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Can Standards and Voluntary Certification Help Community Banks and Fintechs Grow, Together?

COVID-19 has laid bare the need to have good technological solutions for the systems and services upon which we rely. In the financial sector, perhaps more than many others, the pace of innovation is beholden to regulatory parameters, but there is some optimism that Fintechs can help fill the gap in traditional financial products, especially in emerging markets. As in our in recent post about digital banking modernization by the OCC, regulators are feeling out the interest in certain programs. On Monday, July 20, 2020, the FDIC announced a request for public input on a certification program to “promote the efficient and effective adoption of innovative technologies at FDIC-supervised financial institutions.”

More specifically, the FDIC is seeking input regarding whether the development of relevant standards in connection with a voluntary certification process could be applied to third-party models and whether such standards would allow more financial institutions, particularly community banks, to engage with third parties that provide these models, including Fintechs. Such a voluntary certification program could, in theory, reduce costs of doing business for both the financial institutions and providers of models and permit FDIC supervision resources to be used more efficiently and effectively.

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Lessons for Community Bank Boards from the Great Recession to Apply in the Pandemic

In March, I dialed into the first ever “conference call only” meeting of a 14 year old community bank. The main office of the bank is located in Philadelphia and there was growing concern about the rapidly increasing number of Coronavirus cases in New York and New Jersey, and the spread of new cases into eastern Pennsylvania. I recalled that our board had reviewed an updated version of the bank’s pandemic policy in December but I couldn’t remember the details. Suddenly that policy had relevance in a way I could never have imagined. In April, our board held its second conference call only meeting, and we are likely to continue that pattern for several more months.

We are all aware of the circumstances that led to pandemic policies being retrieved from file folders and read with interest for the first time.  What we don’t yet know is how severe the resulting economic shock will be, and the degree to which loan portfolios of community banks will be adversely impacted.  It is clear, however, that the adverse impact on small to medium sized businesses across the U.S. has been considerable. As the CEO of one of our law firm’s bank clients in the Southwest recently remarked, we are experiencing the first ever government imposed recession.

God willing, the banking industry will remain strong and be a source of support for the nation’s economy as we recover from the onslaught of COVID-19.  In that context, the boards of community banks could benefit from recalling some hard learned lessons from the recent Great Recession. 

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In Praise of Community and Regional Banks

Last week my partner Rob Klingler posted an impassioned plea to the SBA and bank regulators to allow banks with less than 500 employees to be borrowers under the Paycheck Protection Program, or PPP as it has become known. Rob joined a chorus of voices across the country pointing out that community banks are small businesses too, and if the jobs of employees at a community bank can be saved isn’t that as helpful to the economy as any other small business? Unfortunately, the overhang of TARP appears to continue to cloud decisions in Washington and banks were excluded from receiving loans under the PPP. Irony drips from that decision. At the beginning of the last financial crisis, when the business fortunes of some of the largest banks appeared at risk, Washington rushed to their aid with TARP. Now, at the beginning of a financial crisis that is hitting small business hard, community banks are being told they are the only small businesses in America which must soldier on without government financial assistance.

In that context, isn’t it remarkable that small and mid-sized businesses across the country are flocking to community and regional banks for responsive assistance in the PPP process? My practice has always been a mix of corporate finance and advisory work for middle market businesses and consulting and board advisory work for banks. I like the balance and the perspective that mix brings. Over the past two weeks this view into two worlds has revealed to me the true nature of relationship banking, and the absolute commitment to that concept at most community and regional banks. My clients and contacts in the middle market business world have been frequently asking for updates on the roll out of the PPP program. That was understandable and to be expected. What I did not expect was the volume of calls I’ve been receiving for referrals to smaller banks from customers of large banks. Those calls often begin with expressions of frustration at the inability to get anyone from the larger bank on a call or even to respond to an email regarding the PPP process, and that the most frequent communication received is “you need to visit our website for assistance.” In an environment where hundreds of thousands and likely millions of small to medium sized businesses across the country are suddenly struggling, and with no sense of the near term path, it really matters to the persons running those businesses that they receive support, encouragement and, if possible, assistance from their bankers. It is in the difficult times when relationship banking really matters, not the boom times.

