Many of us who are native Southerners sat with mouths agape as we read the announcement of the $66 billion (!) all-stock merger of equals between super regional banks BB&T and SunTrust. Few of us who grew up in Georgia have not been personally impacted by these banks in some way or another. For me, my aunt worked at Trust Company Bank when I was a kid, and BB&T bought a local thrift (Carrollton Federal), making its way into our home market where it remains today. After college, law school barely beat out an offer to work in SunTrust’s commercial lending training program, and BB&T currently holds the mortgage on my home. With all of those ties, I feel somewhat nostalgic when reading that the bank will be rebranded as a part of the merger.
With that said, the real time business implications for all of us are even larger. The day before the merger, my friend Jeff Davis wrote a smart piece ($) detailing the virtues of merger of equals transactions in today’s world. BB&T recently discussed on its earnings call that it was accelerating cost savings initiatives in order to invest more in its digital offerings. With the announced merger, one can assume that the lab for digital innovation of the combined bank (to be based in Charlotte, a bit of a disappointment to the Atlanta community) will make a massive effort to transform the banking experience of the bank’s customers, a truly meaningful segment of the market. We have recently commented that the transformation of the Atlanta banking market is now a reality, and this combination promises to further evolve how many banking customers think of and interact with their banks.
With both college and professional (not to mention fantasy) football in full swing, we find many conversations with clients drifting to topics from the
gridiron at this time of year. Given that many of us are devoting a significant amount of our personal time to following our favorite teams, many times business points are best illustrated at this time of year by using football analogies.
Certain sports agents have posited that the highest achieving football coaches could easily run Fortune 500 companies but instead chose to coach football for a living. While that point is debatable, we can certainly draw from the talking points of today’s best coaches in setting a framework for approaching a merger transaction. While we can’t deliver Nick Saban, Bill Belichick, or Kirby Smart to your boardroom, use these sound bites to your advantage in setting the tone for how your board addresses an M&A transaction.
Trust the process. “The Process” has become a hallmark of the University of Alabama’s championship dynasty. Coach Saban focuses on the individual elements that yield the best results by the end of the season. Similarly, a well-planned process can be trusted to yield the best long-term results. This simple point is among the easiest for boards to miss. We are often concerned when clients engage in “opportunistic” M&A activity. Instead, we prefer to see a carefully planned process that includes the following fundamental elements:
* Parameters around the profile that potential partners should have, including market presence, lines of business, and size;
* Clearly defined financial goals and walkaway points; i.e., those metrics beyond which no deal can be justified;
* For sellers, the forms of consideration that will be acceptable (i.e., publicly-traded stock, privately-held stock, or cash); and
* Selection of qualified advisors.
Self-scout. Great football teams have an honest self-awareness of their strengths and weaknesses and grasp them on a deeper level than their opponents. Buyers and sellers should also have a frank assessment of their shortcomings. In planning for the M&A process, those weaknesses should be addressed in advance to the extent possible. To the extent they cannot be fixed in advance of embarking on an M&A process, parties should provide a transparent assessment of their weaknesses to potential partners. Doing so enhances credibility and builds trust in the other facets of due diligence.
Know the tendencies of your opponent. On the other side of self-scouting is a great team’s ability to understand and address the weaknesses of its opponents. While we never advise clients to think of M&A partners as adversaries, advance due diligence of a potential partner to identify their needs can certainly help lead to a successful transaction. At its core, a good M&A transaction is about giving a potential partner something it does not have and cannot build for itself. To the extent that parties can identify the needs of potential partners in advance of their initial conversations, they can speak directly to those needs at the outset, thus positioning themselves as an optimal partner in a crowded M&A field.
We are looking forward to running the M&A Simulation at Bank Director’s 2018 Acquire or Be Acquired Conference with our friends at FIG Partners. This is the second year we’ve teamed up with FIG Partners to present a simulation of the community bank merger and acquisition sale process. We’ve identified the basics of this year’s fictional banks, and are looking forward to another exciting simulation.
The simulation is an exclusive session at Acquire or Be Acquired, is open to 45 bank attendees only and fills up quickly. If you’re planning to attend AOBA and want to ensure your spot in the simulation, please contact us. If you’re interested in attending and haven’t already registered the conference, please contact us to receive our sponsorship code for a $400 discount.
The 2017 simulation involved competing bidders for a billion dollar community bank, identified as Bank A. Bank B, a $1.3 billion institution, offered a merger of equals opportunity, hoping that one plus one could equal three, while Bank C, a $6 billion institution with strong organic growth, was able to win the hearts and minds of Bank A with a strong all stock offer. The simulation ultimately mirrored what we often see, small buyers must be very creative or seek opportunities that are not coveted by larger, more highly valued public buyers. See our write-up of the 2017 M&A Simulation for additional information.
