The Sub S Bank Report (Volume 14, Issue 1)

The deadline for C corporation banks to apply to participate in the Small Business Lending Fund (SBLF) was recently extended to May 16, 2011. The purpose of the SBLF—commonly referred to as “TARP Lite”—is to encourage community banks to increase small business lending by providing them with low-cost, Tier 1 capital. The problem with the SBLF is that, by its terms, roughly one-third of eligible banks are presently precluded from participating in the program.

Fortunately, Treasury has announced that it is working on an alternative structure that would enable Subchapter S banks, mutuals and community development loan funds to participate in the SBLF. We were recently informed by Treasury officials that these term sheets are presently in the final review process.  In all likelihood, the May 16 deadline for C corp. banks will also apply to S corp. banks as well.

The SBLF was essentially modeled after the TARP Capital Purchase Program (CPP), but has fewer restrictions than the CPP and is limited to healthy community banks with total assets of $10 billion or less. The program provides that participating banks will issue preferred stock (no warrants this time) in exchange for an investment by Treasury of up to 5% of the institution’s risk-weighted assets. This preferred stock structure, however, effectively prohibits all Subchapter S banks from participating in the SBLF (because Sub S banks are not permitted to issue preferred stock).

This apparent conundrum is nothing new to the Treasury Department. In late 2008, when Treasury unveiled the CPP as its solution to filling the capital void left in the banking industry, it unwittingly excluded Sub S banks from participating because of the same preferred stock structure. Several months later, Treasury ultimately released an alternate structure through which Sub S institutions would issue subordinated debt in lieu of preferred stock.

Despite a clear roadmap for an S corporation-compatible format, Sub S bankers once again find themselves on the sidelines anxiously awaiting their turn to play. Oddly, Treasury chose to roll out the term sheet for C corporation banks with no real timeframe or plan for how to include Sub S banks despite the fact that the Sub S bank 

community comprises over one-third of the banks eligible to participate in the SBLF. To date, Treasury has yet to provide any clear guidance on how or when Sub S banks will be able to participate in the SBLF.

Recently, at the Annual Convention of the Independent Community Bankers of America, Jason Tepperman, Treasury’s Director of the SBLF, indicated that Treasury is developing a solution that would enable participation by S corporation banks, mutuals and community development loan funds. Mr. Tepperman was hopeful that a term sheet for Sub S banks would be released within the coming weeks.

When asked, however, whether the Sub S bank term sheet would also mirror the terms of the CPP for Sub S banks, Mr. Tepperman only indicated that Treasury is working through a number of issues, one of which would be the need for the Federal Reserve to issue a rule designating Treasury’s SBLF investment as Tier 1 capital. Given that the Federal Reserve has previously issued such a rule with respect to the CPP, this issue should not be an insurmountable hurdle. The other concerns Mr. Tepperman referenced were also previously addressed by Treasury in connection with the CPP.

We have contacted Treasury and offered our assistance in formulating the Sub S term sheet, but were informed that Treasury is handling matters internally. We will continue to be in regular contact with officials at Treasury until a term sheet for Sub S banks is released. Sub S Banks interested in participating in the SBLF are encouraged to contact the author for additional information and further updates on this program.

Bruce Toppin is the Executive Director of the Subchapter S Bank Association and a partner in the law firm of Kennedy, Toppin & Sutherland, LLP, specializing in assisting community banks with corporate, banking, regulatory and securities matters. He can be reached by email at btoppin@ktsllp.com or by phone at (210) 228-4414.

If you’ve been through an exam this year, chances are you probably received a lot more questions regarding Interest Rate Risk (IRR) management than ever before. When asked about the IRR position of the bank, it is no longer the norm to simply pull the report out of the filing cabinet, hand it to the examiner and call it a day. Today, banks and other financial institutions are being urged to re-visit existing regulatory policies and take actions to improve current IRR management going forward. Below we will outline some key points from the FFIEC advisory released at the beginning of last year and offer insights as to what examiners are expecting to see when visiting your bank.

