Management

By: Stephen Clinton, President, Capital Market Securities

Mid-November Market Update
The U.S. is undergoing its longest economic expansion on record, breaking the record of 120 months of economic growth recorded from March 1991 to March 2001. Starting in June of 2009, this record-setting run saw GDP recording growth, albeit at a slower growth rate than previous expansions. The unemployment rate is at 3.6% and job growth continues with employers adding an average of 167,000 jobs this year. The current expansion also includes the longest stretch of job creation on record. The current U.S. economic growth is being driven by consumer spending as businesses have slowed business investment due to the uncertainties surrounding tariffs and global growth concerns.

In late October, the Fed lowered short-term interest rates for the third time this year. These moves follow last year’s four interest rate increases designed to guard against concerns about inflation and financial bubbles. The move to a more accommodative stance is designed to cushion the economy against a slowdown in business investment and in recognition of the uncertainties surrounding the U.S.-China trade conflict. U.S. inflation remains low and below the 2% Fed target which has reduced the Fed’s concern about rising prices and higher labor costs.

While the U.S. economy continues to chug along, things are not as optimistic for our trading partners. China’s economy is slowing dramatically; Japan’s economy grew at the slowest pace in a year in October; and Germany barely skirted a recession in the third quarter. These countries represent the world’s second, third, and fourth largest economies in the world. The global economic slowdown may make it difficult for the U.S. to continue to record GNP growth.
The home mortgage market has benefited from lower interest rates. The average 30-year home mortgage rate has fallen to near 4% from a recent high of 5.2% last November. Lenders made $700 billion in home loans in the July-to-September quarter, the most in 14 years. Mortgage origination activity is on pace to hit the highest level since 2006, the peak of the last housing boom. Refinancing activity is in part responsible for this renewed lending activity with refinancings jumping 75% from last year.

The U.S. government spent nearly $1 trillion more in fiscal year 2019 than it took in, which resulted in the highest deficit in seven years. The deficit has now increased for the last four years, the longest stretch of U.S. deficit growth since the early 1980’s, a period that included two recessions and an unemployment rate near 11%. The deficit has increased 68% since 2016 during a time when there is historically low unemployment and a growing economy. The loss of tax revenues from tax cuts, along with a bipartisan budget deal that increased government spending, are responsible for the growing deficits. Long-term costs associated with an aging population, including Social Security and Medicare, are expected to continue to put pressures on balancing the budget in the future.

U.S. corporate earnings remain strong. With most of the third quarter earnings announcements in the books, 75% have posted results above analysts’ expectations. While overall profits are lower than last year by approximately 2.7%, analysts are projecting improved earnings next year. One growing concern about nonfinancial companies being discussed is the high level of debt corporations hold. The level of corporate debt is at the highest level ever. Low interest rates have made the choice of debt preferable to equity for corporations. This has caused a leveraging of balance sheets.

Short-term interest rates have fallen 35% this year as of November 15. The 3-month T-Bill ended at 1.57%, principally due to the three Fed interest rate cuts. The 10-year T-Note was at 1.84% at November 15, down 85 basis points from the end of last year. After spending some time with a partially inverted yield curve, the shape of the yield curve has moved to its more traditional upward slope. The spread between the 3-month T-Bill and the 10-year T-Note was a narrow 27 basis points.

The stock market reached new highs as of November 15. The Dow Jones Industrial Index was up 20.05% for the year. The broader Nasdaq Index closed up 28.72%. The Nasdaq Bank index was up 16.73%, but the KBW Bank Index was up 26.44%. The stronger upward movement of the KBW Bank Index reflects the strong price increases recorded by larger banks this year.
The market has experienced a high level of market volatility this year. The ups and downs of the U.S.-China trade talks has caused wide market swings. Brexit has been a concern for the market. Protests in Hong Kong have captured attention. The U.S. impeachment inquiry presents market risk. We expect the market to continue to be volatile due to these concerns as well as other issues that may surface and capture the market’s attention.

Interesting Tid Bits

Tariffs – The U.S. collected a record $7 billion in import tariffs in September. This was up 50% from last year as new duties kicked in on Chinese imports.

Taxation – For the first time on record, the 400 wealthiest Americans last year paid a lower total tax rate (federal, state, and local taxes) than any other income group. The overall tax rate on the richest 400 households was 23% last year compared to 70% in 1950 and 47% in 1980.

Manufacturing – Manufacturing makes up approximately 11% of the U.S. GNP, which is down from 16% twenty years ago. Factory workers now make up 8.5% of the overall workforce which is down from 13% two decades ago. There are now more local government employees than factory workers.

Merger and Acquisition Activity
Through November 15 this year, there were 229 bank and thrift announced merger transactions. This compares to 231 deals in the same period last year. The median price to tangible book for transactions involving bank sellers was 158%.

