The Value of Internal Audit Through a Fresh Set of Eyes

By: Jeanette McKeever, CCBIA, Consultant & Internal Audit Operations Manager

There is risk in every aspect of the banking industry and the regulatory environment seems to continually change. As to the governance and control functions of the banking industry, it may be refreshing to the board of directors, audit committee, and executive management to have their internal audit function re-assessed and validated though a fresh set of eyes to assure that the controls in place are functioning as intended.

A strong internal control system, including an independent and effective internal audit function, is part of sound corporate governance. The board of directors, audit committee, senior management, and supervisors must be satisfied with the effectiveness of the bank’s internal audit function, that policies and practices are followed, and that management takes appropriate and timely corrective action in response to internal control weaknesses identified by internal auditors. An internal audit function provides vital assurance to a bank’s board of directors (which ultimately remains responsible for the internal audit function, whether in-house or outsourced) as to the quality of the bank’s internal control system. In doing so, the function helps reduce the risk of loss and reputational damage to the bank.

All internal auditors (whether in-house or outsourced) must have integrity and professional competence, including the knowledge and experience of each internal auditor and of team members collectively. This is essential to the effectiveness of the internal audit function.

We encourage bank internal auditors to comply with national professional standards, such as those issued by the Institute of Internal Auditors, and to promote due consideration of prudent issues in the development of internal audit standards and practices.

The scope of the internal audit function’s activities should ensure adequate coverage of matters of regulatory interest within the bank’s audit plan.  Regular communication by the audit committee, management, and affected personnel is crucial to identify the weaknesses and risk associated to assure that timely remedial actions are taken.

Young & Associates, Inc. can independently assess the effectiveness and efficiency of the bank’s internal controls and processes to provide value and assurance that the internal control structure in place operates according to sound principles and standards.

For more information on how we might provide internal audit services specific to your bank’s needs, whether it is outsourced or co-sourced, please contact me at 1.800.525.9775 or e-mail jmckeever@younginc.com.

Liquidity Risk Management

By: Martina Dowidchuk, Senior Consultant

Does your liquidity management meet the standards of increased regulatory scrutiny?

What was once deemed acceptable is gradually coming under a more rigid review, and financial institutions need to be prepared to show that their liquidity risk oversight complies with both supervisory guidance and sound industry practices.

The liquidity risk may not be among the areas of community banks’ immediate concern given the abundance of liquidity in the banking industry today. However, the history shows that liquidity reserves can change quickly and the changes may occur outside of management’s control. A bank’s liquidity position may be adequate under certain operating environments, yet be insufficient under adverse environments. Adequate liquidity governance is considered as important as the bank’s liquidity position. While the sophistication of the liquidity measurement tools varies with the bank’s complexity and risk profiles, all institutions are expected to have a formal
liquidity policy and contingency funding plan that are supported by a liquidity cash flow forecast, projected liquidity position analysis, stress testing, and dynamic liquidity metrics customized to match the bank’s balance sheets.

Some of the common liquidity risk management pitfalls found during annual independent reviews include:

Cash Flow Plan

  • Lack of projected cash flow analysis
  • Inconsistencies between liquidity cash flow assumptions and strategic plan/budget
  • Lack of documentation supporting liquidity plan assumptions
  • Overdependence on outdated static liquidity ratios and lack of forward-looking metrics
  • Lack of back-testing of the model

Stress Scenarios

  • Stress testing of projected cash flows not performed
  • Stress tests focusing on a single stress event rather than a combination of stress factors
  • Stress tests lacking the assessment of a liquidity crisis impact on contingent funding sources
  • Insufficient severity of stress tests

Contingency Funding Plan Document

  • Contingency funding plan failing to address certain key components, such as the identification of early warning indicators, alternative funding sources, crisis management team, and action plan details
  • Lack of metrics defined to assess the adequacy of primary and contingent funding sources in the baseline and stressed scenarios

Liquidity Policy

  • Inadequate risk limits or lack of acceptable levels of funding concentrations defined in the liquidity policy
  • Liquidity policy failing to address responsibilities for maintenance of the cash flow model, model documentation, periodic assumption review, and model validation

