In order for a loan modification to be considered a TDR, two specific conditions must be present:

1. A concession must be granted by the lender.
2. The borrower must be experiencing financial difficulty.

Note that all loans that have undergone a troubled debt restructuring are considered to be impaired loans. Due to the divergence in how financial institutions determine which loan modifications constitute a TDR, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-02 last spring to help clarify and offer guidance. Specifically, the ASU helps financial institutions determine whether a concession has been granted and whether a debtor is experiencing financial difficulty.

According to ASU 2011-02, a concession may have been granted if the borrower does not otherwise have access to funds at a market rate for debt with similar risk characteristics, or if there are more than insignificant payment delays, among other factors.

Indications of financial difficulty may include delinquency on any debt, whether within or outside your bank; a declaration of bankruptcy; substantial doubt as to whether the borrower will continue as a going concern; or a forecast that the borrower’s cash flows will be insufficient to service existing debt for the foreseeable future, among other factors.

The standards update also precludes banks from using a borrower’s effective interest rate to determine whether a loan modification constitutes a TDR, regardless of whether or not this test was used in the past.

ASU 2011-02 is effective for annual periods ending on or after December 15, 2012, for non-public entities. It should be applied retroactively to the beginning of the annual period of adoption.

Please give us a call if you have more specific questions about ASU 2011-02.

Some pundits opined that Dodd-Frank sounded the death-knell for community banks by raising capital and equity requirements, increasing regulatory burdens (and costs) and limiting how much banks can charge merchants in interchange fees, thus lowering non-interest fee income. (Note: While banks with less than $10 billion in assets are exempt from the limitation on interchange fees, these banks may be forced to lower their interchange fees to compete with larger banks.)

Nearly two years have passed since Dodd-Frank became law, during which time many of the law’s provisions have been implemented and started to take effect. This makes now a good time to reassess the question: What will Dodd-Frank mean for community banks?

Impact on Profitability
There’s little (if any) doubt that Dodd-Frank will have a negative impact on bank profitability. Higher capital requirements combined with lower income and higher compliance expenses will result in a lower return on equity (ROE) for most community banks. (See the chart below for a DuPont analysis of bank profitability.)

So the question becomes: What level of return will bank investors be willing to accept? In one survey, investment bankers and financial industry consultants estimated that the provisions of Dodd-Frank would lower the ROE of community banks with less than $500 million in assets to between 6 percent and 8 percent. However, bank investors generally look for returns in the 11 percent to 14 percent range.

All things being equal, if a bank has to maintain more capital, it will have to earn more money on every dollar of revenue it generates and every dollar invested in assets in order to maintain the same ROE. To do this, return on assets (ROA) must go up.

Bank revenue is driven primarily by interest and non-interest margin. Community banks have traditionally generated interest income through residential mortgages, acquisition and development (A&D) and construction loans, and commercial real estate (CRE) loans. However, a number of factors, including regulatory caps on CRE and construction loans as a percentage of capital, will likely reduce these sources of revenue.

Interest expenses, meanwhile, may rise in the future due to new disclosure and reporting requirements (like the new small business reporting requirements that are similar to HMDA), new lending non-discrimination rules and the repeal of Reg Q. On the non-interest side, income (which consists primarily of fees) will likely fall due to the factors noted above, while non-interest expenses (including incremental compliance costs) will probably rise.

What It All Means
All of this adds up to one inescapable conclusion: Lower revenue, higher capital requirements and higher costs are likely to adversely impact bank profitability in the future. And community banks are especially vulnerable because they usually don’t have the scale and alternative sources of fee income across which they can spread incremental compliance costs.

The net result will likely be consolidation of community banks. Banks with less than $1 billion in assets will find it especially difficult to remain independent in the post-Dodd-Frank world.

Some community banks will be forced to either go into acquisition mode or be acquired themselves. Many expected this shakeout to start last year, but it hasn’t materialized yet. This is primarily due to the fact that bank stocks remain depressed, and there’s still a disconnect between buyers and sellers.

Many sellers believe their bank is worth 1.5x–2x book value, when in reality, it may not even be worth book value. And buyers remain suspicious of the quality of bank earnings – and they realize that it’s a buyer’s market now, and likely will stay that way for the foreseeable future.

