Expert Panel: What Mistakes Do Banks Commonly Make?

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Bank Director’s Western Peer Exchange October 24-25 in San Francisco is an inaugural event to get bank leaders west of the Mississippi to engage with each other on the issues that matter most to them, hopefully solving problems at their banks and making connections that can help them well into the future. As Bank Director gets ready for the peer exchange, we asked the experts who plan to attend what advice they could offer on mistakes they see banks make.

If you could correct one mistake you see banks commonly make, what would it be?

Polsky_Barbara.pngDenial. It’s one of the biggest mistakes banks commonly make. Leading up to the recent financial crisis, many banks were in denial about their commercial real estate concentration risks, and then during the financial crisis many banks continued to be in denial about the ever-decreasing value of their other-real-estate-owned (OREO) and real estate loan portfolios. It is true that the lessons from the financial crisis have made banks cautious. But caution is different from denial. Many banks remain in denial about weaknesses in their Bank Secrecy Act policies (a hot issue for their bank regulators) or about the need to bolster noninterest income (a hot issue for their successful competitors) or about their president’s excessive compensation (a hot issue for their activist shareholders). The devil isn’t in the details; the devil is in the denial.

—Barbara S. Polsky, Manatt, Phelps & Phillips, LLP

Hay_Laura.pngConversations about compensation often begin with the question, “What are other banks doing?” rather than, “Given our specific strategy and goals, how can we best structure our programs to motivate the right behaviors and drive performance?” Our firm encourages clients to look to their compensation strategy first. High-performing banks are often characterized by clear, straightforward compensation programs based on a strong compensation philosophy that drives business results. Knowing what other banks are doing through competitive data then helps to generate ideas, establish pay levels and provides a reference point for ensuring your pay designs are within the bounds of market practices.

—Laura Hay, Pearl Meyer & Partners

Nachand_Gabe.pngA common mistake among community banks is assuming the implementation of an enterprise risk management (ERM) process is an expensive proposition that lacks the benefits to warrant the cost. Certainly there are a number of expensive software solutions that provide the sticker shock to warrant this concern; but, the reality is most community banks are embarking on the ERM implementation path without using purchased software. We estimate that 80 percent of what is needed for an ERM program already exists at your institution. So banks are supplementing existing processes and procedures with a risk committee comprised of members across the organization, considering all potential risks—not just those in traditional risk assessments, and developing reporting for the board that is easily understood, timely and responsive to the bank’s significant and emerging risks.

—B. Gabe Nachand, Moss Adams LLP

Hovde_Steve.pngBankers are conservative by nature, and the credit crisis served as a stark reminder why they should be. Still, many banks—particularly smaller, community banks—are reluctant to take advantage of strategic opportunities that could significantly enhance shareholder value. FDIC-assisted transactions have been one of the most sure-fire ways to boost size, income, and franchise value during the downturn, yet we generally see the same large, serial acquirers taking advantage of these deals. In addition, there is no better time to be an acquirer than right now, when valuations are near all-time lows. Undoubtedly, larger banks command significant valuation premiums today, so growing the balance sheet and broadening a bank’s footprint through strategic acquisitions or effecting a strategic merger should be discussed seriously between management and the board. Too many healthy banks are content to sit on the sidelines without taking advantage of this unique period in banking.

—Steven D. Hovde, Hovde Group, LLC

Foreclosed Properties: What is a Board to Do?

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bank-owned.jpgIn the wake of the recent (and in some markets, ongoing) real estate downturn, many banks are saddled with levels of other real estate owned, frequently referred to as OREO, well in excess of historically normal levels. The strongest banks have been able to deal with OREO issues very easily—by simply selling the properties at the highest prices reasonably possible—but many banks, even banks that inherited OREO through FDIC-assisted acquisitions, need a strategy for dealing with the OREO on their books.  Certain recent actions by regulators (including the Federal Reserve’s recent guidance regarding rental of OREO properties) and other public and private parties underscore the need for a systematic and organized approach to addressing OREO disposition and exposure to liability for properties that remain on the books. The focus of this article is to provide some high level keys to developing and implementing a strategy from the board level down.

