In August, the Congressional Oversight Panel (the COP) released its report, “The Continued Risk of Troubled Assets.” The report covers, among other things, a summary of methods that have been and are being used to manage toxic assets. Community bank organizers and acquisition teams can turn to this section of the report as a refresher on the dangers of getting caught up in the race to lend more and more.
The report details the strategies used in two prior crises, along with those used in the current situation. The two prior crises mentioned are the Less Developed Country (LDC) Crisis and the savings and loan (S&L) crisis; both were predicated by, among other things, rapid increases in certain types of lending.
LDC crisis The LDC crisis was characterized by:
• Rapid increase in debt made to Latin American countries
• A concentration of debt among the largest money-center banks
• Broad-based defaults (40 countries were in default by the end of 1982)
Strategies used by banks and legislators to manage through these defaults included:
• Debt restructure
• Increased loan loss reserves
• Conversion of debt into tradable bonds to remove debt from bank balance sheets
• Debt forgiveness
S&L crisis In the same decade, U.S. thrifts faced another asset quality crisis which led to the failure of more than 1000 savings and loans institutions. Circumstances included:
• Rapid increase in real estate and commercial loans
• Concentration of bad assets in a subset of thrifts (primarily those located in Texas)
• Insufficient regulatory oversight
• Broad-based defaults
The S&L crisis was addressed with the formation of the Resolution Trust Corporation or RTC. The RTC was tasked with selling the assets, good ones and bad, of any thrift placed in receivership. Assets were primarily sold at auctions, but equity partnerships were also used—particularly in situations where the RTC wanted to recover more than market value would allow. In those cases, a private partner would manage the assets and eventually sell them, providing the RTC with a portion of the proceeds. In still other situations, the RTC used securitization to liquidate certain commercial and multifamily loan assets.
According to the COP report, the RTC recovered approximately 85 percent of the assets it acquired.
The RTC’s success was assisted by a functioning market that allowed for the valuation of these assets. This is a circumstance that has not been consistently present in the current banking crisis—indicating that an RTC-style solution would not be as effective today. For that reason and others, the Treasury took a more sweeping approach this time around, setting up the TARP to reinforce balance sheets, requiring stress tests to prevent future problems, and establishing the PIPP to heal the market for these assets. The COP report does question whether debt restructure, as used in the LDC crisis, could have or should have played a larger role in the Treasury’s solution.
From the broadest perspective, you could say buying a bank is like buying a car: you pick the one you want, kick the tires, and then make an offer. But because banking is a highly regulated industry and a bank purchase is never accomplished by one person alone, the sales process tends to get complicated and very time consuming. Many factors, like the experience level of those spearheading the project, can create success or cause failure.
Here are ten hot topics to address when moving forward on a bank purchase project.
Organizers Diversity is a key quality of an effective bank organization team. When selecting organizers, you should be mindful of compiling a broad cross-section of knowledge and networking power. Your organizers should come from different business backgrounds and various professions. Of course, the target size of your group limits the amount of diversity possible. But if you are building a group of ten organizers/directors, for example, you may want to maximize the knowledge base by selecting individuals from ten different backgrounds.
Capital Your organizers have to be connected well enough to be able to raise an appropriate level of capital. The exact amount of money needed will vary based on a number of factors, including the bank size, the composition of the organizing team, preferences of management and, of course, the business plan. The regulatory environment is a factor as well, particularly in this post-financial-crisis era. An average range might be $14 to $18 million.
Management team The executive management team consists of three individuals:
1. President/Chief Executive Officer
2. Chief Financial Officer/Cashier
3. Chief Lending Officer/Chief Credit Officer
Make these choices carefully. Extensive banking and management experience is a prerequisite for all three positions.
Business plan and applicationThe application process for purchasing an existing bank is similar to that required when establishing a new bank. Essentially, regulators want to know every detail about your group’s plans for the bank once the acquisition is finalized. Communicating these details is no small task; a completed application may be 2,000 pages or more in length. A wrong word or unclear explanation can cause confusion among regulators, which creates delays in the approval process.
In our experience, the production of an acceptable bank application requires extensive collaboration between De Novo Strategy, the organizers, management team and legal counsel.