Survival in the post-reform banking world requires a strategic plan. Please give us a call if you’d like to discuss your bank’s plans in more detail.

Given this, many banks are starting to peek their heads out from beneath their shells and resume more aggressive marketing and new business development efforts that have been shelved the past few years while they hunkered down in survival mode. In doing so, some are targeting niche markets for small business lending, including nonprofit institutions and professional practices.

Historically, these have both been profitable niches for many community banks. But taking advantage of new lending opportunities in these niches requires a dedicated focus and unique marketing strategies.

First Step: Cultivate Referral Sources
The first and most basic strategy for targeting these niches is to cultivate referral sources that can make introductions to nonprofits and professional practices (specifically, medical and dental professionals).

This is really no different from your referral source strategy for getting introductions to any type of small business. If you have built up a database of small business referral sources (like accountants, attorneys and other centers of influence for small business owners), comb through it to find the ones that might have relationships with nonprofits and professional practices.

Next, look for opportunities to get actively involved with some of the nonprofit institutions in your community. This may include churches and synagogues; hospitals; private and charter schools; community food banks; and groups that support wounded veterans, to name just a few. Organizations like these often seek out bankers to serve on their boards of directors, especially in smaller communities.

Some community banks require that their lenders be actively involved in at least one nonprofit, allowing them to choose a cause and organization they want to support and serve on work time. This may help give your bank a foot in the door when it comes to identifying and taking advantage of new lending opportunities at the nonprofits, while also supporting causes that your lenders are passionate about.

Similarly, your bank should look for opportunities to participate in civic organizations like local Chambers of Commerce and Lions and Rotary Clubs. Both nonprofits and professional practices tend to be active in these organizations, so they can provide fertile ground for networking and drumming up new lending business.

Medical and Dental Professionals
In today’s post-healthcare reform world, there are more opportunities than ever to market to medical and dental professionals.

For example, you could host a half-day seminar for area medical practices on the impact of one or more provisions of healthcare reform on the practice. For that matter, you can host seminars on anything that’s practical, timely and relevant for medical and dental practices: personal financial planning and wealth management, tax law, sales and marketing, or estate planning, just to name a few.

Locate and hire the presenter, book the facility (or maybe you can hold the seminar at your bank if you have the right space for it) and create high-quality, personalized invitations you can send out to qualifying professional practices in your community. Seminars like this provide a great opportunity to network and interface with prospective new borrowers without having to compete with other lenders at civic events.

Another idea is to build relationships with companies that provide services to professional practices. Medical record imaging is a good example: Most professional practices today are migrating to Electronic Health Records (EHR) and there are a number of service providers that are helping them do this. Such companies are an excellent referral source to help you get your foot in the door of their professional practice clients.

Dental practices, in particular, have proven to be good borrowers for many community banks. While new practices may carry high levels of debt in order to finance the latest high-tech equipment needed to outfit a dental practice today, default rates for dental practices tend to be low, so they can be attractive if you can make the numbers work.

List vendors like Dun & Bradstreet sell prospect lists that can help you identify nonprofit institutions and professional practices that might be good candidates for new loans. You can get very targeted in your list acquisition efforts, specifying such criteria as sales volume or annual revenue, number of employees, ZIP codes and NAICS codes, and even profitability, among other factors.

Dig into Financial Statements
Beyond marketing strategies like these, you can also uncover potential new lending opportunities with nonprofits and professional practices by digging into their financial statements.

For example, medical and dental practices may have put off the purchase of fixed assets for the past few years while they tried to ride out the recession. One way to spot this is to compare the relationship between accumulated depreciation on the balance sheet with the net book value of fixed assets. If the latter is significantly less than the former, the practice may be in need of an equipment upgrade.

Having this kind of information in hand enables you to be proactive by approaching professional practices about lending opportunities to meet their needs for capital expenditures. Even better, go one step further by pre-approving a practice for an equipment term loan. Otherwise, the equipment vendor may get the first shot at the financing.

