Many financial institutions, particularly community banks, have enhanced the experience level of their boards by adding a director who is a banker or serves on the board of another financial institution. In general, utilizing a director who has current experience with another financial institution is a great way to add valuable perspective to a variety of issues that the board may encounter. In addition, as private equity funds made substantial investments in financial institutions, they often bargained for guaranteed board seats. The individuals selected by private equity firms as board representatives often serve on a number of different bank boards. As market conditions have led to increased bank failures, however, a problem has resurfaced that may cause some financial institutions to take a closer look at nominating directors who also serve other financial institutions: cross-guarantee liability to the FDIC.
The concept of cross-guarantee liability was added to the Federal Deposit Insurance Act by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). The pertinent provision states that any insured depository institution shall be liable for any loss incurred by the FDIC in connection with:
- the default (failure) of a “commonly controlled” insured depository institution; or
- open bank assistance provided to a “commonly controlled” institution that is in danger of failure.
This means that if two banks are “commonly controlled” and one of them fails, the other bank can be held liable to the FDIC for the amount of its losses or estimated losses in connection with the failure. As many of us see each Friday, the amounts of these estimated losses are often quite high. In fact, the FDIC’s estimated losses for 2011 bank failures were approximately 20 percent of total failed bank assets for the year. Accordingly, the prospect of cross-guarantee liability can be a tremendous financial issue for the surviving bank.
A Letter to our Clients and Friends in the Financial Institutions Industry (Spring 2012)
Walt Moeling and Jim McAlpin spoke at the 2012 Acquire or Be Acquired Conference sponsored by Bank Director Magazine. Their topic was “The Path to Recovery – Building Value in a Changing Environment.” In preparation for their presentation at the AOBA conference, Walt and Jim surveyed a group of leading industry observers to obtain their insights. (A printer-friendly version of the Letter to Clients is also available.)
We thought you would be interested in what we heard this year in response to these questions, and the following is an excerpt from Walt’s and Jim’s presentation at the AOBA Conference:
Background
6,800 commercial banks (91% of all U.S. banks) have assets of less than $1 billion. Only 560 banks have assets between $1 billion and $10 billion, and only 106 institutions have assets greater than $10 billion. 2,500 banks (33% of all U.S. banks) have assets less than $100 million.
Both ROE and ROA for banks with less than $10 billion in assets improved in 2011, but still were about 65% to 70% of historical averages.
Economists surveyed by The Wall Street Journal expect U.S. GDP growth of just 2.3% for 2012. [The Wall Street Journal, December 22, 2011.]
2012 Bryan Cave Survey
We surveyed 50 industry thought leaders, including bank consultants and advisers, investment bankers and partners at private equity firms. We asked them to look forward over the next few years and give us their thoughts on factors considered by bankers and boards of directors when conducting strategic planning. We received more than 40 responses from across the country. Many of our respondents have allowed us to share their comments either with attribution or anonymously.
“What will be the pace of growth in the U.S. economy and in bank assets over the next 3 years?”
Survey respondents consistently predicted the pace of growth in the U.S. economy over the next 3 years to be between 2% and 3%.
Over the past several years we have seen the regulatory agencies become much more focused on board oversight and performance. This is a natural point of focus for regulators in a time of crisis in the banking industry. The fiduciary and oversight obligations of members of boards of directors are well established, and there is a road map in the corporate records for following the actions and deliberations of a board. I would suggest, however, that a board of directors could receive a gold star for the quality of its minute records and its adherence to the established principles of corporate governance, and yet fall well short of being an effective working group.
This is the third in a series of articles of best practices for bank boards. (Parts 1 and 2 can be found here and here, respectively.) Over the past several decades my partners and I have worked with hundreds of bank boards. Regardless of the size of the entity we have noticed a number of common characteristics and practices of the most effective boards of directors. This series of articles describes ten of those best practices. The first two articles in the series focused on the best practices of selecting good board members, adopting a meaningful agenda, providing the board with the most useful information, encouraging board participation, and making the committees work. In this article I will discuss three additional best practices – meeting in executive session, making use of a nominating committee and director assessments, and participating in the examination process.
