Friday, September 12, 2014

Required Reading:
 Strategy and Risk Oversight
for Bank Directors



You can easily imagine many community bank directors, usually outside independent directors, saying:
"You know, I get the theory of risk management in banking, and yes, I understand and appreciate the 50,000-foot level sermons about risk, and sure, I'm slowly learning the jargon of the craft of risk management; but I still have an important question --- What practical actions should I personally be taking regarding risk oversight at my meetings of the bank's board of directors?"
To help answer that question, I came across a really terrific article titled Strategy and Risk Oversight, written by Charles Thayer, in the September 2014 issue of the Western Independent Bankers Directors Digest newsletter.  Besides being Chairman Emeritus of the American Association of Bank Directors, Charles is a highly respected banker with a long track record in the industry.  He is a prominent thinker and frequent speaker on issues of bank corporate governance.  

Being a bank director himself, he knows how the talk walks.

It's been said that wisdom is knowledge leavened with the lessons of practical experience.  It was applause-inducing to see Charles share his perspectives and weave the various lines of the risk oversight melody into a harmony of actual board-level practice.  His article deserves broader distribution.  Not an ounce of fluff in it, but a ton of value.

The link to the article is here: Strategy and Risk Oversight and a .pdf copy is here.

The link should work just fine, but unfortunately, some corporate IT firewalls will block access to the .pdf copy.



Tuesday, September 2, 2014

A Freudian Blip




There is a qualitative difference in the mentality and set of business values between practitioners of traditional international finance and those involved in what's called offshore finance.  Offshore finance takes place at the outer margins of the financial world and its proponents tend to take, let's say, a more expansive and elastic view of the generally-accepted concepts of legal and ethical behavior.

Where mainline international finance would shy away from unsavory and shady, but technical legal activities, the high priests of offshore finance use this gray-area of finance as the foundation for their industry.  The worst of the offshore players actually cross the line into facilitating illegal activities.

This very real distinction between the two is steadily being eroded, however, as international finance and offshore finance are increasingly being conflated and bleed into each other in certain mainstream international banking centres (not misspelled).   And in very recent and high-profile ways, this is getting some very large global banks into a costly heap of legal trouble. 

So it is with much dismay that I came across this piece, a couple of weeks ago, from FitchRatings: "Branch Resolution May Disrupt Credit Hierarchy".  The analysts at Fitch decided to use the recent seizure, by the Central Bank of Cyprus, of the Cyprus branch of  Tanzania-based FBME Bank Ltd. to make a broader point about the impact of host-country branch resolutions on the interests of bank creditors generally.  
"The ability of a local regulator to resolve foreign bank branches can lead to unequal outcomes for same-ranked creditors, and complicates cross-border resolution, Fitch Ratings says. Branch resolution rules in many countries including the US and EU can create a "first mover" incentive that may make orderly cross-border resolution more challenging.

The resolution of the Cypriot branch of FBME (not rated), a Tanzania-based bank, on 21 July under the domestic bank resolution law is an example of a national regulator independently placing a foreign branch into resolution. The branch was put into resolution by the Cypriot authorities after being named by the US Treasury as a "foreign financial institution of money-laundering concern". We believe the prospect of branch resolution has wider significance, even though FBME's circumstances are specific to that bank."
Now, wouldn't you think that there just might be an 'abetting suspected transnational criminal enterprises' exception to Fitch's macro-prudential global financial stability concerns when it comes to shutting down or "ring-fencing" host-country bank branches?

There is no moral equivalence between efforts to fight crimes, like money laundering and terrorist financing, and macro-prudential financial stability concerns.  The Fitch piece, in my opinion, is only making an indirect point that host-country pursuit of suspected criminal enterprises, could have an adverse impact on people or entities they owed money to.

Read this excerpt from FinCEN's announcement on this rogue offshore bank to get a feel for today's burst of high dudgeon:
 “FBME promotes itself on the basis of its weak Anti-Money Laundering (AML) controls in order to attract illicit finance business from the darkest corners of the criminal underworld.” said FinCEN Director Jennifer Shasky Calvery. “Unfortunately, this business plan has been far too successful. But today’s action, effectively shutting FBME off from the U.S. financial system, is a necessary step to disrupt the bank’s efforts and send the message that the United States will not stand by while financial institutions help those who intend to harm or threaten Americans.”
FBME’s business model is based on its weak AML controls. FBME changed its country of incorporation numerous times, partly due to its inability to adhere to regulatory requirements. It has established itself with a nominal headquarters in Tanzania. However, FBME transacts over 90 percent of its global banking business through branches in Cyprus. Finally, FBME has taken active steps to evade oversight by the Cypriot regulatory authorities in the recent past.