Management Oversight

  • ALCO discussions related to liquidity management not containing sufficient detail and not reflected appropriately in the ALCO meeting minutes
  • Lack of periodic testing of the stand-by funding lines
  • Lack of liquidity model assumption review or documentation of such review
  • Lack of periodic independent reviews of the liquidity risk management process

If you are interested in an independent review of your existing liquidity program and a model validation or are looking for assistance with developing a contingency funding plan, liquidity cash flow plan, and liquidity stress testing, please contact me at 1.800.525.9775 or mdowidchuk@younginc.com. Young & Associates, Inc. offers an array of liquidity products and services that can help you to ensure compliance with the latest regulatory expectations.

A Look to the Future

By: Jerry Sutherin, President & CEO, Young & Associates, Inc.

On January 31, 2018, I was fortunate to have the opportunity to purchase Young & Associates, Inc. from Mr. Gary Young, the company’s founder and current Chairman. Nearly 40 years ago, Gary created this organization with a vision of providing community banks with consulting services that were typically cost-prohibitive to perform internally. Since its inception in 1978, Young & Associates has evolved from a small start-up organization offering select outsourcing and educational services to one of the premier bank consulting firms with clients nationwide and overseas. We now offer consulting, education, and outsourcing services for nearly every aspect of banking.

From the outset of our acquisition discussions, Gary and I agreed that the greatest asset of the company is its employees. Over the years, not only has Gary developed unique servicing platforms for the industry but more importantly, he has assembled an employee base that is second to none. These employees provide a level of expertise and service to our clients that remains unparalleled in the community banking industry.

To quote Gary, “I founded Young & Associates with the goal of assisting community banks while maintaining a family atmosphere that valued and respected the people that I work with.” Going forward, it is my primary objective to carry on this legacy that Gary has created. I look forward to making this a seamless transition building on the solid foundation that Gary has built over the years. With the work of our employees and support of our clients, there is no doubt that Gary’s legacy will continue for years to come.

Although the ownership of Young & Associates, Inc. has changed, the company’s name, mission, personnel, quality of service, and structure will not change in any way. Gary now serves as Chairman of the Board and will remain actively involved with the business through January 2019, providing the same high-quality service while also assisting me with the transition. In addition to ensuring a smooth internal transition, Gary and I remain focused on making sure that the relationship with our clients remains strong. Existing and new clients are encouraged to contact me, Gary, or any of our consultants to discuss this transition and how we might be able to earn your business.

Capital Market Commentary – 2018 Forecast and 2017 in Review

By: Stephen Clinton, President, Capital Market Securities, Inc.

The stock market continued its climb to new heights in 2017. The stock market was propelled by the election of President Trump, which brought the expectation of lower taxes, less regulation, and an administration favorable to businesses. The Dow ended 2017 at 24,719.22, an increase of 25.08% for the year. The S&P 500 also improved nicely, ending up 19.42%. The market, despite a correction in early February, has increased further from 2017’s year-end values.

The Fed continued its plan to move short-term interest rates higher in 2017. The Fed moved short-term rates up 25 b.p. in March, June, and December. The three-month T-Bill ended December at 1.39%, an increase of 88 b.p. from year-end 2016. Longer-term interest rates were little changed from year-end 2016, resulting in a flatter yield curve.

Job creation continued in 2017, and the unemployment rate in December was 4.1%. The unemployment rate is at a level not seen in 17 years. The low unemployment rate would typically lead to rising wages, but wage growth was only around 2% in 2017.

