Andrew K. Gibbs

Hieronymus Bosch, The Garden of Earthly Delights, 1490-1510, Museo del Prado, Madrid.One of BankWatch’s favorite artists is the Dutch painter Hieronymus Bosch (1450-1516). His work is both enigmatic and fantastical, with bizarre human/animal hybrid forms and other monstrous creations of Bosch’s fecund imagination. Indicating its lasting relevance and, in a sense, modernity, centuries later Bosch’s work served as inspiration when the Surrealist movement sought to depict dreamlike scenes formed from the depths of their unconscious mind. One triptych, The Garden of Earthly Delights, depicts a utopian scene in the middle panel adjacent to a hellscape in the right panel.It serves as an apt metaphor for the banking industry’s stomach churning volatility in 2023.As in the hellscape panel on the right side of the triptych, the banking industry sunk to the depths of despair beginning in March 2023, tormented by bank failures and deposit runs.From year-end 2022 to the nadir in May 2023, the Nasdaq Bank Index sunk 34%. Bank stocks rebounded during the summer but remained under pressure through the fall as the ten year Treasury rate briefly exceeded 5%.Finally, more dovish comments from Chairman Powell lifted sentiments, causing the Nasdaq Bank index to appreciate by 12% in November 2023 and 15% in December 2023.While we have not returned to a banking utopia, the greener pastures in which Bosch’s hybrid forms graze in the triptych’s middle panel seem more representative of industry conditions at year-end 2023.2023 PerformanceFor 2023, the Nasdaq Bank Index and the KBWNasdaq Regional Bank Index depreciated by 7% and 4%, respectively (see Figure 1 ). This marks the second year of negative performance for bank stock indices. Between year-end 2021 and 2023—covering the entire period of rising rates—the Nasdaq Bank and Regional Bank indices decreased by 24% and 13%, respectively (see Figure 2).After losing 19% in 2022, the S&P recovered in 2023 with 24% appreciation, meaning that the S&P 500 at year-end 2023 returned to a level virtually identical to year-end 2021. Struggling with earnings pressure, banks lost favor with growth minded investors, thereby underperforming the broader market.Figure 1 :: Index Performance (12/31/22 - 12/31/23)Figure 2 :: Index Performance (12/31/21 - 12/31/23)Figure 3 stratifies the 328 banks and thrifts traded on the NYSE and Nasdaq by asset size. Banks in the three strata between $1 billion and $100 billion performed similarly, with the median bank’s stock price falling by about 5% in 2023. Between 30% to 40% of banks reported share price appreciation over year-end 2022. The largest banks outperformed in 2023, as several banks like J.P. Morgan Chase (NYSE: JPM) “over-earned” their long-term return on equity target. JPM and other money center banks were boosted by low-cost deposits flowing from smaller banks in the wake of the failures of SVB, Signature Bank, and First Republic Bank.JPM also recorded a bargain purchase gain from the acquisition of First Republic Bank as did First Citizens BancShares (NYSE: FCNCA) and New York Community (NYSE: NYCB), the winning bidders for SVB and Signature Bank.Figure 3Figure 4 replicates the analysis for the period between year-end 2021 and year-end 2023. Not all banks have struggled through this rising rate environment, as 28% of banks reported share price appreciation over the two-year period. Nevertheless, the largest number of banks have experienced a 10% to 20% decline in their share prices.Figure 4Catalysts for (Under)PerformanceChanges in the net interest margin have the greatest effect on profitability and share price performance in the current environment, given limited credit issues. Figure 5 includes publicly traded banks with assets between $1 billion and $10 billion, sorted into quartiles based on their NIM change between the fourth quarter of 2022 and the third quarter of 2023.Figure 5The first quartile, including banks with the most severe NIM pressure, experienced a median stock price change of negative 14% in 2023. Meanwhile, banks in the fourth quartile—with the least NIM pressure or even NIM expansion—eked out a positive 2% change in stock price.This relationship holds true if we consider the entire rising rate period between the first quarter of 2022 and the third quarter of 2023 (see Figure 6). Over this period, approximately one-half of the banks reported a higher NIM; however, the market provided a meager reward with share prices for banks in the fourth quartile appreciating by a median of 4%. This reflects the market’s focus on the more recent trend in the margin—generally downward for most banks—rather than a historical anchor in a low rate environment. Meanwhile, the banks in the first quartile that were most exposed to rising rates suffered a median -24% change in their stock prices.Figure 6Valuation ImplicationsFigure 7 illustrates the earnings pressure resulting from tighter NIMs.For 2023, analysts’ EPS estimates indicate a median EPS decline of 15% for publicly traded banks with assets between $1 and $15 billion, with 73% of the banks in the analysis expected to face lower year-over-year earnings in 2023. These estimates are based upon recent data. Measured from January 2023, the reduction in earnings estimates is much more severe, meaning analysts cut estimates as the year progressed.Figure 7The outlook is only marginally better in 2024, as the median decline in EPS is 8%. Analysts generally expect NIMs to stabilize, or at least decline at a more modest rate, in the first half of 2024, followed by some expansion in the second half of 2024. The NIM stabilization in the latter half of 2024 leads to earnings growth in 2025 for most banks, with a median EPS growth rate of 10%. However, only 28% of banks in our analysis are projected to have higher EPS in 2025 than in 2022.With the share price recovery in late 2023, publicly traded banks with assets between $1 and $15 billion reported a median price/one year forward earnings multiple of 11.5x and a price/tangible book value multiple of 1.26x. As indicated in Figure 8, these multiples are in-line with the range over the last five years. Therefore, the catalyst for further share price appreciation likely will be earnings improvement rather than P/E multiple expansion.Figure 8ConclusionThe worst has passed for banks, with slowing deposit attrition and stabilizing NIMs, unless credit performs materially worse than expected.However, conditions likely are not ripe for rapid earnings growth. First, NIMs likely will recover more slowly than they contracted due to volume of assets repricing years into the future. Second, many banks are reporting slowing loan growth, as higher rates have gradually eroded loan demand. Third, if loan demand exists, marginal funding remains difficult to obtain at a favorable cost of funds.For many publicly traded banks, returning to the garden of earthly delights remains a ways off.Orginally appeared in the January 2024 issue of Bank Watch.

The first quarter of 2022 marked the most volatile period since the first quarter of 2020.The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.Equity IndicesIndex data per S&P Capital IQ ProBroad market indices contracted through February 23, 2022, driven by valuation concerns for growth stocksBank stocks remained stable through February 23, 2022, as valuations remained reasonable relative to historical normsSince February 23, 2022 bank stocks have experienced modest pressure, primarily among larger banks that may have some exposure to RussiaWhile markets were volatile after the Ukraine invasion, broad market averages reported a robust recovery in the week of March 18, 2022 and continued gaining into last weekTreasury RatesTreasury yields per FRED, Federal Reserve Bank of St. LouisTreasury rates increased during 1Q22, with a greater share of the expansion occurring prior to February 23, 2022The yield curve flattened in 1Q22Yields on 3- and 10-year Treasuries were virtually identical as of March 24, 2022, relative to a 55 bps spread as of year-end 2021Debt SpreadsCorporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis CMBS spreads per ICE Index PlatformCorporate debt and commercial MBS option-adjusted spreads widened in 1Q22Prior to the Ukraine invasion, high yield bond spreads widened to a similar degree, regardless of rating.However, since the invasion, BB-rated issuers have outperformed B- and CCC-rated issuers1Q22 spread widening in BBB-rated corporate bonds (40 bps) is the largest since 1Q20Although commercial real estate may appear somewhat more insulated from geopolitical considerations than the corporate bond market, CMBS spreads widened to a greater degree than corporate bond spreads in 1Q22CommoditiesOil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis Corn & wheat prices per BloombergCommodities experienced higher price appreciation than other asset classes in 1Q22Wheat prices, already rising prior to the invasion, leapt after it.This reflects potential production disruptions in Ukraine, sanctions on Russia, and transportation issues in the Black SeaOil prices dropped in the weeks after the invasion of Ukraine but still notched a 49% increase in 1Q22Our agriculturally-oriented banks still expect U.S. farmers to fare well in 2022, despite higher input prices and difficulty obtaining some supplies like fertilizerResidential MortgagesThe 30-year mortgage rate, as reported by Freddie Mac, exceeded 4.00% in the week ended March 18, 2022.This is the first time the mortgage rate has exceeded 4% since May 2019.For the week ended March 25, 2022, the 30-year mortgage rate climbed higher to 4.42%Mortgage rates widened to a greater extent than long-term Treasury rates in 1Q22UWM Holdings, the largest wholesale mortgage lender, in its March 1, 2022 earnings release projected that 1Q22 originations would decline by 24% to 40% from 4Q21 originations.Mortgage rates have increased further after it provided this estimate

Key Considerations in the Valuation of Banks and Bank Holding CompaniesThis whitepaper focuses on the two issues most central to our work with depository institutions at Mercer Capital:What drives value for a depository institution?How are these drivers distilled into a value for a given depository institution?In this whitepaper, we dive into the more technical valuation issues, but at its core, value is a function of the following:A specified financial metric or metricsGrowthRisk

After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.AOBA’s emphasis has evolved.When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.AOBA 2022 sought to unify several discordant themes.The first theme is fracturing and convergence.While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.The second theme is threat and opportunity.Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.We’ll cover four themes from AOBA 2022.1. FinTech Competitors/Partners & the Nature of CompetitionFinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.The last FinTech theme related to “partnerships.”This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.2. Traditional Bank M&A:Tailwinds & HeadwindsMercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch.Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.Several headwinds to activity exist though:Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.With the banking industry consolidating, fewer potential buyers exist.Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.Another trend to watch is M&A activity involving non-traditional buyers.Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.In a reversal of roles, FinTech companies now have entered the scene as acquirers.In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.3. Subordinated Debt:Act Now?The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.Pricing tightened throughout 2021.Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.4. The Regulatory Wild CardSome attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.ConclusionWe sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.Future conferences will reveal the extent to which traditional and non-traditional competitors converge.Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.