In this the new era of banking, our clients are continually looking for ways to enhance efficiency and effectiveness at all levels of their organizations. This line of thinking has led to the revolution of the bank branch and the adoption of many new technologies aimed at serving customers and automating or otherwise increasing process efficiency. Perhaps most importantly, however, banks have begun to focus on optimizing their governance structures and practices, particularly at the board level.
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As we discuss this topic with our clients, the conversation quickly turns to the role and function of the bank’s director loan or credit committee, which we refer to herein as the “Loan Committee.” We continue to believe that Loan Committees should move away from the practice of making underwriting decisions on individual credits absent a specific legal requirement, and here we set forth the position that this change should be made in order to enhance Board effectiveness, not just to avoid potential liability.
Ensuring Board Effectiveness
Whenever we advise clients with regard to governance, our fundamental approach is to determine whether a given course of action helps or hinders the Board’s ability to carry out its core functions. Defining the core functions of a Board can be a difficult task. Fortunately, the staff of the Board of Governors of the Federal Reserve System recently outlined its view of the core functions of a bank Board. We agree with the Federal Reserve’s outline of these functions as set forth in its proposed guidance regarding Board Effectiveness applicable to large banks, which was based on a study of the practices of high-performing boards. Based on our experiences, many of the concepts expressed in that proposed guidance constitute board best practices for banks of any asset size. The proposed guidance indicates that a board should:
set clear, aligned, and consistent direction;
actively manage information flow and board discussions;
hold senior management accountable;
support the independence and stature of independent risk management and internal audit; and
maintain a capable board composition and governance structure.
We believe that an evaluation of the board’s oversight role relative to the credit function is a necessary part of the proper, ongoing evaluation of a bank’s governance structure. As it conducts this self-analysis, a board should evaluate whether the practice of underwriting and making credit decisions on a credit-by-credit basis supports its pursuit of the first four functions. We believe that it likely does not.
Considering Individual Credit Decisions May Hinder the Committee’s Ability to Set Overall Direction for the Credit Function.
We have observed time and time again Loan Committee discussions diving “into the weeds” and, in our experience, once they are there they tend to stay there. In most Loan Committee meetings, the presenting officer directs the committee’s attention to an individual credit package and discusses the merits and challenges related to the proposal. Committee members then typically ask detailed questions about the particular financial metrics, borrower, or the intended project, assuming that any discussion occurs at all prior to taking a vote.
While it may sometimes be healthy to quiz officers on their understanding of a credit package, focusing on this level of detail may deprive the Loan Committee of the ability to focus on setting direction for the bank’s overall loan portfolio. In fact, in many of the discussions of individual credits, detailed questions about the individual loan package may in fact distract from the strategic and policy questions that really should be asked at the board level, such as “What is the market able to absorb with regard to projects of this type?” and “What is our overall exposure to this segment of our market?”
Bank directors have played a crucial role in the turnaround of the banking industry, an accomplishment that deserves recognition in light of the fact that it has been done under tremendous regulatory burden and tepid economic growth. Given that, why do we continue to question why the country’s most respected business people would be willing to serve as bank directors? Respected attorney and industry commentator Thomas Vartanian recently asked in an opinion piece in The Wall Street Journal, “Why would anyone sane be a bank director?” Well, sane people are serving as bank directors every day, and in doing so they are benefiting the economy without exposing themselves to undue risk.
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The regulatory environment for bank directors is clearly improving. The Federal Reserve’s recent proposal to reassess the way in which it interacts with boards is appropriate if overdue, and the other banking agencies should follow the path that the Federal Reserve has set forth. We also witnessed the FDIC acting very aggressively in pursuing lawsuits against directors of failed banks in the wake of the financial crisis. However, suggesting that the FDIC relax its standards for pursuing cases against bank directors is not only unrealistic, it misses the greater point for the industry in that it needs to continue to refine its governance practices in order to provide for better decision-making by bank directors and to enhance protections from liability for individual directors.
In order to fully understand the point of this position, it is important to clear up a couple of commonly-held misconceptions. First, when the FDIC sues a bank director after a bank failure, it does so for the benefit of the Deposit Insurance Fund, which is essentially an insurance cooperative for the banking industry. As a result, the FDIC should be viewed as a purely economic actor, no different from any other plaintiff’s firm in the business of suing corporate directors. Lawsuits by FDIC should not be given any higher profile or greater credibility than any number of other suits against corporate directors that inevitability occur during market downturns. There should be no additional stigma, and certainly no additional fear, with regard to a claim by the FDIC on the basis that it is “the government.”
From 2006 through 2016, the number of insured depository institutions in the United States has fallen from 8,691 charters to 5,922, a decline of 2,769 charters or a 32% loss. This headline loss number is worth talking about, but is neither news nor new. The loss of charters is a frequent source of discussions around bank board rooms, stories from trade press, and chatter at banking conferences. The number of insured charters has also been in steady decline, with at least 33 years of declining numbers.
