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.

The concept of cross-guarantee liability was developed in response to some perceived abuses by multi-bank holding companies during the 1980s. In those instances, one or more institutions owned by a multi-bank holding company failed, causing significant losses to the FDIC, while the other subsidiaries of the multi-bank holding remained open and viable, allowing the holding company to continue to profit from their operations while the FDIC was stuck with the losses from the failed institutions. With authority to assess cross-guarantee liability now in hand, however, the FDIC has shown a willingness to assert cross-guarantee liability under facts that would not be considered by most to be abusive. In this cycle, the FDIC appears to be willing to take full advantage of the assessment authority granted to it by FIRREA, using cross- guarantee liability as a “sword” to provide a recovery to the Deposit Insurance Fund.

The imposition of cross-guarantee liability starts with an assessment of control. Whether institutions are “commonly controlled” for purposes of determining cross- guarantee liability depends upon whether each institution is under the control of a common entity under the Bank Holding Company Act of 1956, as amended (BHC Act). Because the determination of control is made under the BHC Act, the Federal Reserve’s BHC Act control guidance is helpful. However, this guidance is very dense and can be quite complicated, requiring a review of the ownership structure, management practices, and other business affiliations of the two institutions. However, one thing is clear: In questions of control, institutions that share “management officials”—common directors and/or executive officers—are generally more likely to be found to be under common control than those that do not, all other factors being similar.

As a result, institutions with directors who serve on other bank boards or as officers of other banks should assess potential cross-guarantee risk through the director nomination process. Nominating committees (or other committees of the board reviewing director qualifications) should ask the following questions:

• Does the individual serve on as a director or officer of another financial institution?
• Is there a basis for determining that the two institutions are under common control? Answering this question will likely require consultation with legal counsel.
• Is the other financial institution in a financial condition that is less than sound?

If the answer to all of these questions is “yes,” the nominating committee should think carefully about whether nominating that individual is a good idea. In addition, institutions guaranteeing board seats to investors (such as in connection with a private equity investment) should consider an exception to the nomination requirement when the election of the representative could create a risk of assessment of cross-guarantee liability.

A risk assessment requires an in-depth factual, legal and financial analysis. There are few organizations that will find out this issue places them at risk, but it’s worth attention because the consequences can be severe. As a result, an assessment of this risk should be an integral part of the annual nomination process.

This article was original published on BankDirector.com.

Related posts:

1. FDIC Brings Suit Against Former Directors and Officers of Freedom Bank of Georgia
2. Bank Eligibility to Bid for Loss Sharing Arrangements
3. FDIC Brings Suit Against Former Officers of Failed California Bank

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%.

Estimates for growth in bank assets ranged from 2% to 5% in 2012, and from 3% to 5% in years 2013 and 2014.

Jim Stokes of SunTrust Robinson Humphrey:  “Almost all community bank budgets for 2012 have shown zero loan growth, but improved earnings through cost control and normalized provision. Margins may improve slightly as NPAs resolve.”

Chris Marinac of FIG Partners:   ”Bank assets, in the aggregate, likely expand by no more than 5% cumulatively from year-end 2011 to year-end 2014. If the economy expands 1.5% on average in each of the next 3 years, then the cumulative effect is 4.6%. We think a rising economic output could be funded entirely with cash and existing resources such that credit does not expand, but, since interest rates are at historic lows, we think credit expansion still occurs and probably mirrors the macro GDP figures nationwide.”

Bill Wagner of Raymond James:  “I think you have to separate the banking industry into sub-segments. The larger banks will return to normalized profitability within the next two years. However, smaller community banks will unlikely return to pre-recession profitability within the next three years due to margin pressures, credit costs (especially in the Southeast) [and] regulatory burdens.”

“What changes should be expected in profitability for top quartile performance banks by year end 2014?”

For banks under $500 million in assets, survey respondents predicted 2014 ROA in a range of 60 bps to 90 bps and ROE between 8% and 10%.

For banks between $500 million and $1 billion in assets, respondents predicted 2014 expectations for ROA in a range of 70 bps to 100 bps and for ROE to fall between 9% and 11% in that same time period.

For banks between $1 billion and $10 billion in assets, expectations for 2014 ROA ranged between 100 bps to 125 bps, with ROE for the period predicted to be between 12% and 15%.

