Preparing Your Bank for Sale

bank-sale-2-18-16.pngIf your board is considering a sale of the institution, you’re not ready to sell if you’re not prepared to sell. There are a variety of issues that your board will need to consider if it wants to maximize the value of the bank’s franchise in a sale. Many, although not all of these considerations, involve the bank’s balance sheet. Other important issues include cutting overhead costs and dealing with regulatory compliance issues. Sal Inserra, an Atlanta-based partner for the accounting and consulting firm Crowe Horwath LLP, offered the following advice to Bank Director Editor in Chief Jack Milligan.

Take a hard look at impaired loans on your balance sheet.
When bank executives consider a sale and analyze the loan portfolio, they are not always looking at it from the perspective of a potential buyer. If there’s a problem customer, they have a sense of the potential collection on that impaired loan. When buyers come in cold, they don’t have that history. They are doing an antiseptic review. It is numbers on a page that lead to a conclusion. They’re not going to accept the backstory as a reason why they should pay more for the loan than they think they should. If you have another appraisal in hand that shows the value higher, they may give credence to that, but not as it relates to the sob story. From the buyer’s perspective, if a loan is leveraged with 100 percent loan-to-value with a five-year life, the prospective buyer will require accretion yield of 9 percent to be attractive given the risk. If the coupon on that loan is only 5 percent, the buyer is only going to pay 75 cents on the dollar to achieve their yield. You have to get past the subjective analysis and get more objective detail about that impaired loan. You need to get the most current financial information possible about that impaired loan and the borrower.

Avoid bad leverage transactions as much as possible.
A bad leverage transaction sometimes occurs when the bank has excess deposits and invests in securities of different durations in an attempt to leverage the capital in the financial institution. Depending on how far out into the future the bank is leveraged, it could end up in a bad position where the assets are at a fixed rate, and the liabilities are at a variable rate. And because the bank is maximizing yield, as liabilities start creeping up, net interest margin can erode rather quickly. In the current market, unless the bank wants to go out four or five years or more on a bond and take some credit risk in something other than a U.S. Treasury security, the bank is going to have a pretty narrow net interest margin. Rather than buy low-earning securities, you might benefit your bank’s value by waiting for a buyer with a high loan-to-deposit ratio that needs additional funding. If the seller has excess funding that hasn’t been tied up, that could be a very lucrative purchase to a bank that needs the funding. But once the seller has tied that funding up in something with a narrow net interest margin, the buyer will have to unwind that in order to get value. And if the buyer has to take a hit to unwind that investment, it’s going to impact the seller’s value.

Manage excess capital on the balance sheet.
This is really about how you spin the story of selling the bank. Let’s say you have $50 million in capital. So if you sell for two times book value, you would get $100 million. But of that $50 million, let’s say that $10 million has not been deployed, so you’re not going to get two times $50 million. You’re going to get 1.60 times $50 million, which is $80 million. However, if the bank gets rid of that $10 million in excess capital by paying it out in dividends, it will receive $70 million, but because it is now working off a $40 million base, the bank reports a higher premium. Net cash is still $80 million when you consider the dividend.

Another approach would be to try to leverage up that excess capital. Where you may have turned down a loan before because the pricing wasn’t good, but it was still going to create a good margin and a decent return on investment, the bank may want to invest in the loan because at least it becomes an earning asset. This strategy will depend on what is available in the market.

Shed costly assets or debt before attempting to sell the bank.
Since the value of the bank is based on future earnings, if the bank is carrying some high cost debt, it’s going to impact future margins. Or if the bank has low yielding assets, that’s going to affect future margins. When buyers come in to price those assets and liabilities, they’re going to knock down the value of the bank. Most high cost debt has a prepayment penalty associated with it, so there’s a net cost to get out of that debt. But when it comes to low yielding assets, the bank can maximize net interest margin by getting rid of assets that are going to cause issues for future earnings.

