Twelve Steps for Successful Acquisitions

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acquisition-11-21-18.pngOftentimes bankers and research analysts espouse the track records of acquisitive banks by focusing on the outcomes of transactions, not the work that went into getting them announced. As you and your board consider growing your bank franchise via purchases of, or mergers with, other banks, consider these steps as a guideline to better outcomes:

  1. Prepare your management team
    Does your team have any track record in courting, negotiating, closing and integrating a merger? If not, perhaps adding to your team is warranted.
  2. Prepare your board
    Understand what your financial goals and stress-points are, create a subcommittee to work with management on strategy, get educated about merger contracts and fiduciary obligations.
  3. Prepare your largest shareholders
    In many privately held banks there are large shareholders, families or individuals, who would have their ownership diluted if stock were used as currency to pay for another bank. It is important to get their support on your strategy as the value of their holdings will be impacted (hopefully positively) by your actions.
  4. Prepare your employees 
    While you cannot be specific about your targets until you need to broaden the “circle of trust,” let key employees know that their organization wants to grow via purchases. They will deal with the day-to-day reality of integration, get them excited that your organization is one they want to be with long-term.
  5. Prepare your counsel
    Just as some bankers focus on commercial or consumer loans, some law firms focus on regulatory matters, loan documents or corporate finance. Does your current counsel have demonstrated experience in merger processes? In addition, your counsel should help to educate your Board about the steps required to complete a transaction.
  6. Prepare the Street
    We have seen in recent months several large bank acquisitions announced where the market was unpleasantly surprised; a bank they viewed as a seller suddenly became a buyer. Some of these companies have since underperformed the broader bank market by 5 to 10 percent. If it has been several years between acquisitions, prep the market beforehand that you might resume the strategy. BB&T recently laid parameters for going back on the acquisition trail. And while their stock was down some on the news, it has since more than recovered.
  7. Prepare your IT providers 
    Most customers are lost when you close your transaction by the small annoyances that come with a systems conversion. Understand if your current core systems have additional capacity or begin to get systems in place that can grow as you grow.
  8. Prepare your regulator(s)
    Whether it is the state, the FDIC, OCC or the Fed, they generally do not like surprises. Get some soft guidance from them on their expectations for capital levels and growth rates. Before you formally announce any merger, with your counsel, give the regulators a courtesy heads-up.
  9. Prepare your rating agency
    If you are a rated bank, think about your debt holders as well as equity holders, especially if you need access to acquisition financing. Share with them the broad plan of growth and your tolerances for goodwill and other negative capital events.
  10. Prepare your financing sources
    Do you have a line-of-credit in place at the holding company that could be drawn to finance the cash portion of acquisition consideration? Have you demonstrated that you can fund in the senior or subordinated debt markets, perhaps by pre-funding capital? Are there large shareholders willing to commit more equity to your strategy?
  11. Prepare your targets
    If the Street does not know, and your shareholders do not know, and your bankers and lawyers do not know, then the targets you might have in mind also will not know you are a buyer. Courting another CEO is a time-consuming process, but completely necessary and should be started 12-18 months before you are in the position to pull the trigger. Your goal is to be on their “A” list of calls, and have the chance to compete, either exclusively or in a controlled auction process.
  12. Prepare to walk away 
    After you have done all this work, it is easy to get “deal fever” when that first process comes along. Sometimes you need to recognize it is a trial run for the real thing and be prepared to pack your bags and go home. The best deal most companies have ever done is the one they didn’t do.

Three Lessons for Bankers From Warren Buffett

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strategy-11-16-18.pngIt’s reasonable to argue that the greatest banker in the United States today isn’t a banker at all—he’s an insurance guy.

You might have heard of him.

Warren Buffett.

As the chairman and CEO of Berkshire Hathaway, an insurance-focused conglomerate based in Omaha, Nebraska, Buffett oversees one of the largest portfolios of bank investments in the country.

Berkshire owns major stakes in a Who’s Who list of historically high-performing banks:

  • 9.9 percent of Wells Fargo & Co. 
  • 6.8 percent of Bank of America Corp.
  • 6.3 percent of U.S. Bancorp
  • 5.3 percent of The Bank of New York Mellon Corporation
  • 3.7 percent of M&T Bank Corp.