Corporate Governance /
Policies & Procedures:

As we know, ultimate responsibility for risks (including IRR) undertaken by an institution lie with the Board of Directors.  Examiners usually assume this is known and thus primarily focus on reviewing the activities of the Board and ALCO with regard to IRR.  The bank needs to demonstrate that management, the Board of Directors, and ALCO are periodically meeting and reviewing IRR exposure. Aside from just meeting, they also want to see there is documentation on what was reviewed and discussed along with any strategy decisions based off those discussions. Education is a critical component here as examiners will also attempt to assess the degree to which the groups are familiar with Interest Rate Risk and the underlying concepts.

• Basic understanding of Interest Rate Risk and the four components of risk (Repricing risk, Basis risk, Yield Curve risk & Option risk).
• Working knowledge of the model calculations and framework being used.
• Understanding of the model inputs and assumptions; in particular, knowing which assumptions are user defined and what’s been set up as a default.
• From a policy standpoint, understanding of policy risk limits and where they exist in the model’s reports.
• Ensuring that the institution’s asset/liability policy includes those IRR limits and the procedures to follow when those limits are surpassed.

Measurement and Monitoring of IRR:

Supervisors expect institutions to have robust IRR measurement processes and systems relative to their size and complexity. Recently, more and more times examiners are asking banks to implement more sophisticated models. If you’re currently using a call report based or internally created model, be prepared to receive questions on the mechanics of the model and justify that it’s appropriate for monitoring IRR for your bank.  A good model should address the following:

• Basic Rate Scenarios – parallel movements (100bps, 200bps, 300bps in magnitude), no change in the balance sheet size. This can be thought of as the “base” scenarios, it is important to run one of these scenarios first and later incorporate balance sheet growth or mix changes on a subsequent report.

• Stress Testing – In addition to the base scenario, it is helpful to model +400bps rate moves, non-parallel rate changes and perhaps an immediate rate shock (rates go up overnight) to show various scenarios on the bank’s earnings and capital structure.

• Assumption Testing – Re-run the base case model with significant changes to the key assumptions to show the effect they have on the outputs of the model. An example of this could be adjusting the sensitivities of non-maturing demand from 30% to 70% to illustrate how interest expense increases in a rising rate environment.

Internal Controls and Validation:

Internal controls are procedures designed ensure that the objectives of the bank are being carried out effectively and reliably. For IRR, making sure your model is both validated and back tested are very important during an examination. It is important to distinguish that validation is looking at the integrity of the model itself, while back testing dives into the actual projections produced by the model and compares them with historic results.

• Model Validation – This document should outline that the model calculations are sound and appropriate for measuring IRR. An updated copy should be obtained at minimum every two years. This validation should be provided by your vendor if the modeling is outsourced.

• Model Back Testing – Annually back test the model projections, inputs, and assumptions against historical data to ensure the model is producing meaningful results. This too can be provided by the vendor for outsourced models.

Conclusion

The days of the paper napkin A/L model are over. Financial institutions must adapt to the new regulatory environment and always be prepared for a more in-depth review of the IRR management infrastructure.  If you feel the current set of procedures for IRR management are lacking, they probably are. Start taking steps in the right direction by reading the advisory and applying it to the bank’s current procedures.  Remember, weaknesses in management processes or high levels of IRR exposure may result in corrective actions or critiques. These recommendations can include reducing IRR exposure, raising capital, strengthening IRR management expertise and improvement of the measurement systems in place.

Matt Harris is a Financial Strategist with The Baker Group.  He can be reached by e-mail at mharris@gobaker.com.

Last May, the Financial Accounting Standards Board (FASB) released an Exposure Draft on Accounting for Financial Instruments proposing significant changes to the method of accounting for certain financial instruments. The accounting of instruments covered under the proposal was intended to be modified to better represent the characteristics of the particular financial instruments involved, and to base accounting of such instruments on how the assets and liabilities were used in business. A key proposal of the Exposure Draft would have required financial assets held for the collection of cash to be reported with both amortized cost and fair value information in an institution’s financial statements. Thus, banks would be required to carry loans, debt securities and other particular beneficial interests at fair value, with certain changes in fair value recognized in other comprehensive income if such debt instruments—primarily loans—were being held long-term for collection or payment of contractual cash flows.

