Tomorrow’s winners will be those banks that look beyond today’s rough times, and prepare for key opportunities.
By Michelle Gula, president and CEO, and Jay Brew, chief bank strategist, m.rae resources, inc., a bank consulting firm based in Bethlehem, Pa., www.mraeresources.com
Things keep looking worse for many sectors. But tomorrow’s winners will be those banks that keep their eye on the whole journey, not just the next period


All roads appear to lead downhill right now for community banking. As you wade through the seemingly endless reports of this worsening credit and liquidity crisis, it is nearly impossible to refute that the events we’ve witnessed to date will lead us into a long and deep recession. Even if you are in the optimistic outlook group, the risk is there, and now is the time to plan accordingly.
 Don’t just wade through the mire waiting for the good news to be delivered. You must begin to think, plan, and lead as if the good days are already here.
Indeed, in recollecting recent banking history, we are reminded that in the crazy 1980s many banks gave up much value when things went south. That’s because they had short-term reactions, instead of proactive long-term implementation. We can learn from history.
Three faces of banking
In the midst of this worsening situation, we are seeing three types of leaders–those whose banks have yet to be impacted; those who have been hit hard with the credit and liquidity issues; and those who regardless of the level of impact are committed to their future.
Unscathed optimists. Of those leaders whose banks have yet to be impacted, most continue to believe that their tactical one- to three-year plans will keep them on track. What is troublesome about this unscathed segment is that they truly believe they will remain exempt from difficulties. As a result, they have not taken the steps needed to plan through this crisis.
It’s important to note that the community banking community is indeed starting to show signs of cracks. Over the last 12 months, community banks between $100 million and $5 billion have seen, on average, nonaccrual loans rise 72%; chargeoffs increase 63%; and provisioning for losses go up 105%.
Nonperforming loans are at the same level they were at during the peak of the 2001 recession.
And these numbers are from the third quarter—when the economy was still strong!
Pessimists caught in the headlights. The second type of leader we have observed is the one hit hard with credit and liquidity issues. These blows have left the entire board and management team frozen. They are dealing with only the current nonperforming loans and failing to continue to build franchise value. The core issue here is the ripple effect on the entire bank–causing uncertainty and lack of focus.
So often, the board and management get so tied up in their problems that they ignore the bank’s future. The employees see a grim management team constantly in long meetings behind closed doors. Think of the message this sends to the employees and customers. Communication is a planned event. Ensure you are doing it often, and keep the team motivated to build the franchise value.
Realists who want to survive. The final type of leader we’ve observed is the one who, regardless of their level of problems, is committed to focusing their entire institution on increasing future franchise value.
This is the leader we want to highlight and learn from here. Now is the time to solidify and renew your strategic directives–proactively attack this uncertain economic environment with investments in training, management development, and even recruiting. You as community bank leaders must take steps to manage your way out of this difficult time, and just as importantly, lead as if you were already on the other side.
Balancing strategy and risk
Where can you start? The first step is to pull out your strategic document. As you evaluate it, ask: “Does it state clear, concise goals? Identify value? Evaluate risk and return? Establish succession planning? Set measurable benchmarks?” You need to be sure that your plan is structured properly to get you to where you wish to be in the long-term–after the current downturn is over.
Next, start assessing your bank’s risk in a recessionary environment by considering the implication of declining interest rates and a steepened yield curve. Risk assessment is always an essential part of a community bank strategic plan. But now, more than ever, it’s important for boards and management teams to be aware of the degrees of risk taken while determining the direction of the bank in the near- and long-term. In addition, incorporate regional and national economic information into your ALCO and board meetings to stay on top of how risk is addressed within the framework of your long-term plan.
Here’s a framework for beginning a risk assessment:
1. What is your level of credit risk? In our book, The Art of Risk in Community Banking, we define credit risk not by whether you have nonperforming loans, but what impact the loan portfolio would experience in an economic downturn. Ask yourself, “Would my bank experience higher or lower nonperforming loans than other banks nationally or in the region?” This is important because credit risk is “the mother of all risks.” Don’t just focus on what is occurring now, but have dialogue about what should occur as you move forward, out of this credit environment. Make trending reports, peer comparison reports, and similar data yardsticks when discussing the pitfalls of your credit policies and long-term plans.
And, if your bank does have problems with credit risk or impaired assets, be proactive to the highest degree by developing an Emergency Strategic Plan. This plan is short-term in nature but addresses all issues and what actions need to be taken. The regulators respect this proactive approach.