As we enter 2018, there are a number of items worth monitoring:

  • Economic Growth. U.S. economic growth for 2017 came in at 2.5%, comparable to prior years. The slow but steady expansion that began in mid-2009 ranks as the third longest economic expansion in U.S. history. Should the recovery continue into the second half of 2019, it would become the longest recovery on record, surpassing the 1990’s economic boom.
  • Housing. Home prices continued to rise in 2017. The S&P/Case-Shiller National Home Price Index rose 6.2% in the 12 months ending in November. The rising price for homes has exceeded inflation and wage growth for several years. The limited housing inventory has aided the rise in prices along with historically low mortgage rates. U.S. single-family homebuilding surged to more than 10-year highs in November. Existing home sales were up 5.6% in December, while new home sales increased 17.5%.
  • Industrial Production. U.S. manufacturing activity remains strong. The Institute for Supply Management said its purchasing managers index rose to 59.7 in December, the second highest level since early 2011. A reading over 50 indicates expansion in the sector; below 50 suggests contraction. Boeing recently announced deliveries of 763 aircraft in 2017, a record for the company. Auto sales were down 1.8% in 2017, but with sales of 17.2 million vehicles, it marked the first time the industry has surpassed 17 million for three consecutive years.
  • Consumers. Consumer confidence is positive. The University of Michigan’s consumer sentiment index average level for 2017 was the highest since 2000. A sign of the strong consumer sentiment is reflected in consumer debt. In the fourth quarter, consumer debt, excluding mortgages and other home loans, rose 5.5% from a year earlier. That is the highest amount since the Federal Reserve Bank of New York began tracking the data in 1999. Moreover, consumers’ non-housing debts accounted for just over 29% of their overall debt load, also the highest amount on record.
  • Inflation. The Fed’s preferred measure of inflation in January was 2.1%, moving above the Fed’s target of 2% for the first time in a while. The anticipated 3% growth of the economy along with the tight labor market and rising interest rates is expected to finally push inflation upward.
  • Political Risks. There are a number of geo-political risks that could significantly change the outlook for 2018. Among these are the ongoing Brexit process, North Korea nuclear saber rattling, and President Trump’s plans to renegotiate NAFTA. Furthermore, the dysfunction in Washington creates uncertainty.

Predictions for 2018

  • Lending Activity. We anticipate an increase in lending activity. We think the lower tax rate for businesses will encourage businesses to expand their operations.
  • Interest Rates. The Fed has indicated that three rate increases are probable in 2018. We think that we will get those increases.
  • Home Prices. We expect the growth rate in home prices to be lower than in the past several years. We think higher interest rates will come into play and make housing less affordable. We also think that the less favorable tax status of the deductibility of mortgage interest will have an impact on some home buyers.
  • Inflation. We do see inflation moving up in 2018. As mentioned above, we expect wage increases to heighten. The low unemployment rate and the shortage of skilled labor in many markets will put pressure on employers to increase wages to attract and retain workers. We also think the growing economy will impact commodity prices.
  • Jobs. We envision unemployment to remain low as businesses expand.
  • Regulation. We expect bankers to be disappointed about the lack of regulatory relief in 2018. It will be difficult for regulatory relief to filter down the bank regulatory bureaucracy.

Merger and Acquisition Activity
Merger activity in 2017 was slightly higher than the activity in 2016. In 2017, there were 267 announced mergers of banks and thrifts compared to 244 deals in 2016. In terms of deal size, the total assets of sellers totaled $147 billion in 2017, compared to $188 billion in 2016 and $459 billion in 2015. Pricing on 2017 bank sales improved significantly from 2016’s pricing, recording a median price to book multiple of 162% and a price to earnings multiple of 20.9 times. We believe that 2018 will see increased merger activity spurred, in part, by bank buyers’ enhanced profitability from reduced corporate taxes

Capital Market Services
Young & Associates, Inc. has a successful track record of working with our bank clients in the development and implementation of capital strategies. Through our affiliate, Capital Market Securities, Inc., we have assisted clients in a variety of capital market transactions. For more information on our capital market services, please contact Stephen Clinton at sclinton@younginc.com or 1.800.376.8662.

Young & Associates, Inc. Changes Ownership on 1/31/18

We are pleased to announce that Young & Associates, Inc. has been sold by Gary J. Young, the company’s founder, to Jerry Sutherin, a Senior Consultant with the firm, effective January 31, 2018. While ownership has changed, the company’s name, mission, personnel, quality of services, and structure will not change in any way.