FBME openly advertises the bank to its potential customer base as willing to facilitate the evasion of AML regulations. In addition, FBME solicits and is widely recognized by its high-risk customers for ease of use. These facts, taken in concert with FBME’s extensive efforts over the years to evade regulatory oversight, illustrate FBME’s willingness to service the global criminal element."
This is the tame version of the FBME saga.  Read FinCEN's Notice of Findings for some real eye-opening details.  Any sympathy one might have for mainstream international banks, who may have processed transactions involving this alleged miscreant bank, should quickly evaporate.

In my opinion, the analysts at Fitch picked a poor example for a segue into their topic.  One would think that this FBME situation would be cause to congratulate government authorities, both in the U.S. and Cyprus, for being the sentinels of the reputation of international finance.

Given that this piece was issued during the European vacation season doldrums, when copy editors might have been sunning themselves in the Costa del Sol instead, the folks at FitchRatings might consider asking for a Mulligan.



Thursday, August 7, 2014

Putting the Duel Back Into the
 Dual Banking System




In January, the Office of the Comptroller of the Currency (OCC) released a Notice of Proposed Rulemaking (NPR) to amend the existing 12 CFR 30 - Safety and Soundness Standards by establishing a set of formal safety and soundness standards specifically for national banks with total assets greater than $50 billion.  These proposed safety and soundness standards (called Appendix D) are based on the OCC's heightened expectations program.  The NPR also establishes explicit and enforceable standards for oversight by the boards of directors of these banks.  The public comment period is over and the OCC is digesting the responses received from the banking industry and the public.

The heightened expectations program was established to strengthen the governance and risk management practices in the OCC's largest national banks.  The gist of the heightened expectations program is that corporate governance and risk management practices in our nation's largest national banks need to be "strong", not merely "satisfactory".

Since the Federal Reserve and FDIC, federal regulators of state-chartered member and non-member banks respectively, have not followed the OCC's approach, it's probably safe to infer that they have staked their institutional expectations for bank corporate governance and risk management somewhere along the continuum between "satisfactory" and "strong", either in a blanket sense or on a bank-by-bank basis.  The potential liability to the boards of directors of these state-chartered banks are those already outlined in existing law, regulation, guidelines, and common law precedent.

With his effort to codify these safety and soundness standards in federal law, the Comptroller of the Currency has thrown down the gauntlet; metaphorically giving a glove slap to the faces of  regulators of the largest state-chartered banks, by implicitly fingering them as the bank supervisory custodians of lower (or at least unexpressed) expectations.  In more chivalrous days, such a derision of someone else's bureaucratic character would set the stage for an old-fashioned duel.

Except in this case, the Comptroller of the Currency will be holding a pistol with its barrel bent downward at a 90-degree angle, so that in whichever direction he points that pistol, he is likely to shoot himself in the foot.

Don't get me wrong, I am a big supporter of the OCC's effort to codify enforceable best-practice standards and install real accountability in our largest banks through the mechanism of heightened expectations.  See my previous blog posting - Strong Coffee and Weak Tea   But upon reflection, I now also strongly believe that doing so outside the forum of interagency cooperation, without an accompanying policy statement signifying interagency consensus, is the grandest of follies.  It could foreshadow a seismic change in the distribution of federal- vs. state-chartered banks among the population of banks with assets greater than $50 billion... a group small in number, but immense in banking marketplace presence.

At the present time, about two-thirds of the group have federally-chartered lead banks with the remainder having state-chartered lead banks.  Under the Comptroller's current informal version of his heightened expectations program those national banks are already being held to those higher expectations through the moral suasion exerted through the ongoing bank supervision process.  

The remaining banks in the group, the state-chartered banks, are not under the jurisdiction of the OCC and are therefore not subject to the heightened expectations program.  These state-chartered banks operate under governance standards presently outlined in law, regulation, and individual state or Federal Reserve or FDIC examination handbook guidelines.

