for the loans it will buy, such as AA loans, and Prosper categorizes them using data on consumers such as a FICO credit score, payment history and debt to income ratios.

But what are the risks? Fitch Ratings’ Brendan Sheehy, director of financial institutions, thinks the online marketplaces could loosen their underwriting standards to generate additional fees for themselves. In 2013, origination fees made up 88 percent of Lending Club’s total net revenues. And he’s not sure how much visibility community banks really will have into the underwriting models the online marketplaces will use. But he also thinks for now, these types of loans will remain a small part of the typical community bank portfolio. Andrew Deringer, the head of financial institutions for Lending Club, says the Lending Club wouldn’t sacrifice its reputation and goodwill by loosening underwriting standards. “The credibility Lending Club has with investors is paramount to the model,’’ he says. “We only build that credibility by building predictable performance to our investors.”

As far as the possibility that Lending Club could steal customers from banks such as Sugar River and offer them other products, the BancAlliance deal includes a provision to protect the bank’s customers from getting other offers from the Lending Club.

How Banks Can Profit from SBA Lending


4-7-14-SBA.pngAll community banks are looking for ways to leverage their staff, maximize profit, minimize expense and build flexibility into their loan portfolios.

One effective way to do this is to participate in SBA lending and to use an SBA outsource provider to provide your bank with a simple and cost effective way to offer this product.

The primary SBA lending program, the SBA 7(a) guaranty loan, allows the bank to make small business loans and receive a 75 percent guarantee from the U.S. government. The guaranteed portions of these loans can be sold in the secondary market, with current gain on sale premiums of 13.5 percent net to the bank. So if a bank makes a $1 million SBA loan and sells the $750,000 guaranteed portion, it will generate a premium or fee income of $101,250.

In addition, when the guaranteed portion of an SBA loan is sold, the investor buys the guaranty at a rate that is 1 percent less than the note rate. In this example, if you have a $1 million SBA loan at an interest rate of 6 percent and the bank sells the $750,000 guaranteed piece, the investor buys it at a 1 percent discount off the note rate and receives a yield of 5 percent. This means that the bank will earn 6 percent on the $250,000 portion that they retained and 1 percent on the $750,000 or $7,500 per year, not accounting for amortization of the loan. If you compare that $7,500 per year in servicing income to the $250,000 that the bank retains on its books, you can see that it represents an additional 3 percent yield on the retained portion. That 3 percent of servicing, plus the note rate of 6 percent, shows that the bank’s gross yield on the retained portion of the loan is now 9 percent. This additional yield is something to consider if your bank is competing for a loan with a larger bank that is trying to undercut your bank on pricing. The added servicing income will enable you to maintain your yield even on loans that have lower pricing.

While SBA lending can be very profitable, it should be viewed as more than just a profit center for your bank.

The SBA loan guarantee can be used to refinance existing loans to mitigate risk in your loan portfolio or to help retain clients who are close to the bank’s legal lending limits. Using SBA lending to refinance existing bank loans can be helpful in reducing real estate concentrations since properties like hotels, mini storage facilities and care facilities are included as investment properties by regulators. If a bank has these types of properties on their books, they can often refinance the loan and sell the guaranteed portion to reduce a concentration and free up capital. Using the SBA guaranty to make loans that fall into an investment property category is a good way of managing portfolio concentrations.

Why does SBA outsourcing make sense?
Outsourcing your SBA lending department eliminates the need to allocate resources and budget for an SBA department since there are no upfront or overhead costs associated with it. Outsourcing eliminates the risk of hiring an SBA team and then not generating sufficient loan volume to support the cost of that staff. SBA personnel costs are high, and it can be difficult to find qualified people. Also, without an experienced and dedicated SBA group, your loan officers will typically avoid handling SBA loan applications for fear of dealing with the complex SBA rules and process.

Outsourcing also enables a community bank to acquire, through the outsource provider, an experienced staff, which in turn enables it to provide an accurate and efficient process to its SBA borrowers. An SBA outsource provider can efficiently process, document, close, sell to the secondary market and service your loans. Typically these services charge between 0.6 percent to 2 percent of the loan amount.

Conclusion
In today’s competitive market, the SBA program offers too many profit enhancement and risk mitigation opportunities to simply ignore its value. In order to maximize success, bankers need to have every tool available to them.

Top Three Recommendations for Valuing and Accounting for Acquired Loans


bsns-man-binoculars.jpgAs acquisitions of troubled and failed institutions continue, understanding the accounting for acquired loans is more critical than ever. The most often overlooked area in any transaction is the alignment of internal and external resources with accounting systems to facilitate a smooth transition of recordkeeping for loans—the most significant asset class acquired.