Upon the effective date of the sale, Mr. Young became Chairman of the Board, and Mr. Sutherin became President and CEO. Young will remain actively involved with the firm for one year, continuing to provide the same high quality service he has provided for the past 40 years. Mr. Young said, “I founded Young & Associates with a goal of assisting community banks while maintaining a family atmosphere that valued and respected all of the people that I work with. After 39+ years, I have accomplished that goal, and that mission will continue through Jerry’s leadership.”

Tommy Troyer, Executive Vice President, will continue to serve in that position, where he successfully uses his professional expertise, detail-oriented management style, and excellent people skills while working with both clients and employees.

Mr. Sutherin has worked at Young & Associates, Inc. for nearly four years. Mr. Sutherin said, “I look forward to making a seamless transition at Young & Associates, building upon the solid foundation that Gary has built over the past 40 years. It is my goal that our clients and employees will continue to receive the same professional, high-quality experience that they have come to expect here over the years.”

With over 30 years in the financial services industry, Sutherin has worked primarily in the company’s Lending and Loan Review Division where he provided community banks throughout the U.S. with third-party loan review, lending policies and procedures, loan portfolio due diligence, and ALLL Review services. Prior to joining Young & Associates, Inc., Sutherin worked in varying capacities ranging from overseeing an Asset Quality/Loan Review function at a large regional bank, to managing a $2.5 billion loan portfolio responsible for loan performance, credit quality, and departmental efficiency.

Young & Associates, Inc. has provided practical products and services to community financial institutions since 1978, and we look forward to serving our clients for many years to come. Please join us in congratulating both Jerry and Gary on this sale.

ADA Website Compliance Notes from the Field

By: Mike Lehr, Human Resources Consultant

About this time last year, the topic of website accessibility and accommodation under Title III of the Americans with Disabilities Act (ADA) hit the community banking industry with full fury. Since that time both banks and service providers have upped their game. So, now is a good time for us to assess and share what we have learned in our ADA website audits.

There are two ways to assess sites. The more common and less expensive way involves scanning the site using software. Based on the logic coded into it, the software identifies potential issues. The second, less common, and more expensive way involves professionals or sight-impaired people using the site with a screen reader. A screen reader is software that converts a site page to text and reads it to the user.

Both ways involve a professional overseeing the process to interpret the results. Yet, something else drives both ways that tend to lead clients astray – measurability. The old adage of “what gets measured gets done” hits full force here. However, just because it’s a number doesn’t mean it’s more important. We are finding that the software scan, because of its beautifully quantifiable graphics, is causing many of our clients to focus on minor, even insignificant aspects of their sites that have little to no impact on the site’s overall accessibility.

In the end, if a bank ever ends up in court, it’s not about software being able to access the site. It’s about individuals with disabilities. Yet, it is much harder to quantify that into an eye-catching chart. For instance, a client called worried about their PDFs. The software scan showed them inaccessible. Moreover, they spent a lot of time trying to fix them. The nature of the documents were such that they required a professional printer. In short, it wasn’t a Word document. Upon closer look, there were only a dozen of them. All but one were on the same page of the site. Furthermore, the page saw little traffic from customers and prospects. Plainly, the page wasn’t important.

Yet, since bankers can be conscientious to a fault, it bugged them that these PDFs kept showing up “red” as an issue. By itself it’s not bad. In context of the whole site though, it is. This was energy, time, and money diverted from far more important issues. One was whether a sight-impaired person can navigate the site. Software can’t determine this. One can only determine this reliably by using a screen reader or by observing a sight-impaired person trying.

For instance, it’s not uncommon these days to find sites that have multiple ways to navigate them. On one hand, you have the traditional horizontal navigation. On the other, you have the more recent mobile friendly navigation (“hamburger menu”). Still yet, some sites use vertical left-hand (or less common right-hand) navigation. That’s three ways to navigate the site. We’ve seen these on a couple of sites already. This doesn’t even include all the links and smaller menus that might be contained within the page.

Now, to a sight-impaired person, this is nothing but chaos. Keep in mind, a non-sight-impaired person can see the whole site at once. It’s two-dimensional. He/she can select whatever menu they like. A sight-impaired person doesn’t have this luxury. That’s because a screen reader can only read one word at a time. It’s a linear process, one-dimensional.