In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences.This month, we expand upon the potential asset quality implications of the current environment. One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.”We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans.However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment.Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.At the outset, we should recognize the limitations on our oracular abilities.Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses.The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure.We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers.Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:Experience gleaned from the 2008 and 2009 Great Financial CrisisCollateral and industry concentrations in banks’ loan portfolios“The World Breaks Everyone and Afterward Many Are Strong in the Broken Places”A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I.While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point.Is this reasonable?Guardedly, yes; in part because no preferable alternatives exist.But how may the current crisis develop differently, though, in terms of future loan losses?Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the finalperiod prior to the Great Financial Crisis’ onset.One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years.Have similar imbalances emerged more recently?We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period).Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period.The needle looking to pop the proverbial bubble has no obvious target.Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks.The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories.Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.Are these historical loss rates applicable to the current environment?Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion).Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree).Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks.For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens. Regarding community banks, we have greater concern regarding the following:Commercial and industrial lending. Whether due to business opportunities or regulatory pressure to lessen commercial real estate concentrations, we have observed shifts in portfolios in favor of C&I lending and are uncertain regarding the maintenance of underwriting standards.Some evidence also exists that C&I loan losses were increasing prior to the crisis, although the impact appeared episodic. Commercial real estate. While we can claim no originality, our analyses currently emphasize borrower and collateral types to identify sectors more exposed to COVID-19 countermeasures.We recognize, though, that this can obscure important distinctions.For example, hotels reliant on conference attendance likely are more exposed than properties serving interstate highway stopovers.Further, we expect that the pandemic will alter behavior, or accelerate trends already underway, in ways that affect CRE borrowers, whether that is businesses normalizing Zoom calls instead of in-person meetings or consumers shifting permanently from in-store to on-line shopping.In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations.This often reflected a tailwind from the agricultural sector.It would not be surprising if this occurs again.Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers. Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.“They fancied themselves free, and no one will ever be free so long as there are pestilences.”The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II.Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists.Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:Moody’s predicts that the default rate for speculative grade corporate bonds will reach 14.4% by the end of March 2021, up from 4.7% for the trailing twelve months ended March 31, 2020.This represents a level only slightly below the 14.7% peak reaching during the 2008 to 2009 financial crisis.1Fitch projects defaults on institutional term loans to reach $80 billion in 2020 (5% to 6% of such loans), exceeding the $78 billion record set in 2009.2Borrowers representing 17% of the commercial mortgage-backed security universe have contacted servicers regarding payment relief.Loans secured by hotel, retail, and multifamily properties represent approximately 75% of inquiries.Fitch also questions whether 90-day payment deferrals are sufficient.3Delinquent loans in commercial mortgage backed securities are projected to reach between 8.25% and 8.75% of the universe by September 30, 2020, approaching the peak of 9.0% reported in July 2011.4The delinquency rate was 1.3% as of March 2020.Fitch identified the most vulnerable sectors as hotel, retail, student housing, and single tenant properties secured by non-creditworthy tenants.Among these sectors, Fitch estimates that hotel and retail delinquencies will reach approximately 30% and 20%, respectively, relative to 1.4% and 3.5% as of March 2020.The prior recessionary peaks were 21.3% and 7.7% for hotel and retail loans, respectively.For multifamily properties, Fitch projects that bad debt expense from tenant nonpayment will exceed 10%.However, Fitch notes that its delinquency estimates do not consider forbearances.Fitch estimates that hotel loans with a pre-pandemic debt service coverage ratio (DSCR) of less than 2.75x on an interest-only basis are at risk of default.Guarantor support may limit the ultimate default rate, though.Retail and multifamily loans with a pre-pandemic DSCR of less than 1.75x and 1.20x, respectively, on an interest-only basis are at risk of default.Fitch did not apply any specific coronavirus stresses to office or industrial properties.5Among banks releasing industry exposures, Western Alliance Bancorp (WAL) reported the largest hotel concentration at 8.5% of total loans.Data provider STR reported a 79% year-over-year decline in revenue per available room for the week ended April 18, 2020, reflecting a 64% decline in occupancy (to 23%).6First Financial Bancorp (FFBC) reported the largest retail concentration among banks reporting such granular detail at 16% of total loans.Numerous other banks reported concentrations between 10% and 15% of total loans.7Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability.Shadow lenders like business development companies and private credit lenders likely are more exposed than banks.Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis.As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes.Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.ConclusionCommunity banks rightfully pride themselves as the lenders to America’s small business sector.These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies.Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal.This leaves the community bank sector at risk.However, other factors support the industry’s ability to survive the turmoil:Extensive governmental responses such as the PPP loan program provide a lifeline to small businesses until conditions begin to recover.The industry enters this phase of the credit cycle with fewer apparent imbalances than prior to the Great Financial Crisis.A greater focus since the Great Financial Crisis on portfolio diversification and cash flow metrics proves that lessoned were learned.The smaller, more rural markets in which many community banks operate may prove more resilient, at least in the short term, than larger markets.Permissiveness from regulators regarding payment modifications will allow banks to respond sensitively to borrower distress.Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses.The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 20202 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 20207 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020 Originally published in Bank Watch, April 2020.

To close our series on community bank valuation, we focus on concepts that arise when evaluating a controlling interest in another bank, such as arises in an acquisition scenario.  While the methodologies we described with respect to the valuation of minority interests in banks have some applicability, the M&A marketplace has developed a host of other techniques to evaluate the price to be paid, or received, in a bank acquisition.In the Valuing Minority Interests segment of this series, we discussed that valuation is a function of three variables:  a financial metric, risk, and growth.  From a buyer’s standpoint, the ultimate goal of a transaction, of course, is to enhance shareholder value, which would occur if the target entity can, on balance, enhance (or at least not detract from) the buyer’s financial metrics, risk, and growth.  This can be achieved in several ways:The direct earnings contribution of the target, or the accretion to the buyer’s earnings per share if the consideration consists of the buyer’s stock. In a bank M&A scenario, this accretion often derives from cost savings resulting from eliminating duplicative branches, back office functions, and the like.An acquisition can provide diversification benefits, such as different types of loans, additional geographic markets, or new funding sources. If these characteristics of the target reduce any concentrations held by the buyer, the acquirer’s overall risk may lessen.  However, numerous buyers have regretted entering lines of business or new markets via acquisition with which the buyer’s management team lacked the requisite familiarity.Accessing new markets or lines or business lines through acquisition gives the buyer more “looks” at new customers and transactions. For many banks, moving the needle on asset size or growth means looking outwardly beyond its existing markets or products, and the needle moves faster with an acquisition strategy versus a de novo market expansion strategy. These benefits are not without risks, though.  Some of the more significant acquisition risks include:Credit surprises. One or two unexpected losses usually do not affect the underlying rationale for a transaction, although it may create some uncomfortable conversations with investors regarding the buyer’s due diligence process.  A more significant risk is that the buyer’s risk tolerance differs from the seller’s approach, leading to a potentially significant disruption to future revenues as risk appetites are synchronized.  However, credit surprises often cannot be detached from the prevailing economic environment.  In a post mortem, many transactions closed in the 2006 time frame look ill-advised given the subsequent financial crisis.  Ultimately, factors outside the buyer’s control may have the most impact on post-transaction credit surprises.Cultural incompatibility. While sometimes difficult to detect from the outside, differences small and large between the cultures of the buyer and target can jeopardize the anticipated post-merger benefits.  More often than not, this is manifest in personnel issues.  Mergers are like chum in the water to competitors; buyers can expect competitors to look for any opening to attract personnel from the target bank.Similarities to Valuations of Minority InterestsThe previous installment of this series introduced the comparable company and discounted cash flow methods to bank valuations.  Both of these methods remain relevant in assessing a controlling interest in a bank, meaning an interest of sufficient size to dictate the direction of the bank.  Most often, controlling interest valuations arise in the context of an acquisition.Comparable Transactions MethodIn a controlling interest valuation, the comparable company method can be used.  However, the resulting values often would be adjusted by a “control premium”, which is measured by reference to the value of historical M&A transactions relative to a publicly-traded seller’s pre-deal announcement stock price.  This approach has the advantage of synchronizing the controlling interest valuation to current market conditions, which can be a drawback of the comparable transactions approach.More often, though, the comparable company method morphs into the comparable transactions method in an M&A setting.  Comparable M&A transactions can be identified by reference to geography, asset size, performance, time period, and the like.  Ideally, the transactions would be announced close in proximity to the date of the analysis; however, narrowly defining the financial or geographic criteria may mean accepting transactions announced over a longer time period.  The computation of pricing multiples, such as price/earnings or price/tangible book value, is facilitated by the widespread data availability regarding targets and the straightforward deal structures that usually allow analysts to identify the consideration paid to the sellers.  That is, contingent consideration, like earn-outs, is rare.  However, deal values are not always publicly reported for transactions involving privately-held institutions.While the comparable transactions approach is intuitive – by measuring what another buyer paid for another entity in an industry with thousands of relatively homogeneous participants – the most significant limitation of the comparable transactions method is created by market volatility.  Buyers’ ability to pay is correlated with their stock prices, and most bank M&A transactions include a stock component.  Deals struck at a certain price when bank stocks traded at 16x earnings would not occur at that same price if bank stocks trade at 12x earnings without crushing dilution to the buyer.  Thus, prices observed in bank M&A transactions need to be viewed in light of the market environment existing at the time of the transaction announcement data relative to the valuation date.Discounted Cash Flow MethodWe introduced the discounted cash flow method as a forward-looking approach to valuation reliant upon a projection of future performance.  In an M&A scenario, buyers usually start with the target’s stand-alone forecast, unaffected by the merger.  Acquirers then add layers to the forecast reflecting the impact of the transaction, such as:Expense savings. In a mature industry, realization of cost savings typically is a significant contributor to the transaction economics, with buyers often announcing cost savings equal to 30% to 40% of the target’s operating expenses.  These are derived primarily from eliminating duplicative branches, back office functions, and the like.  As the expense savings estimates increase, there often is a rising risk of customer attrition, with cuts going beyond the back office into activities more noticeable to customers, like branch hours or staffing. While buyers may expect a certain level of expense savings, it is not clear that buyers “credit” the seller with all of the expense savings the buyer takes the risk of achieving.  