Consolidation in the banking industry is heating up. Regulatory compliance costs, declining economies of scale, tiny net interest margins, shareholder liquidity demands, concerns about possible changes in tax laws and succession planning continue driving acquisitions for strategic growth.
Unlike many industries, where the signing and closing of an acquisition agreement may be nearly simultaneous, the execution of a definitive acquisition agreement in the bank space is really just the beginning of the acquisition process. Once the definitive agreement is executed, the parties begin compiling the information necessary to complete the regulatory applications that must be submitted to the appropriate state and federal bank regulatory agencies. Upon receipt and a quick review of a filed application, the agencies send an acknowledgement letter and likely a request for additional information. The comprehensive review begins under the relevant statutory factors and criteria found in the Bank Merger Act, Bank Holding Company Act or other relevant statutes or regulations. Formal review generally takes 30 to 60 days after an application is “complete.”
The process specifically considers, among other things: (1) competitive factors; (2) the financial and managerial resources and future prospects of the company or companies and the banks concerned; (3) the supervisory records of the financial institutions involved; (4) the convenience and needs of the communities to be served and the banks’ Community Reinvestment Act (CRA) records; (5) the effectiveness of the banks in combating money laundering activities; and (6) the extent to which a proposal would result in greater or more concentrated risks to the stability of the United States banking or financial system.
During this process, the applicant and regulator will exchange questions, answers, and clarifications back and forth in order to satisfy the applicable statutory factors or decision criteria towards final approval of the transaction. Each of the requests for additional information and clarifications are focused on making sure that the application record is complete. Just because information or documents are shared during the course of the supervisory process does not mean that the same information or documents will not be requested during the application process. The discussions and review of materials during the supervisory process is separate from the “application record,” so it helps bank management teams to be prepared to reproduce information already shared with the supervisory teams. A best practice for banks is to document what happens during the supervisory process so they have it handy in case something specific is re-requested as part of an application.
Recently, we consistently received a number of requests for additional information that include questions not otherwise included in the standard application forms. Below, we review four of the more common requests.
1. Impact of the Covid-19 Pandemic. Regulators are requesting additional information focused on the impact of the coronavirus pandemic. Both state and federal regulators are requesting a statement on the impact of the Covid-19 pandemic that discusses the impact on capital, asset quality, earnings, liquidity and the local economy. State and federal agencies are including a request to discuss trends in delinquency loan modifications and problem loans when reviewing the impact on asset quality, and an estimate for the volume of temporary surge deposits when reviewing the impact on liquidity.
2. Additional, Specific Financial Information. Beyond the traditional pro forma balance sheets and income statements that banks are accustomed to providing as part of the application process, we are receiving rather extensive requests for additional financial information and clarifications. Two specific requests are particular noteworthy. First, a request for financial information around potential stress scenarios, which we are receiving for acquirors and transactions of all sizes.
Second, and almost as a bolt-on to the stress scenario discussion, are the requests related to capital planning. These questions focus on the acquiror’s plan where financial targets are not met or the need to raise capital arises due to a stressed environment. While not actually asking for a capital plan, the agencies have not been disappointed to receive one in response to this line of inquiry.
3. List of Shareholders. Regardless of whether the banks indicate potential changes in the ownership structure of an acquiror or whether the consideration is entirely cash from the acquiror, agencies (most commonly the Federal Reserve), are requesting a pro forma shareholder listing for the acquiror. Specifically, this shareholder listing should break out those shareholders acting in concert that will own, control, or hold with power to vote 5% or more of an acquiring BHC. Consider this an opportunity for both the acquiror and the Federal Reserve to make sure control filings related to the acquiror are up to date.
4. Integration. Finally, requests for additional information from acquirors have consistently included a request for a discussion on integration of the target, beyond the traditional due diligence line of inquiry included in the application form. The questions focus on how the acquiror will effectively oversee the integration of the target, given the increase in assets size. Acquirors are expected to include a discussion of plan’s to bolster key risk management functions, internal controls, and policies and procedures. Again, we are receiving this request regardless of the size of the acquiror, target or transaction, even in cases where the target is less than 10% of the size of the acquiror.