Focus on cost control prior to a sale.
When it comes to cost control, the first thing to look at is the branch network. It’s no secret that branch activity continues to decrease as folks get more and more comfortable with digital banking. I love [author Brett King’s motto], “Banking is no longer somewhere you go, it’s something you do.” And the value of a seller’s branch network may be going down because the cost of maintaining those branches is still significant, not only from a hard cost standpoint but also with training staff, marketing and all the other costs of operating a branch. So take a hard look at those branches that buyers are going to consider exiting. If the bank can start narrowing those costs by closing some of those marginal branches, so that the buyer can see what the run rate is going forward, that will help improve value because the value is going to be driven on the multiple of future earnings.

The other thing I would focus on is staffing. A lot of banks have made big strides in technology, but they haven’t reevaluated their head counts. And they need to do a review of what is necessary to operate and deliver service. A phrase I hear a lot is, “We’re not going to change our head count, we’re going to grow into it.” And that doesn’t necessarily work because as you grow, it doesn’t mean the resources are going to be able to continue to help you get to the next level. So doing a critical analysis of head count is key. Those are the two major variables—branches and people—that when addressed can help you improve your efficiency.

Avoid entering into long-term contracts if you’re considering a sale.
The thing that just makes me scratch my head is when a board is thinking about selling the bank and a year before it pulls the trigger, it enters into a four- or five-year core processing contract. The cost associated with exiting a core processing contract, unless it happens to be the same company that they buyer uses, is incredible. I’ve seen millions of dollars spent to exit a core processing contract.

Factor regulatory compliance issues in a potential sale.
If the bank knows its potential acquirers, it knows its potential new regulators. The key issue is making sure that regulator knows the seller has its compliance house in order. The seller can put together an in-house review or use external resources to address the issues of that potential regulator. If I’m a $2 billion asset bank and it’s likely that I’m going to become part of an institution that’s over $10 billion in assets, I need to be focused on issues that the Consumer Financial Protection Bureau is focused on, because I know that my portfolio is going to be subject to a CFPB review. If I’m a $200 million asset bank and I’m going to merge into bank that’s in the $2 billion to $3 billion range, that may present a higher level of scrutiny. So knowing my potential acquirer allows for adequate preparation.

What’s More Important—Size or Profitability?

scale-12-9-15.pngDoes size matter in banking? Many senior bank executives and directors plainly think that it does, based on the results of Bank Director’s 2016 Bank M&A Survey. Sixty-seven percent of the survey respondents said they believe their banks need to grow significantly larger to stay competitive in today’s more highly concentrated marketplace, and about a third of them say their institutions need to get to at least $1 billion in assets.

I struggle with this logic because there is nothing that is necessarily magical about size per se—and particularly a specific number like $1 billion—that makes it more likely that a bank will be able to attain an acceptable level of profitability. The argument you frequently hear is that scale helps you spread your compliance costs—which have gone up precipitously in recent years—over a larger base. It also makes it easier to afford the kind of technological investments that are necessary to stay competitive in a marketplace where consumers and small businesses are using digital and mobile channels in increasing numbers. Both rationales have some basis in fact, but I wonder how many boards of directors have actually put their banks up for sale solely because they couldn’t afford the costs of regulatory compliance and/or technology upgrades. I think not very many.

One of banking’s most persistent problems in recent years has been a low interest rate environment that has compressed net interest margins across the industry and made it difficult to grow both top line revenue and bottom line profits. And herein, I believe, lays the rationale for many of the acquisitions that we have seen in recent years. Perhaps by getting bigger, many CEOs and their boards think they can become more profitable—but that doesn’t just happen ipso facto. Almost always, there’s vital post-acquisition work that needs to be done, such as cutting duplicate administrative costs, rationalizing overlapping branch networks, or deploying one of the merger partners’ expertise in a particular area to the other partners’ untapped market.