Also, he/she might tell the screen reader to only read navigation menus. So, if he/she starts hearing two or three different menus, it becomes hard to visualize in his/her mind how he/she might use the site. To a sight impaired person, they blend together as one. That’s frustrating. It’s also something else . . . inaccessible.

Yet, in most cases, as long as these menus are coded and tagged right, the software scan won’t catch them. Moreover, and back to the original point about measurability, it’s hard to quantify this user experience. The solution then is to code one of these menus invisible to screen readers. Of course, that means the remaining one has to be comprehensive and robust.

In the end, it’s a battle between easily measurable but unimportant PDFs and unmeasurable but important navigation. What gets measured gets done. Thus, the unimportant gets done and the important doesn’t. That’s why we can give compliance ratings to clients who still have issues on their software scans and non-compliant ones to clients whose scans show no issues.

In short then, invest in a screen reader. If not, partner with someone who has one. Banks can generate much goodwill by reaching out to groups and societies that support Americans with Disabilities. Remember, computers don’t use sites. People do. People also testify in court.

For more information on this article or to learn how Young & Associates, Inc. can assist your bank with its ADA website compliance, contact Mike Lehr at 1.800.525.9775 or mlehr@younginc.com.

Capital Market Commentary – August 2017

By: Stephen Clinton, President, Capital Market Securities, Inc.

Market Update
The U.S. has entered the ninth year of economic expansion. While the growth has not been spectacular, it has been steady. GDP expanded at a 2.6% annual rate in the second quarter. The GDP growth in the current recovery has averaged 2.1%. This compares to the 3.6% average of the 1990’s recovery and the 4.9% average for the 1960’s expansion. (These are the most recent economic recoveries of comparable length to the current expansion.)

  • American’s largest companies were reported to be on pace to post two consecutive quarters of double-digit profit growth for the first time since 2011. Factors explaining the growth in profitability include a weaker dollar that helped U.S. exports, limited wage growth, and cost cutting programs.
  • Unemployment was reported at 4.4% in June, near the lowest rate in a decade.
  • Despite nearing full employment, wage growth has increased only modestly. It was reported that wages increased .5% in the second quarter.
  • At the Federal Reserve meeting in July, the Fed held interest rates unchanged but announced that it soon will begin to shrink its securities portfolio. The Fed currently holds more than $4 trillion of investments; a large portion of these were purchased as part of the Fed’s quantitative easing programs.
  • Consumer spending rose at a 2.8% pace in the second quarter, an increase from 1.9% in the first quarter. However, concerns remain about the spending outlook at a time of soft wage growth, stalling car sales, and a growing overhang of auto and student-loan debt.
  • U.S. business investment rose for the second straight quarter. In the second quarter, nonresidential fixed investment advanced at a 5.2% pace. That comes on the heels of a 7.2% gain the prior quarter. The continuation of strong business spending suggests firms have confidence in the durability of the economic expansion.
  • The U.S. housing market continues to improve. After falling throughout the usually busy spring season, the monthly index of signed contracts to purchase existing homes increased 1.5% in June compared with May. The Case-Shiller Index, which measures the increase in home prices across the country, rose 5.6% in the 12 months ending in May.
  • Overall, inflation continues to be held in check. The U.S. inflation index was 1.4% in May, well below the Fed’s 2% target.

The stock market has reached all-time highs. This has occurred despite the lack of action on President Trump’s plans for lowering taxes and economic stimulus. Should these initiatives be enacted, 2017 should be a very good year for investors.

Interesting Tid Bits ƒƒ

  • The New York Times recently reported that homeowners now stay in their homes for an average of 8½ years, up from the 3½ year average in 2008.
  • Twenty years ago, there were 7,322 listed public companies in the U.S. At the end of 2016, there were only 3,671 companies publicly traded on U.S. exchanges.
  • Deer & Co., the maker of farming equipment, is the fifth largest agricultural lender. This is in addition to the billions that they lend to farmers to fund purchases of their farming equipment.
  • It is widely anticipated that the Libor index will be phased out over the next five years. Libor is used to set the price on trillions of dollars of loans.