That is, the risk of achieving the expense savings effectively is split between the buyer and seller, with the favorability of the split in one direction or the other dictated by the negotiating power of the buyer and seller.Revenue enhancements. Buyers may expect some revenue enhancements to occur from the transaction, such as if the buyer has a more expansive product suite than the target or a higher legal lending limit.  However, buyers often loathe to include these in transaction modeling, and revenue enhancements are seldom reported as a driver of the EPS accretion expected from a transaction.Accounting adjustments. While fair value marks on assets acquired and liabilities assumed should not drive the economics of a transaction, they can affect the near-term earnings generated by the pro forma entity.  Therefore, buyers usually are keenly aware of the accounting implications of a transaction. One advantage of a discounted cash flow approach is that it allows the buyer to evaluate, for a given price, the level of earnings contribution needed from the target to justify that price.  While if you torture the numbers long enough they will confess to anything, as a statistics professor of mine was fond of saying, buyers should not lose sight of the reality of implementing the modeled business strategies.Additional ConsiderationsWhile the comparable transactions and discounted cash flow models crossover – no pun intended with another valuation approach we describe below – from a minority interest valuation environment, several valuation techniques are unique to M&A scenarios.Tangible Book Value Earn-BackAfter the financial crisis, investors became focused on the tangible book value per share earn-back period, sometimes to the point of seemingly ignoring other valuation metrics.  There are several ways to compute this, but the most common is the “crossover” method.  This requires two forecasts:The buyer’s tangible book value per share, absent the acquisitionThe buyer’s pro forma tangible book value per share with the target The analyst then calculates the number of periods between (a) the current date and (b) the date in the future when pro forma tangible book value per share exceeds stand-alone tangible book value per share.  Ultimately, the earn-back period is driven by factors like:The price/earnings or price/tangible book value multiples of the buyer’s stock relative to the multiples implied by the transaction valueThe extent of the merger cost synergies The tangible book value earn-back method also exacts a penalty for deal-related charges, as a higher level of deal charges extends the earn-back period.  From an income statement standpoint these charges often are treated as non-recurring and, in a sense, neutral to value.  However, these charges represent a real use of capital, which the TBV earn-back approach explicitly captures. Investors often look favorably upon transactions with earn-back periods of fewer than three years, while deals with earn-back periods exceeding five years often face a chilly reception in the market.  The earn-back period often is the real governor of deal pricing in the marketplace, which investors often like because it overcomes some limitations posed by EPS accretion analyses.Earnings per Share AccretionAs for the tangible book value per share earn-back period analysis, an EPS accretion analysis requires that the buyer forecast its EPS with and without the acquired entity.  EPS accretion simply is the change in EPS resulting from the transaction.  The attraction of this analysis lies in the correlation between EPS and value.  For a buyer trading at 12x earnings, a deal that is $0.10 accretive to EPS should enhance shareholder value by $1.20 per share, holding other factors constant.But how much accretion is appropriate?  Should a deal be 1% accretive to be a “good” deal, or 10% accretive?  It is difficult to answer this question in isolation.  This is especially true for a deal comprised largely of cash, where the buyer is forgoing the use of its capital for shareholder dividends or share repurchases in favor of an M&A transaction.  Recent deal announcements often indicate EPS accretion in the mid to high single digits with fully phased-in expense savings.Contribution AnalysisA contribution analysis is most useful in transactions involving primarily stock consideration.  It compares the buyer and seller’s ownership of the pro forma company with their relative contribution of earnings, loans, deposits, tangible equity, etc.  In a merger of equals transaction, where the two merger parties are roughly similar in size, this type of analysis is important in setting the final ownership percentages of the two banks.ConclusionA valuation of a controlling interest may take many forms; fortunately, the strengths of certain valuation methods described here offset the weaknesses of others (and vice versa).  Value ultimately is a range concept, meaning that there seldom is a single value at which a deal fails to make economic sense.  There are good deals, reasonable deals, and dumb deals.  Evaluating a number of valuation indications puts a buyer in the best position to slot a transaction into one of these three categories and to negotiate a deal that accomplishes its objective of enhancing financial performance, controlling risk, and developing new growth opportunities.  It is crucial to remember, though, that deals are tougher to execute in reality than in a spreadsheet.This concludes our multi-part series examining the analysis and valuation of financial institutions.  While approximately 5,000 banks exist, the industry is not monolithic.  Instead, significant differences exist in financial performance, risk appetite, and growth trajectory.  No valuation is complete without understanding the common issues faced by all banks – such as the interest rate environment or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.

In the June 2019 BankWatch we began a multi-part series exploring the valuation of community banks. The first segment introduced key valuation drivers: various financial metrics, growth, and risk. The second and third editions described the analysis of bank and bank holding company financial data with an emphasis on gleaning insights that affect the valuation drivers. We now conclude our series by assembling these pieces into the final product, a valuation of a specific bank.While it would streamline the valuation process, there is no single value for a bank that is applicable to every conceivable scenario giving rise to the need for a valuation. Instead, valuation is context dependent. This edition of the series focuses on the valuation of minority interests in banks, which do not provide the ability to dictate control over the bank’s operations. The next edition focuses on valuation considerations applicable to controlling interests in banks that arise in acquisition scenarios.Valuation ApproachesValuation specialists identify three broad valuation approaches within which several valuation methods exist:The Asset Approach develops a value for a bank’s common equity based on the difference between its assets and liabilities, both adjusted to market value. This approach is less common in practice, given analysts’ focus on banks’ earnings capacity and market pricing data. In theory, a rigorous application of the asset approach would require determining the value of the bank’s intangible assets, such as its customer relationships, which introduces considerable complexity.The Market Approach provides indications of value by reference to actual transactions involving securities issued by comparable institutions. The obvious advantage of this approach is the coherence between the goal of the valuation itself (the derivation of market value) and the data used (market transactions). The disadvantage, though, is that perfectly comparable market data seldom exists. While we will not cover the topic in this article, transactions in the subject bank’s common stock, which often occur for privately held banks due to their frequently widespread ownership and stature in the community, may serve as another indication of value under the market approach.The Income Approach includes several methods that convert a cash flow stream (such as earnings or dividends) into a value. Two broad subsets of the income approach exist – single period capitalization methods and discounted cash flow methods. For bankers, a single period capitalization is analogous to a net operating income capitalization in a real estate appraisal; it requires an earnings metric and a capitalization multiple. Alternatively, bank valuations often use projection-based methodologies that convert a future stream of benefits into a value. The strengths and weaknesses of a projection-based methodology derive from a commonality – it requires a forecast of future performance. While creating such a forecast is consistent with the forward-looking nature of investor returns, predicting the future is, as they say, difficult. The following discussion focuses on the valuation methodologies used most commonly for banks, the comparable company method and the discounted cash flow method.Comparable Company MethodBank analysts are awash in data, both regarding banks’ financial performance but also market data regarding publicly traded banks’ valuation. Table 1 presents a breakdown by trading market of the number of listed banks in November 2019. To narrow this surfeit of comparable company data, analysts often screen the publicly traded bank universe based on characteristics such as the following: Size, such as total assets or market capitalizationProfitability, such as return on assets or return on equityLocationAsset qualityRevenue mix, such as the proportion of revenue from loan sales or asset management feesBalance sheet composition, such as the proportion of loans or dependence on wholesale fundingTrading market or volume Even after applying screens similar to the preceding, it remains doubtful that the publicly traded banks will exactly mirror the subject bank’s characteristics. This is especially true when valuing smaller community banks, as a relatively limited number of publicly traded banks exist with assets of less than $500 million that trade in more liquid markets. Ultimately, the analyst must determine an appropriate valuation multiple based on the subject bank’s perceived growth opportunities and risk attributes relative to the public companies. For example, analysts can compare the subject bank’s historical and projected EPS growth rates against the public companies’ EPS growth rates, with a materially lower growth outlook for the subject bank suggesting a lower pricing multiple. Part 1 of this community bank valuation series described various valuation metrics applicable to banks, most prominently earnings and tangible book value. It is important to reiterate that while bankers and analysts often reference price/tangible book value multiples, the earning power of the institution drives its value. Chart 1 illustrates this point, showing that price/tangible book value multiples rise along with the core return on tangible common equity. This chart includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion. Since banking is a more mature industry, bank price/earnings multiples tend to vary within a relatively tight range. Chart 2 provides some perspective on historical price/earnings and price/tangible book value multiples, which includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion and a return on core tangible common equity between 5% and 15%. Trading multiples in the first several years of the analysis may be distorted by recessionary conditions, while the multiples reported for 2016 and 2017 were exaggerated by optimism regarding the potential, at that time, for tax and regulatory reform. The diminished multiples at yearend 2018 and September 30, 2019 reflect a challenging interest rate environment, marked by a flat to inverted yield curve, and the possibility for rising credit losses in a cooling economy. Discounted Cash Flow MethodThe discounted cash flow (DCF) method relies upon three primary inputs:A projection of cash flows distributable to investors over a finite time period » A terminal, or residual, value representing the value of all cash flows occurring after the end of the finite forecast periodA discount rate to convert the discrete cash flows and terminal value to present value1. Cash FlowFirst, a few suggestions regarding projections:For a financial institution, projecting an income statement without a balance sheet usually is inadvisable, as this obscures important linkages between the two financial statements. For example, the bank’s projected net interest income growth may require a level of loan growth not permitted by the bank’s capital resources.Including a roll-forward of the loan loss reserve illustrates key asset quality metrics, such as the ratios of loan charge-offs to loans and loan loss reserves to loans. The level of charge-offs should be assessed against the bank’s historical performance and the economic outlook.Key financial metrics, both for the balance sheet and income statement, should be assessed against the bank’s historical performance and peer banks.While projections can be prepared on a consolidated basis, we prefer developing separate projections for the bank and its holding company. This makes explicit the relationships between the two entities, such as the holding company’s reliance on the bank for cash flow. For leveraged holding companies, a sources and uses of funds schedule is useful. In preparing a DCF analysis for a bank, the most meaningful cash flow measure is distributable tangible equity. The analyst sets a threshold ratio of tangible common equity/tangible assets or another regulatory capital ratio based on management’s expectations, regulatory requirements, and/or peer and publicly traded comparable company levels. Equity generated by the bank above this target level is assumed to be distributed to the holding company. After determining the holding company’s expenses and debt service requirements, the remaining amount represents shareholder cash flow, which then is captured in the DCF valuation analysis.2. Discount RateFor a financial institution, the discount rate represents the entity’s cost of equity. Outside the financial services industry, analysts most commonly employ a weighted average cost of capital (WACC) as the discount rate, which blends the cost of the company’s debt and equity funding. However, banks are unique in that most of their funding comes from