The recent talk of Washington, among the Illuminati inside-the-beltway, has been the popularity of what have been called "tax inversions".  Where U.S. corporations are changing their tax domicile through mergers with other corporations in overseas jurisdictions with lower income tax rates; arbitraging their taxing authorities and thereby lessening their income tax burdens.  Something similar, onshore regulatory arbitrage, could happen if the Comptroller's heightened expectations guidelines are adopted in the Code of Federal Regulations without an explicit interagency policy backstop.

First, simply switching from a federal to a state bank charter in your home state makes the Comptroller's heightened expectations program go away - poof!  Second, as the "tax inversion" proponents have demonstrated, you do not have to move your operations to move your official corporate domicile.  In fact, there are many banks today where their official headquarters are in one city or state, while their corporate officers live and work elsewhere.  So the potential exists not only to convert to a state bank charter, but also to select any state bank regulator willing to roll out the Welcome Wagon in the states where the bank already has an established branch presence.

The latter option might even be attractive to those national banks with corporate domiciles in New York State.  In the State of New York, given the recent banker-bashing pyrotechnics by state officials, the state-level regulatory arbitrage calculus is more complicated... on one hand, there is the fire, and on the other hand, the frying pan.  By moving a corporate domicile to a different state and changing the home-state/host-state equation, the 1997 Nationwide Cooperative Agreement (signed by all state bank regulators) kicks in and at least the prospect exists for the state-level regulatory dynamics to change significantly.

The bane of bold leadership is that the Comptroller of the Currency becomes, by definition, a pioneer.  Pioneers were an important part of what made this country great.  But every pioneer weighed the implications of go-it-alone leadership against the benefits of collective action.

As hard and frustrating as the interagency agreement process can be, the OCC needs to push harder for an interagency policy statement on this topic because the ramifications of going-it-alone could radically change the present stasis in the balance of the dual banking system and put OCC on a slippery slope of becoming less relevant.  As the old saying points out, sometimes the lone pioneer is the guy lying face down in the mud with an arrow in his back.



Monday, July 21, 2014

Is the Show About to Start?



The banking industry and its observers have been talking about it since the U.S. officially emerged from the financial crisis and the follow-on Great Recession --- When are interest rates going to begin to normalize and, given that we used several novel (and untested) monetary policy tools in the U.S., will the path to interest rate normalization be fraught with unanticipated negative consequences for the banking industry?

The government-administered suppression of short-term interest rates through the Federal Reserve's Zero Interest Rate Policy (ZIRP) and its half-nelson push-down on rates along the longer end of the yield curve through three cycles of quantitative easing (QE) seems to be coming to a close.  The Federal Open Market Committee's (FOMC) own consensus projections show 2015 as likely to herald the first upticks in the federal funds rate in many years.

After seeing a significant drop in the headline unemployment rate over the last year to 6.1% (busting through Ben Bernanke's 6.5% reference point), last week Fed Chairman Janet Yellen, in congressional testimony, uttered a phrase - a  caution really - that should reverberate in the sanctums of bank Asset-Liability Committees (ALCOs) across the globe:
“If the labor market continues to improve more quickly than anticipated by the Federal Open Market Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid [my emphasis] than currently envisioned,”
Also trying to make the case that the old show might soon be over and that the new show might be potentially surprising, are the respected intellects at Cumberland Advisors, who noted in a recent analysis piece - "Tapering is Now Tightening", that beginning this month, Federal Reserve System purchases of government debt falls below the volume of monthly U.S. government debt issuance.  The Fed is no longer fully absorbing new U.S. government debt issuance.

In a related piece, entitled "Hope is not a Strategy", they also present the case that the odds of a significant and surprising spike in interest rates, rather than a more interest rate risk-manageable moderate ramping-up of interest rates, may not be inconsequential.

For community banks, the emerging visibility of an interest rate tipping point, is a better news/bad news scenario.  The better news is that macro-structural net interest margin compression may ease up.  Banks have been suffering ongoing and painful net interest margin compression over the last few years, caused largely by the Fed's repression of interest rates, yield curve flattening, and the dropping loan volumes suffered during the economic decline phase of the Great Recession. Thankfully, at least loan volumes are slowly rising again.