These are four of the more common requests for additional information that we have encountered as deal activity heats up. As consolidation advances and more banks file applications, staff at the state and federal agencies may take longer to review and respond to applications matters. We see these common requests above as an opportunity to provide more material in the initial phase of the application process, in order to shorten the review timeframe and back and forth as much as possible. In any event, acquirors should be prepared to respond to these requests as part of navigating the regulatory process post-signing.
Recent trends indicate that many bankers are considering adding significant scale by targeting peer institutions for outright acquisition.
These transactions, which we call “peer mergers,” are comparable to so-called “merger of equals,” except that the management team, operational structure and culture of the acquiring institution will mostly remain the same for the combined institution. This avoids the most obvious difficulty with successfully executing a merger of equals: combining two institutions without one side of the equation feeling “less equal” than the other. Peer mergers still carry plenty of their own risks, but keeping the management team and operational structure mostly intact is appealing and can greatly reduce the need to cut redundancies post-merger by eliminating them at the outset. Here are three key concepts to keep in mind when considering such a merger.
Choose a Good Strategic Fit
Why are we doing this deal? Will we be solving challenges or creating new ones? Is the combined institution greater than the sum of its parts?
Choosing to do a peer merger may be as straightforward as needing to add scale. However, banks desiring scale to fortify their balance sheet and gain operational and regulatory efficiencies may find that the wrong partner creates more headaches than it solves. Long-term solutions may be more difficult to manage at a larger combined institution, especially if there is a significant clash in cultures. In most cases, identifying a target needs to be about more than just scale. Does the merger gain entry into high-growth markets, meaningfully diversify credit risk, add complementary products and teams, or create significant synergies and efficiencies? Does your bank need to merge in order to accomplish those goals, or are there simpler, cleaner alternatives?
Get Ahead of Challenges
What are the challenges posed by the merger? How can those challenges be addressed? How quickly can those challenges be overcome?
We always recommend to our clients to be as proactive as possible about identifying and solving issues as early as they can in the acquisition negotiation process. This is even more true in a peer merger, where the consequences of a miscalculation are amplified by the transaction’s scale. The merger agreement doesn’t need to be signed to start this process. In fact, addressing issues prior to execution may very well reveal even deeper problems than due diligence would have otherwise shown, and allow for solutions or protections to be negotiated into the merger agreement. Especially try to hammer out the compensation of the potentially retained management personnel as early as possible; you don’t want to find out post-signing that key personnel aren’t as keen on staying with the combined institution as you’d thought — especially if that would trigger change in control payments.
Look Down the Road
What are our long-term strategic goals, and how does the merger get us closer to them? What will the combined institution look like 3 to 5 years from now? How does this benefit our shareholders?
Forecasting what the combined institution will look like in the long term involves much more than looking at pro formas and financial projections. Will your operational structure be able to handle the combined institution’s business volume at closing? Will it be able to five years down the road without a difficult and expensive overhaul? Will you be operating in your target markets, or will further geographic growth be needed and how will you achieve it? Will you cross asset size thresholds that trigger more onerous regulatory oversight in the near future?
Another important consideration is the impact on your shareholders — both the old and the new. Consider how you will give your shareholders the ability to cash out their investments. Will you conduct stock buybacks? Is a public listing on the table? Do you give target shareholders the opportunity to cash out at closing?
Both the potential benefits and risks of a typical merger are magnified in a peer merger, due to the scale of the transaction. With extensive strategic and operational foresight and careful navigation of the potential pitfalls, peer mergers offer a way to quickly add scale and supercharge your bank.
Acquiring another bank will be one of the most important decisions that a board of directors ever makes. A well-played acquisition can be a transformational event for a bank, strengthening its market presence or expanding it into new markets, and enhancing its profitability.
But an acquisition is not without risk, and a poorly conceived or poorly executed transaction could also result in a significant setback for your bank. Failing to deliver on promises that have been made to the bank’s shareholders and other stakeholders could preclude you from making additional acquisitions in the future. Banking is a consolidating industry, and acquisitive banks earn the opportunity to participate one deal at a time.
When a board is considering a potential acquisition, there are five critical assessments of the target institution that it should make.