Gaining scale can increase a bank’s profits in an absolute sense, but not necessarily its profitability. Profit is the actual amount of earnings that a bank makes for a particular reporting period, while its profitability is what it makes relative to its asset base (return on assets) or market capitalization (return on equity). I believe that profitability is the better yardstick with which to judge the effectiveness of a management team and board of directors because it measures how well they did with what they had to work with. And behind every successful acquisition is, I believe, a strategy for how to increase the combined bank’s profitability rather than its absolute profits.

I really don’t consider doing an acquisition to be a “strategy” per se. An M&A transaction is exactly that—a transaction. This might seem like an overly nuanced point, but “strategy” is what the acquirer intends to do with its prize after the deal closes. How does the acquirer use its new, larger platform to increase its profitability? In fact, I would go so far as to say that if the acquirer’s ROA and (if it is a public company) ROE don’t improve materially within 18 months of the deal’s closing date, than the acquisition has probably failed to live up to its potential even if the bank’s net income is higher. 

Strategy is so important, in fact, that many highly successful banks avoid the M&A game altogether and focus all of their efforts on organic growth, which is rarely achieved and sustained without a well-conceived plan for how to make it happen. I don’t discount the fact that regulatory compliance and technology costs have gone up significantly in recent years, but growth through acquisition needs to be done with a larger purpose behind it than just getting bigger.

The State of Risk: 2013 Risk Practices Survey

3-22-13_Risk_Web_Story.pngIt may not be a surprise to most bankers, but keeping up with regulatory changes was cited as a top risk management challenge by 72 percent of risk officers and 69 percent of bank board members in a recent survey conducted by Bank Director and Wolters Kluwer Financial Services, a consulting firm focused on risk management and regulatory compliance.

“If you take a look at just what happened in the month of January with the regulations that [the] CFPB [Consumer Financial Protection Bureau] issued,” says Timothy Burniston, vice president and senior director of the risk and compliance consulting practice at Wolters Kluwer, “there were a number of separate rulemakings that were released in final form that are going to have an effect on institutions.”

The 2013 Risk Practices Survey was completed by a group of risk officers and board members at banks over $5 billion in assets through January of this year.

Sixty-one percent of risk officers and 41 percent of directors also revealed that maintaining the technology and data structure to support risk decision-making is a challenge.  “The sustainability of the technology products that exist in the marketplace is not very high,” says John Fleshood, executive vice president, risk management at $17.5-billion asset Wintrust Financial Corp., a financial services holding company headquartered in Rosemont, Illinois.

Ninety percent of risk officers and 75 percent of directors reported that their banks either have or are in the process of creating an enterprise risk management program.  Fifty-six percent of risk officers and 38 percent of directors cited regulatory requirements as one of the primary reasons their bank invested in an enterprise risk management program.

The top reason cited by risk officers for this investment, at 61 percent, was to ensure consistent, solid performance.

Directors seem more concerned with ensuring success of the bank’s strategic direction (50 percent) and developing a governance system that sets the tone from the top (41 percent).  “As a director, that’s the kind of view of the organization that I would want to have,” says Burniston.  “I would want to make sure that I understand what’s going on in every critical area that presents risk to my institution, and for management to be in a position to explain the interconnectivity, the relationships between those risks, [and] how the organization holistically is taking a look at it.”

When asked about the biggest challenges in supporting an enterprise risk management program, 61 percent of risk officers cited collecting, analyzing and reporting risk data as a top concern. Fifty percent cited creation of a risk culture, in which employees are motivated to own and manage risk, as a key concern.  “Ultimately what you want from a risk management program is that you have [everyone in] your organization thinking about risk in their daily job and how it affects their daily job,” says Phil Gaglia, chief risk officer of First Interstate BancSystem Inc., a $7-billion financial holding company based in Billings, Montana.

When asked about specific risk categories, operational risk is the top concern of both risk officers, at 83 percent, and directors, at 56 percent.  Christina Speh, director of new markets and compliance strategy in the risk and consulting practice at Wolters Kluwer, is glad to see this focus on operational risk, as it was not a focus for banks in the past but caused a lot of problems in the industry over the last several years.  The breakdown in the mortgage industry was a breakdown on the operational side, says Speh.  “The compliance processes had been set, and the financial requirements were being followed, what happened was a breakdown in the operations,” she says, “and many of the settlement requirements required the operational breakdowns to be fixed.”