This suffering has prompted many community bank boards of directors, particularly those in competitive and price-sensitive geographies, to seriously consider throwing in the towel and trying to sell out.  Rationally thinking that a reasonable return to stockholders in this environment appears out of reach -  at least without taking imprudent risks or taking on the uncertain payback of re-engineering their business models.  The noxious brew of net interest margin compression, flat non-interest revenue, and escalating non-interest expenses - largely due to new (or more forcefully emphasized) regulatory expectations has changed the underlying economics of the small community banking model.

It's only small consolation to the average community bank that there was a partial offset to margin compression via increased liquidity and safety preferences on the part of anxious consumers and businesses.  Surging pools of non-maturity transaction deposits helped lower the interest expense side of the net interest margin equation.

Enter the latest Semiannual Risk Perspective recently issued by the Office of the Comptroller of the Currency.  Unlike its previous editions, where its counsel regarding interest rate risk could be likened to a yellow flashing caution light; the tone of the current edition changes to a red flashing warning light - stop and look both ways before proceeding.

Previous editions of the Semiannual Risk Perspective repeatedly warned community banks against engaging in what I'll call "down and out banking" - attempting to increase asset yields by moving down the credit quality scale to fund less-creditworthy obligors and by moving out along the yield curve by extending maturities in order to capture incremental yield.  In one case, as rising rates impact variable-rate portfolios (or short maturity fixed rate), it's a formula for transforming interest rate risk into credit risk as marginal borrowers cope with the stress of higher debt service requirements.  In the other case, you flirt with underwater securities portfolios and the liquidity and credit-risk issues that come with the territory.

The Semiannual Risk Perspective makes a teachable moment out of this by highlighting a couple of sobering statistics - National banks with less than $1 billion in total assets have increased long-term asset concentrations from 17% in 2006 to 31% at year-end 2013 --- almost a doubling.  And by the way, that's an average.  I'd love to see the median long-term asset concentration and the range, so that we could get some visibility about where the top half lives.  Any call report data miners out there?

Moreover, strong deposit inflows, uneven loan growth, and net interest margin pressure has created a situation where the growth in investment securities portfolios in those same banks has been centered in mortgage-backed securities - creating the potential for duration extension in a rising rate environment.

And let's not forget the bank capital management gymnastics that will come from the new capital rule effective January 1, 2015.  Smaller banks have a one-time, irrevocable option to neutralize certain Accumulated Other Comprehensive Income (AOCI) components - essentially unrealized gains and losses on available-for-sale securities.  If the option is not selected, AOCI will be incorporated into the Common Equity Tier 1 capital ratio.

This AOCI neutralization creates both "shadow capital" - market value gains that could be converted into measured regulatory capital at the expense of the future income stream - and "shadow losses" - market value losses that could erode measured regulatory capital if liquidity or other risk management imperatives forced the unexpected disposition of some, or all, of these available-for-sale securities.  This "shadowy" regulatory capital treatment needs to be incorporated into real world capital planning, including in stress test scenarios.

Lastly, there's the issue of  "The Surge" in non-maturity transaction deposits and how elastic those balances will be in a rising interest rate environment.  Historical balance analysis has only limited benefit as we are in uncharted waters here.  In a ZIRP and QE environment, there is little opportunity cost to a consumer or business to keeping a boatload of cash idle in a transaction account at a bank.  That equation changes in an interest rate normalization scenario.  How it changes remains to be seen.  But one thing is probably sure, human nature tends toward the hopeful outcomes in life and probably in interest rate risk modeling too... and as the folks at Cumberland Advisors mentioned - hope is not a strategy.

For important background regulatory guidance documents on interest rate risk, please consult the 2010 interagency Advisory on Interest Rate Risk Management and the 2012 update Frequently Asked Questions.



Note to Readers:  Thank you for bearing with me during this period of radio silence on The National Bank Examiner blog.  Under the theory that two tires on the same axle go bald at a similar rate, I had to have surgery to replace my other hip joint.  Result: a wonderful success.  Goodbye to the chronic pain of arthritis.  Thank you, Dr. Courtney Sherman, of the Mayo Clinic in Jacksonville, Florida!


Sunday, May 18, 2014

Footnoting Bank Supervision



Consider this press release from the Board of Governors of the Federal Reserve System,  the press release from Cullen/Frost Bankers, Inc., and this story in the San Antonio Express-News discussing the Fed's Order approving the acquisition of WNB Bancshares of Odessa, Texas by San Antonio, Texas-based Cullen/Frost Bankers, Inc.   