Board TrainingBefore the bank changes hands, the Board of Directors must undergo extensive training to learn their duties and responsibilities as directors.
Time commitment The organizers and Board members must be prepared to devote an appropriate amount of time and energy to direct the acquisition and, later, the bank. You can expect your team to put in five to twenty hours per month on the bank project.
Market research No assumptions can be made about the market or competitive dynamics. Market research must be completed to ensure that the business plan is realistic and the bank’s goals are achievable, given the constraints of its resources.
LocationThe organization team should address the bank’s location: Is it appropriate? Is the branch large enough to support the bank’s five-year growth plan? Can the community both support and benefit from the bank’s operations, as defined in the business plan?
Products and servicesIt’s likely that the product and service set offered by the existing bank isn’t optimal. A careful review of profit potential of each product offered will be necessary. As well, those products need to be analyzed in terms of the needs of the local market.
Pre-opening ExpensesPre-opening expenses are funded out of pocket by the members of the organization group. A typical pre-opening price tag is approximately $75,000 per organizer or more. The group will need to decide how to collect these funds; this is often done in three or four equal payments, spread out over the first six months of the project.
SNL recently published an article discussing the FDIC's new policy change on de novo banks. In "Extending Bank's Adolescence," author Christina M. Mitchell writes, the "change effectively extends adolescence for young banks, lengthening the period of increased regulatory supervision required for de novo institutions in a move that industry observers say will heighten the already considerable barriers to opening new banks." Over the past few years, the regulators have nearly shut down the flow of de novo bank openings with a drastic increase in regulatory scrutiny. As the regulatory approval timeline continues to increase, the capital requirements and start-up expenses of opening a bank have climbed significantly. These challenges are keeping many potential investors on the sidelines, and too few of them are looking for other opportunities to enter the banking industry, such as Buying a Bank.
To read Ms. Mitchell's full article click on the link:
Extending Bank's Adolescence.
The FDIC has announced its intention to extend the de novo period for certain new banking institutions. The previous de novo period was three years; the new one will be seven years. This change is significant because newly insured institutions are subject to more scrutiny and higher minimum capital ratios during that de novo period. Along with extending the de novo period, the FDIC will also subject de novos to more risk management examinations and require prior approval for any de novo business plan changes.
Heightened risk for seven years
Regulators say the supervisory updates are needed because de novos pose a heightened risk to the banking system. According to the FDIC, too many of the actual failures that occurred in 2008 and 2009 were banks that had been open for fewer than seven years. On top of that, a good number of those failures were banks that had been operating between four and seven years-banks that, under current policy, were not subject to the heightened de novo regulations.
According to data compiled by FinCriAdvisor (http://www.fincriadvisor.com/2009-09-07/FDICdenovopolicy), twenty-three, or 19.6 percent, of the 109 bank failures occurring between January 1, 2008 and August 21, 2009 were de novos. Of those twenty-three, six were within the three-year de novo period; the rest, 74 percent, failed between their fourth and seventh years of operation.
Exceptions
The extended de novo period will apply to existing newly insured institutions as well as banks for which charters have not yet been issued. Since the number of new charters awarded by the FDIC in recent months is relatively minimal, the changes affect existing banks far more than would-be banks. The only de novos that won't be subject to the extension and heightened scrutiny are those that are subsidiaries of eligible holding companies.
Eligible holding companies must have consolidated assets of $150 million or more. Bank holding companies are required to have BOPEC ratings of at least 2; thrift holding companies must have an A rating.
Details
Capital requirement. A primary change implied by the extension of the de novo period is an increased capital requirement. De novos are currently required to maintain a Tier 1 leverage ratio of at least 8 percent during the de novo period. A longer de novo period means that young institutions will have to maintain this higher ratio for seven years instead of three.
Examination frequency. Along with extending the de novo period, the FDIC will also increase the frequency of risk management exams for de novo banks. Periodic risk management exams, which begin after the institution's first birthday, will occur once annually rather than once every eighteen months. De novos will have to budget for the extra costs associated with the additional examinations.