Despite the challenges, both directors and risk officers expressed a high level of confidence in their bank’s ability to manage risk across all lines of business, with 91 percent of directors and 89 percent of risk officers identifying themselves as very confident or confident.  None of the respondents expressed a negative view on their bank’s ability to manage risk.  When directors were asked to rate the bank management team’s ability to identify, manage and control potential risks to the bank, 91 percent of directors rated their management team’s work in this area as excellent or good.

As to the board’s role in risk management, risk officers appear to be fairly confident in the abilities of their directors.  Eighty-three percent of risk officers rated their board’s ability to understand and interpret risk data as excellent or good. Perhaps this confidence level is understandable, as both groups indicate that, over the last three years, boards are devoting more time to risk management issues, with all risk officers and 91 percent of directors reporting an increase.  Pressure on banks brought about by regulatory changes as well as other issues has caused risk management to get more board-level attention.  “The attention to risk management has been fairly high even preceding the financial crisis, but we learned a lot of things going through that process,” says James Bork, senior banking compliance analyst at Wolters Kluwer.  Regulatory change has been a part of that education.  “I think it has raised awareness on the part of directors to the many ways that risk can infiltrate an organization,” he says.

“[Directors are] asking questions that they weren’t asking several years ago,” says Burniston, “which shows that they are definitely tuned in to the need to make sure that they’re on top of risk in their institutions. “

Download the summary results for Directors in PDF format.

Download the summary results for Risk Managers in PDF format.

Bank Director surveyed in January risk officers and members of the board of directors with $5 billion or more in assets, using two similar but separate surveys.  Nineteen respondents were risk officers and 32 were directors. 

Banking Panel: Top Challenges in 2013

Everybody in banking knows this by now. Banks have been hit with an onslaught of new regulations right when low interest rates are continuing to erode profitability. But what will happen in 2013? Experts who will speak at Bank Director’s upcoming April Bank Chairman/CEO Peer Exchange say what they think boards will be dealing with next year.

 “What is the top strategic challenge facing bank CEOs, chairmen and their boards in 2013?”

Brown_Scott.jpgThe greatest challenge to CEOs, chairmen and their boards will be how to generate acceptable returns to shareholders in the face of ever-growing compliance concerns and a continued sluggish economy with high unemployment and historically low interest rates.  Without an administration change, 2013 promises to continue increasing and more stringent banking supervision and additional regulation, including consumer compliance initiatives and aggressive enforcement from the Consumer Financial Protection Bureau and new capital requirements from Basel III.  This will not only impact decisions on day-to-day operations and planning but also shape thinking on mergers and acquisitions  activity and the raising of capital.  Specifically, if new capital rules are adopted, boards will need to explore the availability of capital, and whether capital can be raised at satisfactory pricing levels.

— Scott Brown, Kilpatrick Townsend & Stockton LLP

Boehmer_David.jpgTalent. There is a shifting environment of constant change that is the new normal for how all businesses operate. Pressure is intensifying—from regulators to creative innovators who are bucking the traditional banking models trying to influence change.  Bottom line, CEOs need to have the right talent in place to lead effectively—not only to confront the current challenges, but to create an organization with a connected culture to be the bank of the future.

— David Boehmer, Heidrick & Struggles

Plotkin_Ben.jpgThe top challenge is that banks cannot earn their cost of capital in today’s environment.  The combination of higher capital requirements, margin pressure due to extraordinarily low rates, slow economic growth and cost pressures associated with regulation translates into inadequate returns for shareholders.  A CEO’s job is to outperform peers in this environment while making investors realize that these challenges will not last forever.  In the event that a bank can’t operate more effectively than its peers, it is the CEO’s responsibility to his/her board to face that reality and proactively explore exit opportunities.