Nonprofits and professional practices with maturing balloon payments are another place to look. If they bought or refinanced commercial real estate with a three- or five-year balloon payment back before the bubble burst, these loans will be maturing soon. You can spot loan maturity dates on CPA-pre-pared financial statements or simply ask the business for a debt maturity schedule. In some jurisdictions, maturing loans can even be identified via public records.

Due to regulatory requirements, the nonprofit’s or professional practice’s current bank may not be able to refinance the loan – or it may simply choose not to due to a lesser appetite for commercial real estate (CRE) loans. Or maybe the business wants to refinance to lock in a low fixed interest rate. Either way, maturing balloon payments could signify new CRE lending opportunities.

Please contact us if you’d like to discuss these and other strategies for targeting nonprofit institutions and professional practices in more detail.

The good news is that the total loan and lease charge-off rate has steadily declined since peaking at 3.04 percent in the fourth quarter of 2009 – it was down to 1.68 percent in the second quarter of 2011 (seasonally adjusted). Given this, there may be opportunities now and in the near future to recover some of the charge-offs your bank has taken over the past few years.

Keep in mind that problem borrowers are like phoenixes: They often rise from the ashes. So establishing a robust charge-off recovery operation now could pay off handsomely in the form of hundreds of thousands (if not millions) of dollars in loan recoveries. It’s not unusual for banks to recover 15 percent to 25 percent of charged-off loans after a recession.

Depending on the amount of your bank’s loan and lease charge-offs, you could hire someone internally who specializes in this or retain an asset recovery firm to pursue charged-off loans. In previous downturns, this type of cottage industry has emerged, and the severity of this downturn may present even more opportunities.

Some asset recovery firms buy portfolios of charged-off loans, while others take a percentage of the debt they recover. Here are two important points to keep in mind with regard to recovering charge-offs:

1. If you negotiate a charge-off as part of a debt resolution by writing down a portion of a borrower’s outstanding debt, be sure to negotiate a mechanism for recovering the charged-off debt under certain circumstances in the future.
2. Recovering any portion of a charged-off loan will add to your allowance for loan and lease losses (ALLL) – even if you never make a charge to the provision for ALLL. This will bolster your capital ratio and also minimize the need for additional ALLL provisions.

For more details on recovering charge-offs, please contact our office.

Virtually every bank establishes a minimum debt service coverage ratio for borrowers as part of its loan policy – generally 1:2 or 1:2.5. But there are multiple ways the ratio can be calculated (see chart below for two examples).

Two Commonly Used Formulas to Calculate Minimum Debt Service Ratio

Net Income + Depreciation & Other Non-Cash Charges
Interest + Current Maturities of Long-Term Debt
or
EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)
Interest + Current Maturities of Long-Term Debt

Right or Wrong?
Neither method is necessarily right or wrong, but they can lead to different results, which can lead to disagreements within the bank about whether a borrower cash flows or not. Not surprisingly, the lender will probably use the method most likely to result in getting the loan approved, while the analyst will tend to use the method that provides the most protection for the bank.

Absent guidance, new lenders you’ve brought on board will probably calculate debt service coverage the way they were trained to at their previous bank – which may or may not be the way you want them to.

Here are a few nuances to keep in mind with regard to calculating debt service coverage:

• Remember that because EBITDA is a pre-tax measure of cash flow, the loan’s principal payment should be tax-affected. To make a principal payment of $50,000, for example, a borrower will need to earn $76,000 pre-tax (at a 34 percent tax rate). Failure to tax-affect the principal payment could result in a significant overstatement of the borrower’s ability to earn debt service.
• For this reason, EBIDA (which doesn’t factor in taxes) is often considered to be a more accurate measure of a company’s ability to earn its debt service. But don’t forget to subtract an estimate of distributions in lieu of taxes (e.g., 34 percent of net income) for S corps, partnerships and LLCs.
• Current maturities of long-term debt are considered to be principal payments due within the next 12 months. But do you use this year’s or last year’s current maturities? If you are measuring compliance with loan agreements or assessing a borrower’s ability to earn debt service this year, use last year’s current maturities. If you’re projecting a borrower’s ability to earn debt service on a new loan, use this year’s current maturities.
• When adding back depreciation, keep in mind that borrowers will have to replace these fixed assets at some point. Therefore, you should subtract an estimate of replacement capex. If you don’t, you’re implying that the bank will fund replacement capex, which you may or may not be prepared to do.
• When calculating debt service coverage for revolving debt and lines of credit, are you assuming the line will be paid down at some point during the year, or that it will be termed out and included in the debt service coverage calculation? If the intent is to term out the line of credit at some point, an assumed amortization of the line should be included in the debt service coverage calculation. Also, do you assume the line of credit is fully funded?