At December 31, 2013, WNB Bancshares had $1.5 billion in total assets and Cullen/Frost Bankers, Inc. had $24.4 billion in total assets.  This small acquisition would grow Cullen/Frost Bankers, Inc.'s total assets by only about 6%.

What catches your eye, tickles the antennae, and raises questions is footnote 33 on Page 19 of the Fed's merger approval.  It states:

"Cullen/Frost has committed not to engage in any expansionary activities, including branching within its existing market areas, until such time that the Board has deemed Cullen/Frost to have clearly developed a policy to support future expansion in its compliance program, including fair lending [my emphasis], and to hire additional staff with requisite knowledge and experience to manage and control the bank’s fair lending risk, which might be heightened by expansion." 

Now, if all factors were deemed satisfactory (the approval Order raises no compliance issues), why would the Fed even insert that footnote requiring the agreement of the bank to immediately refrain from any expansionary activities?   Not even one measly strip mall or street corner branch until the bank 'ups its game' in the area of compliance risk management, including the area of fair lending.  "No (more) soup for you!" as the old Seinfeld show character would say.

And what sets the mental klaxons sounding and sirens wailing is that one of the compliance management issues raised is fair lending.  Any bank examiner knows that fair lending is an electric and radioactive compliance issue - one of the few third rails of compliance supervision.  So much so that it ranks as high, or higher, on the compliance scale than another high profile compliance issue - Bank Secrecy Act/Anti-Money Laundering (BSA/AML) compliance.

Bottom line, you just don't raise the hypersensitive issue of fair lending and not be expected to explain, in detail, why you demanded this stand-still commitment from the bank.  The Fed has not offered an explanation and, so far as I know, no one in authority has requested one.

Direct talk (and action) by the Fed has been supplanted by oblique and hazy references coupled with a significant corporate commitment to refrain from further expansion, all buried in a footnote on page 19 of the approval Order.  The Fed's press release introduction doesn't even mention it.

The folks at the Fed in Dallas and Washington ought to be looking sheepishly down at their shoes; they lost bank supervision style points on this one.  I just hope that the Fed's new Large Institution Supervision Coordinating Committee (LISCC), which has bank supervision responsibility for our nation's systemically important financial institutions, doesn't contract this same malady.  The Captains of Finance, black-eyed and bloodied from years of public floggings a more direct approach to bank supervision, surely noticed this little gem.

Sunday, May 11, 2014

Time for Bank Charter Reform?

Credit: "Plato's Cave" Kombo Chapfika, 2008


This week's superb article in the New York Times, Loans That Avoid Banks? Maybe Not  is notable not only for its content and analysis, but also for signaling modern implications for the basic existential question in our industry, "What is a bank?"

The triptych above entitled "Plato's Cave" gives a surrealistic interpretation to Plato's famous Allegory of the Cave (summary here).  The allegory's general concepts can be applied to the question: "What is a bank?" in the sense that we see the world  through a personal frame of reference and a collective frame of reference.  We also see that world through lenses that could be characterized as plain sight, microscopic (seeing things close up), telescopic (seeing things from a distance), and panoramic (the shape and spirit of the times we live in).  Because we perceive the world we live in through these various frames of reference and lenses, we are always challenged by the difficulty of distinguishing between what is apparent and what is real.

For example, the usual and customary way of sizing and ranking banks in the U.S. is by total balance sheet assets or total deposits.  That traditional way of sizing banks stems from our legal and accounting frame of reference about the form of a bank - cash, investments, loans, premises, deposits, borrowings, shareholder capital at risk, and a charter granted by a government authority.

A banker friend of mine in Miami, the Americas director for a large European bank, has for years sized and ranked his "bank" in the Florida marketplace as the sum total of the balance sheet assets of the subsidiary U.S. commercial bank, the parent's foreign branch in Miami, and the assets under management (AUM) of both entities.  In other words, in his formulation of bank size, the bank is the sum total of all of its customer-facing touch points... its spheres of financial marketplace influence.

My friend's sizing of his bank's presence in the Florida marketplace expands upon the formal and traditional definition of a bank by changing the frame of reference for his banking operation to be more aligned with the functions of a banking intermediary.  In a broad sense, a bank applies expertise (knowledge capital), technology, and, when necessary, their proprietary financial capital in a manner which meets the financial services needs of providers and users of funds in the marketplace.