2. What is your liquidity risk? Liquidity has not been much of an issue in recent times. In fact, many of the problems being experienced today are the result of too much liquidity. To this point, the FDIC recently released a paper that bankers should not take liquidity risk lightly. Many bankers say they can borrow plenty of money from their Federal Home Loan Bank. But FDIC is urging banks not to rely on this source and instead, create liquidity contingency plans. The lines of people in front of Northern Rock in England and the high rates that Countrywide has been offering on its CDs are both wake-up calls on liquidity risk. To turn your liquidity risk around, make alternative funding options and the capture of cash-type deposits priority discussion items in your long-term planning.
3. What earnings at risk does your bank have? Most asset-liability models are reporting a huge increase in prepayments on loans and investments. The models cannot discern the likelihood of refinancing between one asset and another. The reality is that not everyone will be able to refinance as was the experience in the early years of 2000. The amount of prepayments is anyone’s guess, but one could model a number of scenarios from worst to best case. To begin, test your ALCO model. Did it actually predict in 2005 what your margins did in 2006-07? If not, an investment in better risk assessment tools should be part of your long-term plans.
And, if your bank is going to have a year of reduced earnings, take advantage by taking losses on investments, loans, or even high-cost borrowings. If you’re down, you are down, no matter if it is 10% or 75%. The strategy is to make future years better. Many banks did just that at the end of last year.
4. What is the bank’s capital risk? The average equity-to-assets ratio for community banks is 10.77%, while risk-based capital is 15.27%. This would suggest that the community banking industry is entering this difficult period in a well-capitalized position. Boards should review capital levels in relation to their credit risk. Will the bank meet minimum capital requirements if earnings are affected? If the bank is operating with lower credit risk, is there a war chest for strategic acquisitions? Make these conversations high priority, to ensure you are well-equipped for issues at hand, and growth issues through the next five to ten years. The board should incorporate a long-term capital plan that includes a dividend plan.
Unfortunately, if a bank needs capital, raising it in this environment could be very difficult. Issuing trust preferred debt was easy early in 2007. But presently, there it is a tough market. The majority of trust preferred issuance was placed into CDOs (Collateralized Debt Obligations) which have been headlined with the subprime crisis. As an alternative to securitization markets, bankers could consider offering private placements of trust preferreds in their local market.
5. Make reputation risk part of the review and discussion by the board and management. Avoiding issues can only harm the long-term reputation of the bank. That’s why communication with your employees, shareholders, and the public should be constant and consistent.
We’ve seen where a simple message from the CEO, stating that the bank was not involved with subprime lending and that it followed conservative lending practices, has positively impacted the bank’s share price.
On the other hand, we’ve also seen banks with legitimate problems sending cryptic messages to the public and failing to post press releases on their websites.
Within your strategic plan, spell out how the bank will communicate with the public. Be up front about the current situation and impart that there is a plan of action. And don’t forget your internal audience. While key employees will always be needed to put out fires, this cannot be done at the detriment of the entire organization. Continue to deploy vibrant marketing tactics and new products that are dynamic. It will have a positive impact on everyone and send the message that the bank is moving forward.
Take the positive view
Now that we’ve considered risk, let’s consider present and future opportunities. 
Don’t put your growth goals on hold. There will always be significant opportunities for strong community banks. If a board and management team strategically outline the opportunities they want to pursue, they will be able to take swift action when an opportunity arises.
Consider potential acquisition opportunities. There could be very attractive acquisition candidates, but many boards will throw up their hands and retreat in the face of problems. For those bankers that experienced the 1980s, you’ll remember that many could not deal with heightened risk and regulatory pressures.
The community banking industry has enjoyed a very long stretch without a credit cycle. This, of course, has created an environment where many banks relaxed their lending standards to get deals. On average, community banks grew loans 16% over the last 12 months. How many of these credits were marginal?
As a result, there is a new generation of directors, management teams, and loan officers who have never had to deal with a significant workout, not to mention multiple workouts. Some of them will be hit, if not already, with significant trouble for the first time. And, how many of these boards will ultimately decide that selling out is the easiest option?
For your bank to take advantage of acquisitions, your strategic plan should have a list of all possible candidates that will build out the bank’s long-term footprint. These banks should be analyzed on a quarterly basis to determine if problems are arising. Using different indicators and ratio trends, you can detect deterioration in a bank’s condition.