Cash Available For Debt Service
It’s important to note that the debt service coverage ratio only measures a borrower’s ability to earn its debt service – it doesn’t address how much cash is actually available to service debt. The company could invest earnings in new receivables and inventory to support growth, for example, or the owner could take earnings as distributions to support his or her lifestyle.

This is where the Uniform Credit Analysis (UCA) cash flow statement comes into play. UCA measures how much cash is available for debt service by highlighting changes in the balance sheet that impact cash. Consider these two ways of using a UCA cash flow statement:

1. Cash After Operations – Essentially, this is EBITDA less changes in working capital. This will often be negative for a company that is growing and positive for a company in financial distress, making it very misleading.
2. Cash After Debt Amortization (CADA) – Positive CADA indicates that a company has enough internally generated cash to cover working capital requirements, operating expenses, taxes, owner distributions and debt service. Only mature companies or growing companies with large gross margins and short operating cycles usually have a positive CADA, and neither of these is typically a large borrower.

Bank management should define within its loan policy how debt service coverage will be calculated. Not doing so opens the door to disagreements, misunderstandings and inaccuracies that can derail good credits or result in problem loans. Please give us a call If you have questions about how to calculate debt service coverage for borrowers.

For example, regulatory guidance now effectively caps the amount of capital commercial banks can invest in commercial real estate (CRE) and acquisition, development and construction loans as a percentage of total capital. As a result, many banks are now focusing on making more commercial and industrial (or C&I) loans in order to diversify their portfolios.

Back in the Game
Having been out of C&I lending for so long, however, some banks are finding it’s not easy to get back in the game. Many new commercial lenders have very little (if any) experience in C&I lending, and fewer have the kind of formal credit training most lenders received a decade or two ago. And many lenders who are trained in C&I would admit that their skills have grown rusty after having focused heavily on CRE for so long.

Also, the underwriting process for C&I lending is substantially different from how underwriting is performed on other types of commercial loans.

The fact is, most community banks aren’t equipped with the systems or infrastructure required to understand and control the supporting collateral of C&I loans or monitor the borrowing base. Nor do they have staff adequately trained in this level of collateral monitoring. You need lenders who know how to physically inspect and value collateral – there’s more to it than just counting boxes.

If your bank is shifting its focus to C&I lending, your first step should be to make sure you don’t end up making what are essentially unsecured C&I loans without even realizing it. This is what often happens when a community bank takes a blanket lien on receivables and inventory without understanding the nuances involved in monitoring this kind of collateral.

Borrower Collateral Requirements
When presenting receivables and inventory as collateral for a C&I loan, borrowers should be required to provide regular financial statements, a listing of aged receivables and payables, and a detailed summary of inventory, as well as submit to regular site inspections by the lender. Employ a borrowing base that specifies what does and does not qualify as eligible collateral; e.g., foreign receivables and receivables more than 90 days old do not qualify.

Similarly, when it comes to equipment pledged as collateral for C&I loans, you need to have a good understanding of exactly what the equipment is, its potential resale value and how easy or difficult the equipment might be to resell. For example, is the pledged equipment general purpose or special purpose?

There’s an old saying that bankers shouldn’t finance based on equipment that’s bigger than the doors of the building – because you have to physically get the equipment out of there. Also keep in mind, depending on the building’s ownership structure, owners could assert their right as landlord to deny a lender access to the property to repossess the equipment pledged as collateral if rent is delinquent.

When accepting owner-occupied real estate as collateral for C&I loans, remember that it’s the cash flow from the business that should be the source of repayment for the loan. Therefore, the loan should be underwritten with the business as the primary source of re-payment and the real estate as the secondary source, with the real estate valued as investor-owned, not owner-occupied.

