The $9MM Badger Relationship
There is something for everyone looking for lending pitfalls in the coming months.
Mortgages, subprime auto lending, commercial-and-industrial loans and student lending are ripe for setbacks and, in some cases, crises.
Here is a breakdown of each of those risk factors, the reasons behind them and the possible upsides or alternative strategies.
The refinance market has largely carried the mortgage industry over the past few years because consumers took advantage of historically low rates. Now that the Federal Open Market Committee has raised rates twice in the past year, and the benchmark 10-year Treasury has spiked upward since the presidential election, many expect the refinancing market to nosedive.
“We’ll see refinancing all but dry up, and the mortgage business is going to really suffer” in 2017, said Donald Musso, CEO of FinPro Capital Advisors, a bank consulting firm in Gladstone, N.J.
The question becomes whether an improvement in the overall health of the housing market can take up the slack.
“It’s going to be sales that drive your mortgage lending now,” said Jay Pelham, president of the $3 billion-asset TotalBank in Miami.
That may be easier said than done. The incoming Trump administration and the Republican-led Congress have signaled they may reduce the mortgage interest deduction, a move that the National Association of Realtors and other housing industry groups have warned will wallop the housing market.
Banks’ mortgage fortunes could vary among geographic markets, too. The South Florida market, especially downtown Miami, appears to be set for a high level of purchase activity, Pelham said.
“If you look at our downtown market, it’s full of restaurants, jobs and apartments that both professionals and young people want,” he said. “When I look at prices per square foot here, we are still cheap compared to New York, London and Chicago.”
For months, regulators have forcefully warned about soaring balances of subprime auto loans and the risks associated with them. The data seemed to back them up.
In March, Fitch Ratings reported that more than 5% of securitized subprime auto loans were at least 60 days late, the highest delinquency rate in 20 years.
And the 90-day delinquency rate for subprime auto loans was 2% in the third quarter, versus 1.9% a year earlier and 1.4% in the third quarter of 2012, according to a Federal Reserve Bank of New York report. Over the same period, delinquency rates for borrowers with higher credit scores were relatively flat. Meanwhile, about 3.6% of overall auto loan balances were 90 days behind in payments.
Lenders have downplayed those concerns, saying that they have applied strict underwriting standards.
Yet some banks have begun to take precautions. The $143 billion-asset Fifth Third Bancorp in Cincinnati and the $147 billion-asset Citizens Financial Group in Providence, R.I., this fall announced plans to scale back indirect auto lending.
At the same time, some community banks have shown greater interest in auto lending as consumer demand for car loans continues to soar. The $4 billion-asset Fidelity Southern in Atlanta and the $9 billion-asset First Interstate BancSystem in Billings, Mont., each posted double-digit increases in auto loans in the third quarter.
Lenders have recently made improvements in how they underwrite subprime auto loans, and that may prevent a big meltdown, said Jon Winick, CEO of Clark Street Capital, a bank consulting firm in Chicago.
“There have been real innovations in the subprime auto space that are unique to that asset class,” he said. “You can prevent someone from using their own car if they’re 30 days delinquent and you don’t have that level of control with a real estate deal.”
Tough competition for commercial-and-industrial loans has created one of the riskiest situations as many banks are said to have cut pricing to win business.
Banks have crowded into the C&I space for plenty of reasons. One is that regulators have placed a great deal of emphasis on commercial real estate loan concentrations, and banks have responded by improving risk management and bolstering capital levels. Those steps may help limit CRE losses, but they have encouraged more banks to risk expansion in C&I loans as they hunt for places to deploy their capital.
There is so much competition in the C&I market that many players have caved to borrowers’ demands for lower rates and better terms, Winick said.
“Underwriting standards have collapsed the most in C&I,” he said.
At the same time, C&I loans present significant challenges when they default as they are typically not collateralized by tangible assets.
“If a C&I project defaults, you don’t have an automobile you can repossess or a house you can foreclose on,” Winick said.
But there are some potential bright spots for C&I. One is that the presidential election is over, which should remove the anxiety that had led many businesses to hold back on capital spending for months because of political uncertainties, Musso said. Talk of tax cuts and regulatory relief has played well in commercial sectors.