deposits, and the cost of deposits does not rise along with the entity’s risk of financial distress (because of FDIC insurance). Therefore, a significant theoretical underpinning for using a WACC – that the cost of debt increases along with the entity’s risk of default – is undermined for a bank. Analytical consistency is created in a DCF analysis by matching a cash flow to equity investors (i.e., dividends) with a cost of equity.A bank’s cost of equity can be estimated based on the historical excess returns generated by equity investments over Treasury rates, as adjusted by a “beta” metric that captures the volatility of bank stocks relative to the broader market. Analysts may also consider entity-specific risk factors – such as a concentration in a limited geographic market, elevated credit quality concerns, and the like – that serve to distinguish the risk faced by investors in the subject institution relative to the norm for publicly traded banks from which cost of equity data is derived.3. Terminal ValueThe terminal value is a function of a financial metric at the end of the forecast period, such as net income or tangible book value, and an appropriate valuation multiple. Two techniques exist to determine a terminal value multiple. First, the Gordon Growth Model develops an earnings multiple using (a) the discount rate and (b) a long-term, sustainable growth rate. Second, as illustrated in Chart 2, bank pricing multiples tend to vary within a relatively tight range, and a historical average trading multiple can inform the terminal value multiple selection.Correlating the AnalysisIn most analyses, the values derived using the market and income approaches will differ. Given a range, an analyst must consider the strengths and weaknesses of each indicated value to arrive at a final concluded value. For example, earnings based indications of value derived using the market approach may be more relevant in “normal” times, as the values are consistent with investors’ orientation towards earnings as the ultimate source of returns (either dividends or capital appreciation). However, in more distressed times when earnings are depressed, indications of value using book value assume more relevance. If a bank has completed a recent acquisition or is in the midst of a strategic overhaul, then the discounted cash flow method may deserve greater emphasis. We prefer to assign quantitative weights to each indication of value, which provide transparency into the process by which value is determined.Relative Value AnalysisThe analysis is not complete, however, when a correlated value is obtained. It is crucial to compare the valuation multiples implied by the concluded value, such as the effective price/earnings and price/tangible book value multiples, against those reported by publicly traded banks. Any divergences should be explainable. For example, if the bank operates in a market with constrained growth prospects, then a lower than average price/earnings multiple may be appropriate. A higher return on equity for a subject bank, relative to the comparable companies, often results in a higher price/tangible book value multiple. As another reference point, the effective pricing multiples may be benchmarked against bank merger and acquisition pricing to ensure that an appropriate relationship exists between the subject minority interest value and a possible merger value.ConclusionThere are many valuation issues that remain untouched by this article in the interest of brevity, such as the valuation treatment of S corporations and the discount for lack of marketability applicable to minority interests in banks with no active trading market. Instead, this article addresses issues commonly faced in valuing minority interests in any community bank. A well-reasoned valuation of a community bank requires understanding the valuation conventions applicable to banks, such as pricing multiples commonly employed or the appropriate source of cash flow in a DCF analysis, but within a risk and growth framework that underlies the valuation of all equity instruments. Relating these valuation parameters to a comprehensive analysis of a bank’s financial performance, risk factors, and strategic outlook results in a rigorous and convincing determination of value. In the next edition, we will move beyond the valuation of minority interests in banks, focusing on specific valuation nuances that arise when engaging in a valuation for merger purposes.Originally published in Bank Watch, November 2019.

The August 2019 BankWatch described key considerations in analyzing the financial statements of banks. However, we did not address one crucial set of relationships – those between a bank holding company (“BHC”) and its subsidiary depository institution.Most banks are owned by bank holding companies. While investors often state that they own an interest in a bank, this may not be legally precise. Usually, they own a share of stock in a bank holding company, which in turn owns a controlling interest in a subsidiary bank’s common stock. Where a bank holding company exists, this entity’s common stock generally is the subject of valuation analyses.Part 3 of the Community Bank Valuation series explores important relationships between banks and their holding companies, focusing particularly on cash flow and leverage.The Holding Company’s Balance SheetCompared to a bank’s balance sheet, a holding company’s balance sheet has fewer moving parts. The “left side” of its balance sheet, or its assets, usually is rather boring. The more intriguing analytical question, though, is how the bank holding company finances its investment in the bank. The following table presents a balance sheet for a BHC controlling 100% of the common stock of a bank with $500 million of total assets. Usually, the holding company’s assets consist virtually entirely of its investment in its subsidiary bank or banks, which equals the bank’s total equity. The investment in the bank is carried at equity, meaning that it increases by the bank’s net income and decreases by dividends paid from the bank to the holding company, among other transactions. Other material assets may include: Cash. BHCs with cash obligations paid at the holding company, such as interest payments or compensation, often will maintain a cash buffer to cover several months of operating expenses. In some cases, BHCs will maintain a larger cash position to react opportunistically if the bank subsidiary needs a capital injection for its growth or to repurchase BHC shares.Other Assets. Non-bank assets typically are relatively modest and consist of investments in other entities (such as an insurance agency), intangible assets related to acquisitions that were not “pushed down” to the subsidiary, or facilities. In periods marked by higher levels of nonperforming assets, BHCs may hold problem assets, which is one strategy to reduce the bank’s classified asset/ capital ratio. Interestingly, BHCs can borrow from banks – just not their bank subsidiary – and other capital providers. If the funds are downstreamed into the bank, the borrowings can be transformed from an instrument not includible in the BHC’s regulatory capital into Tier 1 capital at the bank. In order of seniority these funding sources include:Bank Stock Loans. These loans are collateralized by the subsidiary bank’s stock and typically are obtained from another bank. As a secured borrowing, these loans generally have a lower cost than other alternatives. However, in the event of a default, the lender can foreclose on their collateral (i.e., the bank stock).Subordinated Debt. After passage of the Dodd-Frank Act and the Basel III capital regulations, subordinated debt became a more prominent funding source, usually for organic growth or acquisitions. Various regulatory requirements govern subordinated debt offerings, but most community bank placements provide for a ten year term with the interest rate fixed for five years. The securities may be considered Tier 2 capital for the holding company.Trust Preferred Securities (“TruPS”). TruPS were created in the 1990s to combine the Tier 1 capital treatment of preferred stock with the tax deductibility of debt. Rightly or wrongly, this instrument was viewed negatively by some regulators after the financial crisis, and the Basel III regulations effectively nullified new issuances. Many BHCs still hold grandfathered TruPS, though, which often do not mature until the 2030s. TruPS generally have interest rates that float with LIBOR, are subordinated to all other BHC obligations, and provide the issuer the right to defer payments for up to five years without triggering a default. TruPS count as Tier 1 capital for BHCs with under $15 billion in assets that are considered to be “large” BHCs that fie Y-9LP and Y-9C call reports with the Federal Reserve. A BHC’s equity usually consists almost entirely of common stock, which generally must be the principal form of capitalization under BHC regulations. However, BHCs can issue preferred stock, and regulations view most favorably non-cumulative, perpetual preferred stock.Analytical ConsiderationsWhy do holding companies exist? First, they provide an efficient way to raise funds that can be injected as capital into the bank, thereby accommodating its organic growth. Second, they can facilitate acquisitions. Third, BHCs can more efficiently conduct shareholder transactions, such as repurchases.By using leverage, a BHC can enhance the bank’s stand-alone return on equity (or exacerbate the ROE pressure arising from adverse financial scenarios). As indicated in Table 2, BHC leverage magnifies the subsidiary bank’s 12.0% ROE to 12.9% after considering the cost of the BHC’s debt. As for a non-financial company, too much leverage can mean that the beneficial effect to shareholders of a higher ROE is swamped by the additional risk of financial distress. Various metrics exist to measure the holding company’s leverage, but one is the “double leverage” ratio, which is calculated as the investment in the bank subsidiary divided by the BHC’s equity. As indicated in Table 1 on page one, the BHC’s ratio is 113%, which is consistent with the median reported by all smaller BHCs at June 30, 2019 (112%, excluding some BHCs for which the BHC’s equity exceeds the bank investment). Cash FlowUnfortunately, BHC regulatory filings and audited financial statements do not provide a sources and uses of funds schedule, although some cash flow data is provided. Nevertheless, understanding the BHC’s obligations, and the cash required to service those obligations, is essential.Sources of funds consist principally of the following:Dividends from the bank subsidiary. The depth of this source of cash flow should be evaluated in light of the bank’s profitability, capital levels, and growth opportunities.Debt issuancesCommon stock salesIntercompany payments. For example, the bank may reimburse the holding company for certain expenses paid by the BHC. Additionally, banks and BHCs often have tax-sharing arrangements. If the holding company incurs expenses, then it may realize an offsetting tax benefit. Uses of funds include the following:Debt serviceShareholder dividendsShare repurchasesOperating expenses. Expenses such as compensation, directors’ fees, and certain insurance premiums may be recorded by the holding company Analysts should compare a bank’s ability to pay dividends, given its profitability level and need to retain earnings to fund its growth, against the BHC’s various claims on cash. Mismatches can sometimes arise due to changes in the bank’s performance or operating strategy. For example, consider a BHC that historically has paid high dividends to shareholders. If its subsidiary bank adopts a new strategic plan focused on organic growth, then the bank will need to retain earnings rather than pay dividends to the BHC and, ultimately, BHC shareholders. Additional borrowings could fund a short-term gap, but this is not a long-term solution to a BHC cash flow mismatch. Two other special circumstances arise when analyzing BHC cash flow:Acquisitions. Prior to entering into a transaction, the BHC’s plan for funding any cash consideration should evaluate the availability and desirability of dividends from the bank, debt offerings, and stock sales. Further, the cash acquired from the target BHC may provide another source of transaction funding.S Corporations. Shareholders in an S corporation rely on the BHC for distributions to offset their pass-through tax liability, while the BHC in turn relies on the bank for dividends to fund those tax payments. There are no special capital rules at the bank level that provide flexibility regarding the payment of dividends to offset BHC shareholders’ tax liability when other restrictions on dividends may exist. That is, C corporation and S corporation banks face the same capital regulations. Boards of S corporations may desire to operate, at the margin, with a greater capital buffer to avoid a situation where the shareholders have taxable income but the BHC is unable to make distributions.CapitalCapital requirements for BHCs vary based upon their asset size. Under current regulations, BHCs with assets below $3.0 billion are subject to the Federal Reserve’s Small Bank Holding Company Policy Statement. This regulation does not establish any specific minimum capital ratios for small BHCs; however, a debt/ equity ratio limitation exists for debt arising from acquisitions. Therefore, small BHCs have significant flexibility in managing their capital structure, although the Federal Reserve theoretically remains a check on their creativity.Large BHCs are subject to the Basel III regulations, which involve capital ratios calculated based on Tier 1 and total capital. Tier 1 capital generally is limited to common equity, non-cumulative perpetual preferred stock, and grandfathered TruPS. In addition to the allowance for loan losses, Tier 2 capital may include subordinated debt. Large BHC management can balance these capital sources to minimize the BHC’s weighted average cost of capital, maintain flexibility for unexpected events or opportunities, and ensure compliance with regulatory expectations.ConclusionWhile the subsidiary bank receives most of the analytical attention, the holding company on a standalone (or parent company) basis should not be overlooked. This is particularly true if the holding company has significant obligations to service debt or pay other expenses. By understanding the linkages between the bank and holding company, analysts can better assess a BHC’s potential future returns to shareholders and risk factors posed by the BHC that could jeopardize those returns.Originally published in Bank Watch, September 2019.