— Ben A. Plotkin,Stifel, Nicolaus & Company and Stifel Financial Corporation

Bronstein_Gary.jpgNotwithstanding the difficult business climate and the continuing economic challenges facing the banking industry today, the regulatory burden is the top strategic challenge facing bank management and boards today. While the reelection of Obama results in some certainty that the barrage of new regulations will continue, there continues to be considerable uncertainty. For example, what will the creation of the CFPB mean for community banks not directly regulated by the CFPB? What will happen with Basell III? Regulatory costs are also a significant factor when considering the optimal asset size to best leverage today’s cost of doing business.  

— Gary Bronstein, Kilpatrick Townsend & Stockton LLP

Regulatory Fatigue Syndrome: Identifying the Symptoms and Treating the Patient

Rx.jpgDuring the annual Bank Director Bank Executive & Board Compensation conference that was held recently in Chicago, Illinois, peer exchange sessions revealed that board members and executives alike are struggling to keep pace with an industry that continues to change. 

In the directors’ peer exchange meetings, directors often said that trying to keep up with the changing regulatory environment is as distracting as it is fatiguing. 

This year’s conference seemed focused on the stabilizing market, and from a director’s standpoint, establishing best practices for approving, monitoring and maintaining appropriate compensation programs, rather than on technical updates as in years past. While all this can make you feel like you’re battling the flu—proper “diagnosis and treatment” can help directors through this malady.

Symptoms of Regulatory Fatigue Syndrome

1. Blurry vision from prolonged reading of legislation, proposed regulations, guidance and advisor mailings.

2. Frequent headaches from balancing the need to eliminate risk in compensation programs to appease regulators while at the same time trying to increase the connection between pay and performance to appease institutional investors—though in many respects they can be diametrically opposed.

3. Intermittent nausea from endless board meetings that move from one regulatory issue to the next with little time for the consideration of strategic business issues.

4. General fatigue from worrying about missing one or more of the many new regulations that may or may not yet be effective.


1. Focus on current rules. Be aware of and consider proposed rulemaking, but specifically address rules that are in effect or issues that are before you today.  For example, is the bank subject to TARP or its legacy constraints? Is the bank in troubled condition and subject to the compensation limitations of Rule 359? Has the bank taken steps to implement the principles of the Guidance on Sound Incentive Compensation? Has the bank reviewed its compensation programs for its mortgage lenders, or does the bank need to publicly address a “no” vote recommendation from Institutional Shareholder Services or a bad result on a say on pay vote?

2. Review your charter. Review your compensation committee charter to ensure that your charter addresses the duties that are required of your committee based on current law. Your charter should reflect the committee’s duty to assess risk in your compensation programs and should provide for authority and funding to hire independent advisors.  Consider a committee checklist that will track the duties outlined in the charter in order to help ensure that the committee addresses each of its tasks at some time during each year.

3. Rely on your advisors. Work with your advisors to understand what regulatory changes may be coming and rely on them to let you know when you need to focus on each of the new rules. For example, do you need to deal with claw-back policies, CEO pay vs. performance disclosure, the CEO pay ratio relative to employee median pay disclosure, the compensation committee member and advisor independence requirements, or mortgage lender pay practices? 

4. Understand that risk mitigation is scalable. When trying to decipher all of the possible plan changes that might help manage, mitigate or eliminate risks, you should be mindful that the actions you take can be relative to the size and complexity of your bank and its compensation plans.  The actions taken by a $50-billion bank with complex plans are not necessarily the same that will be taken by a $1-billion bank with less complex and understandable compensation programs.  Many good practices will trickle down from the more complex organizations, but the risks are different, so your actions should be different as well.

5. Focus on establishing good procedures. Make sure you have good internal controls in place with respect to your compensation plans and that your senior risk officer is involved in the plans’ development and management. Your compensation committee should understand how the plans work, what the associated risks may be, and if changes should be made. The committee does not need to manage the plans (unless they apply to proxy officers), but they need to understand and manage the risks presented.

