Audit Committee: The Top Three Things Never to Forget


reminder.jpgFor community banks, these are interesting times. The economic recovery hasn’t gained enough steam for institutions to be able to count on solid returns. Many banks also face a lingering credit crunch as access to capital remains restricted nearly four years after the Troubled Asset Relief Program. In fact, more than 350 institutions, many of them community banks, still have TARP and many of them are having trouble raising the capital needed to repay government funds. To top it all off, the coming implementation of the Dodd-Frank Act has created uncertainty—although community banks were exempted from some of the law’s more stringent requirements, there are still concerns that even smaller institutions will eventually be held to the same standard.

Against this backdrop, the work of audit committees has taken on added importance. With a slim margin of error and a shifting regulatory landscape, verifying that the proper internal controls and compliance measures are in place can be the difference between thriving, barely surviving, and falling behind the competition. Here are the top three issues that audit committees of community banks need to have on their radar for the coming year.

1. Don’t Neglect Audit Fundamentals

Audit committee members should approach their annual audit not as a routine exercise but as an opportunity to reassert their independence, neutrality and objectivity. Although audit committee members are well acquainted with their institution’s strengths and weaknesses, they should force themselves to adopt an impartial perspective when assessing external audit findings.

With this in mind, audit committee members should make sure the external auditor is asking the right questions and verify that the audit is being conducted with a healthy dose of skepticism. By dispensing with preconceptions about their institution, committee members can remain open to all answers, explore all possibilities—and more important—be prepared to take the actions necessary to address any issues the external audit uncovers. Furthermore, members can help promote a culture of strong internal controls by demonstrating their commitment to a thorough audit.

2. Try to Anticipate What Comes Next

As regulations and requirements continue to evolve, audit committees needn’t wait for the Federal Reserve or other agencies to release guidance to get a sense of the potential impact on their institution. Fortunately, seeing the future doesn’t have to involve a trip to a psychic for a tarot card reading. The following sources can provide important hints of what to expect.

  • The Center for Audit Quality, based in Washington, D.C., regularly publishes insight and the latest developments. Its board includes leaders from public auditing firms and it is affiliated with the American Institute of Certified Public Accountants.
  • The Public Company Accounting Oversight Board (PCAOB) was established by Congress to oversee the audits of public companies and seeks to promote informative, accurate and independent audit reports.
  • The Securities and Exchange Commission (SEC) has a list of proposed rules on its website that offer evidence on currents trends and areas that the agency is exploring.
  • The business press, both in its coverage and the mix of stories, can be a barometer of where policymakers and enforcement agencies are directing their focus.

3. Be Forthright in Communicating About Negative Audits

Community banks, by the very nature of their close relationship with customers and local businesses, must take special care in explaining audit findings. In the event of a negative or potentially damaging audit, audit committees can play an instrumental role in developing a communications strategy, particularly since an audit can uncover complex or arcane issues that may be difficult for other bank executives or the public to understand.

Across all communications channels—from press releases and investor relations calls to Securities and Exchange Commission filings—committee members should work to be sure that the information is consistent. Moreover, an institution should strive to demonstrate that it embraces accountability and transparency. The tone and messaging can help send a powerful signal that the bank has nothing to hide and is taking the necessary steps to address issues. Information on performance that goes beyond the financial statements is important to maintaining confidence in your institution. For example, non-GAAP key performance indicators such as customer retention and assets under management can offer context and help allay any fears among the public.

By remaining objective, proactive and transparent, the audit committees of community banks can help their institutions stay nimble in the face of changing conditions while instilling confidence in local customers.

Troubled financial institutions face their own compensation restrictions


stormy-board.jpgWhile financial institutions will shy away from the hint of a “troubled condition” designation, such designations are unfortunately a common fact of life in today’s economy. Many more banks and thrifts are finding themselves subject to new compensation restrictions when they fall into the “troubled” category. After an institution is determined to be in troubled condition, it becomes subject to the restrictions on golden parachute payments set forth in 12 C.F.R. Part 359 (“Part 359”).  If its condition continues to deteriorate, the institution might also become subject to the prompt corrective action (“PCA”) rules, which limits the ability to pay bonuses and increase salaries.

Overview of Part 359.  Part 359 limits the ability of financial institutions and their holding companies to pay, or enter into contracts to pay, golden parachute payments to institution-affiliated parties (“IAPs”).  The Part 359 troubled condition “taint” will flow from a troubled institution to its healthy holding company and also from a troubled holding company to a healthy institution (but not from a troubled institution, through a healthy holding company, to a healthy subsidiary).