Capital Market Services
Capital Market Securities, Inc. has assisted clients in a variety of capital market transactions. For more information on our capital market services, please contact Stephen Clinton at 1.800.376.8662 or sclinton@younginc.com.

By: Martina Dowidchuk, Senior Consultant

The stock market continues to remind us of its inefficiencies. Most banks saw their stock values decline last year despite the industry’s record levels of earnings, continuing growth, and strong asset quality levels. In fact, the month of December 2018 recorded the greatest monthly stock decline since 1931. The broad market index, the Nasdaq Composite Index, was down 9.5% for the month of December and the banks were impacted even more than the overall market with the Nasdaq Bank Index falling 14.1%. For the year 2018, bank prices declined by 17.9% as measured by the Nasdaq Bank Index. This market correction was caused by a combination of economic and political factors, as well as the market’s perception of their impact on the industry. The Nasdaq Bank Index has showed a considerable improvement since the end of 2018, but as of July 30, 2019, it continues to be more than 9% below the level it reached 12 months ago.

While there will always be external factors outside of any bank’s control affecting the market pricing, the intuitive fundamental relationships tend to remain true among broadly-traded stocks. Regardless of the overall market’s ups and downs, the market values of banks with a higher profitability, stronger growth prospects, and other positive fundamentals are typically higher when compared to banks with weaker performance. However, this is not always true for banks with a limited stock trading activity. To ensure that the improvements in the bank’s performance translate into the shareholder value, the earnings prospects and financial strength need to be proactively communicated to the proper audience so that investors realize the value of a community bank stock and the bank gets a proper credit for its performance.

One of the easiest and fastest proactive measures available is to obtain an independent third-party valuation of the bank’s stock. Professional appraisers use multiple valuation techniques that encompass both sound financial theory and the latest market realities. Different considerations are made depending on the type and purpose of the valuation. Some valuations may require a minority interest value (i.e., a trading value), while others may call for a controlling interest value (i.e., change of control value). A valuation report evaluates the bank’s performance from different perspectives and provides an immediate stock value estimate that can then be communicated to shareholders and potential investors, providing a base point for future trades, stock repurchases, employee stock ownership programs, etc. Furthermore, if the bank has not previously had a valuation of its stock completed, the result in many cases could be a significant, immediate increase in shareholder value as the bank and its shareholders realize the true value and potential of the stock.

For community banks, understanding and proactively managing the shareholder value can be vital for many reasons. Young & Associates, Inc. has been providing valuation services and advice encompassing a variety of transactions and valuation purposes for over 40 years. Our experience in merger and acquisition activities, bank formations, and other capital market transactions gives us the expertise to help our clients understand their market value and make informed decisions as they implement their strategic initiatives. For more information on how Young & Associates, Inc. can assist your bank in this area, give me a call at 330.422.3449 or send an email to mdowidchuk@younginc.com.

By: Bob Viering, Senior Consultant and Manager of Lending Services

For many community banks today, remaining independent is the number one strategic priority. There are many reasons boards believe remaining independent is important: the board believes that the shareholders’ investment will be maximized over a longer time horizon; that the bank as an independent local bank can best serve the needs of the community; that the employees as a whole will be far better served (and have jobs) by remaining independent. These are all reasonable and sincere reasons.

So, if staying independent is important, why are an increasing number of banks selling today? One of the biggest reasons that banks sell is that the board is not confident that there is anyone ready to take over management of the bank. Developing a successor internally is a multi-year process to groom a talented individual to learn enough about the day-to-day responsibilities and skills needed to manage a bank successfully. Hiring a new CEO externally sounds easy, but to find that right person that not only has the skills and background to succeed and also can fit in the community and, most importantly, the bank’s culture can be a very challenging process, especially if you are in a rural community. If something happens that the CEO role is suddenly open, or the CEO decides to retire in a year or less, all too often there is not enough time to find that right person, and the easier decision is to sell while the bank is still running smoothly.

It sounds like having a plan on how the CEO position will be filled is the answer. We’ve seen very simple plans that are a few short paragraphs that basically say, “Joe and Mary can run the bank in the interim. If one of them is not the right person, we’ll just hire someone.” Even for a very small bank, it’s almost never this easy. Even if you believe one of the top managers has the “right stuff” to be the next leader, have you thought about what skills they may need to develop to be ready? Have they had any real experience leading a group or an important project that gives you confidence they can run the place? Can you picture that person standing up in front of your shareholders? Or representing your bank to regulators? Or allowing your other key employees to operate successfully? Can they run the bank when times get tough (and they always do)? If you answered positively to these questions, do you have a plan, with timeframes, to provide the types of training and experience so that they will be ready to take over?