That Buffett made such substantial investments in banks isn’t a coincidence.

If there are two things he appreciates at a visceral level, owing to his experience in insurance, it’s leverage and cycles—the same two qualities that make banking so unique.

This is why it’s worth listening to Buffett when he opines on banking, as he often does in his annual letters and media interviews.

This is from his 1991 shareholder letter:

“When assets are 20 times equity—a common ratio in [the bank] industry—mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the ‘institutional imperative:’ the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.”

Buffett is referring to the havoc wreaked on banks during a pronounced downturn in commercial real estate in the early 1990s, when Berkshire bought 10 percent of Wells Fargo.

His point is that it’s critical for bankers to maintain discipline, especially when all of those around you are not.

Another thing Buffett talks about a lot is competitive advantage.

Here he is in a 2009 interview with Fortune:

“If you’re the low-cost producer in any business—and money is your raw material in banking—you’ve got a hell of an edge. If you have a half-point edge . . . half a point on $1 trillion is $5 billion a year.”

And here‘s a selection from his 1987 shareholder letter flushing out the idea more fully, though in the context of the insurance industry, which faces nearly identical competitive dynamics to banking:

“The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.”

One nuance about efficiency in banking is it doesn’t just boost profitability directly by freeing up more revenue to fall to the bottom line; equally important is its indirect effect.

This is a point U.S. Bancorp’s chairman and CEO Andy Cecere made in a recent, albeit unrelated, interview about the bank with Bank Director.

Efficient banks needn’t stretch on credit quality to generate satisfactory returns, which reduces loan losses at the bottom of the credit cycle, Cecere says. And as a corollary, efficient banks can compete more aggressively for the most creditworthy customers, further limiting credit losses in tough times.

It isn’t a coincidence, in turn, that U.S. Bancorp has consistently been one of the industry’s most efficient banks and disciplined underwriters since its transformative merger nearly two decades ago.

And while neither Buffett nor his philosophy came up during the interview with Cecere, Berkshire Hathaway is one of U.S. Bancorp’s biggest shareholders.

A final lesson about banking that can be gleaned from Buffett involves his approach to mergers and acquisitions.

Buffett has said repeatedly in the past that he’d rather pay a fair price for a wonderful company than a wonderful price for a fair company. Also, all things being equal, Buffett has always preferred for existing management to stay and continue on their path of success.

“Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a ‘cheap’ price. Instead, our only interest is in buying into well-managed banks at fair prices.”

It’s a style reminiscent of the uncommon partnership approach to mergers and acquisitions used by John B. McCoy, who dined annually with Buffett, to transform the former Bank One from the third largest bank in Columbus, Ohio, into the sixth largest bank in the country, before later merging into JPMorgan Chase & Co.

In short, although it’s true that most people don’t think of Buffett as a banker, that doesn’t mean bankers can’t learn a lot from his observations on the industry.

How To Prepare Compensation Plans For An IPO

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IPO-11-5-18.pngThe decision to take your bank public will set the course of your company for years to come. There are several critical steps to prepare your compensation program before the IPO and before your bank is a public company.

Steps to prepare for the IPO

1. Assemble Your Compensation Team
Determine the team focused on compensation matters. If you have employees with IPO experience and compensation plans, they could be a key asset. Similarly, if you have employees without IPO experience but have public company experience, they could be a key team member as well.

2. Create Your IPO-Related Task List
Your bank may have implemented many compensation and governance related items already, but they should be reviewed for their appropriateness for a public company.

Key tasks required prior to the IPO will vary, however, here is a list of compensation tasks on every pre-IPO list.