Short-term interest rates have moved up in response to the Fed’s actions of increasing short-term rates with the 3-month T-Bill ending July at 1.07%.

The 10-year T-Note ended July at 2.30%. The yield curve has flattened this year with the 10-year T-Note falling 14 basis points while short-term rates moved up 56 basis points.

The general stock market reached historic highs in July. The Dow Jones Industrial Index ended July 31 at an all-time high and was up 10.77% for the year. The Nasdaq Index closed up 17.93% for the year. Banks have under-performed the general stock market this year. The Nasdaq Bank index was down 3.10% for the year. However, since the election, bank stocks are up 22.50%, which is a larger increase than the Dow Jones Industrial Index since the election.

Merger and Acquisition Activity
Through July there were 147 bank and thrift announced merger transactions. This compares to 151 deals for the comparable period in 2016. Despite the slightly lower number of deals, the total assets involved in transactions increased from $109 billion to $124 billion. The median price to tangible book for transactions involving bank sellers was 162%.

Developing a Consensus on Capital Adequacy – The First Step in Strategic Planning

By: Gary J. Young, Founder and CEO

The most critical component of every strategic plan is a thorough understanding of your position on capital adequacy and your target for capital. They are not the same.

The Regulator View of Capital
As community bankers, we have all heard the mantra that we need to increase capital. It may be an over simplification, but to the regulator more is always better. The regulator does not have interest in your shareholders. And as I will discuss later in this article, an increase in capital lowers the return on equity, or the return to shareholders. The regulator’s #1 job is to ensure a safe and sound banking system. Your job is to satisfy the regulators and your shareholders. You have to balance the interests of both. You need to proactively communicate your bank’s opinion regarding capital.

An example of the need to balance is shown below. There are four banks with a 1% ROA. However, the equity/asset ratio at each is different ranging from an 8.0% leverage ratio to a 12.0% leverage ratio. By dividing the ROA by the leverage ratio, you get the ROE. By multiplying the ROE by an assumed PE, you get the multiple of book. In this example, the bank with an 8.0% leverage ratio has a value of $30 million while the bank with a 12.0% leverage ratio has a value of $20 million. The amount of capital provides a significant difference in the return to shareholders.

Capital Adequacy
I agree with the OCC. Capital adequacy at each bank is uniquely based on the current and planned risk within the bank. And, it is the responsibility of the bank board to determine capital adequacy with the input from executive management. Capital adequacy is the point that if capital falls below, the Capital Contingency Plan must be implemented. In other words, let’s assume capital adequacy has been defined as a 7.5% leverage ratio, or an 11.25% total risk-based ratio. If actual capital falls below either measure the bank should implement the methodology for improving capital as described in the Capital Contingency Plan.

Capital Target
A bank’s target or goal for capital is higher than capital adequacy. It is an estimate of the amount the board of directors has decided is desired to take advantage of opportunities such as additional organic growth, branch expansion, purchase of a bank or branch, stock repurchase, etc., or to use as additional insurance or protection against negative events that could hurt profitability and capital. As an example, a 7.5% leverage ratio could be defined as capital adequacy, but the target level of capital is 9.0%.

The Right Amount
There is no right amount. The average $300 million – $1 billion bank has a 10.3% leverage ratio and a 15.4% total risk-based capital ratio. Most everyone would agree that banks do not need that level of capital. But, every bank is unique with different levels of risk and different levels of risk appetite. The important thing is that executive management and the board of directors understand that there is a shareholder cost to holding excess capital. That doesn’t make it wrong. The board of directors has multiple responsibilities and at times these can be conflicting. From the shareholder perspective, you want to maximize the return on equity and shareholder value which assumes leveraging capital, but you must also oversee the operation of a safe and sound bank. And, at the heart of safety is capital adequacy. It takes balance and awareness of both to determine the right level of capital for your bank. My concern is that through the Great Recession and after, the capital mantra has been more is better. Well frankly, more is not necessarily better. I am suggesting that it is time to balance the capital need for risk management with the capital need for improving shareholder value.