True Asset-Based Lending
Finally, you could structure a formal asset-based lending arrangement with borrowers for C&I loans. This would involve formula-based advances on a line of credit, periodic inspections of collateral, and bank control of proceeds from receivables, which would be sent directly to a specially designated post office box or bank account controlled by the bank. Such arrangements, however, are expensive and time-consuming on the part of the bank and require specialized lender expertise.

One alternative for community banks is to hire a CPA firm to provide field reviews for non-attest clients. Another is to partner with a secured lender who specializes in asset-based lending. This way, the bank can maintain the primary relationship with the customer – including retaining customer deposits and fee-based services and perhaps making other types of loans – while allowing the asset-based lender to make the C&I loan or provide assistance in monitoring the collateral.

Forging relationships now with asset-based lenders in your community could pay big dividends down the road. When looking for asset-based lenders to partner with, be sure to investigate them carefully: How long have they been in business? How well capitalized are they? What is the quality of their internal systems for monitoring collateral? How many local banks have used (or are using) them? Professional experience and adequate capitalization are especially crucial.

What’s Your Value Proposition?
Portfolio diversification and regulatory guidance aside, you must offer small businesses a true value proposition if you want to gain or retain them as your customers – regardless of the kinds of loans or services you can provide.

Community banks have traditionally accomplished this by positioning themselves as a trusted advisor small business owners can go to for more than just loans and banking services, but for every aspect of small business financial management. Be sure to keep this in mind as you plan your bank’s strategies for the new year.

Give us a call if you’d like to discuss your bank’s lending strategies in more detail.

These changes will have a significant impact on the financial statements sub-mitted by many of your business borrowers. In particular, they will result in the addition of long-term payment obligations to borrowers’ balance sheets, which would likely impact their ability to meet debt service coverage and financial leverage ratios and other covenants included in small business loan agreements.

A Little Background
U.S. GAAP has always distinguished between two different types of leases: capital leases, in which leased assets are recorded on the books and depreciated similarly to debt, and operating leases, which are off-balance-sheet, expensed and deducted from net income.

As the movement toward a convergence of U.S. GAAP and International Financial Reporting Standards (IFRS) has gained steam over the past few years, the issue of lease accounting has been at the forefront. IFRS does not distinguish between capital and operating leases, but rather treats all leases from an accounting standpoint in the same way that U.S. GAAP treats capital leases, leaving them on the books to be depreciated.

Advocates of the proposed new lease accounting standards believe that these standards more faithfully represent the economic reality of leasing activities, and that they reflect more concrete accounting principles as opposed to less-specific “bright line rules.”

In July, FASB and the International Accounting Standards Board (IASB) announced that they would reissue the proposed new lease accounting standards for public comment before the end of this year. Some experts believe that this means the new standards could officially be issued in early 2012 and implemented a year or two after that.

From the Banker’s Perspective
What does all this mean from your perspective as a small business lender? The requirement to record small business leases as liabilities — and, as such, payment obligations — on the balance sheet will result in substantially more leverage being added to their balance sheets. In the balance sheet equation, Assets = Liabilities + Owners Equity, the present value of the right to occupy the space during the term of the lease would be booked as the asset to offset the lease liability.

You are likely to see balance sheets with additional long-term obligations (referred to as “obligations under leases”) that are similar to long-term debt. This will affect a borrower’s ability to meet loan covenants and agreements. In particular, the proposed changes in lease accounting will impact borrowers’ debt service coverage and financial leverage ratios. The accounting treatment of operating leases could also affect a banker’s calculation of tangible net worth.

As banks adopt more conservative credit standards and debt service coverage ratios are increased, adding lease payments to the numerator will make it more difficult for companies to comply.

Meanwhile, from a small business borrower’s viewpoint, the new lease accounting standards will force them to view leases from a broader perspective — in view of all of their other debt obligations, not just as an off-balance-sheet transaction.