Use a Canary report as an indicator of a bank’s health. Developed by the Comptroller’s Office as an early warning sign of problems, these reports got their names from the canaries used to detect poison gas in mines. Analyzing total Canary indicators and trends in Canary indicators is a useful and straightforward way to determine risk.
For example, a bank visit last March revealed that they had 10 Canary indicators (out of a possible 15). After advising the bank that they were operating with too much risk, they responded by saying they had everything under control. In the third quarter, they announced that loan problems would wipe out the year’s earnings.
Every bank should monitor their Canary report and present it quarterly to the board for review and discussion.
Consider opportunities to invest on the cheap. The reality is, just about every publicly traded financial business associated with the word “bank” has seen enormous declines in its stock price—whether it is having problems or not. But not every community bank will have problems. And, we’ve not seen the volume of banks trading at book or below since the perils of the 1980’s. This is an opportunity.
Many banks in the 1980s bought bank stocks when they were out of favor, even more illiquid bank stocks. Over time, these banks had enormous returns. Who is better at understanding community banks than community bankers?
This could be the time to invest. The same tools for recognizing local acquisitions can be used to analyze banks in other regions. Investing in bank stocks could be viewed as an acquisition strategy, minus the hassles of acquisition. One could also look at this as a strategy to diversify the bank’s footprint.
Consider today an opportunity to invest in the bank’s future. This is the type of environment where banks should strategically spend some money to invest in the future. Since the bank stock market is depressed, does anyone care about your earnings as long as they are stable? Does it make more sense to take any earnings increase and spend it on initiatives that will build a stronger future?
This could be the time to hire. Depending on merger activity in your area or problem banks, there may be qualified bankers looking for a stable bank. Senior lenders, experienced management, and top-notch customer service representatives may be looking for a change. The bank’s strategic plan should define what positions the bank needs over time. Boards and senior management should think like the bank they will be in ten years. Most likely you will at least double your size. You will need people that can operate a much larger bank. Now may be the perfect time to have them join your team.
And whether you acquire new people or retain the same, remember to invest in proper training to help your employee base become more effective.
Just about every community bank should make core deposit growth an essential of its strategic plan. When you analyze every item on your balance sheet, core deposits have the highest market value. This is the basic premise of economic value of equity (EVE). Core deposits generally carry a 10% to 18% premium value, while loans can have between -4% and positive 4% premium. So ask yourself, “What do you want more of?” It is obvious that community banks should have the strategy to be core deposit driven by creating more relationships. This is traditional, profitable banking, and it creates the highest future share value. Besides, going after core deposits is far more enjoyable than dealing with loan problems!
Banks with problems are probably not taking care of their best customers and are probably too tied up to go after new customers. So this is a great time to build core deposits. (See feature on deposit-gathering strategies on page 38.)
It is essential that your product line, delivery systems, front line people, and sales teams be up for the challenge. As we mentioned, it is also a time when you can invest some money in technology, people, and training. Community banks should have the “best” to increase the odds of capturing core deposits.
Unfortunately, many front line staff do not have a firm understanding of why core deposits are desired—for example, why opening a checking account is far better than a CD. And management’s response is often to introduce a “sales culture” to enhance performance. We’ve learned that staff need to be trained to help customers make decisions that are beneficial to them, and ultimately, build the relationship.
All too often frontline issues go undetected by senior management. Advising customers to take out a CD versus opening a money market account, not introducing themselves, or listing service fees instead of benefits are a detriment to your bottom line.
We’ve even been privy to mystery shopping results where a CSR told a business prospect that “there are lots of bigger banks in the area if they didn’t have what he needed.” It’s crucial to train well, ensure consistency, and check in often.
As for the loan officers, they are often looked to as business development officers and are expected to bring in business core deposits. This is also a misstep we see repeatedly. Loan officers tend to be in contact with businesses that need money. It is more important to go after businesses that have money and don’t need loans.
And finally, don’t forget benchmarks. Benchmarks are an essential of every strategic initiative.
How do you know if a strategy is being effectively implemented if you are not watching key benchmarks? Benchmarks should include EVE and specific ratios that are tied to the goals of your strategic plan. For example, if a goal is to grow core deposits, a trend graph with the goals and actual results would be informative.
As you continue through this cycle, engage in proactive strategic planning to protect or enhance your institution’s value. You don’t need to sit tight and see what happens. These economic events are rare opportunities that without strong leadership and long-term planning could pass you by. BJ

The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0208/index.php?startid=16
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