An IAP is broadly defined and can include any director, officer, employee, shareholder, or consultant.  In certain situations, it can also capture independent contractors including attorneys, appraisers, and accountants.

A “golden parachute payment” (“parachute payment”) is any payment of compensation (or agreement to make such a payment) to a current or former IAP of a troubled institution that meets three criteria.  First, the payment or agreement must be contingent upon the termination of the IAP’s employment or association with the financial institution.  Second, the payment or agreement is received on or after, or made in contemplation of, a determination that, among other things, the institution is in troubled condition.  Third, the payment or agreement must be payable to an IAP who is terminated at a time when the institution meets certain conditions, including being subject to a determination that it is in troubled condition.  Even where a contract pre-dates the troubled condition designation, any parachute payment payable thereunder will be prohibited by Part 359 while the institution is in troubled condition.

Certain types of payments and arrangements are excluded from the definition of a parachute payment.  Generally, payments made under tax-qualified retirement plans, welfare benefit plan, “bona fide deferred compensation plans or arrangements,” and certain “nondiscriminatory” severance plans, as well as those required by statute or payable by reason of the death or disability of an IAP are excluded.

In addition to the general categories of excepted payments, the rules under Part 359 permit a financial institution to make certain parachute payments, or enter into agreements providing for parachute payments, where the institution obtains the prior approval of one or more regulatory agencies.  Such approval is required to pay obligations that pre-date the troubled condition, for the institution to pay, or enter into an agreement to pay, severance to someone who is retained as a “white knight,” or to enter into agreements that provide for change in control termination payments (that are contingent on both the occurrence of a change in control and termination of employment).  In nearly every case, if approval is granted, the approved severance payments will be limited to no more than 12 months of base salary (tax gross-ups will not be permitted in any form) to be paid over time and subject to claw back.

In October 2010, the FDIC issued Financial Institution Letter 66-2010 (“FIL-66-2010”) which expanded the information required to be submitted with an application for approval under Part 359 by requiring an institution to demonstrate that the IAP is not a “bad actor” and is not materially responsible for the institution’s troubled condition.  The guidance also provides for a de minimis severance of up to $5,000 per individual that can be paid without regulatory approval, so long as the institution maintains records detailing the recipient’s name, date of payment and payment amount, and also maintains a certification covering each individual who receives a payment.

Overview of Prompt Corrective Action Rules.  The PCA rules designate four capital categories: “adequately capitalized” (which is an institution in “troubled condition”); “undercapitalized;” “significantly undercapitalized;” and “critically undercapitalized.”  If an institution is significantly undercapitalized or critically undercapitalized, the institution becomes subject to additional compensation restrictions.  Undercapitalized institutions may also become subject to these additional restrictions.  When subject to the PCA compensation restrictions, the institution generally cannot pay any bonus to or increase the salary level of senior executive officers.

Opportunity knocks, but there are drawbacks


The mess in banking isn’t over yet.That means hundreds of banks, most of them small, community organizations, likely will fail in the years to come. The flip side of all that carnage is an opportunity for bankers to buy troubled institutions, grow balance sheets during tough economic times and let the Federal Deposit Insurance Corp. take most of the bad assets of the failed bank.
 
The investment bankers and attorneys who attended Bank Director’s May 2nd conference in Chicago agreed on one theme: There are still plenty of deals to be had for banks looking to buy failed institutions from the FDIC, as long as they work hard, fast and smart to do the deals right. 
 
“There is ample opportunity,’’ said Jeffrey Brand, managing director at investment bank Keefe, Bruyette & Woods. “The FDIC will allow you to bid as many times as you like and they will let you be as creative as you like.”
 
There were more than 523 banks with $318.3 billion in assets at the end of last year that had Texas ratios topping 100 percent, said Brand, using SNL Financial data. The Texas ratio is commonly used to predict bank failure, and is the amount of non-performing assets and loans, plus loans delinquent for more than 90 days, divided by tangible equity capital and loan loss reserves. If it’s more than 100 percent, that’s trouble.
 
The number of troubled banks also appears to be increasing. The number of banks with Texas ratios above 100 percent increased 4.5 percent from the third quarter.
 
The FDIC’s “problem” bank list also appears to be growing. It reached a record high for this cycle of 884 banks at the end of last year, more than 10 percent of the total banking system. That number was up from 860 the quarter before.

Louis Dubin, president of Resolution Asset Management Co., said the states with the most number of troubled banks are Georgia, Florida, Illinois and Minnesota.