For banks with assets over $10 billion, 2014 predictions for ROA ranged from 115 bps to 130 bps, with ROE predictions for the same period falling between 12% and 15%.

We next asked our survey respondents about anticipated acquisition multiples by year-end 2014.

From the responses we received, it appears that 1.50x book is the new 2.50x book.

For well performing banks with under $1 billion in assets, our survey respondents predicted a range of 1.25x to 1.50x book and 12 x to 14 x earnings by 2014.

Again this year, a number of our respondents shared the view that the greatest likelihood for “premium” pricing will be for banks between $1 billion and $10 billion in assets. A range of 1.50x to 1.75x book was predicted for banks in that size range, with the possibility of 1.75x to 2.00x book for the very strongest. Price to earnings predictions ranged from 13.5x to 18x.

“What conditions will need to exist before the open M&A market becomes vibrant again, and when do you think that may happen?”

Instead of a summary of the responses, we have included below a few of the responses to this question that capture the overall sentiment of our survey participants.

Chris Marinac of FIG Partners:  “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 modestly gain momentum as 2013 unfolds, and by 2014 it will be a great deal different.”

Peyton Green of Sterne Agee:  “Rising collateral values (real estate) are the key. ALL of the buyers we speak to are at best suspicious of the marks that targets have taken. Sellers need to become realistic about the pricing conditions. Fair Value accounting and weak real estate conditions remain the biggest hurdles to clear.”

“Assuming adequate capital and the absence of any special regulatory restrictions, what are the most important steps that a bank with $250 million in assets could take over the next few years to build greater market value in its franchise?”

We’ve picked a few responses that capture what we heard from many of the survey participants.

Curtis Carpenter of Sheshunoff:  “Organic loan growth is quickly becoming the key to community bank profitability. If the current low-interest rate environment persists, the ability to generate loans will become the distinguishing characteristic of profitable banks. Consequently, those banks with proven loan generation capability will fetch the highest prices in mergers.”

Jon Winick of Clark Street Capital:  “Focus on 2-3 things that differentiate your bank and leverage your capabilities. While it may make sense to diversify beyond commercial real estate, don’t blindly follow the herd into C&I lending. In fact, it is going to be difficult for most banks to grow assets organically without considering commercial real estate. While expense control is important, do not ignore the revenue side. Poach a high-quality lender from a larger competitor so that you can demonstrate portfolio growth.” 

Jeff Brand of KBW: “Dominate your ‘micro’ market as it relates to deposits and your lending competency and try to achieve critical mass (~$750m).” 

Mark Ross of Stifel Nicolaus:  “… Clean house on the credit side until you have a pristine portfolio. Take the pain as soon as possible. [If you] have ability to expand the franchise… be in the most desirable locations (although that is a moving target).”

Bill Herrell of Morgan Keegan:  “For a bank <$250MM in assets, preserve capital by managing NPAs and expenses closely while building local deposit market share. Growth will continue to be constrained by increased demands for higher capital ratios and lack of access to outside capital. By building a local deposit base, there is a higher likelihood you become a favored target in your market. You can then take the capital you have preserved and “invest it” in the larger buyer’s liquid currency.”

We then asked our respondents how their answer would change for a bank with $1 billion in assets.

Mark Ross of Stifel Nicolaus:  “The same [as for smaller banks], except with a greater ability to expand de novo locations to optimize desirability to an acquirer or make small acquisitions of branches… ”

Sal Inserra of Crowe Horwath:  “Need to hire a very good treasurer who sees an investment portfolio as a viable alternative for long term objectives so we don’t chase every new fad. Need to revisit investing capital in brick and mortar. No more columns and elevators. Need to be leaner and more techno savvy…. Technology will be the key to growth. Need to also identify your profitable customers. Since banks this size are typically inefficient, there are a number of smaller customers that are a net cost to the bank they cannot afford.”

Matt Kelley of Sterne Agee:  “Banks with healthy capital should be buying back stock more aggressively when trading at discounts to tangible book value. Need to have faith that terminal values for healthy banks (1.6x TBV in Northeast) will at least hold steady over the next several years. Buying back shares below tangible book value is a safe and well received use of capital Also shows the investment community your own positive view on valuation and future value.”