The June BankWatch featured the first part of a series describing key considerations in the valuation of banks and bank holding companies. While that installment provided a general overview of key concepts, this month we pivot to the analysis of bank financial statements and performance.1 Unlike many privately held, less regulated companies, banks produce reams of financial reports covering every minutia of their operations. For analytical personality types, it’s a dream.The approach taken to analyze a bank’s performance, though, must recognize depositories’ unique nature, relative to non-financial companies. Differences between banks and non-financial companies include:Close interactions between the balance sheet and income statement. Banking revenues are connected tightly to the balance sheet, unlike for nonfinancial companies. In fact, you often can estimate a bank’s net income or the growth therein solely by reviewing several years of balance sheets. Banks have an “inventory” of assets that earn interest, referred to as “earning assets,” which drive most of their revenues. Earning assets include loans, securities (usually highly-rated bonds like Treasuries or municipal securities), and short-term liquid assets. Changes in the volume of assets and the mix of these assets, such as the relative proportions of lower yielding securities and higher yielding loans, significantly influence revenues.The value of liabilities. For non-financial companies, acquisition motivations seldom revolve around obtaining the target entity’s liabilities. The effective management of working capital and debt certainly influences shareholder value for non-financial companies, but few attempt to stockpile low-cost liabilities absent other business objectives. Banks, though, periodically buy and sell branches and their related deposits. The prices (or “premiums”) paid in these transactions reveal that bank deposits, the predominate funding source for banks, have discrete value. That is, banks actually pay for the right to assume another bank’s liabilities.Why do banks seek to acquire deposits? First, all earning assets must be funded; otherwise, the balance sheet would fail to balance. Ergo, more deposits allow for more earning assets. Second, retail deposits tend to cost less than other alternative sources of funds. Banks have access to wholesale funding sources, such as brokered deposits and Federal Home Loan Bank advances, but these generally have higher interest rates than retail deposits. Third, retail deposits are stable, due to the relationship existing between the bank and customer. This provides assurance to bank managers, investors, and regulators that a disruption to a wholesale funding source will not trigger a liquidity shortfall. Fourth, deposits provide a vehicle to generate noninterest income, such as service charges or interchange. The strength of a bank’s deposit portfolio, such as the proportion of noninterest-bearing deposits, therefore influences its overall profitability and franchise value.Capital Adequacy. In addition to board and shareholder preferences, nonfinancial companies often have debt covenants that constrain leverage. Banks, though, have an entire multi-pronged regulatory structure governing their allowable leverage. Shareholders’ equity and regulatory capital are not the same; however, the computation of regulatory capital begins with shareholders’ equity. Two types of capital metrics exist – leverage metrics and risk-based metrics. The leverage metric simply divides a measure of regulatory capital by the bank’s total assets, while risk-based metrics adjust the bank’s assets for their relative risk. For example, some government agency securities have a risk weight equal to 20% of their balance, while many loans receive a risk weight equal to 100% of their balance.Capital adequacy requirements have several influences on banks. Most importantly, failing to meet minimum capital ratios leads to severe repercussions, such as limitations on dividends and stricter regulatory oversight, and is (as you may imagine) deleterious to shareholder value. More subtly, capital requirements influence asset pricing decisions and balance sheet structure. That is, if two assets have the same interest rate but different risk weights, the value maximizing bank would seek to hold the asset with the lower risk weight. Stated differently, if a bank targets a specific return on equity, then the bank can accept a lower interest rate on an asset with a smaller risk weight and still achieve its overall return on equity objectives.Regulatory structure. In exchange for receiving a bank charter and deposit insurance, all facets of a bank’s operations are tightly regulated to protect the integrity of the banking system and, ultimately, the FDIC’s Deposit Insurance Fund that covers depositors of failed banks. Banks are rated under the CAMELS system, which contains categories for Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. Separately, banks receive ratings on information technology and trust activities. While a bank’s CAMELS score is confidential, these six categories provide a useful analytical framework for both regulators and investors.Understanding the Balance SheetWe now cover several components of a bank’s balance sheet.Short-Term Liquid Assets and SecuritiesBanks are, by their nature, engaged in liquidity transformation, whereby funds that can be withdrawn on demand (deposits) are converted into illiquid assets (loans). Several alternatives exist to mitigate the risk associated with this liquidity transformation, but one universal approach is maintaining a portfolio of on-balance sheet liquid assets. Additionally, banks maintain securities as a source of earning assets, particularly when loan demand is relatively limited.Liquid assets generally consist of highly-rated securities issued by the U.S. Treasury, various governmental agencies, and state and local governments, as well as various types of mortgage-backed securities. Relative to loans, banks trade off some yield for the liquidity and credit quality of securities. Key analytical considerations include:Portfolio Size. While there certainly are exceptions, most high performing banks seek to limit the size of the securities portfolio; that is, they emphasize the liquidity features of the securities portfolio, while generating earnings primarily from the loan portfolio.Portfolio Composition. The portfolio mix affects yield and risk. For example, mortgage-backed securities may provide higher yields than Treasuries, but more uncertainty exists as to the timing of cash flows. Also, the credit risk associated with any non-governmental securities, such as corporate bonds, should be identified.Portfolio “Duration.” Duration measures the impact of different interest rate environments on the value of securities; it may also be viewed as a measure of the life of the securities. One way to enhance yield often is to purchase securities with longer durations; however, this increases exposure to adverse price movements if interest rates increase.LoansA typical bank generates most of its revenue from interest income generated by the loan portfolio; further, the lending function presents significant risk in the event borrowers fail to perform under the contractual loan terms. While loans are more lucrative than securities from a yield standpoint, the cost of originating and servicing a loan portfolio – such as lender compensation – can be significant. Key analytical considerations include:Portfolio Composition. Bank financial statements include several loan portfolio categories, based on the collateral or purpose of each loan. Investors should consider changes in the portfolio over time and compare the portfolio mix to peer averages. Significant growth in a portfolio segment raises risk management questions, and regulatory guidance provides thresholds for certain types of real estate lending. Departures from peer averages may provide a sense of the subject bank’s credit risk, as well as the portfolio’s yield. Analysts may also wish to evaluate whether any concentrations exist, such as to certain industry niches or customer segments.Portfolio Duration. Banks compete with other banks (and non-banks in some cases) on interest rate, loan structure, and underwriting requirements. Most banks will say they do not compete on underwriting requirements, such as offering higher loan/value ratios, which leaves rate and structure. To attract borrowers, banks may offer more favorable loan structures, such as longer-term fixed rate loans. Viewed in isolation, this exposes banks to greater interest rate risk; however, this loan structure may be entirely justified in light of the interest rate risk of the entire balance sheet.Allowance for Loan & Lease Losses (“ALLL”)Banks maintain reserves against loans that have defaulted or may default in the future. While a new regime for determining the ALLL will be implemented beginning for some banks in 2020, the size of the ALLL under current and future accounting standards generally varies between banks based on (a) portfolio size, (b) portfolio composition, as certain loan types inherently possess greater risk of credit loss, (c) the level of problem or impaired loans, and (d) management’s judgment as to an appropriate ALLL level. Calculating the ALLL necessarily includes some qualitative inputs, such as regarding the outlook for the economy and business conditions, and reasonable bankers can disagree about an appropriate ALLL level. Key analytical considerations regarding the ALLL and overall asset quality include:ALLL Metrics. The ALLL – as a percentage of total loans, nonperforming loans, or loan charge-offs – can be benchmarked against the bank’s historical levels and peer averages. One shortcoming of the traditional ALLL methodology, which may or may not be remediated by the new ALLL methodology, is that reserves tend to be procyclical, meaning that reserves tend to decline leading into a recession (thereby enhancing earnings) but must be augmented during periods of economic stress when banks have less financial capacity to bolster reserves.Charge-Off Metrics. The ALLL decreases by charge-offs on defaulted loans, while recoveries on previously defaulted loans serve to increase the ALLL. One of the most important financial ratios compares loan charge-offs, net of recoveries, to total loans. Deviations from the bank’s historical performance should be investigated. For example, are the losses concentrated in one type of lending or widespread across the portfolio? Is the change due to general economic conditions or idiosyncratic factors unique to the bank’s portfolio? Is a new lending product performing as expected?Charge-off ratios also provide insight into the amount of credit risk accepted by a bank, relative to its peer group. However, credit losses should not be viewed in isolation – yields matter as well. It is safe to assume, though, that higher than peer charge-offs, coupled with lower than peer loan yields, is a poor combination. While banks strive to avoid credit losses, a lengthy period marked by virtually nil credit losses could suggest that the bank’s underwriting is too