Taking A Holiday Break

 Best Wishes for Yours!

from the First National Community Bank of New Richmond, Wisconsin

I won't be posting commentary for the next two Mondays in order to enjoy the holidays with family.  Best wishes to all of you for a terrific holiday season!  And remember, when old Uncle Charlie plants himself on the couch in front of you and starts rambling on endlessly about how wonderful things were in the good old days, it's an opportunity for you to tune out and grab your iPad.  Take a look at some of the older posts on The National Bank Examiner.  Some topics are timely, some are timeless, and because they are free, all are priceless.

2013:

 Community Bank M&A Tipping Point?

The latest FDIC quarterly banking profile shows that the banking industry continues to get back on its feet.  More than half of all institutions showed improvements in their quarterly net income from a year ago, driven largely by improving credit quality.  Headwinds are becoming tailwinds and the downward spiral in credit quality seems to have stabilized.

One gets the sense, from the industry dialogue, that merger and acquisition (M&A) activity at the mid-size and community bank level is poised to increase significantly in 2013.   With recent news stories indicating that the mega-banks have been sidelined by the Fed with regard to M&A activity, the M&A focus moves to the mid-size and community bank segments of the industry.

Three reasons contribute to this hunch.  The first is the program of financial repression created through the Federal Reserve zero interest rate policy and its efforts to push down long-term rates.  A community bank, in particular, has to have a reasonably wide positive carry (net interest margin) to cover its overhead.   Fee income helps, but with what looks like a public jihad against banking fees (think overdraft and interchange fees), there are limits to flexibility on that front.

With loan demand lethargic, options to offset financial repression are few.  Many community bankers are seeing the present Fed zero interest rate policy remaining for years to come.  This is pushing some to pursue classic “down and out” banking - moving down the scale of credit quality and out along the yield curve to squeeze out a few more basis points of yield.  But those practicing “down and out” banking know, in the back of their minds, that a reasonable buyout offer tomorrow would be preferable to the risky, and potentially mortal, balance sheet positions they are building out of necessity and desperation today.

The second is the escalation in the average community bank cost structure. Community bank cost structures are creeping up faster than technology can lower them.   Technology is a great way to lower unit costs of production, but diminishing returns appear to be kicking in.  The cost reduction curve is being slowed by increased expenditures for cyber-security and privacy protection.

Then add in to the community bank cost structure increases in personnel expenses associated with the implementation of the Affordable Care Act, compliance costs associated with the ongoing implementation of the Dodd-Frank Act, Consumer Financial Protection Board regulations in the pipeline, and the increased regulatory agency fondness for “guidelines” (which appear to be recommendations, but are enforced as obligatory through the examination process).

Not helping the cost structure situation either, is the emotional attachment to lightly-trafficked brick-and-mortar branches as monuments to territorial conquest and icons to the exercise of superior generalship in days gone by.  Cede turf to a competitor? Never!

Third, battle fatigue is showing up in more and more community bank CEOs and boards of directors.  Not only is this economic recovery so frustratingly long and slow, but many of the true joys of community banking are being overshadowed by the aforementioned frustrations and obstacles.  The familiar five stages of adaptation are at work: denial, anger, bargaining, depression and acceptance.   This process tends to soften opposition to market value buyout offers.   Stock swaps may also become more popular, as many shareholders may think that buying a ticket on a winning horse may be preferable to being passengers on a foundering vessel.

An Appealing Option

OCC Ombudsman Larry Hattix

Former Comptroller of the Currency, Eugene “Gene” Ludwig, created the OCC's Ombudsman's Office in 1993.  The effectiveness of this program led to a statutory requirement for all federal bank regulatory agencies to establish an independent intra-agency appellate process, including a requirement for each agency to appoint an ombudsman (Section 4806 of the Regulatory Improvement Act of 1994).  Almost 20 years later, the OCC Ombudsman's Office remains in very capable hands, led by a veteran national bank examiner, Larry Hattix.  The current appeals guidance, for national banks and thrifts, is contained in OCC Bulletin 2011-44 – Bank Appeals Process –Guidance for Bankers.

The guidance outlines two tracks for the review of matters that qualify for a bank or thrift appeal.  For the purposes of this article, the term “bank” will mean a national bank or federal savings association.