However, a deeper dive into the numbers reveals some unexpected trends below the headline 32% loss of charters.
Amid criticism from virtually every possible constituency, on March 15, 2017, the Office of the Comptroller of the Currency (OCC) released a draft supplement to its chartering licensing manual related to special purpose national banks leveraging financial technology, or fintech banks. As we indicated in our fintech webinar discussing the proposal last December, the OCC is proposing to apply many conventional requirements for new banks to the fintech charter. While the OCC’s approach is familiar to those of us well versed on the formation of new banks, there are a few interesting items of note to take away from the draft supplement.
More bank than technology firm. Potential applicants for a fintech charter should approach the project with the mindset that they are applying to become a bank using technology as a delivery channel, as opposed to becoming a technology company with banking powers. While the difference might seem like semantics, the outcome should lead potential applicants to have a risk management focus and to include directors, executives, and advisors who have experience in banking and other highly regulated industries. In order to best position a proposal for approval, both the application and the leadership team will need to speak the OCC’s language.
Threading the needle will not be easy. Either explicitly or implicitly in the draft supplement, the OCC requires that applicants for fintech bank charters have a satisfactory financial inclusion plan, avoid products that have “predatory, unfair, or deceptive features,” have adequate profitability, and, of course, be safe and sound. Each bank in the country strives to meet those goals, yet many of them find themselves under pressure from various constituencies to improve their performance in one or more of those areas. For potential fintech banks, can you fulfill a mission of financial inclusion while offering risk-based pricing that is consistent with safety and soundness principles without having consumer groups deem your practices as unfair? On the other hand, can you offer financial inclusion in a manner that consumer groups appreciate while achieving appropriate profitability and risk management? We think the answer to both questions can be yes, but a careful approach will be required to convince the OCC that it should be comfortable accepting the proposed bank’s approach.
On November 29, 2016, the FDIC, as part of its Community Banking Initiative, held an outreach meeting in Atlanta. While the FDIC has indicated that it will publish a handbook regarding applications for deposit insurance in the coming weeks (which we’ll also summarize), we thought it made sense to provide a few highlights from that meeting:
Mechanics. The mechanics of the chartering process are the same as before.
Business Plans. As expected, there will be greater scrutiny on business plans, making sure that banks stick to their business plans post-opening, and (not expressly stated but as translated by me) ensuring that the results of the bank’s business plan do not deviate greatly from the original projections (i.e., providing for limited ability to take advantage of natural growth in the new bank’s markets or lines of business during the first three years of operations if not reflected in projections). Approvals to deviate from one’s business plan will not be granted under most circumstances.
On March 26, 2016, The Economist published an article entitled “The Problem with Profits.” That article discussed the high profitability of U.S. firms and why that seemingly positive fact is actually harmful to the overall economy, mainly because those profits are not being distributed for spending by shareholders or reinvested in business growth. As a result, the economy shrinks as resources flow to these firms and remain on their balance sheets. The focus of the article was a call for increased competition, but we believe we should focus on other conclusions.
While the article gives a tip of the cap to the impact of regulation generally and bank regulation specifically, banks represent the poster child for the negative impacts of limiting the ability of domestic firms to reinvest, an impact that is not directly reflected on balance sheets or income statements.
Since the onset of “new and improved” regulation stemming from Dodd-Frank and other regulatory reforms, we are seeing are clients use their resources to
hold capital on their balance sheets, in some cases to protect against the anticipated negative impacts of an imaginary doomsday scenario;
retain “high quality liquid assets;”
invest in extraordinary compliance expertise and management systems; and
fill buckets left empty from reduced interchange fees, the impact of stress testing, and higher costs to originate mortgage loans, among other things.
As an industry, we frequently point to decreased lending to small businesses and increased consolidation as the evils of increased regulation. In our view, however, the dampening of reinvestment initiatives is much more significant for the industry and for the economy in general.
In June, the Federal Deposit Insurance Corp. (FDIC) issued a rulemaking that proposes to revise how it calculates deposit insurance assessments for banks with $10 billion in assets or less. Scheduled to become effective upon the FDIC’s reserve ratio for the deposit insurance fund (DIF) reaching a targeted level of 1.15 percent, these proposed rules provide an interesting perspective on the underwriting practices and risk forecasting of the FDIC.
The new rules broadly reflect the lessons of the recent community bank crisis and, in response, attempt to more finely tune deposit insurance assessments to reflect a bank’s risk of future failure. Unlike the current assessment rules, which reflect only the bank’s CAMELS ratings and certain simple financial ratios, the proposed assessment rates reflect the bank’s net income, non-performing loan ratios, OREO ratios, core deposit ratios, one-year asset growth, and a loan mix index. The new assessment rates are subject to caps for CAMELS 1- and 2-rated institutions and subject to floors for those institutions that are not in solid regulatory standing.
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