When you are acquiring a bank, you’re getting more than just a balance sheet and branches; you’re also acquiring talent, and it is critical that you assess the quality of that asset. If your bank has a more expansive product set than the target, or has a more aggressive sales culture, how willing and able will the target’s people be to adapt to these changes in strategy and operations? Who are the really talented people in the target’s organization you want to keep? It’s important to identify these individuals in advance and have a plan for retaining them after the deal closes. Does the target have executives at certain positions who are stronger than members of your team? Let’s say your bank’s chief financial officer is nearing retirement age and you haven’t identified a clear successor. Could the target bank’s CFO eventually take his or her place?
Making a thorough technology assessment is crucial, and it begins with the target’s core processing arrangement. If the target uses a different third-party processor, how much would it cost to get out of that contract, and how would that affect the purchase price from your perspective? Can the target’s systems easily accommodate your products if some of them are more advanced, or will significant investments have to be made to offer their customers your products?
It can be difficult to assess another bank’s culture because you’re often dealing with things that are less tangible, like attitudes and values. But cultural incompatibility between two merger partners can prevent a deal from reaching its full potential. Cultural differences can be expressed in many different ways. For example, how do the target’s compensation philosophy and practices align with yours? Does one organization place more emphasis on incentive compensation that the other? Board culture is also important if you’re planning on inviting members of the target’s board to join yours as part of the deal. How do the target’s directors see the roles of management and the board compared to yours? Unless the transaction has been structured as a merger of equals, the acquirer often assumes that its culture will have primacy going forward, but there might be aspects of the target’s culture that are superior, and the acquirer would do well to consider how to inculcate those values or practices in the new organization.
Return on Investment
A bank board may have various motivations for doing an acquisition, but usually there is only one thing most investors care about – how long before the acquisition is accretive to earnings per share? Generally, most investors expect an acquisition to begin making a positive contribution to earnings within one or two years. There are a number of factors that help determine this, beginning with the purchase price. If the acquirer is paying a significant premium, it may take longer for the transaction to become accretive. Other factors that will influence this include duplicative overhead (two CFOs, two corporate secretaries) and overlapping operations (two data centers, branches on opposite corners of the same intersection) that can be eliminated to save costs, as well as revenue enhancements (selling a new product into the target’s customer base) that can help drive earnings.
Capabilities of Your M&A Team
A well-conceived acquisition can still stumble if the integration is handled poorly. If this is your bank’s first acquisition, take the time to identify which executives in your organization will be in charge of combining the two banks into a single, smoothly functioning organization, and honestly assess whether they are equal to the task. Many successful banks find they don’t possess the necessary internal talent and need to engage third parties to ensure a successful integration. In any case, the acquiring bank’s CEO should not be in charge of the integration project. While the CEO may feel it’s imperative that they take control of the process to ensure its success, the greater danger is that it distracts them from running the wider organization to its detriment.
Any acquisition comes with a certain amount of risk. However, proactive consideration toward talent, technology, culture, ROI and a thoughtful selection of the integration team will help enable the board to evaluate the opportunity and positions the acquiring institution for a smooth and successful transition.
The banking industry hasn’t been this well capitalized in a long time. In fact, you have to go back to the 1940s — almost 80 years ago — before you find a time in history when the tangible common equity ratio was this high, says Tom Michaud, president and CEO of investment bank Keefe, Bruyette & Woods, during a presentation for Bank Director’s Inspired By Acquire or Be Acquired platform.
That ratio for FDIC-insured banks has nearly doubled since 2008, he says, reaching 8.5% as of Sept. 30, 2020, says Michaud.
A big part of the industry’s high levels of capital goes back to the passage of the Dodd-Frank Act in 2010, the Congressional response to the financial crisis of 2008-09. Because of that law, banks must maintain new regulatory capital and liquidity ratios that vary based on their size and complexity.
During the pandemic, banks were in much better shape. You can see the impact by looking at the capital ratios of just a handful of big banks. Citigroup, for example, had a tangible common equity ratio in the third quarter of 2020 that was nearly four times what it was in 2008, Michaud says.