The first year examination requirements for de novos will be as follows:
- Limited risk management exam during first six months of operation
- Full risk management exam during first twelve months of operation
- Compliance exams during first twelve months of operation
- CRA evaluation during first twelve months of operation
Thereafter, under the new policy, a risk management exam will be conducted every twelve months until the expiration of the de novo period. Compliance exams and CRA evaluations "will alternate on an annual basis."
Business plan changes. The new policy also requires de novos to get FDIC approval prior to implementing any material changes to the institution's business plan during the seven-year de novo period. Previously, newly insured institutions had to provide the FDIC with a written notice of proposed business plan changes within the three-year de novo period.
The FDIC argues that experience shows the necessity of this requirement; when newly insured institutions deviate from their original business plans, those deviations can often lead them into areas of business where they do not have adequate risk management expertise or resources. "Significant deviations from approved business plans" was one of several common elements the FDIC identified among troubled institutions that have not yet completed their seventh year of operation.
Change requests will be reviewed to ensure that:
- There is a defensible business reason for the change.
- The de novo has the resources-financial and human-to manage any risks created by the change.
While this requirement keeps de novos from jumping into risky lines of business without adequate forethought, it also limits the de novo's ability to adapt quickly to changing circumstances. Should the bank implement changes or deviate from the original business plan without FDIC approval, fines or other penalties could result.
Financial statement updates. In the third year of operation, de novos must now provide the FDIC with current financial statements along with strategic plans and projected financial statements covering years four through seven. This applies to existing institutions that are less than three years old, as well as newly chartered institutions. The FDIC will want to know specifically about the de novo's expansion plans, product/service strategies and the outlook for capital expenditures and dividend payments.
To read the full Financial Institution Letter explaining and defending the altered supervisory procedures, click here: http://www.fdic.gov/news/news/financial/2009/fil09050.html
In July, the FDIC solicited public comments on a proposed policy statement regarding failed bank acquisitions. This policy statement defined new regulations applicable to certain investors of failed banks, with respect to:
• Capital commitments
• The investor’s role as a source of strength for the acquired institution
• Cross guarantees
• Affiliate transactions
• Secrecy law jurisdictions
• Continuity of ownership
• Disclosures
Comments The FDIC received 3190 form letters in support of the policy changes and 61 individual comment letters. A common observation among these comments was that the new requirements would impede the flow of private capital into the banking industry. Specifically, commenters found the 15 percent Tier 1 leverage ratio, the source of strength requirement, and the cross guarantee requirement to be particularly restrictive. Commenters argued that these provisions would competitively disadvantage the banks acquired by private investors. Given this disadvantage, private investors would be more likely to:
• stay out of banking altogether, or
• engage in aggressive business activities after the acquisition has closed.
Commenters also noted that private equity fund agreements typically prohibit source of strength and cross guarantee commitments as described by the FDIC’s proposal. The cross guarantee requirement is particularly distasteful because it would require the investor to risk unrelated and legally separate assets.
Provisions that keep private capital out of the banking industry would ultimately impact the DIF negatively, if the result is a greater number of bank failures.
Other commenters, however, supported the increased restrictions on private equity firms, citing the need to keep risky behavior out of the banking system.
Final provisions In consideration of the comments, the FDIC affected several changes to the proposed policy statement, including the following hot points:
• Clarification regarding the firms to which the policy statement applies. The policy statement will not apply to investors in partnership with depository institution holding companies, where the holding company has “a strong majority interest in the acquired bank or thrift and an established record for successful operation of insured banks or thrifts.” Investors holding no more than 5 percent of total voting power are also excluded.
• Reduction of initial capitalization requirements. The acquired bank must now open with a Tier 1 common equity/total assets ratio of 10 percent. And, this minimum ratio must be maintained for three years.
• Removal of the source of strength requirement.
• Narrowing of the cross guarantee provision. Cross guarantees will only be required when the affected investor group owns more than one institution and those institutions are at least 80 percent owned by common investors.
• Update to the definition of “affiliate” with respect to affiliate transaction provisions. The final statement defines “affiliate” as: “any company in which the Investor owns, directly or indirectly, at least 10 percent of the equity of such company and has maintained such ownership for at least 30 days.”
Read the summary of comments and complete list of changes made to the final policy statement here:
http://www.fdic.gov/news/board/Aug26no1.pdf