Using the case of a community bank, the bank's board of directors has the choice to submit the matter directly to the Ombudsman or to the bank's OCC district deputy comptroller (or in the case of an extremely troubled bank, the Deputy Comptroller for Special Supervision in Washington, D.C.).   I've recently been asked how a community bank's board of directors might choose one path for appealable matters over the other.  Here is my advice:

First, for any preliminary examination determination that may ultimately become an appealable matter, work with your examiner-in-charge and the Assistant Deputy Comptroller of your local OCC field office to try to resolve the matter. Working things out before an examination report is submitted for processing is the best and least costly step, in time and effort, for all concerned.

When a final examination report is rendered and decisions have become final, the community bank's board of directors may continue to feel that it wants to pursue an appealable matter.   In that case, my advice is that they initially go through the bank's district deputy comptroller only if their bank is a CAMELS Composite 1- or 2-rated community bank without an informal or formal enforcement action. Otherwise, take the matter directly to the Ombudsman's Office.

Here is the logic:  If your community bank is CAMELS Composite 2-rated with an informal or formal enforcement action (in place or pending), or 3-rated, or 4-rated under $1 billion in assets, the final decision regarding your bank's examination results and CAMELS ratings was made by the district deputy comptroller, through the mechanism of a District Supervision Review Committee (DSRC).  The same decision-making authority, for extremely troubled banks (4-rated over $1 billion in assets or any 5-rated), is vested in the Deputy Comptroller for Special Supervision in Washington.

OCC Bulletin 2011-44, Bank AppealsProcess – Guidance for Bankers, has this important provision: “Recusal of the Deputy Comptroller: If the Deputy Comptroller directly or indirectly participated in making the decision under review, he or she must transfer the appeal to the Ombudsman after advising the appellant.”

Taking either appeals route, through the appropriate supervisory office or through the Ombudsman, a community bank board of directors will find seasoned and experienced professionals who want to be open, reasonable and equitable.  

And remember, though some decisions are not appealable as outlined in OCC Bulletin 2011-44, the building blocks that led up to the final decisions, and now support those decisions, may themselves be appealable.  

Full TAG Extension - A Contrary View

It's interesting to see the banking trade associations, who normally rail and fulminate at government intervention in the marketplace, madly try to protect the government special favors or munificence already bestowed... I'm talking about the Transaction Account Guarantee Program (TAG).  TAG was an emergency measure, taken at the depths of the 2008 financial crisis, to manage systemic liquidity fears and maintain financial system stability. It granted unlimited FDIC deposit insurance protection to non-interest bearing transaction accounts.  Its latest extension expires on December 31, 2012.  The banking trade associations are lobbying for an additional extension.

In Economics 101, we were taught about the workings of Adam Smith's invisible hand. What we are seeing play out with the TAG extension, is Adam Smith's other hand at work... his visible hand.  The pursuit of self-interest to gain or maintain government largesse.

I'm reminded of an earlier government financial emergency measure, the 1933 Glass-Steagall prohibition on paying interest on demand deposits and the establishment of government-administered ceilings on the maximum rates of interest that could be paid on savings and time deposits. Congress wanted to avoid a repeat of the speculative banking behavior that culminated in the 1929 financial crisis, and that eventually brought on the Great Depression. The idea behind the measure was a sense that excessive competition for deposits (some characterized it as "destructive competition") created an undesirable narrowing of bank net interest margins. This narrowing, in turn, resulted in an anxiety for income that was thought to have promoted risky bank lending and investment practices.

These price controls remained in effect until the 1980 Depository Institutions Deregulation and Monetary Control Act established a six-year phaseout of the maximum rates of interest that could be paid on savings and time deposits in Regulation Q, the Federal Reserve regulation through which these price controls were administered . Even though government-determined interest rates on savings and time deposits went away in 1986, it wasn't until the passage of the Dodd-Frank Act that the last vestige of these measures was repealed. The payment of interest on business demand deposits was allowed as of July 21, 2011. On that day, an amazing 78 years after these emergency measures were first enacted by Congress, Regulation Q, was finally consigned to the ash bin of history.

Even if the extreme hypotheticals advanced by the trade associations for TAG extension  have some kernels of validity, a weaning off of government support is in order. A step-down approach to the normal deposit insurance limit of $250,000 would allow us to examine the true nature of the funds flows, instead of our fears.