With a deluge of government aid and loans such as the Paycheck Protection Program, the industry’s losses during the pandemic have been minimal so far. The Federal Deposit Insurance Corp. has closed just four banks, far fewer than the deluge of failures that took place during the financial crisis. So far, financial institutions have maintained their profitability. Almost no banks that pay a dividend cut theirs last year.
Meanwhile, regulators required many of the large banks, which face extra scrutiny and stress testing compared to smaller banks, to halt share repurchases and cap dividends last year, further pumping up capital levels.
That means that banks have a lot of capital on their books. Analysts predict a wave of share repurchases in the months ahead as banks return capital to shareholders.
“The banking industry continues to make money,” said Al Laufenberg, a managing director at KBW, during another Bank Director session. “The large, publicly traded companies are coming out with statements saying, ‘We have too much capital.’”
Investors have begun to ask more questions about what banks are doing with their capital. “We see investors getting a little bit more aggressive in terms of questions,” he says. “‘What are you going to do for me?”
Bank of America Corp. already has announced a $2.9 billion share repurchase in the first quarter of 2021. In fact, KBW expects all of the nation’s universal and large regional banks to repurchase shares this year, according to research by analysts Christopher McGratty and Kelly Motta. They estimate the universal banks will buy back 7.3% of shares in 2021, while large regionals will buy back 3.5% of shares on average. On Dec. 18, 2020, the Federal Reserve announced those banks would again be allowed to buy back shares after easing earlier restrictions.
Regulators didn’t place as many restrictions during the pandemic on small- and medium-sized banks, so about one-third of them already bought their own stock in the fourth quarter of 2020, according to McGratty.
In terms of planning, banks that announce share repurchases don’t have to do them all at once, Laufenberg says. They can announce a program and then buy back stock when they determine the pricing is right.
Shareholders can benefit when banks buy back stock because that can reduce outstanding shares, increasing the value of individual shares, as long as banks don’t buy back stock when the stock is overvalued. Although bank stock prices compared to tangible book value and earnings have returned to pre-Covid levels, the KBW Regional Banking Index (KRX) has underperformed broader market indices during the past year, making an argument in favor of more repurchases.
Robert Fleetwood, a partner and co-chair of the financial institutions group at the law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP, who spoke on the Bank Director session with Laufenberg, cautions bank executives to find out if their regulators require pre-approval. Every Federal Reserve region is different. Regulators want banks to have as much capital as possible, but Fleetwood says they understand that banks may be overcapitalized at the moment.
High levels of capital will help banks grow in the future, invest in technology, add loans and consolidate. For the short term, though, investors in bank stocks may be the immediate winners.
The COVID-19 pandemic has thrown a wrench in a yearly tradition for publicly traded banks: the annual shareholder meeting.
The United States was struck by the coronavirus crisis in the spring and it may drag into the early summer. In addition to halting the economy and throwing bank operations into overdrive, stay-at-home orders and prohibitions on large gatherings have wreaked havoc on the tradition of the annual shareholder meeting. In response, banks are considering virtual options.
Under normal conditions, shareholders of First Bancorp in Damariscotta, Maine, would assemble at the Samoset Resort for an hourlong annual shareholder meeting followed by lobster rolls for lunch, says CFO Richard Elder. But like many states, Maine Governor Janet Mills issued executive orders in March closing nonessential businesses and implementing other social distancing practices. The $2 billion bank lost its venue at the same time as large gatherings were deemed unsafe.
John Spidi, a partner in the corporate practice group at Jones Walker, had bank clients that faced similar predicaments. One bank planned to hold their meeting at a restaurant that’s now closed, another at a hotel and a third in one of its own branches.
“We’ve had to scramble and figure out what our options were,” he says. “That became a little tricky because every state has different rules on these things.”
The U.S. Securities and Exchange Commission issued guidance permitting virtual meetings and allowing companies that had mailed out proxies to update them with a proxy amendment and a press release accessible on the website. But some states initially only permitted hybrid meetings that included an in-person component. Spidi says some of his clients weighed complying with the law against taking their chances and moving to a virtual meeting.
“That was not an approach that I was comfortable with at all,” he says. “I couldn’t recommend it. I was telling the client what the options were, and the clients were basically saying, ‘We’re going to take that risk. We’re not going to get people together.’”