Acquired loans are accounted for at fair value at the date of acquisition, and accounting for those loans going forward presents a multitude of complexities for accounting personnel and senior management responsible for asset quality and financial reporting. Highlighted here are three best practices an acquirer can use to efficiently manage through acquired loan accounting and limit surprises.

1. Valuation Due Diligence

Many acquirers apply generic rules of thumb when valuing an acquired balance sheet and make broad assumptions about how earnings will be affected by valuation adjustments during the due diligence phase. When time permits, as part of the due diligence process, acquirers should perform a preliminary valuation of the loan portfolio being acquired. In a failed-bank acquisition, however, there typically is not sufficient time to conduct this level of valuation. Given the recent slowdown in closings, though, potential acquirers are finding themselves with more time.

In a normal bank transaction, there typically is enough lead time to perform a preliminary valuation since the acquirer has more control over the timing of the transaction closing. By performing a preliminary valuation, management is able to work through vendor selection prior to closing and can align expectations on valuation methodologies and deliverables to eliminate surprises after an acquisition. Third-party audit firms can review overall methodologies and deliverables well in advance of closing.

By doing this dry-run valuation work ahead of time, accounting personnel can start formulating the appropriate accounting policies and gain a deeper understanding of the financial reporting effect of yet-to-be-made accounting policy elections. Well in advance of closing, the bank should determine how best to construct pools of performing and problem loans for efficient accounting going forward, how to effectively align acquired loans into the existing credit monitoring and allowance methodologies, and which loans are most effectively valued and accounted for individually as opposed to pooled.

2. Early Assessment of Capabilities

Acquirers should identify resources that will be needed within the accounting, loan operations and credit administration functions in order to support the appropriate day-to-day application of accounting for the acquired loan. In addition to assessing personnel, acquirers should evaluate existing accounting systems to identify potential weaknesses in facilitating acquired loan accounting going forward. The acquiring institution’s current software vendor should know its system limitations in applying acquired loan accounting, and these discussions should start early in the process.

Acquirers should also address conversion protocols and timelines for a particular acquisition while discussing system capabilities. This assessment and education process should help determine resources and systems needed to perform the accounting going forward. It also will result in more accurate projections of the value of any particular acquisition since information systems and personnel costs can be more accurately forecast by assessing these areas early.

3. Post-Closing Valuation

Acquirers should perform another review of the acquired portfolio prior to providing final data for the loan valuations. This review should allow acquirers to revisit loan grades and take into account changes in collateral value and credit scores following the initial due diligence. Loan grading and collateral values change over time, and given the limited scope for review under due diligence timelines and the potential for credit deterioration or improvement, acquirers should strive to provide the most up-to-date information to be used in valuing the portfolio. Starting off with an accurate set of assumptions will help minimize surprises going forward.

Originally published on April 23, 2012.

Loan Notes: Big Banks Lose Ground


The largest banks trailed the rest of the industry in terms of loan growth in the third quarter compared to the same period a year ago, according to SNL Financial.

Loan growth among the top 25 bank holding companies was just 3.27 percent during the quarter, compared to 4.2 percent for all bank holding companies above $1 billion in assets in the United States.

SNL called it a sign of how competitive the industry has been. The most active lending segments are commercial and industrial, as well as mortgage and housing-related lending. Credit card and auto lending also has been strong.

Among big banks, the leader in loan growth was TD Bank US Holding Co., the U.S. subsidiary of The Toronto-Dominion Bank of Toronto, Canada, which had 16 percent growth. Tied for second place was BB&T Corp. in Winston-Salem, North Carolina, and Discover Financial Services of Riverwoods, Illinois.

Among banks that saw declining loan portfolios were JPMorgan Chase & Co. in New York, Capital One Financial Corp. in McLean, Virginia, and Regions Financial Corp. in Birmingham, Ala.

Bank Assets Loan Growth Y/Y 3Q (%)

JPMorgan Chase & Co.

$2.3 trillion

-2.87

Bank of America Corp.

$2.2 trillion

-4.27

Citigroup

$1.9 trillion

.13

Wells Fargo & Co.

$1.4 trillion

3.27

U.S. Bancorp

$352 billion

7.46

Source: SNL Financial

Groping Toward Mortgage Compensation Rules


cutting-money.jpgRecently the Consumer Financial Protection Bureau (CFPB) issued a set of proposed rules on mortgage loan originations that include restrictions on compensation that will make it difficult for banks to structure bonus plans for their mortgage loan originators.