The functions of banking can be exercised in several ways; first, by traditionally-defined bank financial intermediation where deposits are taken and bank credit is extended using the proprietary capital of the bank to absorb all risks; second, it can also be exercised via advisory or fiduciary services where the application of expertise is fee-compensated but non-operational risks are borne by the funds provider, or lastly, it could exercised through fee-compensated, customer-directed transaction services such as payments processing.

By changing the frame of reference about what is a bank, you, in essence, change how you view, plan, respond to marketplace developments like web-based crowdfunders, such as Prosper or Lending Club, or payments innovators, like PayPal, Bluebird, or virtual currency creators.

Certain observers of the peer-to-peer lending landscape, for example, have characterized the activity as a major threat to the banking industry - Too Big to Disintermediate? Peer-to-Peer Lending Takes on Traditional Consumer Lending   And as long as bankers consider this activity as separate from their existing preconceptions about the form of a bank, peer-to-peer lending could indeed be considered a growing threat.

But if bankers consider the activity consistent with the function of banking and treat it as a logical, technology-driven evolutionary development in the growth of banking itself, significant opportunities abound.  The opportunity to embrace it, subsume it, and add it to your menu of banking services is there.  

Some banks, like Titan Bank of Wells, Texas, BBVA Compass, and Congressional Bank of Bethesda, Maryland are dipping their toes in the water and are taking what are being characterized as small, calculated risks through partnerships with existing peer-to-peer lenders.

In an ideal government setting, however, the legal form of the banking charter granted by that government would slowly follow the evolving functions of banking in the financial services marketplace, so that proper and consistent prudential and consumer protection regulation can be applied to all providers of the same financial services.

In the United States, the powers granted by a bank charter are explicitly grounded in the Federal enabling legislation for federally-chartered banks.  Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), state-chartered banks are limited to the powers granted to federally-chartered banks, unless the FDIC approves exceptions on a case-by-case basis.

The time may be ripe for some bank charter reform.  While the political will is lacking, the mechanics of legislative bank charter reform could be as uncomplicated as changing the word "and" to "or" in a few places, and revisiting the corporate powers of national banks in 12 USC 24, including the incidental powers provision.

This would provide bank regulators a green light to cast the net wider and say to certain players in the shadow banking community, your activities are identical to, or closely resemble, what we have now legally defined as "banking".  You must now obtain a state or federal bank charter to conduct your business.  The result being, taking some of the "shadow" out of the new technology-driven shadow banking models.

There are some who have mused that shedding the traditional "strict constructionist" mindset of the existing national bank charter definitions and showing an innovative, well-reasoned and plucky application of administrative discretion, Tom Curry, the present Comptroller of the Currency and the chartering authority of federally-chartered banks, could obtain a roughly similar result.

Though he approached a similar issue from a completely opposite direction (deregulatory), does anyone still remember the feisty Comptroller C. Todd Conover and the "non-bank bank" controversy of the 1980's?

None of these new Web 2.X entrants into the shadow banking arena, at this point, present the kinds of macro-level financial stability concerns that would snare them into the orbit of the Financial Stability Oversight Council (FSOC) and thereby subject them to prudential supervision by the Board of Governors of the Federal Reserve System.

But their presence does undermine the concept of "competitive equality" in the marketplace for financial services.   Ideally, all providers of similar financial services should compete on as level a playing field as possible.  That includes all bearing the weight of their regulatory obligations equally.

The growing divergence between banking's legal form and de facto function, if left unchecked, will leave today's banking charter a slowly atrophying and increasingly irrelevant animal; condemned to living out its days in its own sad, dilapidated version of Jurassic Park.  Quaint specimens existing to help inform the world-view of historically-inquisitive visitors.



Monday, March 31, 2014

Stressed Out!

Credit: American Banker


The chart (above) comes from an engaging article by Victoria Finkle in the American Banker entitled Fed's Dodd-Frank Stress Test Results a Mixed Bag for Banks.  The chart lists the Dodd-Frank Act large bank stress test results under the Federal Reserve's most severe adverse macroeconomic and marketplace scenario.