Fortunately, governors have waived these in-person meeting requirements during public health emergencies, sparing his clients. And in Maine, First Bancorp discussed postponing the annual meeting, but encountered bylaw considerations. So they decided to move online.
Banks that have already distributed proxy materials calling their meetings may be in similar situations, Spidi says. Most states require an annual meeting to elect directors, which a bank could feasibly do up until the last day of the year. But most include their proxies with their annual reports from the year prior, which are typically mailed in the first quarter. An option for banks that haven’t sent out their proxy materials is to hold off on calling the meeting until after stay-at-home orders are lifted, he says.
To hold a virtual meeting, First Bancorp’s board needed to sign off on the shift and its basic procedures, though it did not need to update its bylaws. Spidi says other banks may need to call a board meeting to update their bylaws and permit a virtual meeting, and then file a notification with the SEC that the bylaws have been updated.
Elder says First Bancorp briefly considered hosting its own virtual meeting before running into issues around shareholder authentication and voting. They ultimately reached out to Broadridge Financial Solutions, which they use for transfer and proxy services, to organize the event.
Broadridge has offered virtual shareholder meetings for a decade and has seen slow but steady pickup in companies electing the approach, says Cathy Conlon, Broadridge’s head of corporate issuer strategy and product management. Unsurprisingly, demand for virtual meetings has skyrocketed this year, from 326 companies last year 1,500 this year (and counting).
Beyond pandemics, virtual or hybrid meetings make it easier for shareholders to participate, especially if disability, availability or geography is a constraint. The meetings are similar to an earnings call for executives, which shareholders can access through a web address with no required installation or downloads.
“The technology is fairly straightforward,” Conlon says. “This whole situation will allow more and more companies to feel really confident [about virtual meetings], because they’re getting used to this being a virtual world.”
First Bancorp will conduct its first, and potentially only, virtual annual meeting on April 29. Elder says executives have joked about not returning to the resort after the pandemic ends, but adds they might consider a hybrid approach in the future that marries the virtual approach with the lobster roll lunch.
“I think you’ve got to think outside of the box, be open to new ideas and be willing to implement them,” he says. “This just shows when forced to make a change, you can do it.”
Executives and directors at public banks need to prepare for new rules this spring that will make it easier for investors to accumulate meaningful stakes in their companies.
The Federal Reserve Board has approved an update to the control framework for investors in banks or bank holding companies that goes into effect April 1. The update comes as the marketplace undergoes a structural shift in flows from active fund management to passive investing. The changes should make it easier for investors — both passive and active — to determine whether they have a controlling influence over a bank, and provides both banks and investors with greater flexibility.
“Anything that’s pro-shareholder, a bank CEO and board should always be happy to support,” says Larry Mazza, CEO at Fairmont, West Virginia-based MVB Financial, which has $1.9 billion in assets. “The more shareholders and possible shareholders you can have, it’s very positive for the owners.”
The Fed last updated control rules in 2008. This update codifies the regulator’s unwritten precedent and legal interpretations around control issues, which should increase transparency for investors, says Joseph Silvia, a partner at Howard & Howard.
“The goal of the regulators is to make sure that they understand who owns those entities, who runs those entities and who’s in charge, because those entities are backed by the Federal Deposit Insurance Corp.,” he says. “The regulators take a keen interest, especially the Fed, in who’s running these entities.”
The question of who controls a bank has always been complicated, and much of the Fed’s approach has been “ad hoc,” Silvia says. The latest rule is largely a reflection of the Fed’s current practice and contains few changes or surprises — helpful for banks and their investors that are seeking consistency. Large shareholder should be able to determine if their stakes in a bank constitute control in a faster and more-straightforward way. They also may be able to increase their stakes, in some circumstances. Silvia specifically highlights a “fantastic,” “wildly helpful” grid that breaks down what the regulator sees as various indicia of control, which observers can find in the rule’s appendix.
“A lot of investors don’t like the pain of some of these regulations — that helps and hurts. [The] regulation creates predictability and stability,” Mazza says. “Where it hurts is that investors may not go forward with additional investments, which hurts all shareholders.”