Why It’s Important to Get Rid of Bank-Owned Properties

At the outset, it is important to understand why OREO is referred to as a “toxic” asset. In all but the rarest of scenarios, OREO will be deemed a “substandard” asset, which impacts the regulatory standing of the bank. The assets are very expensive to maintain and also expose a bank to a variety of liabilities, as discussed below. Therefore, the end result of any OREO strategy should be to dispose of the asset as soon as reasonably possible. In a depressed real estate market, this strategy goes against the nature of many bankers and bank directors, which generally do not view selling an asset in a depressed market as a good decision, but we have seen time and time again that disposition is the most effective strategy.

We recognize, however, that disposing of OREO is not as easy as it sounds in many markets. For example, there are simply no buyers for certain OREO properties in some markets. Notwithstanding the willingness and ability of a bank to sell the property (or, in some cases, to give it away), there may be no counterparty to take the property. Second, for banks with capital constraints, the bank may not be in a position to absorb the losses associated with disposing of the asset in the current market. As a result, it is important to implement measures to mitigate the bank’s potential liability while the OREO is on the books.

Development of an OREO strategy, particularly one that involves holding certain properties for a period of time, has become increasingly complex as a result of recent industry developments. On one hand, a large financial institution was recently fined by a local court because a piece of property held by the bank was being used as a methamphetamine lab (clearly without the bank’s knowledge), and we are aware of other situations in which a bank has been sued as a result of wrongful acts committed by a third party on its properties. These situations would obviously lead a director to believe that a bank should be very active in ensuring that its OREO properties are in the best condition possible. On the other hand, the FDIC, acting as receiver for Omni Bank, N.A., sued certain former officers for Omni for investing too much in the rehabilitation of its OREO properties, alleging corporate waste that rose to the level of gross negligence.  Layered on top of all of this is the Federal Reserve’s recent guidance that indicates that holding and renting residential OREO can be part of a reasonable disposition strategy.

Given the complicated landscape for dealing with bank-owned properties, we recommend adopting and implementing a board-level policy. This policy will ensure that management understands the guidelines for dealing with OREO in accordance with the bank’s overall strategy.  It will also ensure that the board has business judgment protection should anyone question the bank’s handling of OREO. A strategy and policy should incorporate the following components:

Conduct a present value calculation.  Management should prepare a present value calculation that compares disposing of the property (or group of properties) as soon as possible to holding the property for a more extended period of time.  The analysis should be based upon reasonable assumptions and should incorporate all direct and indirect holding costs of the OREO. From this calculation, management can determine the disposal strategy.

Mitigate risk.  Obtain appropriate insurance for all reasonable risk associated with the property. Have your insurance policy reviewed by a competent insurance broker or attorney.  If the bank is acquiring new property, assign the loan to a special purpose subsidiary to isolate the risks of holding the property to the extent possible.

Place reasonable limits on improvements.  As made clear in the Omni case referenced above, there is a level of investment in bank-owned property for the purpose of preparing it for sale that will be criticized by regulators. While banks can take reasonable steps to improve property to increase its marketability, management should analyze the return on investment in improvements. The bank should not enter into the development business.

Let the professionals handle it.  If a decision is made to continue to hold property for income production, be aware of additional laws that may apply, particularly landlord-tenant laws. In many cases, it will make sense to engage a property management company familiar with these laws to handle the management of the property. A written policy should set forth approved property managers, and the bank should provide appropriate oversight.

Think at a high level.  It is often easy to fall into the trap of deferring a loss because it appears that a property could yield a better return after a holding period. However, decisions to continue to hold property should be made in accordance with an overall strategy, the focus of which should generally be to liquidate as soon as feasible. The old maxim continues to apply: The first loss is usually the best loss.

Management of elevated levels of OREO is never easy for a bank, particularly in light of the current depressed market conditions.  However, with a systematic approach to addressing OREO, banks can avoid taking more of a loss than they must and can get back to the business of banking.