restrictive, sacrificing earnings for pristine credit quality.Loan Loss Provision. The loan loss provision increases the ALLL. A provision generally is necessary to offset periodic loan charge-offs, cover loan portfolio growth, and address risk migration as loans enter and exit impaired or nonperforming status.DepositsAs for loans, bank financial statements distinguish several deposit types, such as demand deposits and CDs. It is useful to decompose deposits further into retail (local customers) and wholesale (institutional) deposits. Key analytical considerations include:Portfolio Size. Deposit market share tends to shift relatively slowly; therefore, quickly raising substantial retail deposits is a difficult proposition. Banks with more rapid loan growth face this challenge acutely. Often these banks rely more significantly on rate sensitive deposits, such as CDs, or more costly wholesale funds. Therefore, analysts should consider the interaction between loan growth objectives and the availability and pricing of incremental deposits.Composition. Investors generally prefer a high ratio of demand deposits, because these accounts usually possess the lowest interest rates, the lowest attrition rates and interest rate sensitivity, and the highest noninterest income. Of course, these accounts also are the most expensive to gather and service, requiring significant investments in branch facilities and personnel. With that said, other successful models exist. Some banks minimize operating costs, but offer higher interest rates to depositors.Rate. Banks generally obtain rate surveys of their local market area, which provide insight into competitive conditions and the bank’s relative position. Also, it is useful to benchmark the bank’s cost of deposits against its peer group. Deposit portfolio composition plays a part in disparities between the subject bank and the peer group, as do regional differences in deposit competition.Shareholders’ Equity and Regulatory CapitalHistorical changes in equity cannot be understood without an equity roll-forward showing changes due to retained earnings, share sales and redemptions, dividends, and other factors. In our opinion, it is crucial to analyze the bank’s current equity position by reference to management’s business plan, as this will reveal amounts available for use proactively to generate shareholder returns (such as dividends, share repurchases, or acquisitions). Alternatively, the analysis may reveal the necessity of either augmenting equity through a stock offering or curtailing growth objectives.The computation of regulatory capital metrics can be obtained from a bank’s regulatory filings. Relative to shareholders’ equity, regulatory capital calculations: (a) exclude most intangible assets and certain deferred tax assets, and (b) include certain types of preferred stock and debt, as well as the ALLL, up to certain limits.Understanding the Income StatementThere are six primary components of the bank’s income statement:Net interest income, or the difference between the income generated by earning assets and the cost of funding.Noninterest income, which includes revenue from other services provided by the bank such as debit cards, trust accounts, or loans intended for sale in the secondary market. The sum of net interest income and noninterest income represents the bank’s total revenues.Noninterest expenses, which principally include employee compensation, occupancy costs, data processing fees, and the like. Income after noninterest expenses commonly is referred to by investors, but not by accountants, as “pre-tax, pre-provision operating income” (or “PPOI”).Loan loss provisionSecurity gains and lossesTaxesNet Interest IncomeThe previous analysis of the balance sheet foreshadowed this net interest income discussion with one important omission – the external interest rate environment. While banks attempt to mitigate the effect on performance of uncontrollable factors like market interest rates, some influence is unavoidable. For example, steeper yield curves generally are more accommodative to net interest income, while banks struggle with flat or inverted yield curves.Another critical financial metric is the net interest margin (“NIM”), measured as the yield on all earning assets minus the cost of funding those assets (or net interest income divided by earning assets). The NIM and net interest income are influenced by the following:The earning asset mix (higher yielding loans, versus lower yielding securities)Asset duration (longer duration earning assets usually receive higher yields)Credit risk (accepting more credit risk should enhance asset yields and NIM)Liability composition (retail versus wholesale deposits, or demand deposits versus CDs)Liability duration (longer duration liabilities usually have higher interest rates)Noninterest IncomeThe sensitivity of net interest income to uncontrollable forces – i.e., market interest rates – makes noninterest income attractive to bankers and investors. Banks generate noninterest income from a panoply of sources, including:Fees on deposit accounts, such as service charges, overdraft income, and debit card interchangeGains on the sale of loans, such as residential mortgage loans or government guaranteed small business loansTrust and wealth management incomeInsurance commissions on policies soldBank owned life insurance where the bank holds policies on employees Some sources of revenue can be even more sensitive to the interest rate environment than net interest income, such as income from residential mortgage originations. Yet other sources have their own linkages to uncontrollable market factors, such as revenues from wealth management activities tied to the market value of account assets. Expanding noninterest income is a holy grail in the banking industry, given limited capital requirements, revenue diversification benefits, and its ability to mitigate interest rate risk while avoiding credit risk. However, many banks’ fee income dreams have foundered on the rocks of reality for several reasons. First, achieving scale is difficult. Second, cross-sales of fee income products to banking customers are challenging. Third, significant cultural differences exist between, say, wealth management and banking operations. A fulsome financial analysis considers the opportunities, challenges, and risks presented by noninterest income.Noninterest ExpensesIn a mature business like banking, expense control always remains a priority.Personnel expenses. Personnel expenses account for 50-60% of total expenses. Significant changes in personnel expenses generally are tied to expansion initiatives, such as adding branches or hiring a lending team from a competitor. Regulatory filings include each bank’s full-time equivalent employees, permitting productivity comparisons between banks.Occupancy expenses. With the shift to digital delivery of banking services, occupancy expenses have remained relatively stable for many community banks, while larger banks have closed branches. Nevertheless, banks often conclude that entering a new market requires a beachhead in the form of a physical branch location.Other expenses. Regulatory filings lump remaining expenses into an “other” category, although audited financial statements usually provide greater detail. More significant contributors to the “other” category include data processing and information technology spending, marketing costs, and regulatory assessments.Loan Loss ProvisionWe covered this income statement component previously with respect to the ALLL.Income TaxesBanks generally report effective tax rates (or actual income tax expense divided by pre-tax income) below their marginal tax rates. This primarily reflects banks’ tax-exempt investments, such as municipal bonds; bank-owned life insurance income; and vehicles that provide for tax credits, like New Market Tax Credits. It is important to note that state tax regimes may differ for banks and non-banks. For example, some states assess taxes on deposits or equity, rather than income, and such taxes are not reported as income tax expense.Return DecompositionAs the preceding discussion suggests, many levers exist to achieve shareholder returns. One bank can operate with lean expenses, but pay higher deposit interest rates (diminishing its NIM) and deemphasize noninterest income. Another bank may pursue a true retail banking model with low cost deposits and higher fee income, offset by the attendant operating costs. There is not necessarily a single correct strategy. Different market niches have divergent needs, and management teams have varying areas of expertise. However, we still can compare the returns on equity (or net income divided by shareholders’ equity) generated by different banks to assess their relative performance.The figure below presents one way to decompose a bank’s return on equity relative to its peer group. This bank generates a higher return on equity than its peer group due to (a) a higher net interest margin, (b) a slightly lower loan loss provision, and (c) higher leverage (shown as the “equity multiplier” in the table).Income Statement MetricsThe figure below cites several common income statement metrics used by investors, as well as their strengths and shortcomings.Sources of InformationBanks file quarterly Call Reports, which are the launching pad for our templated financial analyses. Depending on asset size, bank holding companies file consolidated financial statements with the Federal Reserve. All bank holding companies, small and large, file parent company only financial statements, although the frequency differs. Other potentially relevant sources of information include:Audited financial statements and internal financial dataBoard packets, which often are sufficiently extensive to cover our information requirementsBudgets, projections, and capital plansAsset quality reports, such as criticized loan listings, delinquency reports, concentration analyses, documentation regarding ALLL adequacy, and special asset reports for problem loansInterest rate risk scenario analyses and inventories of the securities portfolioFederal Reserve form FR Y-6 provides the composition of the holding company’s board of directors and significant shareholders’ ownershipConclusionA rigorous examination of the bank’s financial performance, both relative to its history and a relevant peer group and with due consideration of appropriate risk factors, provides a solid foundation for a valuation analysis. As we observed in June’s BankWatch, value is dependent upon a given bank’s growth opportunities and risk factors, both of which can be revealed using the techniques described in this article.1 Given the variety of business models employed by banks, this article is inherently general. Some factors described herein will be more or less relevant (or even not relevant) to a specific bank, while it is quite possible that, for the sake of brevity, we altogether avoided mention of other factors relevant to a specific bank. Readers should therefore conduct their own analysis of a specific bank, taking into account its specific characteristics.Originally published in Bank Watch, August 2019.

