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.

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