Best Practice No. 6 – Meet in Executive Session
It is not uncommon for the most passionate and meaningful discussion among board members to occur in the parking lot of the bank following a board meeting. Much more time is spent in these parking lot sessions discussing a possible sale of the bank and the compensation and performance of the bank CEO than ever takes place in the board room. The most effective boards of directors move these conversations to the board room by means of executive sessions. Whether monthly or quarterly, the independent (i.e., non-management) directors meet in executive session and set their own agenda for those meetings.
I have found that CEOs who welcome and facilitate such executive sessions never regret doing so. Executive sessions provide a structured forum for the independent directors to meet as a group and speak freely regarding matters of interest and concern to them. Many positive ideas and discussions can result from these sessions. If the CEO is also chairman of the board, a “lead director” can chair the executive sessions. A best practice is for the chairman or lead director to meet with the CEO following an executive session and report on the substance of the matters discussed.
Following the failure of over 400 financial institutions since the beginning of 2008, the FDIC has clarified its expectations with respect to collection and retention of bank documents by directors and officers of troubled or failing financial institutions for the purpose of explaining or defending their conduct. The FDIC’s Financial Institution Letter (FIL) released today sets forth the FDIC’s position that “[d]irectors and officers of troubled or failing financial institutions who remove originals or copies of financial institution records under such circumstances breach their fiduciary duty to the institution.” Presumably the FDIC would also object to a director or officer of a healthy bank copying and removing bank documents if the FDIC concludes that it is being done for improper purposes, although the FIL does not specifically address that issue.
Even though the guidance comes late in the game, we believe it is helpful for the FDIC to articulate its position on this matter to provide clarity to industry participants. We are disappointed, however, that the FDIC chose to issue this broad guidance through a financial institution letter (which cites no statutory authority or judicial decisions in support of its position) rather than through a formal rulemaking process whereby affected parties could offer comments.
Just as many bankers believed that the worst of the enforcement environment was behind them, a threat of “new” Consent Orders for some state non-member banks has arisen. These “new” orders are not reflective of banks for which the regulators have identified new problems but are instead based upon the FDIC’s apparent decision that orders that were “led” by state regulators are not adequate for the FDIC’s enforcement purposes. To illustrate this point, the new orders we have seen thus far have been substantively consistent with the existing state orders.
This movement by the FDIC comes at an unfortunate time given overall downward trend in the number of FDIC consent orders being issued as banks continue to identify and manage their problems. From a practical standpoint, the publication of a new FDIC order may result in perception that a bank’s condition is worsening when in fact the bank is well on its way to compliance with the existing state order.
The day when the board’s focus was limited to approving loans and marketing the bank in the community is long past. Today’s boards face a wide array of complex tasks, and, accordingly, the composition, structure and organization of the board must all be geared to facilitate the board’s performing its duties and functioning properly. This process today is lumped under the heading of “corporate governance.”
(For a printer-friendly version of this post, including a sample Director Self Assessment form, please click here.)
The concept of functioning properly, of course, is in the mind of the beholder, but it clearly includes the board’s performing its primary duties of enhancing shareholder value, selecting, compensating and overseeing management and implementing risk management policies.
Boards of publicly traded banks are now fairly well acclimated to the issues comprising corporate governance, and bank regulators are now bringing many of these issues into the community bank board rooms. The regulatory exam almost always includes as its foundation an assessment of the strength of the board, whose oversight is considered critical to the proper functioning of a healthy bank. As a result, it is important for community bank directors to understand corporate governance principles, which fall under three broad categories.
- Board Assessment—Is the board properly structured to provide optimal oversight to the bank?
- Director Independence—Is the board able to effectively review management recommendations and make its own independent decisions regarding the bank’s strategy?
- Management Review and Compensation—Does the bank have the right management team, and are those individuals compensated in a way that incentivizes them to implement the bank’s strategy?
