Spotting Issues in the Community Bank Boardroom: Five Emerging Trends in 2015

By Adam Mustafa

Now that we’re into the second quarter, it’s time to assess some of the emerging trends in the community banking market.  The Invictus Group™ works with many banks of all shapes and sizes across the country. In addition, we have built a proprietary model that allows us to analyze post-stress data of every FDIC-insured bank in the U.S.  This gives us a unique vantage point from which to spot issues as they bubble up in bank board rooms, and offer solutions before they become problems.  Here are five challenges that smart banks should be thinking about:

Subordinated debt is becoming a popular conversation topic with bank directors and CEOs.

There are several reasons.  For those banks large enough to access the capital markets, sub-debt offers an affordable source of capital at a cost of anywhere between 4.5 to 6.5 percent (before taxes).  That price could be short-lived with the increasing possibility of interest rates returning to normal.  Today, private deals generally cost more, anywhere from 6 percent to 9 percent.

In addition, the recent change in the Federal Reserve’s definition of a Small Bank Holding Company from $500 million to $1 billion in assets expands the number of institutions that do not need to maintain regulatory capital ratios at the holding company level.  This will strongly incentivize banks that qualify to raise subordinated debt.  We believe the rule’s unwritten purpose is to enable more banks within that asset range to raise cheap capital to acquire smaller banks, which are large in number and low in significance to the regulators.  We are working with a number of banks in this size range looking to take advantage of this massive M&A opportunity. 

Also, banks with assets greater than $1 billion are looking at sub-debt as a way to better optimize their capital structure.  Sub-debt proceeds can be potentially used to pay down TARP or SBLF, or fund dividends and stock repurchases.  That being said, banks should be very careful with these options.  The risk/return tradeoff of using these proceeds for these types of purposes should be evaluated, and the structuring of the sub-debt will be critical for managing regulatory capital within the context of Basel III (see next point). 

The new Common Equity Tier 1 (CET1) Ratio created by Basel III will become more of a focus for the regulators. 

This is especially true at the holding company level, which is regulated by the Federal Reserve.  Many bank holding companies have other forms of capital, including preferred stock, TARP, SBLF, subordinated debt, and TruPS that may count as Tier 1 capital, but will not count as CET1. 

We work with many banks to help them use stress testing as a calculator for customizing their own capital requirements.  Before Basel III, the Total Risk-Based Capital ratio was always the first ratio that would be breached in a stress scenario.  However, in a post-Basel III world, that flip-flops for many bank holding companies.  Under stress, common equity absorbs most of the losses.  For those institutions that still are funded by TruPS, the loss of Tier 1 capital begins to hemorrhage because the TruPS can only count for up to 25 percent of Tier 1 capital under Basel III.  In other words, stress causes common equity to shrink.  As common equity shrinks, the amount of TruPS that can count as Tier 1 capital shrinks as well.  Ironically, the TruPS that are excluded from Tier 1 Capital can count as Tier 2 capital without limitation.  As a result, a bank holding company can find itself with a shortfall of CET1 under stress, on the brink in terms of the Tier 1 Leverage ratio and Tier 1 Risk-Based ratio, but be just fine on the Total-Risked Based Capital ratio. 

At the end of the day, it becomes clear that one of Basel III’s main purposes was to encourage common stock, which absorbs unexpected losses the best, and discourage other forms of equity.  A stress test, which is not required for community banks, can shed light on this.  Banks under $10 billion of assets shouldn’t necessarily adjust their strategic plans, but they should be prepared to have these capital discussions with regulators and have a contingency plan in case they are required to make adjustments.

Banks are having to make a “Sophie’s Choice” about their loans…every single day.

Let me know if this sounds familiar:  One of your best loan customers has come back to you, looking for a lower interest rate, and looking to lock it in for as long as 10 to 15 years.  They even went to another bank, which drafted a term sheet, and they are giving you a chance to beat it.   

The loan doesn’t sit well with you.  The new terms are reducing the interest rate by 200 basis points, which means you will lose more than one third of the revenue that you’re generating from the relationship today. 

It will be locked in for seven years and the new LTV will be 75 percent and include a cash-out refinance.  The debt-service coverage is fine, albeit at these interest rate levels.  If you make the loan, then you will be stretching your comfort zone from an underwriting perspective.  If you make the loan, your earnings will be better in the short-term.  Heck, making a 4 percent loan still beats buying some short-term T-Bill or GSE security with a 2 percent “yield” (in quotes by design).   So do you make the loan?

These are the tough choices being faced by bankers every day in the trenches.  As the artificially low interest rate environment prolongs and your ‘wreckless’ competitor down the street is making loans at all costs, these issues are exacerbated.

Most banks are treating these loan questions as a series of knee-jerk reactions without realizing the implications.  Other banks are approaching them as loan pricing issues.  Loan pricing models can help, but only so much, since the term sheet the borrower got from the bank down the street will box you in.  Banks need to recognize that this is first and foremost a strategic planning issue.  The strategic plan must set the tone for this new reality.  This is a main focus for us right now with our clients. 

Everyone is tired of talking about interest rate risk, although not for good reason.

Yes, regulators and consultants have been ringing the interest rate risk alarm bell for years now.  Most banks are comfortable with their ALM models, even though the regulators continue to challenge them with tools such as model validation.  We will not go into why we think most ALM models are flawed in this column.  Instead, we will make the simple point that just about every loan on a bank’s books today consists of a loan originated in a near-zero-interest rate environment that this country has never seen before.  The only exceptions are pre-crisis loans still on a bank’s books, and well, you know the story there.  These loans have extraordinary low interest rates, many of them fixed over a long time horizon.  The loans that have floating rates either (i) have floors associated with them, (ii) consist of strong borrowers who will immediately look to refinance or take their business elsewhere on the first rate increase, or (iii) consist of borrowers who are middle-of-the-road from a credit quality perspective and will increasingly struggle to service their debt and meet underwriting standards as rates rise.   There are other issues that have recently emerged that are very serious.  Be on the lookout for some groundbreaking industry analysis coming from Invictus in the near future, though!

Banks in agricultural and energy markets are looking at a “new normal”.   

With oil prices and most commodity prices down since last fall, both agricultural banks and energy banks are facing new uncertainty.  The issues are unique and complex for each, but in both cases, this shift represents a sea change for the banking landscape in these markets.   Any increase in interest rates that leads to an even stronger dollar can exacerbate agricultural and energy prices further in the near future.  Regulators are beginning to ramp up their scrutiny of these banks, and management teams are beginning to become more conservative from an underwriting and growth perspective.  That being said, uncertainty and change also means massive opportunity if you have the right strategy and right toolkit.  We are working with several banks in both of these sectors to take advantage of this opportunity.  Too often, banks trot out their defense in these situations, when they should be trotting out their offense.