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Too Small to Succeed or Ownership Structure to Thrive?

Two recent federal banking agency reports show very different pictures of the banking environment for community banks.  In “Too Small to Succeed? – Community Banks in a New Regulatory Environment,” the Federal Reserve Bank of Dallas lays out the “apparent” rising regulatory burden confronting banks today.  In contract, “Financial Performance and Management Structure of Small, Closely Held Banks,” published in the FDIC Quarterly, provides an empirical analysis of the success of closely held community banks in the FDIC Kansas City, Dallas and Chicago regions.

Lots of Community Banks Remain

As a reminder (which often seems forgotten in these discussions), the U.S. banking industry is still full of community banks.  As of December 31, 2015 (the latest data available), there were 6,182 insured depository institutions in the United States (banks and thrifts, exclusive of credit unions).  Only 107 of those institutions had more than $10 billion in assets; 595 institutions had between $1 and $10 billion, 3,792 had between $100 million and $1 billion, and 1,688 had less than $100 million in assets.  (That’s not to say there isn’t significant concentration; the 110 institutions over $10 billion in assets hold over 81% of the assets in the industry.)

As indicated by the otherwise down-beat Federal Reserve paper, community banks (measured as having less than $10 billion in this analysis) have still maintained 55% of all small-business loans and 75% of all agricultural loans (and banks under $1 billion in total assets still provide 54% of all agricultural loans).  As pointed out by the Federal Reserve paper, community banks accounted for 64% of the $4.6 trillion of total banking assets in 1992, but accounted for only 19% of $15.9 trillion of banking assets in 2015.  While we have certainly had consolidation (both fewer banks, and larger banks), the community bank’s aggregate market ownership has, based on the Federal Reserve’s percentages and totals, actually gone up slightly from $2.9 trillion to $3.0 trillion.

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How to Get the Most out of Annual Board Reviews

There has never been a more challenging time to be a bank director. The combination of today’s hugely competitive banking market, increased regulatory burden and rapid technological developments have raised the bar for director oversight and performance. In response, an increasing number of community banks have begun to assess the performance of directors on an annual basis.

Evaluation of board performance is done in many ways, and ranges from an assessment by the board of its performance as a whole to peer-to-peer evaluation of individual directors. Public company boards are increasingly being encouraged by institutional investors and proxy advisory firms to conduct meaningful assessments of individual director performance. The pace of turnover and change on most bank boards is slow, and more often the result of mandatory retirement age limits than focus by the board on individual director performance. This may be untenable, however, as the pace of external change affecting financial institutions often greatly exceeds the pace of changes on the bank’s board.

While some institutions prefer a more ad hoc approach to assessing the strengths and weaknesses of the board and its directors, we suggest that a more formal approach, perhaps in advance of your board’s annual strategic planning sessions, can be a powerful tool. These assessments can improve communication between management and the board, identify new skills that may not be possessed by the current directors, and encourage engagement by all directors. If used correctly, these assessments often provide valuable information that can focus the board’s strategic plan and help shape future conversations on board and management succession.

So what are the key considerations in designing an effective board evaluation process? Let’s look at some points of emphasis:

  • Think big picture. Ask the board as a whole to consider the skill sets needed for the board to be effective in today’s environment. For example, does the board have a director with a solid understanding of technology and its impact on the financial services industry? Are there any board members with compliance experience in a regulated industry? Does the board have depth in any areas such as financial literacy, in order to provide successors to committee chairs when needed? Do you have any directors who graduated from high school after 1985?
  • Develop a matrix. Determine the gaps in your board’s needs by first writing down all of the skill sets required for an effective board, and then chart which of those needs are filled by current directors. Then discuss which of the missing attributes are most important to fill first. In particular, consider whether demographic changes in your market will make recruiting a diverse and/or female candidate a priority.
  • Determine the best approach to assessment. Engaging in an exercise of skills assessment will often focus a board on which gaps must be filled. It can also focus a board on the need to assess individual board member performance. Many boards are not prepared to launch into a full peer evaluation process, and a self-assessment approach can be a good initial step. Prepare a self-assessment form that touches upon the aspects of being an effective director, such as engagement, preparedness, level of contribution and knowledge of the bank’s business and industry. Then, have each director complete the self-assessment, with a follow-up meeting scheduled with the chair of the governance committee and lead independent director for a conversation about board performance. These conversations are often the most impactful part of the assessment process.
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How the New FDIC Assessment Proposal Will Impact Your Bank

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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Congress Makes Capital Requirements Easier for Small Banks

Author’s Note: On April 9, 2015, the Federal Reserve adopted a final rule to implement the changes discussed below.  The final rule will be effective 30 days after publication in the Federal Register.