“I actually think we may see a modest uptick there because the business community believes we’ll see some relief from the Trump administration,” Musso said.
Another is that banks may have already suffered through the worst part in two subcategories of C&I lending, energy and taxi medallion loans. A rebound in oil prices dampened the losses at energy lenders, while some banks like the $72 billion-asset Comerica in Dallas reduced their exposure to the sector. And executives at the $38 billion-asset Signature Bank in New York recently said that they have restructured troubled taxi loans.
“I think the new normal has come out in taxi loans,” said Dave Etter, managing director of loan review services at Sheshunoff Consulting. “To try to sell taxi loans now is just impossible. You’re just looking to generate some cash flow.”
Finally, some banks have attempted to carve out specialties within the C&I category to diversify loan portfolios and improve yields. The $28 billion-asset First Horizon National in Memphis, Tenn., for example, has expanded in franchise finance and health care finance to help dilute its C&I exposure.
The massive pile of student loan debt threatens to send scores of consumers into financial ruin. The Congress and the incoming Trump administration may try to address the situation by getting the U.S. government out of the student loan business. That could create an opportunity for banks to re-enter the private student loan market.
Investors are betting that will happen. Shares of SLM Corp., the Newark, Del., company known as Sallie Mae, rose 54% from Nov. 8 to Dec. 28, to $10.95. Sallie Mae is the largest private student lender.
Only a few banks remain active in student loans, including Citizens Financial. Those banks stand to benefit from the new political environment, KBW analysts wrote in a December report, and other banks may want a piece of the action.
What most analysts agree on is that the amount of student-loan debt that consumers are carrying is unsustainable.
“It’s my biggest concern in the consumer space, hands down,” Winick said. “We know the losses will be terrible.”
Bankers are entering a new year feeling a sense of déjà vu about regulatory warnings over commercial real estate concentrations.
A decade earlier, regulators were warning that CRE exposure could lead to earnings and capital volatility. While many bankers said those concerns were overblown – arguing that few institutions were in trouble – hundreds of banks ended up failing.
Fast forward to today and regulators are expressing similar reservations, warning that areas such as multifamily could become problematic. Bankers, however, say they believe the industry is better equipped to handle an economic shock, pointing to a system with more capital, backstops from borrowers and improved risk management processes.
Only time will tell if those views are correct and whether bankers will remain relatively cautious.
“You see comments about taking a foot off the gas,” said Peter Cherpack, principal of credit technology at Ardmore Banking Advisors. “The enthusiasm for real estate for many bankers is now somewhat tempered.”
Still, the industry struggles “with bankers who have short memories,” Cherpack said.
Several banks exceed recommended CRE levels, as a percentage of total risk-based capital, prompting regulators late last year to remind banks of their guidance on concentrations. Regulators prefer that CRE remain below 300% of a bank’s total risk-based capital and for construction and land development loans to stay under 100%.
Regulators said in a joint statement that “many CRE asset and lending markets are experiencing substantial growth, and that increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values.”
There is no prohibition for going over those levels, and the numbers aren’t considered limits. Banks may still be targeted for more supervisory analysis and, as a result, should implement enhanced risk controls, such as stress testing for CRE portfolios.
New York Community Bancorp and Astoria Financial earlier this week terminated a $2 billion merger after facing regulatory delays that some industry observers believe could be linked to CRE concentrations.
It seems unlikely that a focus on CRE will let up next year. Fitch Ratings warned last month that CRE lending at U.S. banks had reached record levels that are unsustainable.
“I don’t think commercial real estate will be dropping off the radar,” said Patrick Ryan, president and CEO of First Bank in Hamilton, N.J. “Other areas like cybersecurity might also become an area of focus … but it may not replace CRE.”
A review of the financial crisis provides some rationale for regulators’ diligence. A 2013 report from the Office of the Comptroller of the Currency and the Federal Reserve found that 23% of banks that exceeded guided levels for both CRE and C&D loans failed during the three-year economic downturn, compared with less than 1% of banks that stayed below those levels.
The Federal Deposit Insurance Corp. did not provide a comment for this story. The OCC and the Fed did not comment on the record.