  • Develop an executive compensation philosophy and key objectives – What is your bank’s strategy? Where do you target compensation? Is your pay aligned with performance? What are the objectives of your compensation program? What message do you want to send to shareholders? Craft overarching guidelines to support the process going forward.
  • Evaluate and establish appropriate executive and director compensation levels – Prior to the IPO, your company will have to disclose its executive and director compensation. You want to be sure your compensation programs are reasonable, competitive, and based on peer group data. Establishing a suitable peer group and incorporating the data into your process is key.
  • Equity plan considerations – Will a new equity plan be required, and when will you need shareholder approval? How will you determine the share pool so long-term incentive and equity grant needs can be met for three to five years? Have you evaluated the shareholder advisory firms’ current standards to receive favorable support? Avoid any pitfalls that would result in a “no” vote recommendation.

    If the company is considering one-time IPO-related equity grants, evaluate these in light of market trends, shareholder expectations, retention concerns, financial impact to the company and dilution. Many institutions consider sizeable one-time grants a front-loaded award, and decide to wait before awarding additional equity. Such decisions are based on share pool impact, financial implications, and size of the one-time grants. Carefully determine the value of these awards to minimize risks of unfavorable optics and legal actions.

  • Design ongoing annual and long-term incentive plans – As a public company, it is important to have annual and long-term incentive plans that align pay and performance, are competitive, consistent with company objectives and provide an appropriate mix of pay. As new incentive plans are designed, know that plan details will be disclosed in future public filings. Private banks are accustomed to implementing plans that are regulatory compliant and competitive, but public disclosure has not been required.
  • Implement executive agreements – In many cases, new employment and change-in-control agreements are put in place, often the case even if similar agreements were in effect before the IPO. Several details, including the terms, are subject to public disclosure. Shareholder advisory firms take issue with certain terms and, and having them can automatically result in ‘no’ vote for Management Say on Pay and the re-election of the board’s compensation committee. It is critical to be aware of these pitfalls and avoid them whenever possible.

3. Determine appropriate technical and governance actions
There are key technical and governance issues to evaluate. Some items are required while others are not. Many are considered best practices and important to achieving strong governance. Some of the key items in this category include:

  • Drafting of the SEC required filings including the CD&A (Compensation Discussion and Analysis), compensation tables and other requirements. Reporting errors and omissions can delay the IPO.
  • Determining company stock ownership guidelines – Many new public banks do not adopt stock ownership guidelines immediately, however, if one-time equity grants are awarded, adopting such guidelines immediately sets the parameters for holding these shares. Determine who will be covered by the guidelines (e.g., executives, Section 16 officers, non-employee directors), what the required holdings are, the timeframe permitted, and other terms.
  • Drafting the Compensation Committee Charter – A charter establishes the role and responsibilities of the committee, how it will interact with the board and management, and its ability to engage outside advisors. The charter is typically published on the company’s website.

4. Create a compensation committee calendar after the IPO
Once the IPO is completed, it is important for the compensation committee to focus on its new role, responsibilities and annual tasks. Setting up a calendar of activities supports effective management and should include all areas of committee oversight.

Taking your bank public can be a very exciting endeavor. Do not underestimate the number of new issues management, the compensation committee and the board will have to become familiar with to complete a successful IPO and operate a public company. Being organized, having the right knowledge and support and a flexible timeline will be great tools to help your organization get through this process.

You’ll Never Guess Where BB&T Gets Its Big Ideas

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strategy-10-19-18.pngIt is well worth any banker’s time to read the vision, mission and purpose statements of BB&T, the eighth biggest commercial bank in the United States.

They will sound at first like similar statements from any other bank, but what makes BB&T’s unique is the inspiration behind them.

They weren’t drawn up with the help of consultants or survey data; they are grounded instead in the writings of philosophers—classical thinkers as well as modern proponents of capitalism.

“The philosophers that influenced me the most are Aristotle, Thomas Aquinas, John Locke, and Ayn Rand,” writes John Allison, the chairman and CEO of BB&T from 1989 to 2008, in his 2014 book, The Leadership Crisis and the Free Market Cure.

BB&T has published an entire pamphlet outlining its culture, encapsulated in its vision, mission and purpose statements, which reduce to one key objective: “Our ultimate purpose is to create superior long-term economic rewards for our shareholders.”