Shareholders, and banks themselves that may want to take stakes in other companies, now have increased flexibility on how much money they can invest and how to structure those investments between voting and non-voting shares, as well as how board representation should figure in. Silvia says this should advance the conversations between legal counsel and investors, and spare the Fed from weighing in on “countless inquires” as to what constitutes control.
“Both banks and shareholders will likely benefit from the changes, as it could lower the cost of capital for banks while allowing for a greater presence of independent perspectives in the board room,” wrote Blue Lion Capital partner and analyst Justin Hughes in an email. Blue Lion invests in bank stocks.
The change impacts active and passive investors, the latter of which have grown to be significant holders of bank stocks. Passive vehicles like exchange-traded and mutual funds have experienced $3 trillion in cumulative inflows since 2006, while actively managed funds have seen $2.1 trillion in outflows, according to Keefe, Bruyette & Woods CEO Tom Michaud. Passive ownership of bank stocks has increased 800 basis points since 2013, representing 17.1% of total shares outstanding in the third quarter of 2019. Some funds may be able to increase their stakes in banks without needing to declare control, depending on how the investments are structured.
Still, banks may be concerned about the potential for increased activism in their shares once the rule goes into effect. Silvia says the Fed is familiar with many of the activists in the bank space and will watch investment activity after the rule. They also included language in the final update that encourages investment vehicles who have not been reviewed for indicia of control from the Fed to get in touch, given than no grandfathering was provided to funds that had not been reviewed.
“They’re not really grandfathering any investments,” Silvia says. “There’s not a lot of additional protection.”
If nothing else, the rule is a chance for bank executives and directors to revisit their shareholder base and makeup and learn more about their owners, he adds. They should keep track if the makeup of their shareholders’ stakes changes once the rule goes into effect, especially investors that may become activists.
Has your executive team been approached by leaders of another bank interested in an acquisition? It likely means your bank is doing something right. But, now what?
Many CEOs’ visceral response to being asked to consider a deal is to say, “Thanks, but no thanks” and continue running the bank. While this may be the correct response, this overture is a chance for leadership to objectively revisit the bank’s strategic alternatives to determine the best option for its shareholders and other stakeholders.
Stay the Course
Boards must objectively identify where their bank is in its life cycle — be it turn-around, growth or stability — and what will be needed to successfully compete at the next stage. Ultimately, they must determine if the bank can drive more long-term shareholder value staying independent than it could with a partner. They must also weigh the risk of remaining independent against the potential reward.
Directors should prepare five-year projections, ideally with the help of a financial advisor, that assume the bank continues to operate independently. They should forecast growth and profitability that reasonably reflect current marketplace dynamics and company strategy, and are generally consistent with past performance. Consider opportunities to lower funding costs, consolidate or sell unprofitable branches, add lines of business, or achieve economies of scale through acquisitions or organic growth. However, be cognizant of market headwinds: low interest rate environment, slower projected loan growth, increasing cost of technology and cybersecurity, regulatory burden, competition, demographic trends, upcoming presidential election and so on. The board should also consider organizational issues such as succession planning — a major issue for many community banks. How do these factors impact the future performance of your institution? Will your bank be able to meet shareholder expectations?
Merge with Peer
Peer mergers have been a hot topic of late. The bank space has seen several high-profile transactions: the merger between BB&T Corp. and SunTrust Banks to form Truist Financial Corp.; Memphis, Tennessee-based First Horizon National Corp. and Lafayette, Louisiana-based IBERIABANK Corp.; Columbia, South Carolina-based South State Corp. and Winter Haven, Florida-based CenterState Bank Corp.; and McKinney, Texas-based Independent Bank Group and Dallas-based Texas Capital Bancshares.
The opportunity to double assets while achieving economies of scale can drive significant shareholder value. But these transactions can be tough to nail down because both parties must be willing to compromise on key negotiation topics. Which side selects the chairman? The CEO? How will the board be split? Where will the company be headquartered? What will be the name of the future bank?
Peer mergers can be risky propositions for banks, as cultures don’t always match and integration can take several years. However, the transaction can be a windfall for shareholders in the long run.
A decision to sell almost always generates the greatest immediate value for shareholders. Boards must ascertain if now is the right time, or if the bank can do better on its own.