“There’s the sense that the industry got a little ahead of itself and loaned too much on deals that were not tangible,” said James Kaplan, a lawyer at Quarles & Brady. “It was unclear that these buildings would have tenants, and banks got left holding … something that didn’t have too much value.”
Some industry observers believe those numbers don’t tell the full story, pointing out that not all types of CRE perform the same. Many of the defaulted loans were tied to residential projects that failed when people stopped buying homes.
“I think the way regulators classify CRE – at least from a numbers standpoint – is suboptimal,” said Jon Winick, CEO at Clark Street Capital. “Many of those losses weren’t really CRE projects. They were … classified as CRE but they were really residential.”
Banks largely pulled out of funding speculative construction and development loans after the crisis. Roughly 320 banks at mid-2016 exceeded the 100% guidance on C&D loans as a percentage of total risk-based capital, versus nearly 2,400 in 2007, based on regulatory data.
“Banks understand that construction is more of a risky market … and the first one to collapse,” said Tim Scholten, founder of Visible Progress, a consulting firm. “A project that is half done isn’t good collateral.”
The $4.8 billion-asset Peapack-Gladstone Financial is among the banks that pulled back from C&D loans, which accounted for most of its losses during the last downturn, said Vincent Spero, the Bedminster, N.J., company’s head of commercial real estate.
“We just don’t have the stomach and the appetite for those loans,” Spero said. “You need the infrastructure in place to complete those loans, so we have pursued a different strategy.”
Peapack-Gladstone is focusing on the rent-regulated space for multifamily loans, an area that has historically had lower chargeoff rates and better credit analytics, Spero said. The bank has a CRE to total risk-based capital ratio of almost 590%, according to BankRegData.com.
Peapack-Gladstone has spent close to $1 million on processes, data analytics and third-party vendors to “ensure from a risk management perspective that we’re on top of it,” said Chief Credit Officer Lisa Chalkan. The company earlier this year hired a real estate expert to provide granular data on asset classes that management uses to evaluate limits on different types of loans.
“With the reissuance of the guidance, it was abundantly clear that the regulators were focused on real estate,” Chalkan said. “It just seemed like a prudent time to make changes.”
Industry experts also believe that banks are better capitalized today and would be in a better position to withstand a significant economic downturn. Total risk-based capital at banks with less than $10 billion of assets averaged 15.5% at Sept. 30, up from 14.4% a decade earlier, according to the FDIC.
Banks have also been more careful about underwriting, risk management and deals outside of their comfort zone, said Mitch Razook, president of RLR Management Consulting. Stress testing is also helping a number of banks.
“Lenders are better educated now and underwriters are more conservative,” Razook said. “Banks have a lot more controls in place.”
Though the $1 billion-asset First Bank has a CRE focus – CRE to total risk-based capital was roughly 390%, according to BankRegData.com – it has resisted the urge to diversify by branching out into areas where it lacks expertise, Ryan said. Rather, the company works to have varied assets, such as retail, industrial and mixed use, within its CRE book.
While there is talk that banks are loosening standards, Ryan said he believes many institutions are normalizing their stance after years of having tight criteria.
“If you compare what banks and borrowers are doing today, it is much more controlled, rational and logical compared with what was happening from 2005 to 2007,” Ryan said. “It is probably a better, happy medium.”
“These two transactions demonstrate the broad range of Clark Street’s expertise, as we are the best firm for highly unique and customized transactions. I am confident that no other firm could have delivered as capably as we did on these two deals, and we received broad accolades from our clients.”
In one offering, Clark Street helped a regional bank divest out of a legacy portfolio of largely performing, but classified commercial real estate loans within the Louisville, KY metro area. In selling a complicated portfolio to two different private equity firms, Clark Street solicited bids from over two dozen parties, including several local and regional banks. Final pricing exceeded Clark Street’s initial estimates by approximately 100 basis points.
In another sale that closed in late September, Clark Street helped a bank operating in more than a dozen states divest out of fixed rate residential mortgages acquired for CRA purposes. It was a unique transaction, as the seller of the loans was not the servicer, which presented significant operational challenges. Ultimately, four different parties had to be comfortable with a highly complicated transaction featuring over 400 small-balance residential mortgages. The loans were sold at a premium to par and exceeded the reserve price by over 50 basis points.
