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Sheila Bair argued to Congress last week that the government should "impose greater market discipline on systemically important institutions." Her rationale for the argument was that those large firms have been funded by the market as if they were too big to fail, while their management teams depended on faulty risk management practices; these circumstances, combined with ineffective regulation, created a the bulk of our current economic problems. Bair's commentary indicates that we will ultimately have much more regulation throughout the financial industry, simply because what happens to large institutions will trickle down to impact the smaller community banks.

Bair went on to say:

In a properly functioning market economy there will be winners and losers, and some firms will fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market's incentive to monitor the actions of similarly situated firms. The most important challenge now is to find ways to impose greater market discipline on systemically important financial organizations.

Shareholders, creditors to take losses

It is true that we need to create an effective, bailout-free system to unwind large failing institutions - and to do so without creating a financial tsunami that wipes out the rest of the economy. But the reality is that everyone will feel the impact of a large institution's failure. It is impossible that a CitiBank, Wells Fargo, Bank of America or Chase failure could result in only a slight ripple through the economy. Those closest to the institution will feel the pain the most and people on the far fringe, the least -- but it will be felt by all nonetheless. The government needs to stop trying to make our lives pain-free in all aspects of life. We simply cannot be shielded from ALL risks.

In the current meltdown, for example, shareholders felt the brunt of the financial crisis pain. Investing is an inherently risky enterprise, and to devise regulation that would soften the impacts of investment failure runs contrary to the tenants of our economic system. Because shareholders voluntarily took risks with the companies they invested in and supported, they should absorb the repercussions when those firms fail.

Bair agrees with this argument. She advises:

Under the new resolution regime, Congress should raise the bar higher than existing law and eliminate the possibility of open assistance for individual failing entities. The new resolution powers should result in the shareholders and unsecured creditors taking losses.

Bair also addresses the current priority given to secured creditors. Such creditors have, in the past, made credit decisions based on collateral value without thoughtfully considering creditworthiness as well. This puts the creditor at risk of default and forced liquidation, while encouraging lack of discipline in the market. Addressing this issue can help to minimize costs to receivership and spread out losses related to failures more broadly.

Other key points in Blair's testimony included:

Resolution of systemically important financial firm failures is currently managed through the bankruptcy process, where there is no protection for public interest.

Holding company affiliates are often dependent on the ongoing operations of systemically important firms. Regulation is needed to require these affiliates to have greater autonomy. Holding companies should have wind-down plans.

Open company assistance benefitting shareholders and creditors should be banned by Congress.

A Financial Company Resolution Fund should be established and pre-funded through assessments against large financial firms.

The FDIC should have authority to resolve "systemically important and non-systemically important depository institution holding companies, affiliates and majority-owned subsidiaries." This authority would allow the FDIC to maximize the value of the assets, particularly in cases where certain functions lie outside the FDIC's current authority.

The FDIC supports the creation of a powerful Financial Services Oversight Council to monitor and manage system-wide risks. The Council should be given a minimum rulemaking authority "that must be met and could be exceeded." The Council should oversee a group of regulators, but also have its own power to act if the regulators do not.

The full text of Sheila Bair's testimony can be found at: http://www.fdic.gov/news/news/speeches/chairman/spoct2909.html

An insightful article I read in the Marriott Alumni Magazine stated that an organizations need to have three traits in their culture to thrive. First, a little background.

Growing Corn

Each semester Stan Fawcett, holds up a fresh ear of corn in his supply chain strategy class and asks, "Do farmers grow corn in Iowa?" The students with puzzles looks wonder why the professor would ask such a straightforward question. Fawcett's response is "No." Farmers don't grow corn, "the corn grows itself. Farmers clear the trees, remove the rocks, plow the fields and provide irrigation. Then they add pesticides, fertilizer and all those other things that lead to a bounteous harvest. The farmers' job is to create the environment where the corn can flourish."

This may sound simple, but as managers and leaders, our job is to create a work environment where our employees can grow and flourish in their jobs. By doing this can provide the right conditions to achieve maximum potential and productivity from each employee. The research team from the Marriott School Professors, determined that there are three critical ABC's - affirmation, belonging, and competence.

