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.

Sunday, March 9, 2014

Banks are Social Networks

You might wonder what went through the mind of James W. Marshall, who discovered a gold nugget in the American River on January 24, 1848.  It's doubtful that he fully realized that his discovery would set set off the great California gold rush and the hordes of "49-ers" who would jump start the fortunes of what would shortly become the great State of  California.

Roll the clock forward to early 21st century Silicon Valley, California and what Wikipedia calls Web 2.0 - the second stage of the development of the World Wide Web - characterized especially by the change from static web pages to dynamic or user-generated content and the growth of social networking.  Today, we are living through Web 2.0's own evolution: Mobile Web 2.0 - services that integrate the social web with the core components of mobility - personal, localized, always-on, and ever-present.

The list of these Web-based social networks, though presently dominated by the likes of Facebook, Twitter, and LinkedIn, is growing continuously.  Each is seeking to add value (and riches to their founders) by metaphorically finding gold nuggets in attractive niches within our global social geography.  In the management consultant lexicon, the sponsors of Mobile Web 2.0 are sorting themselves into well-known commercial categories - scale players, niche players, and the occasionally successful "all-in" risk-takers - the disruptors.

Bankers have not been silent about the rising competitive threats to their industry. The trade publications have long been running warning pieces of the Paul Revere genre ("The British are coming! the British are coming!").  Most pointing out that the banking industry may soon be caught in the middle of a classic military pincer movement... with peer-to-peer lending and crowdfunding threatening the asset side of the balance sheet and the numerous nonbank-sponsored online payments alternatives laying siege to the liability side.

Other authors, like Francisco Gonzalez, Chairman and Chief Executive of the global Spanish bank BBVA, recently raised the starkest of choices:  Banks need to take on Amazon and Google or die He warns that banks need to turn to their vast array of accumulated customer data and leverage it to provide customers "exactly what they want, precisely how and when they need it."

Even others, like the recent article, The Next Big Thing You Missed:  How Starbucks Could Replace Your Bank, focus on the creeping encroachment of bank-like services like prepaid card channels and Lego-like snap-together banks, like Simple.

Almost everyone in the industry is raising red or yellow flags about what I'll call an emerging synthetic banking system.  Don't even bother to paint the emerging competition as "shadow banks", these "synthetic banks" are perfectly prepared to fight hand-to-hand combat in the bright sunshine of both Main Street and Wall Street.

Unfortunately, the odds may favor the invaders over time, as they have neither the ponderous weight of government banking regulation, nor high sunk-costs in legacy operations.  Akin to that of ancient Rome, the invaders may also be aided by the inertia of our industry's business culture - where, inevitably, denial always precedes defense.

What's a classic bank to do?  The famous general Sun Tzu, in his classic The Art of War, advised "Know yourself and you will win all battles".  That self-knowledge should begin with the fact that fundamentally:  All banks are social networks.  Your customers are to you, like "followers" are to Twitter, or  "connections" are to LinkedIn, or "users" are to Facebook.  Your customers are networked to your bank because they have chosen you as a trusted advisor and provider of needed financial services.

In the present stage of the banking industry's Mobile Web 2.0 development, the bulk of the emphasis has been on non-social, vertical networking (bank customer-to-bank).  Because we are talking about confidential financial affairs, this vertical communications channel is both "armored" and "hardened" to provide the requisite account privacy, security and other safeguards.  Within the armored and hardened vertical communication channels, many banks are making great strides in improving customer engagement and loyalty to the bank.

There is also a non-armored and non-hardened part of the vertical (bank customer-to-bank) communication channel that passes for social networking by many banks - the Twitter, LinkedIn, and Facebook fluffy marketing stuff, non-specific customer assistance, financial literacy education, public service announcements, and those happy, giggly posts like "It's Friday, we here at AnyBank want you to have a terrifically enjoyable weekend!"

That's a centralized customer communications model that talks "at" people and not really "with" people.  There is an audience lurking, but unfortunately not interacting among themselves, within 'the social network that is a bank'.

Where is the horizontal (bank customer-to-bank customer) networking?  I'm talking about the kind of horizontal networking that makes the social networks (like Twitter, LinkedIn, and Facebook) so popular and highly-used?  Where is the bank customer-to-bank customer horizontal communication interactions on financial or business topics of mutual or common interest?

If you don't think it is possible to have business-like social networking, just look at the success (and soaring stock price) of  Horizontal social interaction is where 'the social network that is a bank' is not being profitably leveraged enough to check the competitive pressures from both banks and nonbank/synthetic banks.

How can a bank build revenue from these horizontal social interactions?  Consider the power of lightly-moderated online forums.  Let's take for instance, and for the sake of discussion, your neo-entrepreneur customers who run innovative internet-based or "brick-and-click" businesses.  They share a common social bond as far as the operations of their businesses are concerned.

In a lightly-moderated online forum, you would have customers sharing thoughts, ideas, and problem-solving among other people with common business interests and who also share a common financial product provider (remember they are already your bank customers).  This pool of horizontal online social interactions provides an avenue to promote the availability of the bank's credit, payments, treasury, and investment/wealth management services opportunistically in the context of the shared business needs of a specific customer segment.

Moreover, it's also an excellent opportunity to refer customers to vetted outside professional services providers... some of whom may also be (now very grateful) bank customers.  Lastly, it also provides valuable customer feedback on the quality of your own banking products or may reveal gaps in your menu of financial product offerings.  Therein lies the untapped potential of a true social network.

Add a high-touch component to the high-tech approach with occasional physical social events over coffee and snacks, luncheons with guest speakers, or wine-and-cheese evenings to further cement a sense of affiliation and relationship with the bank.

By verticalizing confidential personal financial matters in armored and hardened channels and horizontalizing social interactions among bank customer segments with common interests, both virtually and physically, you have the potential to capture some share of that person-to-person networking allure that the Facebooks, Twitters, and LinkedIns presently offer.

Thinking about your bank as a social network is not a cure for the constant competitive pressures coming from the emerging synthetic banking system, but not losing yardage (and hopefully gaining yardage) can keep you in the game.