Troubled Bank Map: 2010 Q4

fdic-failedmap.jpg

TOTAL BANKS: 417
CRITERIA: Texas ratio > 100%, Leverage ratio <9%

Picking up failed banks from the FDIC offers some benefits: the FDIC can take on as much as 80 percent of the failed bank’s losses, using a tranche system based on the size of the losses. Plus, the acquiring bank can cherry pick the assets, locations and employees it wants. The failed bank’s pre-existing contracts are automatically voided on the sale.

And bankers can get creative in terms of how they structure deals. Brand recommended making several bids, including one that follows traditional FDIC deals and one that doesn’t. For instance, banks can price bids to take into account future risk, instead of using a loss share agreement, avoiding the hassles of regular audits from the FDIC to make sure they comply with the loss-share agreement.

“The FDIC is discovering the costs of auditing all these banks to see what their losses are,’’ Brand said. “Now they’re doing deals without loss share (agreements). You don’t need that expensive accounting system. But they are taking away that safety net, too. If losses are worse than estimated, that’s 100 percent coming out of your pocket.”  

One of the drawbacks of FDIC deals is the possibility that the government could change the rules at any time. The loss share agreement lasts a decade for single-family housing assets; five years for commercial properties.

Buyers also don’t have much time to do due diligence. The entire process, from expressing an interest in acquiring a bank, to closing, can take about 90 days, less if the failed bank’s situation is dire.

“They don’t let you wander around the bank talking to all the lending officers,’’ said James McAlpin, an attorney and partner at Bryan Cave in Atlanta.

Bank employees will have to work quickly to make a bid and conduct due diligence. Plus, they must be able to reopen the bank on the Monday after the bank’s Friday closure, and follow timelines to transition the acquired bank and dispose of its assets.

“It is a tremendous strain on your organization,’’ Brand said.

The Crisis in Community Banking


growth.jpgLost in all the Sturm und Drang surrounding the financial crisis of 2008 – when several large U.S. financial institutions either failed (Washington Mutual Inc.), sold themselves off to avoid failure (Wachovia Corp.), or were simply propped by the federal government (Citigroup) – is the very real crisis facing community banks throughout the country.

The nation’s largest banks – all of which received direct capital infusions from the U.S. government under the controversial Troubled Asset Relief Program (TARP) – are once again profitable, and many of them have long since paid back the money. On the other hand, a great many community banks are still struggling to regain their footing – and for them the long nightmare is not yet over. 

Haves vs. Have-Nots
 
The disparity in fortunes between the industry’s largest institutions and smaller regional banks is framed perfectly by two bank stock indexes published by Keefe Bruyette & Woods Inc. The KBW Bank Index (BKX), which is comprised of 24 U.S. money centers or super-regional banks, was up 17% on the year through late October, while the KBW Regional Banking Index (KRX) – which is comprised of 50 smaller regional banks – was up just 3% on the year. Clearly institutional investors like what they see in the BKX universe, and that has allowed large banks to raise capital at a reasonable cost and put their troubled past behind them. 
 
Smaller regionals have had a more torturous recovery – and many of them were actually quite grateful to receive their TARP funds because when that money was being doled out two years ago it was the only available source of capital for most banks. 
 

Overdosing on Real Estate

But most challenged by far are the thousands of small community institutions that are either privately owned or have thinly traded and highly illiquid stocks and haven’t been able to raise fresh capital to fuel their recovery. For the most part, their downfall has been the result of bad commercial real estate and real estate development loans, including loans tied to the grossly overbuilt housing market in such places as Florida, Nevada and Arizona. 
 
Although the U.S. housing bubble attracted lenders, investors and buyers like moths to a flame, there is a reason why so many community banks ended up being so overexposed to real estate. After 30-some years of disintermediation and conglomerization, there are only a limited number of ways that community banks can make money. Several large asset classes, including car loans, credit cards, mortgages and home equity loans, are now dominated by giant financial companies that have enormous marketing and efficiency advantages. 

Expanding Their Business Model

Many community banks focus on small and medium-sized businesses because it’s one market where their superior service gives them a competitive advantage over the big banks, but generally they lack the revenue diversification of their larger peers. So when the residential real estate market took off in the early 2000’s and local developers were looking for loans to finance their construction activities, many smaller banks saw that opportunity as manna sent down from heaven. 
 
As the U.S. economy improves and the real estate market gradually recovers, community banks will rebound as well. Unfortunately, their underlying weakness – the lack of revenue diversification – will remain. And the challenge for community bank CEOs and their directors will be to expand their business models to include a variety of fee-based activities that will make them less reliant on cyclical lending markets like real estate.
 
Otherwise, the community-banking sector will just be an accident waiting for the next recession to happen.