Certainly, this is a tongue-in-cheek approach, but fundamentally the advice is sound. Though there are many moving parts with the regulation of bank compensation practices, they can be addressed and understood by taking them one step at a time.  The old adage that “inch by inch life’s a cinch, but yard by yard it’s very hard” holds very true in trying to digest the multitude of compensation governance influences and constraints.

Part I: Built to Last – Compliance Lessons from the Construction Industry

House_Ruler.jpgIf you’ve ever observed a house being built, you’ve no doubt been struck by the way that millions of details must all come together to form a habitable dwelling. One board out of place or a line that’s not level can wreak havoc and doom a structure that may have stood for centuries. An overlooked element can mean the difference between passing or failing a required inspection. The devil, as they say, is in the details. 

Similarly, details are the devils of the compliance realm. There are literally tens of thousands of details to consider in ensuring compliance. Just like building a house, it takes careful design and planning, timely and well-coordinated execution and attention to detail to build an effective compliance program. Just as building codes dictate there is a right way to build a house—there is a right way to build a compliance program and passing examinations means making sure your program is up to code. 

I’ve been privileged to work alongside some of the industry’s finest minds during my career as a banker, examiner and consultant. Together, we’ve observed common themes among compliance programs that succeed and those that don’t. So, what do the most effective programs have in common? How are they similar to construction projects? 

They have a blueprint, a foundation, and a framework—ensuring consistency across the organization and all regulatory requirements.  

The Blueprint
When contractors (or board members) are charged with oversight, if a clear blueprint is not in place from the beginning, it can be difficult to keep up with change. Remember the wise adage “measure twice, cut once?” With a daunting number of compliance details and no strategic plan, it’s easy to fall into the trap of having a series of tasks but no one looking at the big picture, thus compromising the program.

When designing a compliance program blueprint, it’s important to identify different types of risk: credit, operational, market, legal and reputational. However, risks do not occur independently from each other. Most activities encompass all risks in some form or fashion. For this reason, regulators are starting to take a holistic approach in their examinations. They want to break down the silo perception of risk—because risks rarely fit into just one bucket or another. Since oversight is integral to a financial institution’s overall success, board members need to be sure that everyone is doing their part to ensure that the blueprint is being followed.

The Foundation
A durable building starts with a sound foundation, designed to prevent structural risks. Periodic maintenance is required to ensure that the structure does not become compromised. If flaws are noted, they must be addressed to prevent further deterioration. 

In the world of compliance, a sound foundation is built by establishing a chain of responsibility and a standardization of process. Maintenance, in the form of periodic reports, ensures that the program does not become compromised and any weaknesses are addressed. A defined hierarchy of accountability and standardization increases visibility, minimizes risk exposure and ensures an institution is running efficiently.  

The Framework
After the foundation is laid, four walls and roof are constructed to ensure a sturdy building. On top of the compliance program’s foundation of accountability and standards, a well designed controls environment needs to be built. The “building code” for this framework includes risk assessments, policies, procedures, monitoring and audits. 

Well-run compliance programs incorporate these controls across all key areas of compliance oversight. By focusing on what’s the same about every implementation (i.e., the process, the blueprint, the framework, the controls) an institution can cut its overall workload, costs and frustrations for the compliance program. 

The Inspections
How can you inspect a structure, or your compliance program, in the absence of the foundation and framework? Without standards for building foundations, they’d collapse, crack with frost, fail to shed water, be unable to bear the necessary weight, etc. It takes a plan, the blueprint, to lay the foundation and build the framework providing the well-run compliance program an accountable standard. Built to this standard, we can evaluate adherence and gain comfort knowing that things were done right.

Using lessons learned from the construction industry, financial institutions can maintain compliance accuracy, efficiency and effectiveness. Applying these principles, you can administer your compliance program with less worry, less conflict and at a lower cost than traditional methods will allow. In our next installment in this series, we’ll discuss how to maintain your compliance “house” through effective reporting and oversight.