Even if you are confident you have the right person to take over, or you start early enough to recruit your next leader, what about the next level of management? Are they ready to step up when Joe or Mary ascends to the top spot? Do you have a plan to develop that next level of management? As you step through the layers of your organization, it often becomes clear that there are other key employees that would impact your ability to run the bank smoothly if they leave. What do you do if your head of IT leaves? Is there a replacement? Can the functions be outsourced? Every organization has those key people; they may not even be mangers that are critical to the operation. What’s your plan if they are gone one day?

If you may be facing the expected change at the CEO level and you have other key people that are in sight of retirement, selling can seem like a simple, expedient solution. The key to not being backed into a corner when retirements occur, or when a key person leaving is a threat to the successful operation of the organization, is having a well thought out succession plan. A successful plan has the following elements: it identifies those key individuals in the bank needed to run the organization successfully; it identifies the skills and training needs for those individuals that have the ability to be promoted to more responsible positons, even the CEO role; it has a written plan with timelines for preparing the individual for that next step; and it is updated at least annually to verify that the plan is still the best plan for the bank and that the individuals are progressing as expected.

If you truly want to remain independent, then you must take the time, and it will take time, to develop a meaningful succession plan. Well done, it will take months to develop and time to groom and coach that next level of talent, to review and update your plan as required.

At Young & Associates, Inc. we are committed to the idea that we are all best served by having strong, well-run community banks. If you would like help in developing your succession plan or would like a critical eye to review your existing plan, reach out to us: we’ve got community banking’s back. To contact me, give me a call at 330.422.3476 or send an email to bviering@younginc.com.

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

July Market Update

July marks the beginning of the 11th year of the U.S. economic recovery that began in June 2009. Back then was the end of the Great Recession that followed the 2007-2008 global financial crisis. The current expansion has continued, uninterrupted, ever since. While the annual economic growth has not been remarkable, it has been stable. GDP growth has been around 2% for each of the years of the recovery. However, the recovery has led to a near 50-year low unemployment rate of 3.7% while holding inflation below 2%. Highlights on the economic front include:

• On July 31, the Fed lowered its short-term benchmark interest rate by a quarter of a percentage point, the first rate cut since 2008. Previously, the Fed had conducted several rounds of raising rates as it expected inflation to surface due to the “full employment” conditions. Surprisingly, inflation has remained in check and concerns about the global outlook clouded by trade policy uncertainties allowed the Fed to concede that interest rates were too high.
• The June quarter, for the second quarter in a row, saw industrial production decline at an annual rate of 1.2%. Capacity utilization for the industrial sector decreased 0.2 percentage point in June to 77.9%, a rate that is 1.9 percentage points below its long-run (1972–2018) average.
• The trend in wage growth has slowed from late last year when wages were rising at their fastest rate in a decade. Average hourly earnings in June rose six cents, or 0.2 %. That kept the annual increase in wages at 3.1% for a second straight month.
• Strong consumer spending in the second quarter helped bring the GNP growth to 2.1% in the second quarter. The growth in personal consumption expenditures were reported at 4.3%, compared to 1.1% in the first quarter.
• Home price increases are cooling off after recording strong growth since the recovery began. The Case-Shiller National Home Price Index rose an annual 3.4% in May.
• Big fluctuations in oil prices have occurred in 2019. First, prices surged 48.2% by April 25, due in part to rising tensions between America and Iran. Then prices plunged 20%, with headlines blaming slower global oil demand growth and weak manufacturing data.
• The federal deficit is expected to top $1 trillion for the second year in a row. The principal factors leading to the deficits are the 2017 tax cuts while the federal budget exceeded the spending caps enacted by Congress in 2011 by $300 billion.
• American farmers are hurting. Unusually heavy spring rains have delayed or completely prevented planting across many areas of the Midwest while trade disputes drag down agricultural exports and crop prices. The pain is spreading from farmers to businesses related to farming.
• The stock market has been strong in 2019. The Dow increased 15.16% in the first seven months while the broader Nasdaq market increased 23.21%. Banks followed the upward trend, rising 15.06% as measured by the Nasdaq Bank Index. Banks are reporting strong financial results. Based upon the March FDIC Quarterly Banking Profile, banks increased their net interest income by 6% from the prior year leading to an improvement of profitability by 8.7%. Noncurrent loans are below 1% while banks increased their reserves for future loan losses. Capital ratios continue to climb. The Fed recently announced the results of its annual capital stress tests (CCAR) for large banks and reported no objections to any of their capital plans. This will allow for increased dividends and continued stock buyback activity for these banks.
• Short-term interest rates have declined in 2019 with the 3-month T-Bill moving down from 2.45% at the end of 2018 to 2.08% at the end of July. The 10-year T-Note also declined from 2.69% to 2.02%. The yield curve is partially inverted, with the 3 and 5-year T-Notes trading below 2%.