The Bottom Line
Borrowers that would have qualified for financing before the new lease accounting standards may no longer qualify due to the increased leverage added to their balance sheets and its impact on the calculation of debt service coverage. And borrowers that complied with loan covenants before the new standards may no longer comply for the same reason.

While implementation of the proposed new lease accounting standards may still be two or more years away, now is the time to begin preparing for their potential impact on your borrowers, both current and future. It will be especially important to scrutinize borrowers whose financial statements are not audited or compiled by a CPA.

For more details on how proposed new standards for lease accounting may impact your borrowers, please contact our office. We’d be glad to discuss your specific situation with you.

Reviewed and compiled financial statements generally don’t include another key element of audited statements: an audit committee letter. They may, however, include a management letter, which will indicate whether the CPA uncovered any issues or concerns in the financial statements.

These concerns will be classified as “controlled deficiencies” (the least severe and important), “significant deficiencies” (of moderate severity and importance) or “material weaknesses” (the most severe and important). Note that these concerns do not imply that the financial statements are inaccurate, but rather that the CPA uncovered specific deficiencies in the company’s internal controls.

An audit committee letter, meanwhile, will point out such things as whether:

• Any new accounting treatments were used that could impact the statements (e.g., a switch from LIFO to FIFO accounting).
• There were any disagreements between the CPA and management.
• Management went to another CPA for an outside opinion.
• The CPA made any material adjustments or corrections to the statements.
• The CPA discovered immaterial adjustments he or she felt were too small to require an entry, but important enough to note separately in a letter.

If you’re not receiving management and/or audit letters with your borrowers’ financial statements, it’s incumbent on you to dig deeper into the statements to uncover important details about the borrower’s financial condition and/or internal controls of which you should be aware.

If you have further questions about management and audit committee letters, please give us a call.

But the start of the financial crisis is generally recognized as Lehman Brothers’ bankruptcy filing in September of 2008. This was followed by the Emergency Economic Stabilization Act of 2008 and the establishment of the $700 billion Troubled Asset Relief Program, or TARP, a few weeks later.

The marking of this dubious anniversary makes now a good time to go back and, with the benefit of 20/20 hindsight, examine some of the lessons from the financial crisis to help prevent it from happening again.

1. Capitalization and liquidity are critical to survival.
While the genesis of the financial crisis was poor asset quality, the crisis itself was triggered by capital and liquidity shortfalls in the U.S. banking system. Institutions of all sizes, from Bear Stearns to small community banks, ran out of cash before they could solve their asset quality problems and stabilize themselves.

The fact is, the banking industry went into the economic downturn woe-fully undercapitalized considering the level of risk in banks’ balance sheets. Dodd-Frank and BASEL III attempted to address this by establishing higher capital requirements for banks. As equity is raised relative to assets, however, return on equity (ROE) and profitability will be reduced, which will make it harder for community banks to raise capital. Also, new Trust Preferred securities can no longer be counted toward regulatory capital.

The lesson: Adequate capitalization and liquidity are critical to withstanding financial adversity.

2. Beware of too much leverage and borrowed liquidity.
Investment banks used borrowed liquidity to generate phenomenal returns – which was great, until the credit dried up. When they needed cash the most, it was no longer there.

Many builders and developers, small business owners and homeowners also learned this lesson the hard way, borrowing 100 percent (or more) of the value of their property based on the assumption that values always go up. But when this didn’t happen and it was time to refinance or sell, they were stuck.

The lesson: Leverage and borrowed liquidity are great when they’re working for you, but they can be lethal when they turn against you.

3. Risk can be masked, but it never goes away.
The repackaging and securitization of mortgage-backed securities, many of which included toxic subprime loans, is a classic case of “passing the trash”: At every step in the process, someone got paid, took their money off the table, and passed the trash down the line to the next party. But nobody really understood what was in the securities, nor did they understand the risk.

The lesson: You can slice, dice, repackage and sell risk, but that doesn’t mean it disappears.

4. Incentives can have a perverse impact on the perception of risk.
If lenders are incented for loan production but not held accountable for the loan’s outcome, guess what? You’ll get lots of production, and lots of bad loans!