Jon Winick, CEO of Clark Street Capital, said, “These two transactions demonstrate the broad range of Clark Street’s expertise, as we are the best firm for highly unique and customized transactions. I am confident that no other firm could have delivered as capably as we did on these two deals, and we received broad accolades from our clients.”
Clark Street has the largest database in the industry, with over 40,000 contacts in its collective databases. Over 21,000 professionals receive the BAN Report, our weekly banking industry blog.
Clark Street Capital is a full-service bank advisory firm specializing in loan sales, loan due diligence and valuation, and wholesale lending.
Chicago is often favorably described as the city of neighborhoods, and in banking circles it has a similar reputation for multiplicity – except that’s not necessarily a compliment in banking.
Unit banking laws that remained intact into the1960s fostered scads of single-branch community banks. The Windy City landscape is still littered with small, privately held banks as a result. It has always been assumed that many of them could not survive and would have to sell themselves, and to be sure the Chicagoland area has seen its share of M&A in recent years.
But the more obvious deals, the ones that follow the traditional pattern of big fish buys small, have been done, and that reality raises several questions about the nature of M&A in Chicago and other oversupplied markets around the country.
Are there enough classic buyers and sellers left?
The answer is no, not exactly. The number of big fish is shrinking, and so is the size (and appeal) of the targets.
Since 2010, there have been more than 90 deals announced in Illinois, and recently some of the larger community banks in the Chicago area have announced plans to sell.
Canadian Imperial Bank of Commerce recently agreed to buy PrivateBancorp for $3.8 billion, and that deal would leave the city with fewer large players based in the area.
“Every night before I go to bed, I pray for more buyers,” said William Burgess, a principal in investment banking at Sandler O’Neill. “Right now it remains a buyer’s market because there is just an insufficient number of buyers. I don’t think that will change anytime soon.”
Besides the CIBC-PrivateBancorp deal, First Midwest Bancorp has agreed to buy the $2.5 billion-asset Standard Bancshares for $365 million, and MB Financial said it would buy the $2.8 billion-asset American Chartered Bank for $449 million.
Once those deals close, there will not be any banks based in the Chicago area with between roughly $3.5 billion of assets and $14 billion of assets, Burgess said.
“A big bank deal in Chicago usually involves a seller with $1 billion of assets,” said Christopher McGratty, an analyst with Keefe, Bruyette & Woods. “But there’s not too many of them left. The majority of consolidation is under the radar with these smaller banks being rolled up.”
Who will drive the deals then?
A few classic candidates remain: the $23.7 billion-asset Wintrust Financial, the $10.6 billion-asset First Midwest and the $15.2 billion-asset MB Financial.
The challenge for prospective sellers is that these banks can afford to be choosy, erring on the side of larger banks that are worth the integration costs that come with any deal.
Wintrust in Rosemont, Ill., is one exception to this and has shown a willingness to buy smaller banks. That trend is likely to continue. It has never purchased a bank that was larger than $1 billion and three of its last four bank deals involved sellers that had less than $200 million of assets.
“They are very good at buying things below value,” Burgess said.
Wintrust’s chief executive and president, Ed Wehmer, did not return a call seeking comment.
First Midwest in Itasca, Ill., has done a combination of larger and smaller deals. It is interested in doing further deals in Chicago and in adjacent markets, such as northwest Indiana, southwest Michigan and the Quad Cities region in Iowa, said Michael Scudder, First Midwest’s president and CEO. The bank does not necessarily have an asset size range when looking for potential deals and instead focuses on the strategic value a seller could add to the organization, he said.
MB Financial in Chicago has shown a preference for doing larger deals, including buying Taylor Capital Group in 2014. MB declined to comment for this story.
So where else can struggling bank turn?
Smaller banks could seek more mergers of equals: in other words, pair off with banks of similar size.
However, such deals typically face roadblocks of their own. For one, investors in privately held banks may be looking for liquidity, and merging with another small nonpublic company won’t provide that, Burgess said.
Regulators may also be wary of a small, inexperienced acquirer becoming involved in a deal, said Michael Iannaccone, a senior adviser at Tangent Capital Partners. Buyers need to show that they have the right people, platforms and processes in place to ensure that the transaction goes smoothly.