The $223-billion bank based in Winston-Salem, North Carolina, doesn’t just talk the talk; it walks the walk. It ranks in the 98th percentile among publicly traded banks in terms of the total amount of shareholder value it has created during its time as a public entity.

Yet, there’s a nuance to BB&T’s philosophy on creating value that’s easy to overlook. It doesn’t talk about “maximizing” long-term economic rewards for shareholders; it talks instead about “optimizing” those rewards.

Why the difference?

As Allison writes in his book:

When free market economists and finance theorists refer to maximizing shareholders’ returns, they imply a long-term context. In the real world, maximizing tends to be a short-term concept. BB&T’s mission also focuses on ‘creating a safe and sound investment,’ The goal with this wording is to communicate to potential purchasers of the company’s stock that we are in the game for the long-term and will not take inordinate risk even if that risk could maximize short-term returns.

In no industry is a long-term view more important than banking. Banks, as a group, use more leverage than companies in any other industry, typically borrowing $10 for every $1 worth of capital.

This is by design, of course, as a principal purpose of banking is to leverage society’s capital to fuel economic growth—a point Bank of America’s chairman and CEO, Brian Moynihan, made in a recent interview with Bank Director:

[B]anks came up to help people borrow money, which helps economies grow faster. If you’re constrained to only your equity, you only have so much money to spend. But if you borrow against it, now you can spend more. That’s the magic of leverage in terms of accelerating progress.

But there is a downside to all that leverage—it makes banks vulnerable to economic cycles, explaining why more than 17,000 banks have failed since the Civil War.

Bankers are prone to the same impulses that, at the top of a cycle, cause real estate developers to break ground on skyscrapers, retailers to over-invest in inventory and technology entrepreneurs to believe that traditional rules of economics no longer apply.

The difference is that, thanks to leverage, there’s less margin for error in banking than there is in other industries. A mere 10 percent decline in the value of a typical bank’s assets will render it insolvent.

This is one reason BB&T chose the words of its mission statement so carefully in terms of “optimizing” as opposed to “maximizing” shareholder value.

Another reason is that shareholders aren’t a bank’s only constituency—there are also clients, employees and communities. A bank that doesn’t tend to all four is like a table with only three legs.

It’s by optimizing returns among multiple constituencies, in other words, that a bank can maximize the returns to anyone of them. And if a bank does that through multiple cycles, the outcome is even better.

The net result at BB&T, writes Allison, is that “we operate our business in a long-term context by adding value to our clients, employees, and communities and in that context create superior rewards for shareholders.”

In short, while Aristotle, Thomas Aquinas, John Locke and Ayn Rand may seem like an unlikely source for inspiration in banking, if BB&T’s success is any indication, it’s safe to say they were onto something.

Gender Pay Equity and Board Gender Diversity – Is Your Board Prepared?

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governance-8-1-18.pngGender pay equity and board gender diversity are two areas of focus for both the media and investors. Lately, many large institutional investors have turned their attention to environmental, social and governance (ESG) issues, where board diversity has taken center stage and questions around gender pay equity are increasing. Boards and management should proactively gain an understanding of their current position and any concerns on these fronts to avoid adverse reactions from employees and/or shareholders.

Slow progress on gender diversity in the boardroom has led many large investors to push for an increase in the number of women on boards. Several influential institutional investors such as Blackrock, State Street Global Advisors and Vanguard have added diversity stipulations to their engagement and voting policies, citing studies that link increased female representation on boards with improved shareholder returns. More specifically, these institutions may vote against, and proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis may recommend voting against, the nominating and governance committee members if there are not a least one or two women on the board. These voting policies have been very impactful, and we have seen a dramatic increase in women serving in board roles at the largest organizations.

Compensation Advisory Partners (CAP) researched the 15 largest public diversified financial services companies in the Fortune 100 and found that approximately 50 of companies had at least three women on their board and an additional 20 percent had at least two. As a comparison, CAP researched the board composition of 90 smaller financial services companies with assets between $5 billion and $20 billion and found approximately 15 have at least three females on their board and an additional 15 have at least two. Similar to other compensation and governance trends, we expect smaller financial organizations to catch up with the increased external pressure.