I wrote about this issue back in May, after the bureau had issued guidance stating that banks are permitted to make contributions to a mortgage loan originator’s 401(k) or some other type of qualified plan out of a profit pool derived from mortgage loan originations. However, the CFPB declined to indicate at the time whether banks could pay bonuses to originators based on the profitability of a pool of mortgage loans as part of a non-qualified incentive compensation plan. The distinction is important because in the case of a qualified plan like a 401(k) we’re talking about an individual’s future retirement income, while with a non-qualified bonus plan we’re talking about cash in their pocket today.

First a little bit of important background. Underlying this issue of mortgage originator bonuses is the focus of federal regulatory agencies—including the CFPB—on so-called compensation risk. During the subprime mortgage boom, originators often received extra compensation if they steered borrowers to higher cost loans, which often meant low-income borrowers paid more for their loans than they should have. The Federal Reserve Board proposed stricter rules on mortgage origination compensation in September 2010 under the Truth in Lending Act. Rulemaking authority for the Act was transferred to the bureau under the Dodd-Frank Act, and now the bureau is finishing what the Fed started.

Mortgage originators aren’t the only bankers impacted by all this attention on compensation risk. Banks are also being forced to change their incentive compensation practices for other kinds of lending activity, including commercial real estate and C&I lending. Generally speaking, the regulators don’t want lenders to be rewarded purely on volume; they want to see bonus payments spread out over a longer period of time than, say, just one quarter; and they want the size of the payout tied to the performance of the underlying loan portfolio over some reasonable period of time so lenders don’t get paid upfront for loans that later go bad. And in the case of mortgage originators, regulators don’t want them to be incentivized to screw their customers by pushing them unwittingly into high cost loans when they would qualify for a cheaper loan.

It was not clear last May whether the CFPB would allow banks to pay its mortgage originators any kind of bonus that wasn’t tied to a qualified plan. “Every bank is trying to do a better job of tying compensation to the profitability of the underlying business,” says Kristine Oliver, vice president at Pearl Meyer & Partners. But the bureau has now issued a proposed rule for non-qualified bonus plans that will make that goal much more difficult. Under the latest proposal, banks may pay employees a bonus derived from a pool of mortgage loans only if three conditions are met:

  • Compensation may not be based on the terms of the loans that were originated, so an employee can’t be rewarded for producing more of one kind of loan versus another.
  • The employee can’t have originated more than five mortgage transactions during the last 12 months.
  • However, if the individual’s transactions exceed five, the bonus pool can based on mortgage revenue limited to 25 or 50 percent of the overall revenue in the pool. The bureau has proposed two percentage cap alternatives, 25 percent and 50 percent.

The proposal does address the concern some people had that branch managers who originate an occasional mortgage might not be allowed to receive a bonus based on the profitability of their branches if the branch’s revenue included, say, points or mortgage origination fees. Now those individuals can receive a bonus even if the branch’s revenue includes some mortgage related revenue.

“The bureau has proposed a diminutive exemption,” says Richard Andreano, Jr., a partner in the Washington, D.C. office of Ballard Spahr LLP. “That would work for [occasional originators] but doesn’t work for someone who does more than five but still doesn’t do a whole lot of originations.” An example might be someone manages a mortgage production office and originates more than five loans a year, but is still a low volume producer compared to their rest of their team, so they don’t qualify for a bonus based on mortgage revenue.

More importantly, the proposed cap on the percentage of mortgage-derived revenue that can be included in a bonus or profit-sharing plan will make it impossible for banks to structure incentive compensation plans that will reward their originators solely on the profitability of their business. To get around the cap, banks will have to enlarge the categories of revenue that bonus payments are based on to include other kinds of loans in the mix. That would make it more of a company-wide incentive plan—especially if the cap is as low as 25 percent—which might be what the regulators prefer, but could be a less powerful incentive than a plan where mortgage originators were the only participants.

“That’s where the bureau wasn’t willing to go,” says Andreano.

Banks and other financial services companies that are impacted by the proposed rules have until Oct. 16 to submit their comments to the CFPB. Dodd-Frank requires the bureau to adopt final mortgage originator rules by Jan. 21, 2013, so banks should expect a final rule by then. Unfortunately, as Oliver points out, “People are starting to pull together their incentive plans for 2013,” so any assumptions they make now—like, for example, will the allowable cap be 25 percent or 50 percent—could be subject to change.

FDIC Lawsuits: Avoiding the Worst Outcome


hard-hat.jpghard-hat.jpghard-hat.jpgIn 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.