Strategic Planning
After there is agreement on capital based on risk, planning can begin on the methodology or methodologies to best utilize any existing or planned excess capital. The recommended considerations that follow do not address all of the issues within your mission statement or vision statement. Rather, these address your desire to maximize shareholder return and to maintain your bank’s independence.

Consider the following:ƒƒ

  • Ways to generate additional organic growth. This means growth from your market without any significant increases in infrastructure. This is normally the most profitable short-term methodology.
  • Expansion opportunities. I would suggest looking for opportunities that begin turning a profit in two years or less. While this is long-term, most bankers are in for the long haul. Remember, a branch that increases net income by $500,000 increases shareholder value by $6,500,000, assuming a 13 price-earnings ratio.
  • The purchase of another bank or branches. This can significantly impact capital, but once the target is effectively absorbed by your bank, the value rewards can be great. But, also make sure you adequately consider the risks.
  • A stock repurchase plan. This is a win for the shareholders that want to sell and the shareholders that want to hold. Everyone wins and shareholder value should increase. I look at this as buying your bank as opposed to buying another bank. I recommend to every client that has a tier-1 leverage ratio in excess of 9% that they should at least consider a stock repurchase.
  • A slow, steady increase in dividends to shareholders. If after all other approaches to capital utilization excess capital remains, then increase the dividend. This will increase dividend income to shareholders without jeopardizing capital adequacy.

Consider how all of these items might impact your capital adequacy, return on equity, and shareholder value over a 3-5 year period. Remember, the goal of executive management is to maximize profitability and shareholder value within capital guidelines approved by your board of directors.

Contact
If you would like to discuss this article with me, you can reach me by phone at 330.422.3480 or e-mail at gyoung@younginc.com.

Excess Capital is Hurting Shareholder Return

By: Gary J. Young, President and CEO

The Mantra
As community bankers, we have all heard the mantra to increase capital. This is heard by the banker that has an 8% leverage ratio who needs to increase capital to 9%, by the banker who has a 9% leverage ratio that needs to increase capital to 10%, and by the banker who has a 10% leverage ratio that needs to increase capital to 11%. Based on this view regarding capital, more is always better. I disagree.

Capital Adequacy
I agree with the OCC. Capital adequacy at each bank is uniquely based on the current and planned risk within the bank. And, it is the responsibility of the bank board to determine capital adequacy with the input from executive management. Capital adequacy is the point in which a capital contingency plan is implemented if actual capital falls below that level. In other words, let’s assume capital adequacy has been defined as a 7.5% leverage ratio, or an 11.25% total risk-based ratio. If actual capital falls below either measure the bank should implement the methodology for improving capital as described in the capital contingency plan.

Capital Target
A bank’s target or goal for capital is higher than capital adequacy. It is an estimate of the amount the board of directors has decided is needed to take advantage of opportunities such as additional organic growth, branch expansion, purchase of a bank or branch, stock repurchase, etc., or to use as additional insurance or protection against negative events that could hurt profitability and capital. As an example, a 7.5% leverage ratio could be defined as capital adequacy, but the target level of capital is 9.0%.

Cost
Excess capital has a cost. Let’s assume you had to eliminate $1 million of excess capital. To balance that transaction, you would also eliminate $1 million in assets which would be investments. Let’s assume that the investments had an average yield of 1.5%. After taxes, that would be approximately 1.0%. Based on this example, the return on equity of the $1 million of excess capital is 1.0%. We must agree that 1.0% is unacceptable. Well, it is unacceptable unless that is your return for opportunity capital or insurance capital as described above.

Another example of the cost of excess capital can be seen in the table on page 2. There are four banks with a 1% ROA. However, the equity/asset ratio at each is different, ranging from an 8.0% leverage ratio to a 12.0% leverage ratio. By dividing the ROA by the leverage ratio, you get the ROE. By multiplying the ROE by an assumed PE, you get the multiple of book. In this example, the bank with an 8.0% leverage ratio has a value of $30 million while the bank with a 12.0% leverage ratio has a value of $20 million. This is a simplified example that provides information on the cost of excess capital.