Whether or not selling creates the highest long-term value for shareholders depends on several factors. One factor is the consideration mix, if any, between stock and cash. Cash gives shareholders the flexibility to invest and diversify the net proceeds as they see fit, but capital gains will be taxed immediately. Stock consideration is generally a tax-free exchange, when structured correctly, but it is paramount to select the right partner. Look for a bank with a strong management team and board, a proven track record of building shareholder value and a plan to continue to do so. That partner may not offer you the highest price today, but will most likely deliver a better return to shareholders in the long run, compared to other potential acquirers. Furthermore, a partner that is likely to sell in the near-term could provide a double-dip — a potential homerun for your shareholders.
It is crucial to consider what impact a sale would have on other stakeholders, like employees and the community. Prepare your bank to sell, well in advance of any conversations with potential acquirers. Avoid signing new IT contracts with material termination costs; it is an opportune time to sell when core processing contracts are nearing expiration. In addition, review existing employment agreements and consider establishing a severance plan to protect employees ahead of time.
Being approached by a potential acquirer gives your bank an opportunity to objectively reflect on its strategy and potentially adjust it. Even if your bank hasn’t been contacted by a potential acquirer, the board should still review the bank’s strategic alternatives annually, at a minimum, and determine the best path forward.
A backlash has emerged in response to diversity and inclusion initiatives.
In the past several years, activists, institutional investors and some companies — including banks — have advocated for increased diversity and inclusion on their boards and throughout their firms. These groups believe that a diversity of race, gender, age and opinion is good for business and, ultimately, for shareholders.
But two recent studies draw attention to a burgeoning backlash to these efforts. Whether from message fatigue or concern about the board’s focus, companies may need to be mindful about the promotion and communication of their D&I efforts.
Director support to increase gender and racial diversity in the boardroom fell for the first time since 2013 in PwC’s 2019 governance survey. Thirty-eight percent of directors said gender diversity was very important in 2019, down from 46% in 2018. Those who said racial and ethnic diversity was very important fell to 26%, down from 34% the year prior.
Directors seem to be fatiguing of these messages, says Paula Loop, leader of PwC’s Governance Insights Center, who adds she was surprised at the recent trend.
“The way that we rationalized it is that it appears that directors have heard the message and they’re trying to acknowledge that,” she says.
Respondents to PwC’s survey acknowledged that diversity has added value to their discussions and decisions, Loop says, and that it increasingly makes sense from a business perspective. This finding is supported more broadly: Bank Director’s 2018 Compensation Survey found that 87% of respondents “personally believe” that board diversity, either through age, race or gender, has a positive impact on the bank’s performance.
“We have to remember, especially when you’re thinking about boards, they … don’t move necessary as quickly as one might think,” Loop says. “I feel like we’re in an evolution — but there’s been a lot in the last couple of years.”
Interestingly, PwC observed different responses to the survey based on the gender of respondents. A higher percentage of female directors reported that gender and racial/ethnic diversity on the board was “very important.” Male directors were less inclined to report seeing evidence of the benefits of diversity, and more than half agreed that diversity efforts “are driven by political correctness.”
Male directors were three times as likely as a female director to assert that investors “devote too much attention” to both gender and racial/ethnic diversity. Overall, 63% of directors believe investors are too focused on gender diversity, up from 35% in 2018; 58% report the same when it comes to racial/ethnic diversity, up from 33%.
The different responses along gender lines demonstrates why diversity matters, Loop says. The report shows that gender-diverse slate of directors do have a “different emphasis or different way of thinking.”
“It validates why it’s good to have a diverse group of people in a room when you have a conversation about an important issue,” she says.
But even if a bank makes headway on increasing the gender diversity on its board, there is still another group to think about: shareholders. A recent study found that companies that appoint women to the board experience a decline in their share price for two years after the appointment. The study looked at more than 1,600 U.S. companies between 1998 and 2011.
“Investors seem to be penalizing, rather than rewarding, companies that strive to be more inclusive,” wrote INSEAD researchers Isabelle Solal and Kaisa Snellman in a November 2019 Harvard Business Review article about their study.