Our next question was “What are the most significant factors in achieving enhanced profitability for a typical bank with $250 million in assets?”

• One of our survey respondents wrote that a bank in this size range should focus on efficiency: “For every dollar of expense we are going to get $2.00 to $2.50 of revenue.”
• Another responded that a bank should not be afraid to consolidate jobs.
• A common response was that a bank should focus on non-interest income and exercise tight control on cost of funds (deposit pricing).

Many responded that the most important factor is credit quality, especially since the profit equation is so fragile.

We then asked if there are different factors to be considered for a bank with $1 billion in assets. The responses included:

• A greater emphasis on inexpensive core funding;
• Develop a robust wealth management practice. This service can deepen the client relationship and provide consistent fees;
• Do not be afraid to try new initiatives; and
• Recognize that efficiency is key at this level, given lower yields on larger credits.

Finally, we asked if the respondents had any other advice for bank management.

Bill Herrell of Morgan Keegan:  “Let’s get the boards and management to think about strategy as a series of options versus sequential decisions. If the chosen strategic path doesn’t work then the other options may have expired by the time you decide to pursue them. Making either/or decisions on strategy assumes options are mutually exclusive. In volatile times like these, execution on any option is difficult so we need to pursue various options simultaneously. The capital markets, regulators and competition are too dynamic to pursue options sequentially.”

Phil Moore of Porter Keadle Moore:  Sometimes the blocking and tackling basics are a competitive advantage – provide the services desired on par with the big banks with care and concern.”

Paula Johannsen of Carson Medlin:  “I don’t know what the present value of owning 100% of the risk and waiting for better market multiples is, but I think that it’s not as much as perceived. Therefore, we would advise most of our clients to consider seeking partnerships now – it’s likely to remain a buyer’s market for the foreseeable future.”

Geri Forehand of Sheshunoff:  “Determine if your bank intends to remain independent. If so, the best way to control your own destiny is to achieve high performance.”

What is the Bryan Cave perspective?

There is no industry that has such a vast array of financial data transparently available. Transforming data into a functional strategy is seldom easy, but our group is continuously monitoring the regulatory market and industry conditions. Based on the information we have been provided and our own experiences in representing over 400 banks coast to coast, we offer the following:

• We can once again anticipate economic growth (which is a plus), but as always, it will vary greatly from market to market. For most markets, including traditional Sunbelt markets, particularly those plagued by the real estate declines of the past four years, economic growth for the next three or four years should continue to be slow, in the 2%-3% range.
• There is a strong consensus that regulatory costs will increase, regardless of the size of the bank. These costs will be both direct, as compliance costs grow and FDIC considers the appropriate level of the deposit insurance reserve, and indirect, as the costs of higher capital requirements eat into return on equity.
• Slower growth, higher capital, and higher costs will limit the ability of banks to achieve traditional returns on equity, and for many banks, single digit returns on equity of 8%-9% will represent a significant return.
• For many directors, the new economic reality is totally inconsistent with their ongoing expectation of 15% returns, 2x to 3x book purchase prices, and 15x to 20x price to earnings multiples. Too many directors have not confronted this reality as part of their ongoing strategic planning.
• Banks will have to rethink both their board and management/employee staffing. Directors will have to work harder and longer and be more sophisticated in their approach, regardless of the size of the bank. Employees who are not highly motivated and adequately trained to take on their new tasks in this different environment must be retooled or terminated. This will happen automatically if the bank fails or is sold, but in order to survive and prosper, the bank itself will have to take these steps.
• Core deposit relationships will again be recognized as the primary basis for bank value, and a technologically current platform will be essential to both attract and retain core deposits. The development of technology in payments and other areas has not slowed during the past four years, but for many banks, staying current or adapting to these changes has not taken place. Leveraging core deposit relationships can and should be done to generate current earnings.
• With more modest returns on equity, bank investors will be seeking less volatile and more stable returns supported by increasing dividend payments. This is a return to the model that banks followed until the early- to mid-nineties, when growth and the availability of virtually unlimited leverage caused many investors to be attracted to growth over consistent profitability. As the world at large is less leveraged, we believe a stable and continuing return in low double digits will produce strong investor interest as stability and current returns drive a more stable investment environment.
• Good banks will continue to rid their balance sheets of problem assets, since stable returns cannot be achieved so long as a significant percentage of the loan portfolio is classified or non-performing. We have yet to find bankers who have complained to us that they were unhappy that they sold problem assets and wish they could reacquire them for the price they received.
• Do not count on M&A for an exit strategy: Asset quality concerns, purchase accounting marks, modest share pricing of acquirer’s shares and competition from failed bank sales will continue to dampen acquisition prices and thus activity. Nonetheless, it is wise to monitor what factors are being valued by acquirers.
• In this changing environment, banks, boards, managements and employees must all be refocused on rational objectives that are consistent with both the capacity of the individual banks and the markets in which they operate, and, having achieved that refocus, must devote significant attention purely to execution. The time for bemoaning the fate of tougher regulation, higher capital, lower returns, etc., has passed. We all must recognize the world in which we are now operating and get about the business of serving our constituents once again.

