Short-Term Planning for Recovery and Survival

(This post was authored by Walt Moeling and Dustin Hall.  A version of this post originally appeared in the August 2009 issue of the ABA’s Community Banker magazine.)

The grim economic prognoses we continue to hear about have an immediate impact in the bank board room. Boards must think about short-term planning for recovery and survival because virtually no bank is wholly immune from the current recession.  Although the problems may have started with residential real estate in the Sunbelt, they have gone much beyond that now, impacting banks throughout the country.

As a director you must plan for both long-term and short-term.  Long-term planning is tremendously important, and we hope to make it to the “long-term,” but short-term planning is critical today.

Short-term planning in this context deals with the reality of today’s marketplace.  The focus is not on earnings or even stock value, two traditional focal points for planning.  Instead, the focus is on capital management, liquidity, and asset quality.

Capital Management

Your short-term capital planning in the face of mounting losses cannot focus on today or yesterday; it must focus on tomorrow.  You must ask: Where are we going?  What will happen if housing prices drop for another two and a half years, as predicted by some?  Can our borrowers sustain a more prolonged recession?  If not, where will our capital be three, six, and nine months from now?  In essence, you must stress test your bank to see how far it can go.

A real problem for directors is assuming that capital today is as readily available as it has been for the past 15 years, or that they can sell the bank if there is a real problem.  Unfortunately, there is no public market, and virtually no private equity, for bank stock.  Those sources are presently closed, shall we say, for repair.  Instead, short-term capital is likely to be found only within the boardroom and from family and friends.

You must also think about the various capital-raising instruments potential investors may desire: plain debt, subordinated debt, convertible-subordinated debt, preferred stock, or common stock. At the same time, dilution, which we used to worry about, is much less of an issue today.  For example, Colonial Bank recently raised $300 million at 15% of tangible book value, diluting its tangible book value per share from $4.26 per share to $1.45 per share.  In this economy, bank directors and shareholders, like everyone else, have seen their net worth decline.  They are short of liquidity, and any capital contribution will likely come from borrowed sources.

Liquidity

Liquidity risk has ultimately doomed most of the banks that have failed recently.  The banking industry grew so much prior to the recession by using wholesale funds instead of traditional core deposits that the whole industry is at risk.  Many banks do not understand their deposit portfolio and are shocked to find that 20% of their deposits come from a few customers or that huge amounts of brokered funds will come due shortly.  Because formal action by Federal agencies effectively eliminates the use of brokered deposits, banks are all too frequently finding they have very limited funding sources.

Asset Quality

For many bank directors, the question has become: What are we running, a bank or a real estate company?  Most directors recognize that they probably should not run a real estate company—bankers should be in the business of banking.  To deal with problem real estate, boards must help formulate bank policies that address foreclosures, holding versus disposing of OREO, and collections against borrowers. Only by analyzing all of this can you know where the bank will be six, nine, or twelve months from now.

Today’s regulatory approach assumes that problems will get worse before getting better.  Examiners are assessing where the bank will be six to nine months from now, focusing on impairment (FAS 114) and loan loss reserve environmental factors (FAS 5). These are new topics for most directors, and you must ask management to discuss with the board these two topics because they are critical to short-term planning.

Working with Regulators

Regulators are asking whether the board is in a state of denial about problems with borrowers and assets.  Denial can exist in many places.  Regardless of the original fundamentals, after two-and-a-half years of housing declines, even the strongest borrowers have been affected.  Regulators know this, and when a board says its bank is not like others, regulators assume the board simply does not understand the current problems.

Think about establishing a relationship with the regulators.  Today, the chairman, the chairman of the audit committee, probably the chairman of the loan committee, must be intimately involved in the regulatory process to understand where the regulators are coming from.  You need to know the bank’s true condition, and regulators can be the best sources of that information.

Regulators can be very receptive to those boards engaged in the active, short-term planning we are discussing.  Much like you, today’s regulators are so deep in the problems that they cannot afford to think about the long term; instead, regulators think about failing banks, and which banks can survive.  Banks and boards that chart their own course now will be the big winners.

The Future Is Now

There is a back-to-the-future future, and it is a good future for community banks: We’re going back to the era of the real banker, and retail strategy will be critical to generate the deposits that will drive community banks going forward.

We are seeing growth in real deposits.  Community banks that lost business as Wall Street underpriced them are now likely to see a return of consumer business.  Wall Street’s capacity to fund easy-money credit cards, home equity lines, and automobile loans has been materially diminished, and, as a result, many people will return to our community banks for funding and liquidity.

As we move forward, personal liability is a significant, legitimate concern.  The warning signs that regulators look for and the topics they talk about are failed business strategies (e.g., expanding real estate lending in 2006 and 2007) and inadequate director oversight (e.g., failing to monitor management, engaging in improper self-dealing, violating the loans-to-one borrower rules, and engaging in insider trading).  You must aggressively address any potential violations and increase participation in the bank’s affairs.

As we emerge from this downturn, you must think about your bank’s products and how your bank will take advantage of the hopefully tremendous opportunities for community banks.  However, right now you must engage in the necessary short-term planning to allow your bank to make it to the other side.