In addition, initiatives such as the NYC Comptroller’s Boardroom Accountability Project 2.0, focus on enhancing disclosure of board composition through a skills matrix. California is now the first state considering a bill to require a minimum number of women on all boards of the state’s more than 400 companies. These initiatives are driving heightened attention to the diversity and competencies of the board as a whole.

While information on director composition and profiles is public, this is not the case with gender pay equity across an organization. In the U.K. there is a requirement to disclose gender pay statistics for organizations with at least 250 employees, but that does not currently exist in the U.S. Even so, we have observed some institutional investors use shareholder proposals to pressure large organizations to provide public reports on gender pay.

Several financial institutions have been under scrutiny for a lack of female representation in senior roles despite a majority of their employees being female. Unlike the U.K., where all employees must be included in the sample, shareholder proposals in the U.S. focus on a comparison of “like-for-like jobs.” Over the last three years, companies recommended shareholders vote against the proposal, and support averaged around 15 percent. Only 5 proposals (compared to 14 in 2017) have gone to a vote in 2018, none at financial services companies (compared to 7 in 2017), since several large financial organizations such as Citigroup, Bank of America, JPMorgan Chase & Co., and Wells Fargo & Co. were able to have these requests withdrawn from their annual proxy statement and in exchange agreed to publish their gender pay. In all cases, the reports have shown almost no gap, but the approach by company can vary.

These two movements have put a spotlight on the underlying issue of equal representation in the boardroom and pay equality across organizations. The push for board equality has already resulted in progress especially at larger organizations. Boards are reviewing nominating and governance committee charters and adopting policies to promote diversity in the board recruitment process. On the gender pay equity front, even though disclosure is not required in the U.S., momentum and pressure are building from institutional investors for companies to disclose gender pay gaps.

We expect boards of all companies to start asking management if a gender pay gap exists, and what they should be doing to address any gaps that do exist. Conversations on both these topics should be an agenda item in all boardrooms today.

A Timely Reminder About the Importance of Capital Allocation

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capital-7-6-18.pngCapital allocation may not be something bank executives and directors spend a lot of time thinking about—but they should. To fully maximize performance, a bank must both earn big profits and allocate those profits wisely.

This is why the annual stress tests administered each year by the Federal Reserve are important, even for the 5,570 banks and savings institutions that don’t qualify as systemically important financial institutions, or SIFIs, and are spared the ritual. The widely publicized release of the results is an opportunity for all banks to reassess whether their capital allocation strategies are creating value.

There are two phases to the stress tests. In the first phase, the results of which were released on June 21, the Fed projects the impact of an acute economic downturn on the participating banks’ balance sheets. This is known as the Dodd-Frank Act stress test, or DFAST. So long as a bank’s capital ratios remain above the regulatory minimum through the nine-quarter scenario, then it passes this phase, as was the case with all 35 banks that completed DFAST this year.

The second phase is the Comprehensive Capital Analysis and Review, or CCAR. In this phase, banks request permission from the Fed to increase the amount of capital they return to shareholders by way of dividends and share buybacks. So long as a bank’s proposed capital actions don’t cause its capital ratios from the first phase to dip below the regulatory minimum, and assuming no other deficiencies in the capital-planning process are uncovered by the Fed during CCAR, then the bank’s request will, presumably, be approved.

There’s reason to believe the participating banks in this year’s stress tests will seek permission to release an increasingly large wave of capital. Banks have more capital than they know what to do with right now, which causes consternation because it suppresses return on equity—a ratio of earnings over equity. And last year’s corporate income tax cut will only further fuel the buildup going forward, as profits throughout the industry are expected to climb by as much as 20 percent.

We probably won’t know exactly how much capital the SIFIs as a group plan to return over the next 12 months until, at the soonest, second-quarter earnings are reported in July. But early indications suggest a windfall from most banks. Immediately after CCAR results were released on June 28, for example, Bank of America Corp. said it will increase its dividend by 25 percent and repurchase $20.6 billion worth of stock over the next four quarters, nearly double its repurchase request over last year.