From all of this, we are optimistic that banks aligned as described above will be successful for as many years going forward as they wish. While size will make some of these matters easier, we also believe that with significant focus and the proper board and management team, even small banks can prosper. Everything is relative, and the days of 2000-2007 of unlimited leverage and “Regulation Lite” will not soon return, but so long as banks are able to keep their focus on their constituents, their communities, and their strategic objectives, they can succeed.

We would welcome the opportunity to discuss the results of our survey with your management team or Board. Please feel free to contact any member of the Bryan Cave Financial Institutions Group.

Related posts:

1. Boards and Strategic Planning in a Challenging Environment
2. The Path to Full Profitability by 2013
3. McAlpin and Moeling Present at Acquire or Be Acquired

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.

Best Practice No. 7 – Make Use of a Nominating Committee and Director Assessments

 No director has a “right” to sit on a board. Members of the most effective boards of directors have an active desire to serve the bank, which is evidenced by a high level of engagement, preparation and participation. There should be a transition from the typical practice of automatically re-nominating existing board members to a process of conducting annual director assessments coupled with a nominating committee for director elections.

 The CEO should not be involved with either director assessments or the nominating committee – these are board functions and should be managed by the board under the direction of the chairman or the lead director. Annual director assessments could initially be done by means of self-assessments, coupled with a one on one meeting between each director and the chairman. These one on one meetings can serve as the basis for discussion of the director’s enthusiasm for and participation in the activities of the board.

 The process of implementing an active nominating committee and annual director evaluation process is also about risk management going forward. In these times of continued economic uncertainty and increased regulatory scrutiny it is important that banks have active and engaged directors.

 Best Practice No. 8 – Actively Participate in the Examination Process

Members of the board should be involved in the regulatory examination process. The regulators really do want and expect the board to be involved in and understand the issues which the regulators believe may be facing the bank. Involvement of the entire board or key members of the board from the first management meeting with the examiners to the exit meeting is tangible evidence that the board is actively engaged in oversight of the bank. It can also be beneficial for members of the board to hear the concerns of the regulators directly, and to observe management’s interaction with the examiners.

 I recently attended an exit meeting with bank management following conclusion of an exam. Several of the bank’s directors were present because they wanted to get a preview of the exam findings on asset quality. During the exit meeting the lead examiner raised concern about a risk management issue of potentially significant magnitude. The issue clearly took the bank’s CEO by surprise, but the presence at the meeting of the board’s chairman had a calming effect. The chairman looked across the table at the lead examiner and said in a convincing tone, “We will fix this immediately.” The issue was then quickly resolved, and the final examination report commented favorably on that action. The end result may well have been the same without the presence of board members at the exit meeting, but I believe their presence was very helpful and reflected well on the bank.

This is the third in a series of articles by Jim McAlpin on Best Practices for Bank Boards.  It was originally published on BankDirector.com.  Look for more “best practices” in an upcoming post.

Related posts:

1. Best Practices for Bank Boards – Part 1
2. Best Practices for Bank Boards – Part 2
3. Boards and Strategic Planning in a Challenging Environment

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.

Directors and officers of more than 400 failing financial institutions have faced concerns about bank documents with no formal guidance from the FDIC. A failed bank’s directors’ and officers’ practical concerns were partially related to the fact that the FDIC has sometimes been unwilling or unable to locate or produce bank documents to defense counsel for those directors and officers when they were requested.