“The regulatory environment could slow the small side of the market,” Iannaccone said. “It’s really all based on experience and most small banks, just based on size, don’t have that experience.”
Investors in some small privately held banks may also see no reason to sell, said Jon Winick, CEO of Clark Street Capital. Some shareholders are fine with their investment having mediocre returns simply because they enjoy owning a bank.
“Every investor isn’t a hedge fund manager that is analyzing their investment coldly compared with other alternatives,” Winick added. “Maybe they own a small community bank and it does OK but it isn’t killing it. There’s often no motivation to sell. On some level, it’s fun to own a bank.”
That’s where some good news lies.
Consumers often complain about their banks but are less inclined to bolt than many think, and some electronic services make it easier for them to stick around even if their bank is sold.
“If you do an acquisition correctly, people are creatures of habit, whether a business or a retail customer,” Iannaccone said. “With electronic banking, people get used to all of their bill payments being set up and the bank’s other systems and they really don’t want to switch. They don’t care whether the name on the bank has changed.”
If true, that trend could minimize runoff and make smaller acquisitions just a little more attractive than they might have been in the past.
What will happen to all the bank employees?
Regardless of what further Chicago merger activity takes place, there could be a shake-up of talent from the pending deals alone. Competitors may lure talented lenders away.
Banks are especially keen to recruit employees with strong ties to customers in commercial lending and treasury services, said Robert Voth, a leader in the consumer and commercial financial services practice at Russell Reynolds Associates.
However, bankers are often loyal to their current employers, so a competitor looking to pick up talent needs to show it can provide a better opportunity with its platform, products and services or reputation, Voth said.
“Bankers tend to be parochial by nature,” Voth added. “They don’t want to move but may if their current bank lacks products or there is a truly golden opportunity on the other side.”
ABA baffled by White House economists’ conclusions on Dodd-Frank
By Kevin Dobbs
Kevin Dobbs is a senior reporter and columnist. The views and opinions expressed in this piece represent those of the author or his sources and not necessarily those of S&P Global Market Intelligence. Follow on Twitter @Kevin1Dobbs.
The White House Council of Economic Advisers says the 2010 Dodd-Frank financial reform legislation that led to mounds of new regulations in the aftermath of the financial crisis should not get blamed for community bank consolidation.
The council, led by Chairman Jason Furman, said in an August report that small-bank consolidation is a long-term trend, the result of “structural challenges dating back to the decades before the financial crisis,” including demographic shifts from rural areas to cities and economic recessions.
“There’s no evidence at all that Dodd-Frank has had a negative impact on this sector,” Furman told The Wall Street Journal.
The American Bankers Association finds that bewildering.
“Having thoroughly reviewed the report I must admit to being baffled by your findings,” ABA President and CEO Rob Nichols said in an August letter to Furman. The “notion that the Dodd-Frank Act — and its 24,000 pages of proposed and final rules — has had no impact on community banks is simply untrue.
“A conversation with any community banker would dispel this forced conclusion,” Nichols added. “The thousands of new regulations that have been imposed on community banks is an enormous driver of decisions to sell to a larger bank.”
More than 280 banks — the vast majority of them community lenders — agreed to sell in 2015. More than 150 have inked deals to sell so far this year, according to S&P Global Market Intelligence data.
Insignia Bank in Florida is among them. The bank, with about $250 million in assets, said this month it would sell to the largerStonegate Bank. In an interview, Insignia Chairman and CEO Charles Brown III said his bank did not have to sell, but the benefits of joining forces with a larger company, including the ability to better absorb compliance costs, factored into Insignia’s decision-making.
Regulatory burden “has almost always” played a role in community bank M&A in recent years, Brown said.
Jon Winick, president of bank consultancy Clark Street Capital, said in an interview that Dodd-Frank is not the only reason banks sell. Fierce competition, choppy economic conditions, low interest rates and rising technology costs, among other challenges, play into sellers’ thinking. But regulatory burden “certainly” is an important influence on many, he said.
“Anyone who believes that the community bank landscape has not been adversely affected has been living in an ivory tower somewhere with no grasp of what is happening in the real world,” he said.