For many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?”  Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.

President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.

The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.

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Keys to Success in the FDIC’s Definition of Community Bank

In a recent strategic planning meeting, a bank chairman opined that “community banking is dead.” He is not the only banker and his is not the only bank grappling with this concern. After that meeting, we solicited the input of many of our peers in the industry. Were increasing expenses and shrinking margins killing community banks? Was the ever-quickening pace of technology too much for community banks to overcome? Were the building regulatory demands insurmountable for community banks? As we asked our peers these questions, many of them gave multi-faceted answers based on different assumptions of exactly what was meant by “community bank.” 

Around the same time, the FDIC proposed its own definition of “community bank” as a part of its Community Banking Study, which was published in December 2012. This study not only defends the viability of community banks but also introduces a thought-provoking definition of exactly what constitutes a community bank. The definition includes a component related to size and a component related to core deposit gathering. It also includes components related to the number of offices and percentage of loans to assets. The focus of this article, however, is the following two criteria: 

  • simplicity of business plan; and 
  • operating within a limited geographic area.
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OCC Releases Stress Testing Guidance for Community Banks

On October 18, 2012, the OCC released stress testing guidance  for national banks and federal savings associations with $10 billion or less in total assets.  While the regulatory authorities clarified in May of this year that the Supervisory Guidance on Stress Testing for Banking Organizations with More than $10 Billion in Total Consolidated Assets would not apply to community banks, the OCC has now confirmed that the stress testing requirements in Dodd-Frank have “trickled down” to community banks, at least to those regulated by the OCC. The guidance states that appropriate stress testing should be performed at least annually.

Fortunately for community bankers, the stress testing guidance is greatly scaled back from the rules applicable to larger institutions, and the requirements are flexible in many respects. The guidance specifically states that the OCC does not specifically endorse any particular stress testing model and that banks with smaller scale and lesser complexity may be able to satisfy the requirements of the guidance by performing single spreadsheet analysis in some cases. This acknowledgement is in stark contrast to the onerous requirements applicable to larger banks, which can be read to require testing of all likely and unlikely scenarios using a wide variety of scenarios through the use of a number of different models.

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TARP Extension – Capital for Community Banks?

On December 9, 2009, Treasury Secretary Geithner exercised his discretion to extend the TARP program through October 3, 2010.  In his letter to Congress certifying the extension, Geithner indicated that the Treasury Department would limit new commitments in 2010 to three areas:

  • mitigating foreclosure;
  • “recently launched initiatives to provide capital to small and community banks, which are important sources of credit for small businesses”  (including additional efforts to facilitate small business lending); and
  • increasing Treasury’s commitment to the Term Asset-Backed Securities Loan Facility (TALF).

The “recently launched initiatives to provide capital to small and community banks, which are important sources of credit for small businesses” presumably refers to the new capital program for community banks previously announced by President Obama on October 21, 2009. President Obama had indicated that the Treasury would be developing a program to provide TARP capital to community banks with less than $1 billion in total assets who committed to increase small business lending.  The capital investment, as proposed, would be limited to 2% of risk-weighted assets and would carry a 3% dividend rate for the first five years.  No indications were provided that the Treasury’s viability standard would be modified to permit additional banks to participate.

Secretary Geithner’s reference to this program is the first follow-up we’ve heard since Obama’s announcement.  As recently as last week, local FDIC officials were telling us that the program appeared to be “dead on arrival” in DC, and there appeared to be little support in Washington for further developments.  We understand the FDIC was advising interested banks to not anticipate any further action, and to seek capital elsewhere.

It remains to be seen whether Secretary Geithner’s letter to Congress represents a renewed interest in this program, merely a political statement indicating a focus on small business lending, or a simple preservation of flexibility going forward.

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