Directors and officers of failed banks have the right to contest the FDIC’s charges and have the need for access to records of their service. In addition, under corporate and banking laws of many states, directors have rights to access these documents. Given the restrictions set forth in the FIL, we are hopeful that the FDIC’s processes and procedures for retaining a failed bank’s documents and making them accessible will improve correspondingly.

The FIL acknowledges that bank directors and officers must have access to bank documents to properly perform their functions in overseeing and managing their banks. Clearly it would be a great disservice to the industry for the FDIC to limit a current director’s access to bank information in any way. However, given the restrictions set forth in the FIL and the potential penalties associated with conduct that the FDIC deems objectionable, it is important for bank directors and officers to be aware of the FDIC’s position stated in the FIL. Given the variance between the FDIC’s position and the needs of failed bank directors and officers to access bank documents and information, we recommend seeking the advice of counsel before taking action. Please contact any member of Bryan Cave’s Financial Institutions group for additional information regarding the FIL.

Related posts:

1. Orderly Liquidation Authority and Nonbank Financial Companies – Director and Officer Compensation Clawback
2. FDIC Files Lawsuit Against Former Senior Loan Officer
3. Court Confirms “Gross Negligence” Standard for Bank Director Liabilty in Georgia

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.

As background, in some states, including Georgia and Florida, it has been the common practice of state regulators to issue a Consent Order (formerly referred to as an Order to Cease and Desist) following an examination led by the state regulator at which deficiencies were identified. If the FDIC led the examination, the FDIC would issue the order. If the state issued the order, the FDIC would acknowledge the order, specifically stating that the acknowledgement represented a commitment by the bank’s board of directors to the FDIC to comply with the order.

The FDIC has apparently concluded, however, that it needs to have an order in place that it issues (and not simply acknowledges) in order to meet its internal enforcement objectives. For banks receiving an order for the first time, this goal is being accomplished through the issuance of joint orders by the FDIC and the state regulator. We believe that a significant part of the FDIC’s analysis is centered on the definition of “well capitalized” in 12 C.F.R. §325.103, which requires that a bank not only meet or exceed the 5%, 6%, and 10% capital ratios that we are all familiar with but also that the bank not be subject to a written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC to maintain specific capital levels.

The FDIC believes that a bank meeting the statutory capital ratios could be deemed to continue to be “well capitalized” even if subject to a state-led order with a capital requirement. Because there are a number of important implications associated with a bank’s being less than well capitalized, including automatic application of interest rate caps on deposit products, we believe the FDIC wants to be sure that all institutions subject to orders are deemed less than well capitalized. There are also other legal implications of being subject to an order issued by a federal regulator, including those related to further enforcement actions such as civil money penalties.

If your institution is the subject of a state-led Consent Order or Order to Cease and Desist, you should expect the FDIC to ask your institution to consent to a “new” order following your next examination or in connection with any pending application. As is the case with all enforcement actions, we recommend that you consider the overall impact to your institution of consenting to the order as opposed to seeking an administrative hearing, keeping in mind that many of the order’s requirements are likely consistent with your goals to restore the condition of the bank.

In addition, we recommend that banks in this situation take measures to ensure that the new FDIC order is consistent with, or no broader than, the existing state-led order unless your bank’s circumstances justify broadening the scope of the existing order. We understand that some states are willing to take actions that eliminate duplication of regulatory burdens. Finally, because the FDIC-led orders will be published on the FDIC’s website, we recommend that institutions prepare a thoughtful public relations strategy to address any adverse publicity associated with the order.

Related posts:

1. First Banks, Inc. Announces Successful Trust Preferred Consent Solicitation
2. FDIC Criticizes Civil Money Penalty Insurance
3. Additional FDIC Guidance on Modification of Repurchase Agreements

(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.

Based on our experience, implementing a board assessment process is a very sensitive undertaking, and understanding how other banks have overcome the initial reluctance to start one can be very helpful. While directors are naturally uneasy about assessing board colleagues (and also about being assessed), a good process is largely based on objective standards. For most community bank boards, a good starting point is to ask each director to complete a self-evaluation form (see bottom of this article), which will form the basis for a meeting with the appropriate board committee. In addition to the self-assessment items, the meeting should also be used to uncover any ongoing concerns or issues the director may have with the board or bank. For a more thorough discussion, see the DirectorCorps article entitled: “Board and Individual Director Evaluations.”