This article begins a series focused on the two issues most central to our work at Mercer Capital: What drives value for a depository institution and how are these drivers distilled into a value for a given depository institution?We leave the more technical valuation discussion for subsequent articles. At its core, though, value is a function of a specified financial metric or metrics, growth, and risk.Financial MetricsMany industries have a valuation benchmark used by industry participants, although this metric does not necessarily cohere with benchmarks used by investors. In the banking industry, “book value” fills this role. In fact, there are several potential measures of book value, including:Stated shareholders’ equity, as indicated in the institution’s financial statementsTangible book value, which deducts purchase accounting intangible assets from stated shareholders’ equityTier 1 common equity, which is a regulatory capital measure that is less commonly used as a valuation metric The most commonly used book value metric is tangible book value (or TBV). Like most industry benchmarks, simplicity and commonality are reasons industry participants embrace TBV as a valuation metric. Strengths of TBV as a valuation metric include:It is reported frequently and comparable from institution to institution.TBV is subject to less pronounced volatility than net income; thus, valuation multiples computed using TBV may be less prone to exaggeration when, for example, earnings are temporarily depressed. TBV can be used to capture the mean reversion tendencies of return on equity (ROE). For example, consider an institution with an ROE exceeding its peer group. Over time, as competitors understand and replicate its business model, these excess returns may diminish. An analyst could use TBV multiples to model potential mean reversion in ROE, which is more difficult to capture using a current period price/earnings multiple. While TBV has its place, investors focus primarily on an institution’s earnings and the growth therein. This earnings orientation occurs because investors are forward looking, and TBV inherently is a backward-looking measure representing the sum of an institution’s common stock issuances, net income, dividends, and share redemptions since its inception. In addition to being forward-looking, investors also appreciate that earnings ultimately are the source of returns to shareholders. With earnings, the institution can do any of (or a combination of) the following:1Reinvest (i.e., retain earnings), with the goal of generating higher future earningsPay dividends to shareholdersRepurchase stock, which supports the per share value by reducing the outstanding sharesAcquire other companies. Because goodwill and intangible assets are deducted when computing regulatory capital, earnings offset the TBV dilution created in these transactions More bluntly, investors like growing earnings and cash returns (dividends or share repurchases), which are difficult to provide without a sustainable base of strong earnings. Investors will tolerate some near-term drag on earnings from expansion or risk mitigation strategies, but their patience is not limitless. In many industries, earnings before interest, taxes, depreciation, and amortization (EBITDA) or a similar metric is the preferred earnings measure. However, banks derive most of their revenues from interest spreads, and EBITDA is an inappropriate metric. Instead, bank investors focus on net income and earnings per share. When credit quality is distressed, investors may consider earnings metrics calculated before the loan loss provision, such as pre-tax, pre-provision operating income (PPOI). While earnings-based analyses generally should have valuation primacy in our opinion, TBV multiples nevertheless serves as an important test of reasonableness for a valuation analysis. It would be foolhardy to develop a valuation for a depository institution without calculating the TBV multiple implied by the concluded value. Analysts should be able to reconcile implied TBV multiples to public market or M&A market benchmarks and explain any significant discrepancies. Occasionally, analysts cite balance sheet-based metrics beyond TBV, some of which have more analytical relevance than others. The most useful is a multiple of “core” deposits, a definition of deposits that excludes larger deposits and deposits obtained from wholesale funding markets. Core deposits are time consuming and costly to gather; thus, a multiple of core deposits aligns a bank’s value with its most attractive funding source. A less useful multiple is value as a percentage of total assets, the use of which would implicitly encourage management to stockpile assets without regard to their incremental profitability.GrowthInvestors like growth and accelerating growth even more. Without demonstrating the mathematics, higher expected growth rates produce higher valuation multiples. Further, price/earnings multiples expand at an increasing rate as growth rates increase, as indicated in the following chart. The opposite is true, too, as slowing growth reduces the price/earnings. Banks report innumerable metrics to directors and investors, but what are the most relevant growth indicia to investors? Usually, investors focus on growth in the following: Balance sheet components like loans and deposits, which ultimately drive revenue growthAsset quality and capital adequacyPre-tax, pre-provision operating income, which smooths earnings fluctuations caused by periodic volatility in provisions for loan lossesNet income per shareDividends per shareTangible book value per share Valuation is inherently forward-looking, and historical growth rates are useful mostly as potential predictors of future growth. Further, most investors understand that there is some tradeoff between earnings today and investing for higher earnings in the future. While some near-term pressure on earnings from an expansion strategy is acceptable, strategic investments should not continually be used to explain below average profitability. After all, a bank’s competitors likely are reinvesting as well for the future. How does growth affect value? As a thought experiment, consider a bank with no expected growth in earnings and a 100% dividend payout ratio. Should this bank’s common equity value increase? In this admittedly extreme scenario, the answer is no. This bank’s common equity resembles a preferred stock investment, with a shareholder’s return generated by dividends. That is, for value to grow, one (or preferably more) of the preceding factors must increase. Should a bank prioritize growth in earnings per share, dividends per share, or another metric? The answer likely depends on the bank’s shareholder base. In public markets, investors tend to be more focused on earnings per share growth. If an investor desires income, he or she can sell shares in the public market. For privately-held banks, though, investors often are keenly aware of dividend payments and emphasize the income potential of the investment. Of course, sustaining higher dividend payments requires earnings growth. Growth creates a virtuous cycle – retained earnings lead to higher future net income, allowing for future higher dividends or additional reinvestment, and so the cycle continues. One important caveat exists, though. This virtuous cycle presumes that the retained earnings from a given year are invested in new opportunities yielding the same return on equity as the existing operations. If reinvestment occurs in lower ROE opportunities – such as liquid assets supported by excess capital beyond the level needed to operate the bank safely – then growth in value may be diminished. This discussion of growth segues into the third key valuation factor, risk.RiskMore than most industries, risk management is an overarching responsibility of management and the board of directors and a crucial element to long-term shareholder returns. Banks encounter the following forms of risk:Credit risk, or the risk that the bank’s investments in loans and other assets may not be repaid in full or on a timely basisLiquidity risk, or the risk that arises from transforming liabilities that are due on demand (deposits) into illiquid assets (loans)Interest rate risk, or the risk attributable to assets and liabilities with mismatched pricing structures or durationsOperational risk, such as from malevolent actors like computer hackers While growth rates are observable from reported financial metrics, the risk assumed to achieve that growth often is more difficult to discern – at least in the near-term. Risk can accumulate, layer upon layer, for years until a triggering event happens, such as an economic downturn. Risk also is asymmetric in the sense that a strategy creating incremental risk, such as a new lending product, can be implemented quickly, but exiting the problems resulting from that strategy may take years. From a valuation standpoint, investors seek the highest return for the least risk. Given two banks with identical growth prospects, investors would assign a higher price/earnings multiple to the bank with the lower risk profile. Indicia of risk include:The launch of new products or business lines » Expansion into new geographic marketsHigher than average loan yields coupled with lower than average loan losses None of the preceding factors necessarily imply higher risk vis-à-vis other banks; the key is risk management, not risk avoidance. However, if an investor believes risk is rising for any reason, then that expectation can manifest in our three pronged valuation framework as follows:Financial Metric. The investor may view a bank’s current earnings as unsustainable once the risk associated with a business strategy becomes evident, leading to reduced expectations of future profitability.Growth. An investor may assess that a bank’s growth rates are exaggerated by accepting too much risk in pursuing growth. In this event, earnings growth expectations would be tempered as the bank realigns its growth, risk, and return objectives.Risk. Valuation multiples are inversely related to risk. By increasing the investor’s required return, the investor increases his or her margin of safety in the event of unfavorable financial developments. An old adage is that risk can be quantified and uncertainty cannot. This observation explains why stock prices and pricing multiples can be particularly volatile for banks in periods of economic uncertainty or distress. If investors cannot quantify a bank’s downside exposure, which often is more attributable to general economic anxieties than the quality of the bank’s financial disclosures, then they tend to react by taking a pessimistic stance. As a result, risk premiums can widen dramatically, leading to lower multiples.ConclusionThis article provides an overview of the three key factors underlying bank stock valuations – financial performance, risk, and growth. While these three factors are universal to valuations, we caution that the examples, guidance, and observations in this article may not apply to every depository institution.At Mercer Capital, valuations of clients’ securities are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. These important influences on a valuation analysis cannot be gleaned solely from reviewing a bank’s Call Report. Future editions of this series will describe both the quantitative and qualitative considerations we use to arrive at sound, well-reasoned, and well-supported valuations.1 In theory, a bank could accomplish the preceding without earnings, but eventually that well (i.e., the bank’s TBV) will run dryOriginally published in Bank Watch, June 2019.

Struggling to find a page-turning read for that late summer beach escape?May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA).Like a tightly wound murder mystery, the regulations weave a complex web.Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses.As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.1The Abridged Version of the NPR in One SentenceBank shareholders are eligible for the 20% Qualified Business Income deduction.2 Intrigued?If so, the story continues.PrologueBefore examining the NPR, several tax-related trends are evident in 2018 regulatory filings.Effective tax rates are fallingMore banks are converting from S corporations to C corporationsSecurities portfolio allocations are evolvingDespite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018.Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs.Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.Table 2 indicates conversion activity from C corporation to S corporation status.Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period.Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations.Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes.However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse.As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.Third, tax reform may influence banks’ investment portfolio positioning.While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies.Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018.This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.RefresherInternal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations.If only tax code provisions could be described in one sentence, though.The deduction may be taken against income generated by a Qualified Trade or Business (QTB).A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction.Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not.The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.Other IssuesWhile banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.Qualified Trade or Business DefinitionAn entity must be a Qualified Trade or Business to receive the 20% QBI deduction.From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.”While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition.Unfortunately for taxpayers, the NPR adopts the Section 162 definition.While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague.One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction.For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements.From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.The TCJA’s Definition of an SSTBEntities providing professional services generally are deemed SSTBs.The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets).Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB?Under the TCJA, it was unclear.The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset.This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB.This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.The “Crack and Pack” StrategyCommentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs.For example, consider a law firm that owns a building in which it operates.The law firm is an SSTB and its partners ineligible for the 20% deduction.The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB.Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).Alas, the IRS cracked down on the “crack and pack” strategy.The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction.However, the NPR may not entirely foreclose on all planning strategies.While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership.Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group.Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings.To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.ConclusionLike a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible.Perhaps a sequel to the NPR is in order.Originally published in Bank Watch, August 2018.1As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances. 2 To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018 NPR confirms this eligibility.

A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).1 The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.2C Corporations & The ActIn 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1). The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates. Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion. ImplicationsThe preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:“Allocation” of Tax SavingsLendingMiscellaneousImplication #1: “Allocation” of Tax SavingsWe know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.3 The allocation between these groups remains unknown, though.CustomersJamie Dimon had a succinct explication of the effect of the Act on customers:And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.4The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.Renasant Corporation has noted already potential pressure on its net interest margin.Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.5EmployeesAn early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.ShareholdersMr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.Implication #2: LendingThe Act potentially affects loan volume with future possible effects on credit quality.VolumeLooked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.QualityWhile we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.6 Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property. Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.Implication #3: Miscellaneous ConsiderationsAdditional considerations include:Effect on Tangible Book ValueTable 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs. From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway. Regulatory Capital7The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.8Business InvestmentsAn emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.9Mergers & AcquisitionsOur understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.Permanence of Tax ReformOne parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?S Corporations & The ActAt the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).10 That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.11 Simple.The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6). S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.12ConclusionFor banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.13 We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.This article originally appeared in Mercer Capital's Bank Watch, January 2018.End NotesLest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.Floor plan financing is exempt from this provision.See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.In addition, §179 allows entities to expense the cost of certain assets.The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.We recognize that the risk of exploding heads is acute with reference to §199A.Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.Suffice to say, §199A is considerably more complex than we have described.It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.Interested in more SSTB arcana?Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.