Interviews over the past several years with selling bank executives back that up. Most have cited lofty compliance costs as a key reason to sell. Most have argued that a slew of new regulations have forced small banks to divert precious resources and time away from dealing with customers and toward managing soaring levels of paperwork and meeting examiners’ rising demands. Ultimately, many have said, that was not a sustainable way of doing business. Selling became inevitable.
After Citizens National Bancorp Inc. this spring decided to sell to Simmons First National Corp., for example, Citizens Chairman and CEO Paul Willson said in an interview that both the volume and complexity of new regulations written under Dodd-Frank played a big role in his company’s decision to throw in the towel.
“It takes so much more time, and it is so much more complicated,” he said. “It has become so much more difficult to serve our customers.”
While there are exceptions for community banks under $10 billion in assets to certain rules under Dodd-Frank, Nichols of the ABA said in his letter that often “rules intended for the largest banks are too often considered ‘best practices’ for all banks, compounding the hardship for smaller institutions.”
What is more, he said, “arbitrary size thresholds create disincentives for community banks to grow because of the significant regulation that is added as soon as the threshold is crossed. This limits the services they could provide because of arbitrary rules, not business decisions to meet community needs.”
Against that backdrop, he suggested, consolidation could carry on far too long.
“If this trend continues unabated, there will be fewer financial services in communities and less economic growth,” Nichols said.”Whether intended or not, the Dodd-Frank Act has added fuel to industry consolidation, reduced flexibility for product offerings, and increased the cost of providing financial services — a cost that is ultimately borne by customers.”
The BAN Report: The $11MM Western SBA 504 Portfolio / Homeownership Plummets / FDIC on Third Party Lending / The White House on Community Banks-8/11/16
The $11MM Western SBA 504 Portfolio
Clark Street Capital’s Bank Asset Network (“BAN”) proudly presents: “The $11MM Western SBA 504 Portfolio.” This exclusively-offered portfolio is offered for sale by two institutions (“Seller”). Highlights include:
Loan files are scanned and available in a secure deal room for review. Based on the information presented, a buyer should be able to complete the vast majority of their due diligence remotely.
Please read the executive summary for more information on the portfolio. You will be able to execute the confidentiality agreement electronically by clicking on the upper left hand corner of the link to the executive summary.
At 2% from their 2006 peak, home prices have fully recovered from the great recession,but homeownership fell to a 51-year low in the second quarter at 62.9% with many experts believing they will fall even further.
The housing recovery that began in 2012 has lifted the overall market but left behind a broad swath of the middle class, threatening to create a generation of permanent renters and sowing economic anxiety and frustration for millions of Americans.
Home prices rose in 83% of the nation’s 178 major real-estate markets in the second quarter, according to figures released Wednesday by the National Association of Realtors. Overall prices are now just 2% below the peak reached in July 2006, according to S&P CoreLogic Case-Shiller Indices.
But most of the price gains, economists said, stem from a lack of fresh supply rather than a surge of buyers. The pace of new home construction remains at levels typically associated with recessions, while the homeownership rate in the second quarter was at its lowest point since the Census Bureau began tracking quarterly data in 1965 and the share of first-time home purchases remains mired near three-decade lows.
The lopsided recovery has shut out millions of aspiring homeowners who have been forced to rent because of damaged credit, swelling student loans, tough credit standards and a dearth of affordable homes, economists said.
In all, some 200,000 to 300,000 fewer U.S. households are purchasing a new home each year than would during normal market conditions, estimates Ken Rosen, chairman of the Fisher Center of Real Estate and Urban Economics at the University of California at Berkeley.
The rebound in home prices has now made home ownership less affordable for many Americans, even with low interest rates. Further loosening of residential mortgage underwriting standards, which have already been lowered with 97% financing back, can only go so far and can have bad consequences. The WSJ suggests that a lack of supply is the issue, so perhaps banks need to provide more credit for new construction. Credit has been widely available for new multi-family projects, but banks have been far less likely to finance residential for-sale developments, as the cash flows are far less predictable. Alternatively, there just may be more people, especially young people, that do not value the benefits of owning a home and prefer to rent. The bottom line – this trend is long-term in nature and is unlikely to change anytime soon.