Once implemented, bank boards with effective assessment programs almost invariably reflect improved board performance. The assessment areas are logical:

• Is the size of our board appropriate?
• Do we have directors with experience and expertise required to add value to the board’s oversight of the bank, keeping in mind that representation of large shareholders of the bank and community involvement are only a part of the board’s function?
• Do we have members who have the knowledge and skills to perform our required duties?
• Should we have age requirements?
• Do we have a process to implement annual member review or reassessment?
• Do we have appropriate attendance requirements?
• Are all of our members fully committed to the time and involvement that is now being required of directors?
• Very importantly, are our outside directors truly independent and not otherwise obligated or tied to management?

No director has a “right” to sit on a board (a principle often forgotten), and there should be a transition from the typical automatic re-nomination of the existing board members to a more robust assessment model that addresses the questions above. The burden of initiating this transition, however, should begin and be implemented by the board itself, not by management. The selection of appropriate director nominees is a board issue, and the directors themselves are best positioned to address the needs of the board. This observation leads to the next logical issue: board independence.

Board Independence

There are many different ways to objectively define or measure board independence, but in reality, the issue is subjective, not objective: Does the board make its own decisions? A board that is functioning properly should neither rubber stamp management’s recommendations, nor should it operate in remote vacuum. Management’s recommendations obviously deserve great deference. By the same token, the board is obligated to reach its own conclusions. There should be a logical balance between management input and director independent review.

There are several indicators that a board is exercising appropriate independence. Does the board meet in executive session? Does the board have an independent chairman, or if the board decides the CEO should be the chairman, does the board have a lead director whose job is to act as a structured link between the outside directors and management?

To review regulatory and public stock exchange definitions of independence, see the DirectorCorps article on “Director Independence.” A director is typically not independent if he or she receives compensation above certain thresholds as a vendor or provider of professional services to the company, or if the director owns more than 10 percent of the company’s stock, or if the director is or has served recently as an employee.

However, too often, the independence of individual directors is the sole focus when assessing whether the board has appropriate independence. While the independence of the individual directors is obviously essential to their objective performance, the collective independence of the board should be the focus in reviewing independence. The outside directors of a board with appropriate independence should function as a unit to review management recommendations and ensure that the bank’s overall strategy is being implemented. Directors on a board that is functioning properly can not only reach independent conclusions but also discuss those conclusions in a structured environment that leads to appropriate implementation. The board’s ability to function in this manner is critical to addressing the next corporate governance issue: management review and compensation.

Management Review and Compensation

There is no board function more critical than reviewing, evaluating and compensating management. The independence and objectivity of the directors help make this process beyond reproach. While the views and input of the CEO are essential, over and over we see that bank performance is greatly enhanced where there is an arm’s length, objective assessment by the board of executive management. Where this process is functioning properly, problems and concerns come to the table sooner and are typically more easily resolved. Both shareholders and regulators expect the board to diligently exercise this role, yet all too often, boards abdicate this essential duty in practice. The process of evaluating and compensating management should never be adversarial, but it should be objective. By ensuring that the board has the right directors (through regular board assessment) and that the board is collectively independent, the function of management review and compensation should come naturally.

Implementing “Functioning Properly”

In recent years, oversight of basic corporate governance functions has become vested in many banks in a corporate governance committee, but there are many variations. Some banks place the corporate governance function in a nominating or compensation committee, and some boards use the audit committee. What is most important, however, is that there be a committee of outside directors, with specifically delegated authority and responsibility to perform these roles. The committee so designated should be given authority by the full board to adopt a charter, engage advisers as needed, set the parameters of its jurisdiction, and determine the criteria for committee membership, subject to full board approval. The committee should not be a substitute executive committee or audit committee. Instead, its role is more internally oriented—determining if the bank’s board is functioning properly. If it is, the bank, its shareholders and regulators will all be well served.

This article  was originally published on BankDirector.com. 

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3. Directors and the Exam Process: Get Involved Early

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.

