PART II: Community Banks – A Simple Formula for Thriving and Surviving

This is Part II of a III-Part white paper. If you missed Part I, read it here. 

In this second part, we explore the financial crisis landscape of 2008 and organizational levers for Community Banks. What issues did Community Banks bring on themselves? What did politicians and regulators lay at their doorsteps? The pendulum clearly swung in the other direction, toward overregulation. We will survey the impact this excessive regulatory environment had on investment in systems and to an already competitive industry grappling with the emergence of “disruptors” such as FinTechs, and with advanced technology that deemphasized “bricks and mortars” service delivery.

Organizational Levers

Organizational levers are the broad framework that drives and defines culture, and direction to executive management and the “troops.” Telegraphed clearly, these levers create the outer boundary of an organization’s ethos. Organizational Levers are:

  • An Insightful and Diversified Board

As a Governance Fellow of the National Association of Corporate Directors (NACD), I have learned that Directors should keep their “noses in and fingers out.” I would amend that as “noses and ears in, and fingers out.” As fiduciaries, Directors are not only the monitors of the organization’s fiscal health, but they are the keepers of the corporate culture. The term “Corporate Culture” means different things to different people. However, the culture must be in tune to the community and all the stakeholders the organization serves, to include shareholders, employees, clients, suppliers, regulators. The poor discharge of these responsibilities creates a loss of credibility, and reputation, inside and outside the organization. And there is very little that’s more precious to a bank than credibility and reputation.

In addition to the above, the emphasis  in today’s corporate boards’ echo system is on Environmental, Sustainability, Governance (“ESG”), and diversity. Environmental and sustainability concerns are impacting communities in different ways, and the organization exhibiting sensitivity to this issue is paramount. Focus on governance dials directly into an organization’s reputation and credibility as expressed earlier. And an organization concerned with governance conducts its affairs and telegraphs its processes in a transparent manner, at arm’s length and with integrity.

  • A Strong Credit and Enterprise Risk Management (“ERM”) Culture

Unlike manufacturing that enjoys Gross Profit Margins (“GPM”) of 35-55%, lending margins are 3-5%. Out of that GPM, an organization has to cover overhead, personnel, losses, regulatory costs and dividends. In addition, banks’ capitalizations are thin by nature, meaning that excessive losses borne out of too many wrong decisions would damage the franchise. This burden translates the need for a prudent credit and overall risk culture. It is not just wrong credit decisions from the “ left hand side” of the balance sheet that negatively impact capitalization, it’s poor systems and/or investment decisions, and fraud from the “right hand side” of the balance sheet too.

One of the costliest mistakes to community banks is a heavy reliance on real estate and contractors’ (a guy with a hammer and truck) loans. These by nature are cyclical businesses that are susceptible to economic cycles that impact the economy and arrive almost every ten years or so.

Aggressive loan plans in the absence of fee revenue should not drive the risk culture, which should be set, regardless of pressures, at the “middle of the fairway.”  Risks need to be understood, and taken from the context of prior experience. Venturing into alien risk territory magnifies the risk profile of an already thin margined and highly competitive business.

  • Shedding Bank Holding Company (“BHC”) Structure

Onerous BHC structures put in place to partially facilitate acquisitions bring with them extra capital, and regulatory and reporting burden, not the least of which being classified as systemically important financial institution (“SIFI”) under Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), even if it is not a non-financial entity. Under Dodd Frank, BHCs are regulated by the Federal Reserve in addition to their normal federal (“OCC” or “FDIC”) or state oversight. This naturally adds to a Community Bank’s overall costs.

To exit and streamline the BHC structure, Community banks can easily meet the Dodd Frank three-prong test of (1) size of exposures to creditors, counterparties, and investors; (2) their de minimus effects of a rapid liquidation of assets on the markets for those assets, and (3) the extent to which these smaller banks offer critical functions or services to market participants, and for which there are no ready substitutes.

 

Come back next week for part 3 of this 3-part paper. We will be discussing financial and operational levers.

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