FDIC on Third-Party Lending
The FDIC is seeing comment on recent guidance for Third-Party Lending, in which banks provide credit for non-bank lenders or enter into origination partnerships. This has been a hot topic, as non-bank and online lending has exploded, fueled partly by credit from warehouse lines from depository institutions.
As described in the Third-Party Guidance, the key to the effective use of a third party in any capacity, including third-party lending relationships, is for the financial institution’s management to appropriately assess, measure, monitor, and control the risks associated with the relationship. Engaging in a third-party lending arrangement may enable the institution to achieve strategic or profitability goals, but reduces management’s direct control. Therefore the use of third parties to engage in lending activities increases the need for strong risk management and oversight around the entire process, including a comprehensive compliance management system.
To this end, institutions should establish a third-party lending risk management program and policies prior to entering into any significant third-party lending relationships. The program and policies should be commensurate with the significance, complexity, risk profile, transaction volume, and number of third-party lending relationships. Moreover, institutions engaging in third-party lending activities need a process for evaluating and monitoring specific third-party relationships. This process is described in the Third-Party Guidance as comprising of four elements: (1) risk assessment, (2) due diligence in selecting a third party, (3) contract structuring and review, and (4) oversight.
The FDIC identified several areas of risk, including strategic risk, operational risk, transaction risk, pipeline and liquidity risk, model risk, credit risk, compliance risk, consumer compliance risk, and BSA/AML. For the most part, this guidance seems reasonable and prudent, but the concern is whether regulators expect the bank, which is often merely a lender, to effectively police and monitor a non-bank lender not subject to direct federal regulatory oversight.
The White House on Community Banks
The White House Council of Economic Advisers dismissed claims that financial reform has hurt community banks in a research piece published this week, eliciting groans and protests from bankers and their trade associations.
The findings in this brief, as well as research by other economists, show that access to community banks remains robust and their services have continued to grow in the years since Dodd- Frank has taken effect, though this trend has not been uniform across community banks, with mid-sized and larger community banks seeing stronger growth than the smallest ones. At the same time, though, many community banks—especially the smallest ones—have faced longer-term structural challenges dating back to the decades before the financial crisis. These structural challenges underscore the importance of implementing Dodd-Frank in an equitable way that gives community banks a fair chance to compete, which has been a key priority for the Obama Administration.
Although opponents of financial reform often claim that it has harmed community banks, a closer and more comprehensive review of the economic evidence shows that community banks remain healthy. Critics typically point to declining numbers of community banks as evidence that new regulatory requirements are too restrictive. In reality, due to bank branching patterns, the number of institutions does not provide a comprehensive picture of the health of community banks, and other indicators like lending growth and geographic reach show that community banks remain quite strong. Many community banks—particularly those with assets between $100M and $10B—have continued to grow steadily, as evident by their substantial lending growth, increasing market share in agricultural and mortgage lending, and expansion into new counties. With these trends, access to community banks and the important services that they provide has remained robust across many communities. At the same time, longer-term trends in the banking industry over the past several decades—including bank branching deregulation, merger activity, and other factors—often have created long-term challenges for community banks, particularly for the smallest ones. Macroeconomic conditions in recent years have also contributed to the lower rate of new entry by small banks.
Only a group of economists, detached from the real world, could come up with such stunning and tone-deaf commentary. Or, perhaps, they are simply loyal soldiers for the Administration. How can you not be concerned that the number of bank charters has plummeted in the past few years? Isn’t the number of banks important in terms of competition and access to credit?
Moreover, if you simply asked why banks have decided to sell in the past few years, the vast majority cite higher regulatory costs as a reason to merger or sell with a larger institution. They do raise some interesting points, as you cannot blame regulation for everything, but it certainly has been a contributing factor to a massive wave of consolidation, which has helped reduce the number of banks by nearly 25% in the past decade.
Community banks’ chief lobbying group hails it as a victory, but other observers call a recent Financial Accounting Standards Board concession aimed at easing the anticipated tumult of a change to the way lenders build up loan-loss allowances a big mistake.
“It’s just such a bad idea that it’s laughably bad,” Jon Winick, CEO of bank consultancy Clark Street Capital, said in an interview, pointing his criticism at FASB.