In addition, by identifying key regulatory issues, and particularly disagreements, bank directors have the greatest likelihood for influencing the examination process. It is at this time, after preliminary findings are made but before a final examination report is delivered to the bank, that a bank and its directors should present additional information and viewpoints that might alter the findings in the final examination report. We have found that examiners are willing to review additional information at this juncture and, where appropriate, the examiners will alter their conclusions in response to such information. Ideally, such information is presented prior to the examiners’ exit meeting with the full board. Our experience tells us that this approach is much more effective and timely than a formal appeal of final examination findings.

By inserting themselves into the regulatory examination process, we believe directors can have a positive influence on the regulatory examination process. While we would not recommend having the full board involved in functions that are typically left to management, having an independent point of view involved early in the examination process can be very helpful. Not only can directors display their involvement in the oversight of the bank’s operations, they can also help with strategy for dealing with regulatory issues at a time when conclusions have not yet been formed. Finally, directors can better understand regulatory feedback and can track management’s progress toward addressing regulatory concerns.

This article  was originally published on BankDirector.com. 

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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.

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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.

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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.

The SIGTARP report notes that smaller and medium-sized banks are not existing TARP with the same speed as the larger banks.  Many are not able to pay their dividends and some are operating under an order from their regulator.  Compared with larger banks, the SIGTARP report notes that “community banks may face an uphill battle to exit TARP.”  Community banks do not have the same access to capital as the larger banks and can be more exposed to distressed commercial real estate-related assets and non-performing loans.

SIGTARP reports that “despite the dramatic efforts to expedite the exit of the largest banks from TARP, there appears to be no corresponding concrete plan for community banks’ exit from TARP…” Treasury has acted on a case by base basis to sell its TARP investments (sometimes at a discount) or exchanged for stock with lower priority in connection with a merger, acquisition or sale to a third party that invested new capital, but these actions have remained the exception rather than the rule.  Accordingly, SIGTARP reiterated its prior recommendations:

1. Treasury, in consultation with Federal banking regulators, should develop a clear TARP exit path to ensure that as many community banks as possible repay the TARP investment and prepare to deal with the banks that cannot. Treasury should develop criteria pertaining to restructurings, exchanges, and sales of its TARP investments (including any discount of the TARP investment,
   the treatment of unpaid TARP dividend and interest payments, and warrants).
2. Treasury should assess whether it should renegotiate the terms of its Capital Purchase Program contracts for those community banks that will not be able to exit TARP prior to the dividend rate increase in order to help preserve the value of taxpayers’ investments.

The SIGTARP report acknowledged that Treasury has engaged Houlihan Lokey to provide capital markets disposition services for its remaining CPP investments.  Houlihan is earning a flat fee of $375 thousand a month to provide a variety of services to Treasury, including:

• Analyzing, reviewing and documenting financial, business, regulatory, and market information related to potential transactions of CPP investments;
• Advising and monitoring restructuring strategies prior to the disposition of CPP investments;
• Reporting on the potential performance of certain CPP investments and their disposition given a range of market scenarios and transaction structures;
• Analyzing and proposing disposition alternatives and structures, including the use of additional underwriters, brokers, or other capital markets advisors for the best means and structure to dispose of such assets; and
• Maintaining a compliance program designed to detect and prevent violations of Federal securities laws, and identifying documenting and enforcing controls to mitigate conflicts of interest.

The SIGTARP report notes that Treasury’s next steps in developing clear TARP exit paths for the smaller banks are critical, and encourages Treasury to proactively reach out to participant banks rather than waiting for banks to propose exchanges.  While Treasury does not want to devise standard discounts or terms for small banks to exit CPP, saying “each bank’s situation is unique,” SIGTARP reiterates its recommendations that the issues should be addressed solely on a case-by-case basis.

Given the economics at stake, designing multiple exit strategies that facilitate the conclusion of the CPP may be in everyone’s interest.  In its most simple terms, Treasury invested a total of $204.9 billion in cash, received cash proceeds of $204.6 billion, and still has $19.5 billion in principal amount of securities outstanding. Using the estimated gains of between $7 billion and $17 billion for the program, Treasury expects to receive between 36% and 88% of the remaining outstanding CPP funds (without giving any consideration to remaining warrants or dividends and interest).

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