Community bankers and affiliated industry associations strongly opposed the FASB proposal, arguing that such loans at the community bank level did contain the uniform characteristics that would facilitate the determination of their fair values. Furthermore, establishing the fair value of loans held by community banks was contended to be overly burdensome at an administrative level and, ultimately, would lead to increased operating costs. Industry leaders noted that many community banks hold loans that do not have a readily-available market, as many loans are typically structured to meet a particular customer’s individual needs. As such, implementing a fair value method of accounting for such loans would only serve to create disparities in valuation from bank to bank, since particular valuation assumptions at one bank may not be appropriate at another.

After much debate, in early 2011, FASB unanimously approved an accounting model for financial instruments that reverses its proposal to account for all financial instruments at fair value. The approved model allows institutions to continue carrying a variety of financial instruments at amortized costs. The shift indicates that FASB was responsive to the community banking industry’s concerns and has recognized that although mark-to-market accounting may be appropriate for businesses highly engaged in the trading of financial instruments, it is not the most appropriate accounting measure for loan portfolios. The final disposition of this welcome change is expected to be released this June.

Trust Preferred Securities, or “TRUPS,” have proved to be an invaluable capital raising tool for Subchapter S bank holding companies and their subsidiary banks. Significant consideration, however, must be given before utilizing what appears at first to be an attractive TRUPS option. Indeed, management must understand and carefully consider the consequences of utilizing its right to defer interest payments for up to five years. 

Subchapter S banks and bank holding companies face unique challenges when it comes to raising capital. Unlike their more traditional C corporation counterparts, Subchapter S entities are limited to a single class of stock, and therefore are unable to issue preferred stock or other structured equity products differing from their common equity. Furthermore, limits on the number and types of shareholders create additional challenges. Accordingly, TRUPS have been an extremely important source of capital for Subchapter S banks and bank holding companies.

One unique characteristic of TRUPS is the option to defer interest payments for up to 20 consecutive quarters. The current recession, coupled with increasing demands by regulators for more capital, makes the ability to defer interest payments look increasingly attractive. However, this seemingly beneficial option can come with stringent consequences, particularly for Subchapter S bank holding companies. 

Most importantly, if management elects to defer TRUPS interest payments, the company will not be permitted to pay any other dividends or distributions to its shareholders until all deferred interest (and interest on the deferred interest) is paid in full. Also prohibited are any stock redemptions or repurchases and payments on any debt obligations that rank pari passu or junior to the TRUPS debentures. These restrictions can be particularly onerous for S corp. institutions because their shareholders often rely on cash distributions to meet their federal income tax obligations attributable to the company’s earnings. If the company elects to defer TRUPS interest payments, the company will not be able to make those cash distributions until it has paid the deferred interest.

Another important consideration is the reputational harm that deferring TRUPS interest payments could cause. If the company has plans to raise additional capital (debt or equity), disclosure to potential investors of its inability to pay dividends would likely be necessary in order to comply with relevant securities antifraud provisions. Such disclosure may understandably have a chilling effect on investment interest.

As an alternative to interest deferral, Sub S institutions may want to consider raising additional capital through the issuance of common stock or a form of subordinated debt security. A portion of the proceeds from the securities offering could be maintained at the holding company level, providing the company with an alternate source of cash aside from bank dividends. Also, the company could look to cut expenses elsewhere.

In times of economic hardship, banks naturally try to trim expenses as much as possible. One such area is the deferral of TRUPS interest payments. However, holding company management should give careful consideration to the ramifications of such a deferral before exercising this option. Often there is an alternative solution that would not have such a dramatic impact on the company and its shareholders.

Mr. Waldron is an attorney with the law firm of Kennedy, Toppin & Sutherland, LLP in San Antonio, Texas, and frequent contributor to the Subchapter S Bank Report. He can be reached at (210) 228-9500 or by email at mwaldron@ktsllp.com.