5 Essential Questions Boards Should Ask During the Strategic Planning Season

August 2014

5 Essential Questions Boards Should Ask During the Strategic Planning Season

By Adam Mustafa

As the fall approaches, football is not the only thing we should be anticipating. It’s also the start of the strategic planning season. We are now nearly six years past the financial crisis, and the industry has changed dramatically. More changes are coming as Basel III arrives next year for community banks, the artificial interest rate environment eventually returns to normal, and the inevitable consolidation in the industry accelerates. As banks prepare for 2015 and beyond, their thought process for strategic planning must adapt to this new environment. Below are five key questions that every board room in the country should be asking:

Acquire, Be Acquired, or Stay the Course?

As M&A activity within the industry increases, how is your bank positioned? If you view your bank as an acquirer, have you already invested in the capacity for smart acquisitions? Many banks would like to make their first acquisition, but are afraid of making a mistake. That is a good instinct as there has already been buyer’s remorse on some recent deals. But how do you bridge that gap? Invictus provides its bank M&A clients with groundbreaking forward-looking analytics on targets so they can avoid buying a bill of goods. It is critical to understand the difference between having a strategic, proactive, and patient approach to M&A versus a reactive strategy where you only react to banks that are for sale. The smartest banks with acquisitive capabilities understand that the heavy-lifting is done PRIOR to a target being up for sale, sometimes even years in advance.

If you are planning on staying the course, can your bank generate sufficient returns to your shareholders over the long-term by relying solely on organic growth? The reality is that most banks in the industry are not generating a high enough return. These stay-the-course banks should be comfortable that the organic growth prospects in their market, coupled with untapped operating leverage in their business model, are enough to move the needle.

If you are a seller, when is the right time and what is the right process to maximize shareholder value? Many banks that view themselves as sellers are waiting for multiples to increase. While multiples have increased recently, it is often fool’s gold. Many of those transactions are simply strong banks that decided to cash out early. Since the investment banker’s job is to find the so-called greater fool, there are many transactions that have been overpriced. Waiting for multiples to increase is a dangerous game.

Are we as prepared for a rising interest rate environment as we think?

Many banks are falling into the trap of believing that they are well-positioned for a rising rate environment because their ALM models tell them so. Most ALM models have not yet adapted to the fact that we have been in an unprecedented and artificial interest rate environment for the last six years. Most of the loans on a bank’s books now consist of loans made during this period. These loans are typically strong from an asset quality perspective, but have extraordinarily low interest rates (sub 4% in many cases), longer terms, and primarily a fixed-rate structure. Most ALM models have failed to adapt their prepayment speeds to near zero for these loans. Many ALM models I’ve seen assume that there will be enough new loans originated at higher rates in the future to actually lead to an increase in earnings in a rising rate environment. This is very dangerous and puts too much trust in the Federal Reserve’s ability to tie rising rates to increasing economic activity. Did you know the Fed tested a mini-stagflation scenario with the top 30 BHCs in CCAR in the Adverse Case scenario?

Meanwhile, surge deposits, most of them non-interest bearing, could become more expensive CDs or leave the bank altogether. The investment portfolio may become virtually illiquid if the market value falls below its book value.

Banks should be determining how they want to position themselves for a rising rate environment in their strategic planning process. The ALCO process should then manage the execution of this plan, not the other way around. Don’t let the tail wag the dog.

How much capital do we need?

As Basel III arrives, remember one thing: Basel III only establishes the minimum levels of capital acceptable to regulators. Regulators typically want banks to maintain levels of capital well above those minimums. The question then becomes, how much capital does my bank need?

At Invictus, we help banks customize their own capital requirements by using CCAR-style stress testing. Every bank is unique. A one-size fits all approach to capital requirements doesn’t make sense.

It is critical to find the right balance of capital. Capital is the most expensive source of funding. If you have too much capital, it will be more difficult to generate a sufficient return on that capital. If you have too little capital, you will be constrained.

One tip for strategic planning – determine what you want your assets to look like in the next 3-5 years, and then design the right hand side of your balance sheet to fit that. Your capital plan should be built around your strategic plan. Too many banks do the reverse of this.

How much return do we need on that capital?

At its core, a strategic plan consists of a series of actions that are designed to get you from where you are today to where you want to be. Examples include loan growth, acquisitions, starting or growing new business lines or products, buying or selling branches, and certainly dividends and stock buybacks. Each of these actions should be evaluated from a risk/return perspective relative to other viable alternative uses of that capital. The smartest banks are figuring out where they get the best bang for the buck as they deploy their capital. That’s why they generate the best returns in the industry, irrespective of their size.

How are we competitively positioned in our markets?

Planning should not be done in a vacuum. For example, if you can see that some of your competitors will have capital issues, you can take advantage of that weakness. Many banks are projecting loan growth with blinders on. If you want to grow your CRE by 15 percent next year,  are you growing with the pie, or are you increasing your share of the pie? This will serve as both a reality check to your assumptions, and also guide your execution of the strategy.