Board Assessment
A review of hundreds of regulatory memorandums of understanding (MOUs) and consent orders has produced a clear starting point: Virtually every formal action begins with the requirement that the board increase its involvement and conduct an assessment of the performance and composition of management. The board’s assessment function, however, begins with the directors themselves. This self-assessment by the board is a logical starting point to ensure top board performance.
My colleagues and I frequently meet with bank boards that have received very sobering reports from their bank’s examiners. While the directors’ responses to bad examination reports vary greatly, there is one emotion that is nearly universal: a feeling of helplessness. As a result, directors almost always express a desire to get involved in the exam process after they receive negative feedback from the examiners, whether through requesting meetings with higher-level regulators, appealing the exam findings, or fighting a proposed enforcement action. Unfortunately, those actions, particularly if taken after a final examination report is issued, seem to have little positive impact on the examination process and may even prove to be harmful to the bank.
The good news, however, is that there is a way for directors to get involved in the regulatory examination process that can have a meaningful positive impact. Discussed below is our top recommendation for directors to be involved in the examination process. We believe early, proactive involvement can positively impact the outcome of a regulatory examination and also enhance the board’s understanding of regulatory criticism.
While most directors’ first contact with examiners is at the examiners’ exit meeting with the board, we suggest director involvement earlier in the examination process. There should be one or more outside directors present at the examiners’ preliminary exit meeting with management. During this meeting, the examiners will present their preliminary findings from the examination. In addition to highlighting the engagement and availability of the bank’s directors, attending this meeting allows the directors to understand the key issues in the examination. By hearing the examiners deliver their findings first hand, the directors will have a better sense of the seriousness of the issues being identified. Finally, directors will be able to ask questions of the examiners that might not be easily asked by members of management; e.g., asking for an interpretation of a regulation.
By attending this preliminary exit meeting, directors are also able to ensure that the bank’s board has a timely understanding of the issues presented by the examiners. Members of the bank’s executive management team have a natural tendency to relay examination criticisms to the board through their own point of view. Management may fear adverse action by the board as a result of regulatory criticisms or may feel so strongly about their point of view that they tend to “water down” the comments of the examiners. By having outside directors attend the meeting, those directors can deliver an independent report of the regulatory criticisms to the board.
Over the past several years I have attended dozens of meetings of boards of directors of banks in troubled condition. The vast majority of these boards were well functioning and had dedicated and hard working directors. Geographic location has been the predominant factor in determining winners and losers among banks in this challenging economy. However, there have been several situations in which it appeared to me that the composition of a board, and the interpersonal dynamics among its members, had magnified the impact of the economic downturn. A bank board is like any other working group in that the direction and decisions of a board can be heavily influenced by members who dominate the conversation, or by members who actively discourage discussion or dissent.
This is the second in a series of articles on best practices for bank boards. (Part 1 can be found here.) During the past several decades, my partners and I have worked with hundreds of bank boards, for institutions ranging in size from under $100 million in assets to well over $10 billion in assets. Regardless of the size of the entity, we have noticed a number of common characteristics and practices of the most effective boards of directors. This series of articles describes ten of those best practices. In the first article in the series, I focused on two fundamental best practices—selecting good board members and adopting a meaningful agenda for the board meetings. In this article I will discuss three additional best practices—providing the board with meaningful information, encouraging board member participation and making the committees work.
Best Practice No. 3 – Provide the Board with Information, Not Data
Change the monthly financial report to something meaningful. Most boards need to know only about 20 to 30 key data points and ratios and how those numbers compare to budget, peer banks and prior year results to have a good handle on the condition of the bank. By contrast, the typical financial report at a bank board meeting is encompassed in a 25 to 30 page document that blurs into a very detailed, and often meaningless, recitation of data that is difficult to follow.
Providing meaningful information in an understandable format is essential for the board members to identify and manage risk. Less is often more in effective board presentations.
On January 29, 2011, Bryan Cave partners Jim McAlpin and Walt Moeling presented at the 2012 Bank Director Acquire or Be Acquired conference in Phoenix, Arizona. Their presentation was titled, “The Path to Recovery – Building Value in a Changing Environment.”