A few observations... First, among these 30 large banks, the adverse scenario stress testing results vary widely.  Second, although almost all "passed" the adverse scenario stress test standard, you can see a significant variance in the degree of vulnerability among the players in the group.  Third, in an efficient market, (hopefully) those vulnerabilities would be reflected in the share prices of these banking giants.  Shares of banks with fortress balance sheets, relative to their peers, should command higher premiums.

Let's read the entrails of these large bank stress test results and talk about a "message within the message" as it relates to a totally different group of banks - community banks.  In particular, the role of stress testing in the context of the rapidly increasing pace of community bank merger and acquisition (M&A) activity over the last few months.

How many potential acquirors use adverse scenario stress testing to determine if a vulnerability discount needs to be included in the list of valuation "marks" when doing due diligence and determining an offering price?   ... particularly if folding in the target bank would weaken the pro-forma combined banking operation in an adverse scenario stress test.

How many potential community bank acquirees fail to include an adverse scenario stress test vulnerability premium  if the bank they are selling is contributing to the strengthening or fortification of the pro-forma combined banking operation in an adverse scenario stress test?  ... particularly if the purchase transaction involves an exchange-of-shares component.   Do you, as a seller, want to leave significant shareholder value potentially unaccounted for and left on the table?

How many potential community bank deal-makers are even looking at adverse scenario stress testing in the due diligence process?  How many model severe adverse scenarios through the balance sheet and P&L of the target bank or model those same scenarios through the pro-forma balance sheet and P&L of the proposed combined banking operation?

Sure, there's the loan, investment security, premises, etc. "markup/markdown" process on both sides of the target bank's balance (and off-balance) sheet, but those are generally in the context of conditions as they exist today.  Marks will likewise be adjusted for as-of date credit quality and possibly risk-adjusted so that those numbers account for required regulatory capital set-asides.  Interest rate risk given vaguely-defined directional assumptions about the term structure of interest rates might also be reflected.  But do the due diligence marks and external macroeconomic and marketplace variables come together in a structured, data-driven stress test?

If so, you wouldn't know it if you read the community bank M&A deal press releases.  These proclamations always seem to fit the same old M&A template - price-to-book value, price-times-earnings, earnings accretion timeframes, cost savings claims, the scope of the geographic footprint, leveraging talent, and, oh yeah, those deliciously vague "synergies".  Remember the definition of synergy from business school?  The whole is greater than the sum of its parts (e.g., 2 plus 2 equals 5).

In the fields of science and mathematics, the opposite of synergy is dysergy. Without solid adverse scenario stress testing in the due diligence process, a bank acquiror may be flirting with dysergy.  In the banking arithmetic we old-timers were taught, 2 minus 2 equals "you are now out of capital".   In dysergistic banking terms, the hole is deeper than the remainder of its parts (e.g., 2 minus 2 equals "a hole deeper than you ever imagined").

How do you integrate adverse scenario stress testing into the community bank M&A due diligence process?  Accept and internalize the fact that stress testing is more than a "best" or "helpful" practice, it is a core analytical competency for those community banks bent on acquisition or open to it.

Guidance and tools are available.  For example, the Office of the Comptroller of the Currency (OCC) provides excellent guidance to federally-chartered national banks and savings associations in two key guidance documents:  Community Bank Stress Testing:  Supervisory Guidance (OCC 2012-33) and Guidance for Evaluating Capital Planning and Adequacy (OCC 2012-16).  Though their requirements are targeted to federally-chartered depository institutions, the underlying concepts are fundamental, universal and generally applicable.

The OCC also provides national banks and federal savings associations access to specific stress testing tools for agricultural loans, acquisition & development loans, individual commercial real estate loans, and a portfolio commercial real estate stress test through its secure web site BankNet.  In addition, OCC's district and national experts are available for technical consultation and are only a phone call away.

Professional support is also available from other sources, including other bank regulatory agencies and trade associations.  There are professional services firms who use call report data to do rough, but reasonable, stress test modeling.  Others use defined data-sets from commonly-used vendor operating platforms.  Others offer true stress test customization at a higher price.

Adverse scenario stress testing should be part of your community bank M&A due diligence "to-do" list and part of your proforma combined operation modeling.  Wise buyers and sellers ought to be adding vulnerability premiums or a vulnerability discounts to pricing models to holistically account for risk, support capital planning objectives, and buttress strategic contingency management imperatives.