“What we think is happening is that investors believe that firms who choose to appoint women are firms who care more about diversity than about maximizing shareholder value,” writes Solal, a postdoctoral research fellow at the Stone Centre for the Study of Wealth Inequality at INSEAD, in an email interview.
In subsequent research, they found that investors view appointments of female directors with a company’s “diversity motivation.” The association is “not that surprising,” she writes, given that “almost all” press releases feature the gender of the appointee when that person is a woman, and will often include other references to diversity.
“Gender is never mentioned when the director is a man,” she writes.
Solal says that companies should still appoint women to their boards, especially given that the shareholder skepticism dissipates in two years. But companies should be mindful that overemphasizing a director’s gender or diversity may be unhelpful, and instead highlight the “skills and qualifications of their candidates, regardless of their gender.”
The greatest benefit of being a writer is that you get to talk with lots of interesting people. It’s a constant education. Particularly if you appreciate the opportunity and structure your conversations accordingly.
My style is to conduct broad interviews across a range of topics, whether all the topics are germane to the piece I’m working on at the moment or not. This has helped me construct a mental model of banking, but it also means that a lot of material is left on the cutting room floor, so to speak.
With this in mind, I decided to revisit some of the conversations I’ve had with bankers over the past few months to share the most interesting insights.
Foremost among these is a series of conversations with Robert and Patrick Gaughen, the CEO and president, respectively, of Hingham Institution for Savings, a $2.6 billion bank based in the Boston metropolitan area.
Since the Gaughens gained control of Hingham in 1993, following a two-year proxy contest with its former managers, it has generated a total shareholder return of more than 5,400%, according to my math. That’s more than double the total return of other well-run banks like JPMorgan Chase & Co. and PNC Financial Services Group.
One thing that strikes you when talking with the Gaughens is the depth and sophistication of their banking philosophy. All bankers understand banking. But some understand it on a deeper level than others — that’s the Gaughens.
They approach the industry as investors, or capital allocators, instead of bankers. This seems to be a product of the fact that both Robert Gaughen and his father — Patrick’s grandfather — practiced law before becoming de facto bankers in order to protect investments they had made in banks.
This may seem like a vacuous nuance, but it isn’t. It’s always tempting to subordinate the process of capital allocation to operational processes. After all, if your operations aren’t profitable, you won’t have excess capital to allocate.
What true capital allocators appreciate, however, is that the distinction between capital allocation and operations is nebulous. Everything can be viewed through the prism of capital allocation — from how many employees you hire to which technologies you implement to whether you increase your dividend or repurchase stock.
In this respect, capital allocation is less of a mechanical process than it is a mindset, concentrating one’s attention on measuring the return on each incremental decision.
Another interesting insight that came up in our conversations is the importance of studying other industries. Not only the importance of doing so, I should say, but why it’s so important to do so.
The drive to constantly learn is something that many people preach, but few people practice. This is an element of leadership that can’t be overstated. It serves as the common denominator underlying the performance of the most successful CEOs in banking.
It’s well known that banking is an acutely competitive and commoditized industry, and that those characteristics compress profit margins. But there are two other forces that lead to a lack of differentiation as well.
As Patrick points out, high consultant reuse and an overbearing regulatory schema contribute to a high degree of homogeneity in terms of the way banks are run. The net result is that studying other banks can be less fruitful than one might think.
This isn’t to say that a mastery of banking isn’t critical — it is. But after accumulating a critical mass of knowledge about best practices within banking, the incremental return from intermittently studying other industries, it seems, will exceed the return of concentrating exclusively on banking.
The final point that both Gaughens stress relates to the importance of skin in the game, or executive and director ownership of stock. In their case, their immediate and extended family owns upwards of 40% of Hingham’s outstanding stock. This provides a powerful incentive to care not only about the return on their capital, but also the return of their capital.
Many companies talk about the mystical benefits of alignment between executives and shareholders, as well as having employees that act like owners. But there is simply no substitute for having actual skin in the game. It hones one’s appreciation for the virtues of extraordinary banking, from efficiency to risk management to disciplined growth.
None of this is to say that the Gaughens have everything figured out; they would be the first to admit they don’t. But their philosophy and approach to banking is not only unique, but also tried and true.