Affirmation

Creating opportunities to let all employees know that they are valued helps to satisfy the need in all of us for approval. Everyone wants to feel appreciated for their work and efforts to help the business succeed. Fawcett says, "Managers need to look for opportunities to express appreciation."

Professor Dave Whitlark says, "Employees also feel affirmed when they feel like problem solvers in their organization." As well as helping them "view criticisms as opportunities to help them succeed. One difficult job leaders have is to correct people when they are wrong." In addition, "create an environment where employees accept correction and even look forward to it because they know you want to help them."

Belonging

The second element of a thriving corporate culture is the sense of belonging; it refers to people's need to feel socially connected to coworkers and to the organization itself. Belonging leads to higher quality service and productivity.

Professor Gary Rhoads says, "You can scream at employees, and you can threaten them so they're productive, but if you want them to give quality service, you have to capture their hearts. When productivity goes up, quality doesn't always follow, but when quality goes up, productivity always follows."

Competence

The third element is competence. Rhoads says it this way, "You either lift people up, or tear them down; I'm always surprised how many people take the teardown approach. And the way supervisors tear down employees is they peck away at their competence."

Building confidence can come from simple things like providing extra training, and letting employees be in control of their work performance. In house training by other employees, utilizing outside consultants, helping employees go back to school or sending them to a conference, this investment in education strengthens their competence.

Another method is to have a newbie shadow a veteran for a short period. This tells the trainer that the company has confidence in their performance and it says, "you're a great role model ... and what does the new person learn? A lot from someone an enthusiastic employee. This arrangement actually accelerates the learning curve."

By building corporate culture that effectively uses the three traits, employees become more productive, quality improves and loyalty is developed.

Fawcett smiles when he says, "When ... a manager understands and captures the vision of the ABC's, makes people feel valued, creates a sense of belonging, empowers them through competence, and then unleashes them to solve the world's problems, it's awesome."

To download a full copy of the magazine article paper click: ABC's

In May of 2009, the FDIC authorized the creation of an Advisory Committee Community Banking with the purpose that this committee would help the FDIC understand the particular issues that small rural and urban community banks face in the ever-changing financial landscape.

The committee is consists of no more than 20 volunteer members from the community banks around the country along with small business, education, non-for-profit organizations and other individuals that use the services of these community banks. It is expected that the committee will have an annual budget of $300,000 and two full time FDIC staff people committed to serving their needs. The committee charter will last for two years unless it is renewed by the FDIC. The committee will also report directly to the Chairman of the Board of Directors of the FDIC.

The committee's first meeting was this week and below is the press release from that meeting. At the bottom is a link to the FDIC website where more information may be obtained about the meeting. We hope this positive for the community banking sector as they struggle under the weight of very difficult regulations, limited budgets, and with razor thin margins. They are scheduled to meet twice a year, so the next meeting should be in April.

Press Release from the Advisory Committee on Community Banking

At its first meeting since being established by the FDIC Board in May, the FDIC's Advisory Committee on Community Banking today discussed the impact of the financial crisis on community banks. Other issues addressed were regulatory reform proposals under consideration by Congress and their effect on community banks, the impact of FDIC supervisory proposals on these banks, and community banks' perspectives on funding the FDIC's Deposit Insurance Fund.

"I was extremely pleased with the robust discussion among our committee members on issues that are so critical to both the FDIC and our nation's community banks," said FDIC Chairman Sheila C. Bair. "The committee members voiced a number of interesting ideas that they will pursue."

The Advisory Committee was formed to provide the FDIC with advice and recommendations on a broad range of policy issues with particular impact on small community banks throughout the nation, and the local communities they serve. The committee is comprised of 14 community bankers from across the country, and one representative from academia.

"We are fortunate to have so many highly respected professionals who are willing to volunteer their time and talents to help the FDIC analyze the issues most important to community banks," said Paul Nash, Deputy to the Chairman for External Affairs, and the Designated Federal Official for the Advisory Committee on Community Banking.