The Right Amount
There is no right amount. The average $300 million – $1 billion bank has a 10.3% leverage ratio and a 15.4% total risk-based capital ratio. Most everyone would agree that banks do not need that level of capital. But, every bank is unique with different levels of risk and different levels of risk appetite. The important thing is that executive management and the board of directors understand that there is a shareholder cost to holding excess capital. That doesn’t make it wrong.

The board of directors has multiple responsibilities and at times they can be conflicting. From the shareholder perspective, you want to maximize the return on equity and shareholder value, which assumes leveraging capital, but you must also oversee the operation of a safe and sound bank. And, at the heart of safety is capital adequacy. It takes balance and awareness of both to determine the right level of capital for your bank. My concern is that through the Great Recession and after, the capital mantra has been “more is better.” Well frankly, more is not necessarily better. I am suggesting that it is time to balance the capital need for risk management with the capital need for improving shareholder value.

Best Practices
The question for executive management is what should I do? It is my opinion that best practices would indicate that every bank develop a definition of capital adequacy based on inherent risk. Furthermore, a capital contingency plan should be part of that plan that indicates the steps the bank might take if capital falls below or is projected to fall below the bank’s definition of capital adequacy. You should then have a frank discussion at the board level on the amount of capital that is your goal or meets your comfort level. If you then find that your capital is above that consider the following:

  • Focus on additional organic growth, if possible.
  • Consider expansion opportunities. I would suggest looking for opportunities that begin turning a profit in two years or less.
  • Develop a stock repurchase plan. This is a win for the shareholders that want to sell and the shareholders that want to hold. Everyone wins and shareholder value should increase.
  • Achieve a slow, steady increase in dividends to shareholders.

Consider how all of these items might impact your capital adequacy, return on equity, and shareholder value over a 3-5 year period. Remember, the goal of executive management is to maximize profitability and shareholder value within capital guidelines approved by your board of directors.

Conclusion
If you would like to discuss this article with me, you can reach me by phone at 330.422.3480 or by email at gyoung@younginc.com.

ADA Website Audits

By: Mike Lehr, HR Consultant

Clients of Young & Associates, Inc. have been receiving demand letters from plaintiffs’ law firms, alleging that their websites aren’t accessible to individuals with disabilities. In effect, these letters claim that they are violating
Title III of the Americans with Disabilities Act (ADA). More press and training have surfaced on this issue too.
If your bank has received such a letter, don’t ignore it. Attorneys we know have had to defend their clients in court over these letters. If your bank has not received one, it’s best to begin working with your legal counsel and reviewing
your website before you do. Proactivity can help here. In our audits to date, the main problem has been clients relying too heavily on assurances from their website vendors and on results from compliance software. Auditing software is a tool, not a judge. As a result, individuals with disabilities might be able to access the website, but they have unreasonable difficulty doing so. The website still isn’t in the clear.

That’s why Young & Associates audits employ four tests:

  1.  Compliance software tests
  2. Manual audit of home pages, main navigation pages, and high problematic pages
  3. Screen reader test by Young & Associates consultant
  4. Screen reader test by a sight-impaired person observed by Young & Associates consultant

Young & Associates audits use the Web Content Accessibility Guidelines (WCAG) 2.0 and the Section 508 Standards for federal agencies as their baselines. To meet our clients’ many different needs, we have three different audits to select from:

  1. ADA Developmental Website Audit: The purpose of this audit is to assist the bank in the development of a new website or to provide a cost-effective first look at a current website that has never been audited or tested in any manner. It employs the compliance software test, the manual audit, and a modified screen reading test.
  2. ADA Compliance Website Audit: The purpose of this audit is to perform a formal compliance audit of the website. It employs the full complement of tests.
  3. ADA Follow-Up Website Audit: The purpose of this audit is to review the changes made to the website in response to the findings of other audits. It usually employs just the compliance software test or a modified application of the full complement of tests.

For more information on ADA Website Accessibility Compliance or how Young & Associates, Inc. can assist your bank in this area, download our “Better Understanding ADA Website Compliance & Young Associates Audit,” or contact Mike Lehr, Human Resources Consultant at 1.330.777.0094 or mlehr@younginc.com.