The importance of capital allocation can’t be overstated. It’s one of the most effective ways for a bank to differentiate its performance. Running a prudent and efficient operation is necessary to maximize profits, but if a bank wants to maximize total shareholder return as well, it must also allocate those profits in a way that creates shareholder value.

One way to do so is to repurchase stock at no more than a modest premium to book value. This is easier said than done, however. The only time banks tend to trade for sufficiently low multiples to book value is when the industry is experiencing a crisis, which also happens to be when banks prefer to hoard capital instead of return it to shareholders.

As a result, the best way to add value through capital allocation is generally to use excess capital to make acquisitions. And not just any ole’ acquisition will do. For an acquisition to create value, it must be accretive to a bank’s earnings per share, book value per share or both, either immediately or over a relatively brief period of time.

If you look at the two best-performing publicly traded banks since 1980, measured by total shareholder return, this is the strategy they have followed. M&T Bank, a $119 billion asset bank based in Buffalo, New York, has made 23 acquisitions since then, typically doing so at a discount to prevailing valuations. And Glacier Bancorp, a $12 billion asset bank based in Kalispell, Montana, has bolstered its returns with two dozen bank acquisitions throughout the Rocky Mountain region.

The point is that capital allocation shouldn’t be an afterthought. If you want to earn superior returns, the process of allocating capital must be approached with the same seriousness as the two other pillars of extraordinary performance—prudence and efficiency.

The Dos and Don’ts of Shareholder Recordkeeping for Private Banks

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shareholder-5-1-18.pngPublic and private banks are vastly different, but in some areas, they might be more alike that you may think.

Public banks are required to work with a transfer agent for their investor recordkeeping. Private banks, including institutions that are not listed on a stock exchange or regularly file financial reports with the Securities and Exchange Commission, do not have the same obligations as their publicly traded counterparts; however, this does not mean that sound recordkeeping practices are not just as important.

Based on my more than 30 years in the industry, these are the most important Do’s and Don’ts to consider when it comes to managing your investor records:

DO keep a close eye on your overall share balance. It is critical that the shares held on your share register match the number of shares outstanding that your financial reporting office says are there. Changes in shares outstanding (where there is an increase or decrease in this overall figure) don’t happen very often and may not cause an issue in your day-to-day business. But, if shares are not in balance, trouble will arise in the instance of a change-in-control event, such as an acquisition. The need to rehabilitate the list could complicate and delay the corporate event.

DON’T let share issuance discrepancies linger. When a share transfer takes place, the transaction must be recorded for both the transferor and transferee. For private banks, shares are often not liquid and transfers rarely happen. Given their rarity, it’s important to take special care to properly record transfers on the books of the company. Errors can be hard to find later on— especially when the person who had a photographic memory of the list has retired. It’s best not to let discrepancies happen in the first place, but if they do, resolve them now and avoid a messy accounting issue much later on.

DO pay special attention to executive equity awards. It’s usually not a good idea—or a good career move—to keep improper and inaccurate equity award records of your executives and directors.

DON’T underestimate the importance of data security. Keeping accurate shareholder records is important. Safeguarding that information is even more important. This means protecting data from both outside intrusion and weak internal processes that could threaten it. Data security and security breach notifications are also legal matters that need to be addressed to comply with state and federal law.

DO maintain regular communications with your investors. Part of the C-suite’s business is to continue to attract investors to the company—both to help boost the demand for the stock but also to try to attract some liquidity as well. You can make the C-suite’s job easier by delivering timely communications to your existing investors, keeping them happy.

DON’T lose sight of your regulatory obligations. Companies that file with the SEC obviously need to follow its reporting guidelines. But even those that don’t report to the SEC will need to comply with state or federal regulations applicable to the bank regarding governance and investor relations.

DO perform a regular review of your company charter and bylaws. You should have your counsel review these documents from time to time. This gives you the opportunity to make updates that support your business objectives. For example, you should consider the elimination of stock certificates if they are specifically mentioned in the bylaws.