The members' opinions on the FDIC's proposed rulemaking to prepay three years of deposit insurance assessments will be included in the public comment file.

For more information on the Advisory Committee on Community Banking please visit http://www.fdic.gov/communitybanking/index.html.

In the beginning of 2009, the media was pushing the idea that this would be the year for the community bank. Many smaller banks had not weighted down their balance sheets with subprime loans, asset-backed securities and complex derivatives. In theory, they had the stability to pick up loan customers that had been turned away by larger institutions. Columbus Business First published an article entitled, "Larger competitors' retrenchment may give smaller banks opening." And Business Week said, "As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business customers."

Getting in to the banking industry during a power shift from big banks to small ones would appear to be an attractive opportunity for bank executives and community leaders who wish to be bank investors. But the predictions of a few publications don't sufficiently address the risk involved in buying a bank. Bank investors need to have some framework for separating the good targets from the bad ones.

Characteristics of at-risk community banks

In a speech made last July, San Francisco Fed President Janet Yellen summarized the characteristics of at-risk community banks. She cited:

• High concentrations of construction loans for speculative housing projects
• Concentrations of land acquisition and development loans
• Poor appraisal systems
• Weak risk-monitoring systems

Looking ahead, Yellen also identified "income-producing office, warehouse, and retail commercial property" as an area of potential risk. She cited rising vacancies and poor rent dynamics, which are putting negative pressures on property values. These value declines can be particularly problematic for maturing loans that need to be refinanced. Community banks that maintain large portfolios of commercial property loans should be proactively managing these risks. Bank acquisition groups should verify that target banks are updating property appraisals, recognizing impairments early, and negotiating work-outs with borrowers when appropriate.

Tim Coffey, Research Analyst for FIG Partners, LLC, agrees that commercial real estate is the next area of risk for banks. In an interview, Coffey said,

I think the residential portion of this correction has been dealt with and recognized by bankers and market participants alike. The next shoe to drop is going to be commercial real estate. I don't think there is really any kind of argument about that. How messy it's going to be compared to the residential part remains to be seen.

Coffey's comment was included in a report by The Wall Street Transcript that also quoted commentary from other banking analysts. The consensus among them was that some community banks are still facing potentially disastrous problems ahead.

Separating the good acquisition targets from the bad ones, then, requires careful analysis of the balance sheet, loan portfolio and the bank's current risk management practices. If the bank isn't managing risk proactively, there could be unknown problems brewing within the loan portfolio. Buying a bank with known problem assets is a manageable challenge-but buying a bank with unknown problem assets is something else entirely.

The ongoing wave of bank failures related to the financial crisis continues to impact the health of the FDIC's Deposit Insurance Fund (DIF). At the end of the second quarter, the DIF balance was down to $10.4 billion. Compared to a year ago, when the DIF amounted to $45.2 billion, this is a decline of some 77 percent.

As at-risk banks continue to deteriorate, the DIF's growing loss provisions have simply outpaced accrued and collected premiums, including a special assessment that was levied on insured institutions at the end of the second quarter. Rather than demand another special assessment, the FDIC is trying a new tactic to deal with the fund's depletion: prepaid premiums.

According to an FDIC press release, the FDIC Board "has adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012." The prepayments should generate roughly $45 billion in cash, a much-needed infusion for the anemic DIF.

Numbers game

Time Magazine is calling the tactic "an accounting trick," (http://www.time.com/time/business/article/0,8599,1926877,00.html?iid=tsmodule ) but FDIC Chair Sheila Bair sees it as a necessary step in the fund's restoration. The move won't impact banks' profitability, since they won't recognize the expenses any sooner under prepayment. It will impact liquidity, but the FDIC's position is that banks have sufficient cash to absorb these prepayments.

The push for prepayments underscores the FDIC's commitment to manage through this crisis without asking the Treasury or taxpayers to foot the bill.

Assessment increase ahead

The aforementioned NPR also included an assessment increase of three basis points across the board, to be made effective on January 1, 2011.

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 application

The 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 Training

Before 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.

Location

The 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 services

It’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 Expenses

Pre-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