To address this problem, changes recently went into effect that impact how bank mortgage loan originators and mortgage brokers can be compensated. Effective with mortgage loan applications received on or after April 1, 2011, loan originators and mortgage brokers can no longer receive compensation incentives based on the pricing of the loan (e.g., the APR or loan origination charges). Instead, compensation must be based either on a fixed percentage of the loan amount or a flat dollar amount per loan.

The lesson: Compensation incentives must be structured around accountability for loan outcomes and risk management at every level of the bank.

5. Beware of covariance and contagion.
In the run-up to the financial crisis, many banks allowed high concentrations of risky types of loans (such as acquisition and development, commercial real estate, and agriculture) to build up in their portfolios. Often, this was unintentional, as banks didn’t realize the high degree of covariance that existed among borrowers. To avoid high levels of concentration and covariance in your portfolio, try to determine whether:

• A disproportionate percentage of borrowers are located in the same geographic area
• This geographic area is dominated by a single industry or large employer
• A substantial number of borrowers are interrelated; for instance are they directly or indirectly dependent on a single industry?

 
The lesson: Carefully monitor concentrations and covariance in your loan portfolio and strive for a diversified mix of borrowers.

6. Portfolio credit risk must be monitored and managed.
In their efforts to monitor credit risk, many banks relied on third-party rating agencies (like Standard and Poor’s and Moody’s) and participating banks instead of doing their own due diligence. Another mistake was relying on prior credit performance as a predictor of future performance. This obviously proved to be costly, especially in situations where banks were aggressive in their underwriting and allowed heavy concentrations of high-risk loans (as noted above).

Instead, banks should monitor and manage risk from both a micro (individual loan) and macro (loan portfolio) perspective. To do this, concentrate on building a model loan portfolio that defines the bank’s limits and acceptable risk concentrations. Based on the model, you can create a structured process for assessing the types of risk in your portfolio, how the risks are changing, and how you should make adjustments to keep your portfolio within your desired risk level.

The lesson: There’s no substitute for solid portfolio information and analysis when it comes to managing credit risk.

7. You must stay on top of the value of your collateral.
In a declining market, banks often hesitate to order collateral appraisals, whether on real estate or chattel, because they know they’ll have to write down and charge off the lower value of the collateral immediately, as directed by ASC 310-40 (FAS 114). This write-off directly impacts the bank’s capital level.

Since the financial crisis began, however, regulators are taking a close look at the accuracy of commercial real estate appraisals, in particular, and how recent they are. They expect banks to re-examine the current market value of CRE held as collateral by reappraising property using assumptions that realistically reflect current market conditions.

The lesson: Make sure you have a policy in place for monitoring the value of collateral and ordering reappraisals, as necessary.

8. Transparency is critical when it comes to contingent liabilities.
Many banks made the mistake of not doing enough due diligence on their borrowers to learn about their true contingent liabilities. For example, a bank might be comfortable with its own debt exposure to a builder/developer and the borrower’s liquidity, but have no idea about this borrower’s debt exposure at other lending institutions, either individually or as guarantors of LLCs.

Banks must focus on their borrowers’ global cash flow and all their liabilities, and determine debt service coverage ratios based on a complete financial and debt picture.

The lesson: You must know and analyze the real and contingent liabilities of your counterparties.

By learning — or in many cases, relearning — these and other lessons now, the banking industry may be able to avoid another crisis a few years down the road. There’s no substitute for solid portfolio information and analysis when it comes to managing credit risk.

• The ideal community bank will either have a dominant market share in a rural slow growth market or, if located in an urban market, it will have enough scale and product offering to compete for deposits with larger banks.

• The regulatory costs of operating a bank have increased such that, in all but rural markets, it will be difficult for banks with less than $500 million in assets to produce adequate long-term returns.

• One billion dollars in asset size will not be considered a large bank. In fact, the demands for 11 percent to 14 percent ROE will create a $1 billion minimum size threshold for surviving banks.

• Deposit mix will be the most important key to achieving consistent profitability. Maintaining core deposits and identifying consistent and reliable low-cost funding will be crucial.

• There will be significant consolidation among community banks, with as many as one-quarter of the roughly 6,000 community banks that exist today lost due to mergers, acquisitions or failure.