Making this update allows for the use of book-entry statements (much like those one might see if they own a mutual fund or have their own brokerage account) and for more modern communications and proxy voting technology such as the electronic delivery of annual meeting materials and online voting. Your counsel will need to review applicable banking regulations to ensure these options are available.

Proper tracking of your investors and their holdings is as critical to the success of your business as your relationship with your banking customers. Adhering to strong governance and compliance practices will reduce opportunities for mistakes and risk going forward.

Creating Liquidity: Alternatives To Selling The Bank

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Executives and boards of private banks have to think outside the box if they want to create a path to liquidity for shareholders that doesn’t require selling the bank. In this video, Eric Corrigan of Commerce Street Capital outlines three liquidity alternatives to consider, and shares why a proactive approach can help a bank control its own destiny.

  • Challenges in Creating Liquidity
  • Three Liquidity Alternatives
  • Benefits and Drawbacks to Each Solution
  • Questions Boards Should Be Asking

Capitalizing on Good Times

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With a strong economy, a corporate tax cut and more sympathetic regulators in Washington, banks have a lot to look forward to in 2018. But don’t confuse brains with a bull market—or a tax cut, says Tom Brown of Second Curve Capital. Happy days may be here again, but banks can’t afford to be complacent. In this interview with Steve Williams, a principal at Cornerstone Advisors, Brown offers four tips for CEOs looking to invest their bank’s expected tax windfall back into the business.

  • The Need To Transform
  • How CEOs Should Focus Their Attention

Making the Most of Tax Reform

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tax-reform-1-18-18.pngTax reform could be a net positive for the banking industry, with an expected long-term boost to profits due to a significant cut in the corporate tax rate, from 35 percent to 21 percent. Its proponents believe that it will fuel the broader economy as well.

But despite the anticipated net gains, boards and management teams need to look at how tax reform will impact their organizations. Certain areas will be negatively impacted or warrant discussion to ensure the bank’s making the most of these changes. With that in mind, here are some of the topics your board should tackle in light of tax reform, and how it could affect your bank.

Initial Tax Hit
Tax reform just passed in late December, but many banks are already aware of its short-term downside, as the deferred tax assets on bank balance sheets, calculated based on a higher tax rate, have resulted in write downs on fourth quarter 2017 earnings. (Some banks have deferred tax liabilities on their balance sheets, which will positively impact earnings.)

These losses are expected to be recouped rather quickly. Kristine Hoeflin, a partner at Moss Adams LLP, recommends that banks quickly communicate this to shareholders and other stakeholders, so they understand that this is a one-time loss.

Impact on Compensation Plans
Under the new tax law, companies can no longer deduct executive pay above $1 million—a shift from the old law, which allowed companies to deduct performance-based pay in excess of $1 million. In another change, companies can’t deduct compensation surpassing $1 million for a departed named executive—the CEO, chief financial officer and three highest paid officers. “You can’t beat it by paying it out after they step down,” says Doug Faucette, a partner with the law firm Locke Lord LLP.

Banks still need to provide their executives with competitive compensation, so for most entities this will likely become just another cost of doing business—and with a lower tax rate, the scales still tip in the industry’s favor. However, a review of compensation plans is still warranted, and acquisitive banks will also want to determine the potential impact in a deal.

Another note: Banks are expected to earn more in 2018 as a result of the new tax code. Make sure the bank is truly rewarding the executive’s performance, not improved metrics that resulted from the tax cut.

Impact on Organizational Structures
Banks should also look at their own organizational structures following tax reform, particularly if the bank is a Subchapter S corporation, which has 100 or fewer shareholders and is taxed as a partnership while enjoying the benefits of being a corporation. Management should make a presentation to the board outlining the impact of tax reform on the bank, along with an analysis of how the bank would be affected in a conversion from a Sub S to a C Corporation and management’s recommendation on the best choice for the organization, says Robert Klingler, a partner at the law firm Bryan Cave.

How the bank wants to deploy its profits will factor into this decision, says Hoeflin. For banks that prefer to continually reinvest profits into the company, “the C Corp set-up, with this low tax rate, would present some favorable circumstances,” she explains. For banks that want to share those profits directly with shareholders, the Sub S structure will continue to make more sense, as Sub S shareholders avoid the double taxation that occurs with a C Corporation.