The presentation includes an overview of the results of the 2012 Bryan Cave Survey of investment bankers and bank consultants to assist in providing strategic advice to clients. A sampling of results include:
- “In my opinion, the calendar just needs to turn another 3 to 6 more months and more signs of credit stabilization just need to naturally occur. We think folks will be pleasantly surprised to see the natural “mating process” happen on its own in 2012. [This will] start really slow but moderately gain momentum as 2013 unfolds, and by 2014 it will be a great deal different.” – Chris Marinac, FIG Partners
- “Failed bank opportunities need to disappear (still two more years of this in the Southeast); more healthy buyers need to appear; private equity will become much more involved; buyers prices need to improve; Banks with TARP will likely have to sell as capital markets will not open up in time.” – Bill Wagner, Raymond James
- “Dominate its ‘micro’ market as it relates to deposits and their lending competency and try to achieve critical mass (~$750m).” – Jeff Brand, KBW
- “Sometimes the blocking and tackling basics are a competitive advantage – provide the services desired on par with the big banks with care and concern.” – Phil Moore, Porter Keadle Moore
A copy of their PowerPoint presentation is now available online.
On January 26, 2012, the Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) released its latest Quarterly Report to Congress. At 302 pages, I can’t say that it’s recommended reading for anyone, but there are portions of it that may be of significant interest to those in the industry.
One of the central themes of the SIGTARP report is that TARP will continue to exist for years. In addition to programs designed to support the housing market and certain securities markets that are scheduled to last until as late as 2017, 371 banks remain in the TARP Capital Purchase Program. While I disagree with some of SIGTARP’s conclusions and framework for the issues, I agree that a clear and workable exit plan for community banks is crucial to financial stability.” SIGTARP has recommended that Treasury develop a clear TARP exit path for community banks, especially in light of a steep rise in the TARP dividend rate from 5% to 9% starting as soon as late 2013. “Treasury must develop a workable plan in consultation with the regulators and begin executing that plan to remove uncertainty related to these banks.”
Despite its negative public perception, the overall Capital Purchase Program is universally thought to have earned a positive return for the government. While estimates for the total TARP program continue to show a significant cost, these costs are primarily tied to the housing support programs (which were never intended to be profitable) and relief provided to AIG and the automotive industry. Estimates on the CPP program, on the other hand, range from a gain of between $7 billion and $17 billion. Specifically, the Office of Management and Budget estimated on November 18, 2011 (using data as June 30, 2011) that the CPP would result in a $7 billion gain; the Congressional Budget Office estimated on December 16, 2011 (using data as of November 15, 2011) that the CPP would result in a $17 billion gain; and the Treasury estimated on November 10, 2011 (using data as of September 30, 2011) that the CPP would result in a $13 billion gain. While Treasury may incur losses on some of the remaining investments, the program as a whole (even without considering how bad the economy may have performed in the event the Treasury had not invested in banks under the CPP), will be profitable. Investing is a risk/reward analysis, and any investment strategy, especially when considering investments in over 700 financial institutions, should be viewed at the portfolio level. To that extent, TARP generally, and the CPP specifically, should be viewed as a success.
Under the CPP, Treasury invested a total of $204.9 billion of TARP funds in 707 financial institutions. Through December 31, 2011, 279 banks – including the 10 largest recipients of funds and 137 that exited TARP by refinancing the investment under the Small Business Lending Fund (SBLF) program – had fully repaid CPP or the Treasury had sold the institution’s stock. In addition, 28 banks converted their CPP investments into CDCI investments and 13 banks have partially repaid. On the other hand, 12 CPP investments have been sold for less than their par value and 14 are in various stages of bankruptcy or receivership.
As of December 31, 2011, $185.5 billion of the principal (or 90.5%) had been repaid, leaving approximately $19.5 billion outstanding. Of the repaid amount, $355.6 million was converted into CDCI investments (which is part of TARP), and $2.2 billion was converted into SBLF investments (which is not part of TARP). In addition, Treasury has received approximately $11.4 billion in interest and dividends and $7.7 billion from the sale of common stock warrants that were obtained in connection with the CPP financings.