It’s Not CECL, But It Could Affect YouComplying with the revised disclosure requirements of ASU 2016-01 may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. In listening to presenters at the recent AICPA National Conference on Banks & Savings Institutions, we gathered that some banks are taking their first fitful steps toward implementing the pending accounting rule governing credit impairment. Bankers should not lose sight, however, of another FASB pronouncement that becomes effective, for most banks, in the first quarter of 2018. Accounting Standards Update No. 2016-01 addresses the recognition and measurement of financial assets and liabilities.History of ASU 2016-01A long and winding history preceded the issuance of ASU 2016-01. In 2010, the FASB drafted a predecessor to ASU 2016-01, which required that financial statement issuers carry most financial instruments at fair value. As a result, assets and liabilities presently reported by banks at amortized cost, such as loans, would be marked periodically to fair value. This proposal was almost universally scorned, satisfying neither financial statement issuers nor investors. The FASB followed with a revised exposure draft in 2013, which maintained amortized cost as the measurement methodology for many financial instruments. Stakeholders objected, however, to a new framework in the 2013 exposure draft that linked the measurement method (fair value or amortized cost) to the nature of the investment and the issuer’s anticipated exit strategy. The FASB agreed with these concerns, eliminating this framework from the final rule on cost/benefit grounds.The final pronouncement issued in January 2016 generally maintains existing GAAP for debt instruments, including loans and debt securities. However, the standard modifies current GAAP for equity investments, generally requiring issuers to carry such investments at fair value. Restricted equity securities commonly held by banks, such as stock in the Federal Reserve or Federal Home Loan Bank, are excluded from the scope of ASU 2016-01; therefore, no change in accounting for these investments will occur. Excluding these restricted investments, community banks typically do not hold equity securities, and we do not discuss the accounting for equity investments in this article. Interested readers may wish to review a previous Mercer Capital article summarizing certain changes that ASU 2016-01 makes to equity investment accounting.Entry vs. Exit PricingWhile ASU 2016-01 maintains current accounting for debt instruments, it does contain several revisions to the fair value disclosures presented in financial statement footnotes. Originally issued via SFAS 107, these requirements were codified in ASC Topic 825, Financial Instruments. Although ASU 2016-01 makes several changes to the qualitative and quantitative disclosures that are beyond the scope of this article, the most significant revisions are as follows:“Public Business Entities” must report the fair value of financial instruments using an “exit” price concept, rather than an “entry” price notion.1Non-Public Business Entities are no longer required to present the fair value of financial instruments measured at amortized cost, such as loans, in their footnote disclosures. Current GAAP is ambiguous regarding whether the fair value of financial instruments measured at amortized cost should embrace an “entry” or “exit” price notion. According to the FASB, this has led to inconsistent disclosures between issuers holding otherwise similar financial instruments. Certain sections of ASC Topic 825, which carried over from SFAS 107, could be construed as permitting an “entry price” measurement. For example, existing GAAP provides an illustrative footnote disclosure describing an entity’s fair value estimate for loans receivable:The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. [ASC 825-10-55-3, which is superseded by ASU 2016-01]By referencing “current rates” on “similar loans,” the guidance implicitly suggests an “entry” price notion, which represents the price paid to acquire an asset. Instead, ASC Topic 820, Fair Value Measurement, which was issued subsequent to SFAS 107, clearly defines fair value as an exit price; that is, the price that would be received upon selling an asset.Limitations of ALCO ModelsIn our experience, banks often use fair value estimates derived from their asset/liability management models in completing the fair value footnote disclosures for loan portfolios. Reliance on ALCO models suffers from several weaknesses when viewed from the perspective of achieving an exit price measurement:The discount rates applied in the ALCO model to the loan portfolio’s projected cash flows utilize current issuance rates on comparable loans. In certain market environments, the entry price for a loan portfolio developed using this methodology may not differ materially from its exit value. However, this approach becomes problematic when economic or financial market conditions suddenly change or the bank ceases underwriting certain loan types.The treatment of credit losses is not directly observable. Instead, the ALCO model implicitly assumes that the discount rates applied to the portfolio’s projected cash flow capture the inherent credit risk. However, this process does not necessarily correlate the fair value measurement to underlying credit risk. For example, a bank’s automobile loans underwritten in 2015 may be underperforming expectations at origination and also performing poorly compared with 2016 and 2017 originations. The fair value measurement should not apply the same discount rate to each vintage, given the disparate credit performance.Compliance GuidanceComplying with the revised disclosure requirements of ASU 2016-01, therefore, may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. Mercer Capital has significant experience in determining the fair value of loan portfolios from which we offer the following guidance:ASC 820 emphasizes the use of valuation inputs derived from market transactions, but such transactions seldom occur among loan portfolios similar in nature to those held by community banks. If available, market data should take precedence.Absent market transactions, banks will rely on a discounted cash flow analysis to determine an exit price. To a limited extent, this is consistent with current ALCO modeling, but achieving an exit price requires additional considerations. While valuation should be tailored to each portfolio’s characteristics, certain common elements are embedded in Mercer Capital’s determinations of a loan portfolio’s exit value:Contractual cash flows. Consistent with current ALCO forecasting models, contractual cash flow estimates should be projected using a loan’s balance, interest rate, repricing characteristics, maturity, and borrower payment amounts.Loan Segmentation. To create homogeneous groups of loans for valuation purposes, the portfolio should be segmented based on criteria such as loan type and credit risk. Credit risk, as measured by metrics such as delinquency status or loan grade, can be manifest in the fair value analysis either through the credit loss forecast or the discount rate derivation.Prepayments. The contractual cash flows should be adjusted for potential prepayments, based on market estimates, as available, or the bank’s recent experience.Credit Losses. If not considered in the discount rate derivation, the projected cash flows should be adjusted for potential defaulted loans. In a fair value measurement this is a dynamic, forward-looking concept. It also is consistent with the notion in the Current Expected Credit Loss model—which underlies the recent FASB pronouncement regarding credit losses—that credit losses should be measured over the life of the loan.Discount Rate. The discount rate should be viewed from the perspective of a market participant, given current financial conditions and the nature of the cash flow forecast. Mercer Capital often triangulates between different discount rate approaches, depending on the strength of available data. For example, we may consider (a) a weighted average cost of funding the loan, (b) market yields on traded instruments bearing similar risk, or (c) recent offering rates in the market for similar credit exposures. Mercer Capital has developed fair value estimates for a wide variety of loan portfolios, on an exit price basis, ranging in size from under $100 million to over $1 billion, covering numerous lending niches, and possessing insignificant to severe asset quality deterioration. We have the resources, expertise, and experience to assist banks in complying with the new requirements in ASU 2016-01. This article originally appeared in Mercer Capital's Bank Watch, September 2017.End Note1 The definition of a “public business entity” is broader than the term may suggest. A registrant with the SEC is clearly a PBE, but the definition also includes issuers with securities “traded, listed, or quoted on an exchange or an over-the-counter market” (emphasis added). A number of banks “trade” on an over-the-counter market and therefore would appear to be deemed PBEs, even if they are not an SEC registrant. The following entities are also deemed PBEs:Entities filing Securities Act compliant financial reports with a banking regulator, rather than the SEC.Entities subject to law or regulation requiring such institutions to make publicly available GAAP financial statements, if there are no contractual restrictions on transfer of its securities.

In contemplating August’s market activity, our thoughts drifted to Roman times. In 45 B.C., the Roman Senate honored Julius Caesar by placing his name on the month then known, somewhat drably, as Quintilis. Later, the Senate determined that Augustus Caesar deserved similar recognition, placing his name on the month after July. But this created an immediate issue in the pecking order of Roman rulers – up until then, months alternated between having 30 and 31 days. With July having 31 days, poor Augustus’ stature was diminished by placing his name on a month having only 30 days. To rectify this injustice, the Senate decreed that August also have 31 days, accomplished by borrowing a day from February and shifting other months such that September only had 30 days (to avoid having three consecutive 31-day months).We provide this historical interlude to illustrate that, while July and August now are equivalent in terms of the number of days, the market environment in these two months during 2015 bore few similarities. In August, volatility returned, commodity prices sank, and expectations of Federal Reserve interest rate action in September diminished.Most broad stock market indices declined between 6% and 7% in August, taking the indices generally to negative territory year-to-date in 2015. As indicated in Figure 1, except for the largest banks, publicly-traded banks generally outperformed the broader market, both year-to-date in 2015 and in August specifically. For the year, banks benefited from several factors. First, investors appear to expect that rising interest rates will, if not enhance banks’ earnings, at least prove to be a neutral factor. Other sectors of the market, though, may be less fortunate, as companies face higher interest payments or other adverse effects of higher interest rates. Second, banks generally reported steady growth in earnings per share, as assisted by a benign credit environment. Within any index, though, the performance of individual companies may vary greatly. Seeking to isolate factors influencing the August market performance, we focused on publicly-traded banks with assets between $500 million and $5 billion. Given the market backdrop, these 212 banks performed relatively well in August, with a median share price depreciation of only 1.1% (see Figure 2). For the year, the median bank reported a 2.9% increase in its stock price. While linking company-specific factors to market performance during a volatile period is difficult, we identified three groups of banks that underperformed in August: After losing investor favor in the second half of 2014, banks in the oil patch states of Louisiana, Oklahoma, and Texas performed well in 2015, advancing by 9% between December 31, 2014 and July 31, 2015. However, oil prices falling below $40/barrel dealt these banks a setback in August, as the median share prices of banks in these states fell by 5%.All the banks that completed IPOs during 2015 fell during August, with a median depreciation of 6%. Nevertheless, post-IPO performance remains favorable, as all the banks reported share prices at August 31, 2015 that exceeded their IPO prices by 10% to 20%. Investors in these banks may have wished to realize profits during a volatile period.Banks identified with Asian American communities also suffered, owing to their perceived greater exposure to slowing economies in China and throughout the Asian region. Even after the August decline, though, these banks have reported solid performance in 2015. Several risks that influenced August’s volatility have not dissipated, including uncertainty surrounding China’s opaque (and potentially over-leveraged) economy and the effect of any Fed policy tightening. Analyst estimates for 2016 EPS often suggest favorable growth over 2015, and such estimates bear watching to the extent that the recent market volatility spills over into the real economy.