Shareholder agreements should be reviewed regularly, and will outline how the board can proceed if it wants to change the bank’s structure. “Many times it will involve the consent of the holders of two-thirds of your shares,” says Jonathan Hightower, a Bryan Cave partner, but that threshold differs with each bank. Sometimes the board has the discretion to change the structure without shareholder approval.

Subchapter S banks will still benefit from tax reform—but your bank could benefit even more as a C Corporation, depending on its strategic goals. A current analysis will make that clear to the board.

Another item to note: Banks below $10 billion assets will still qualify for the same deduction for premiums paid to the Federal Deposit Corp. that they have been receiving, but banks between $10 billion and $50 billion will qualify for a partial deduction for these premiums, and banks above $50 billion will no longer qualify for any deduction.

Impact on Local Markets
The mortgage interest deduction is now capped at a principal balance of $750,000, down from $1 million. “That could reduce demand for new home purchase mortgages if folks decide not to move because of the inability to deduct their interest going forward,” says Michael Giammalvo, a partner at Crowe Horwath LLP. Demand could dampen in certain markets more than others. For example, the average home price in California is $697,539, according to Trulia, compared to an average $230,000 for a home in Nebraska.

If your bank has a significant market presence in a state with higher real estate taxes, the cap on itemized deductions at $10,000 for state and local income and property taxes could throw additional cold water on the decision to purchase a new home. “It’s not as tax-advantaged as it used to be, to be a homeowner in an expensive market, says Giammalvo.

Interest is also no longer deductible for home equity lines of credit, so demand could be diminished there as well, adds Giammalvo.

Companies can no longer deduct entertainment expenses—taking a client out for dinner, for example—that were previously deductible at 50 percent of the money spent. That’s a potential pain point for commercial lenders. “I’m hearing from a lot of banks that the inability to deduct entertainment expenses going forward is a problem,” says Giammalvo.

Banks serving businesses with average gross receipts over $25 million should understand that interest expense deductions are now limited for these businesses. “Would we start to see in the banking industry a decrease in demand for lending, because [companies] would find equity for the financing rather than debt sources?” asks Hoeflin.

Take care not to overestimate the positive impact of tax reform on loan demand. While many in the industry expect a wave of commercial loans as companies earn more money, Bill Demchak, CEO of PNC Financial Services Group, has expressed skepticism on this front, as reported in The Wall Street Journal. He believes that companies with more money in their pockets as a result of tax reform will have less need to borrow from banks, dampening rather than fueling demand.

Since each bank’s markets and competitive niches will differ, a strategic discussion around how the impact will be felt will benefit the board and management. “A tailored and careful conversation for each bank, particularly for smaller community banks, makes sense,” says Hightower.

Making the Most of Earnings Gains
Perhaps the biggest question for boards to consider is how to invest the gains derived from a lower rate. Many banks have already announced that they’re spreading the wealth to employees and communities, through one-time donations to a community fund, for example, and hourly wage increases and bonuses for employees.

This a good public relations move for the industry, as the tax cuts were seen by some Americans as a favor to corporate America. “Banks need to make sure that the benefit they’re getting from tax reform really works for the country at large,” says Hightower.

Further, investors will be expecting banks to deploy excess capital to fuel improvements and growth. For banks slow to use that capital for M&A, or to provide share repurchases or dividends to shareholders, “we may actually see activist pressure accelerate and those [banks] may become potential targets,” says Sharon Dogonniuck, senior managing director at Ernst & Young Capital Advisors LLC. Investment in technology is another way to deploy that capital, and could provide a much needed-boost to banks that have struggled with the financial industry’s digital evolution. Smart investment in technology will define community banking’s winners and losers, says Dogonniuk. “Technology costs money, and [banks] need technological scale.”

The discussions occurring now in boardrooms spurred by tax reform could be a once in a lifetime occurrence for the banking industry and businesses at large. “I’ve doing this for 24 years, and we’ve never seen anything like this, where there’s such a transformation in the business tax world,” says Giammalvo.