At issue is the FASB’s plan to move the banking and credit union industries away from their current loan-loss model — one based on incurred losses — and toward an expected-loss model, under which lenders would forecast loan losses years into the future and, notably, set aside allowances for such projected losses at origination. The FASB has said one goal is to enable banks to fortify allowances during normal periods so that when downturns strike, they are not caught off guard and left to hastily ramp up allowances to catch up with mounting losses induced by a recession, such as happened in the aftermath of the 2008 financial crisis. The change also is aimed at minimizing the likelihood of wild earnings swings and providing investors more transparency.
Amid larger industrywide worries about the feasibility of making projections for the life of multiyear loans — and whether banks will ultimately have to focus mostly on short-term loans because accurate forecasts for longer ones would essentially be impossible — community bankers also raised concerns about costs.
They have said that many big banks would use complex computer models to handle their forecasting work to comply with the FASB’s so-called Current Expected Loss Model, or CECL, which is expected to be finalized around midyear. Often, these bankers noted, when Wall Street firms and megabanks take the lead on addressing change, regulators tend to pass down an expectation that smaller lenders follow their lead. Doing so in the case of CECL would require major investments in new technology that many small banks have said they cannot afford.
Addressing those concerns, a FASB panel earlier this month issued a new CECL draft that the ICBA interpreted as an accommodation on the expense front. The panel indicated that it did not expect community banks and other small lenders to invest in costly new models — and that regulators, by extension, should not expect them to either. Instead, community lenders will be able to continue using spreadsheets and their own personal experience with borrowers and local market conditions to make projections.
“That was important,” James Kendrick, vice president of accounting and capital policy at the ICBA, said in an interview. “They don’t expect community banks to use exhaustive, expensive and unprecedented resources to calculate the allowance going forward. … We think it’s a solution that’s very doable.”
In short, the ICBA claimed a win in the fight against one of the elements that bankers fear about CECL. “We think they (FASB) are listening to community bank concerns,” Kendrick said.
But that is not the universally held view.
|“Allowing each bank to come up with its own model is a horrible, horrendous, and horrifying idea.”
–– Jon Winick, CEO of Clark Street Capital
Winick, for one, said in a report for clients that the FASB concession actually would make CECL worse from the perspective of investors and others who try to compare banks — an original goal posited by the FASB when it first introduced the change some five years ago. It also could create industry-changing competitive issues.
“Allowing each bank to come up with its own model is a horrible, horrendous, and horrifying idea,” Winick wrote. “How could one possibly compare one bank to another when each bank gets to make its own predictions of future losses?
“At least today,” he continued, “all banks do it basically the same way. … Imagine the market disruptions when one bank uses a conservative model to predict future losses, while its top competitor uses an aggressive model, and is able to price loans far more favorably.”
At a Hovde Group conference this month, several community bankers privately echoed those sentiments.
In the interview, Winick put it this way: “Right now, we have everyone speaking English with some regional dialects. But this change would create dozens of languages with no good way to interpret any of them.”
As such, he added, “It’s a disastrous idea.”
And, of course, it does not address bankers’ overriding concern: That predicting loan losses on 10-year business loans, or worse, on 30-year mortgages is all but impossible to do. Critics say forcing banks to make such projections, and then requiring them to set aside upfront allowances for possible future losses would accomplish two things: Require banks to absorb big hits early as they work to comply with the change, and secondly, send a false message to investors that the loan-loss projections are something more than guesswork.
“It’s really a horrible, horrible principal,” Joseph Stieven, chairman and CEO of Stieven Capital Advisors, said at the Hovde conference. The bank investor was speaking to a hall full of mostly community bankers, and his words were met with applause and cheers.
Boenning & Scattergood bank analyst Matthew Schultheis offered a similar bottom-line assessment, calling it “an abomination to the rational mind.”
The FASB’s proposed change is an attempt to help banks bolster their allowances to better guard against future downturns — and many in the industry, including Winick, say that’s an admirable goal.
But CECL “is a strange way to go about it,” Winick said. “It’s the wrong way.”
The FASB’s board is scheduled to meet April 27 to further discuss the costs and benefits of CECL. Board members are also slated to discuss the effective date of the change. The latest publicly discussed timeline calls for CECL to take effect in 2019 for publicly traded companies and 2020 for others.