Merger and Acquisition Activity

As of the end of July, bank and thrift merger activity was down approximately 10% from last year at the same time. The median price to tangible book for transactions involving bank sellers was 168%.

Capital Market Services

Capital Market Securities, Inc., has assisted clients in a variety of capital market transactions. For more information on our capital market services, please contact Stephen Clinton at 1.800.376.8662 or sclinton@younginc.com.

By: Mike Lehr, Human Resources Consultant

Never have businesses had to do so much recruiting. Never have they spent so much money on it. Yet, they have never been worse at it. The interviewing of applicants highlights this demise.

Imagine going to a team meeting. It has no agenda. It has no planning. It has no pre-work. People just “wing it.” That’s today’s job interviews. More puzzling, these “meetings” play a key role in the buying of a $20,000 to $200,000 asset annually. In contrast, how much thought and planning went into the last technology purchase for only a one-time cost of $15,000?

Research shows these interviews are a waste. It shows that most times the winner is the applicant most like the interviewers, not the most talented, skilled, or experienced. Yes, some argue that this determines cultural fit. What is that culture though? What is fit? Ask a dozen senior employees. It’s highly likely the responses will lead one to conclude that a unifying culture does not exist.

How to Improve Interviews

To improve interviews, they require more thought, planning, and analysis. That includes asking applicants the same set of questions. Ugh! Most likely, if you’re like I am, my eyes rolled when I first heard this. Much of my thinking had to do with feedback from interviewees. They described straight-jacket interviews where interviewees couldn’t ask or say anything but what was on their prep sheet. Moreover, the questions appeared very similar from one interview to another in the same company.It’s only later after digging into the original design of this approach that I found that it was structured interviews gone awry. It’s not how we should apply them.

How Structured Interviews Work

Here’s how it should work. First, think about the job and the skills it needs. Don’t make a laundry list. Start out with the half-dozen key ones. Then, come up with scenarios that can actually happen in your bank in which the applicant will need those skills. Now, devise “what if” questions around them that would require the use of those skills.

Examples of Questions in Structured Interviews

For example, take the job of branch manager. Take the skill of customer service. Let’s say the scenario is a very upset customer at the platform over fees charged to her account. She is getting loud and stressing the teller or customer service rep. The question now becomes, “How would you handle this?”

As another example, take a customer service rep or teller. The aptitude you want is conscientiousness or integrity. The scenario here could easily be that he/she is out with coworkers in a public place. One of the coworkers starts talking about a customer. Yet, it doesn’t seem he/she is talking loud enough for anyone outside the group to hear. The question could become then, “What would you do if this happened?”

The Grading of Answers to Interview Questions

Once you have these questions, come up with your own answers and grade them. This is key because you’ve thought about the answers before any bias could set in. As the research shows, if we like the person, we are more apt to look at a response favorably even if it’s one we were lukewarm about beforehand.

Now, this doesn’t mean that answers falling outside of those are wrong. It just means you’ve established a guide for determining good answers. After all, if you’re looking for creative problem solving skills, answers that aren’t like yours are important.

Practically Applying Structured Interviews

As I described in my early experiences with this, it’s easy to go over the edge. The entire interviewing team doesn’t have to ask the same questions. In fact, it’s better if they don’t. You can decide who might be best at asking a question. The circumstances, scenario, and importance of that question to the interviewer will often make the decision for us.

This also doesn’t mean that interviewers can’t ask other questions. Some might work to make the interview more conversational as in the case of exchanging pleasantries. In this case though, the answers don’t matter or they count less. After all, if the question was that important, we should have thought of it before any interviews began.

Better Interviews Yield Better Employees

According to Bureau of Labor statistics, 95% of hiring activity aims at filling existing positions. Turnover is at record highs. While many factors contribute to this, such as more employers preferring to hire from outside rather than to promote from within, some are myths, such as increased mobility. According to the same statistics, people are just as likely to move out of state for a better job as they were in the late 1960’s.

So, we can’t use outside factors as excuses. Hiring outside candidates is risky. The data shows promoting from within is better, less costly, and yields better outcomes. Therefore, to remove the risk of hiring outside applicants, improving the interview is low-hanging fruit to lowering drastically that risk.

Yet, even with this it’s easy to bypass the interviews and not take them seriously. Just think of the outside candidate that the president or other employees know. Think of employee referrals. It’s a myth that they automatically produce better employees. Research doesn’t support it. They, too, need to go through the same rigorous interviewing process as lesser known applicants.

In the end, there’s an easy way to determine if your interviewing process is in good shape. Ask this question: Does it have the same or better planning, analysis, and research that went into the bank’s last major technology outlay?

For more insights and guidance on how to improve interviewing of job applicants, including advice on questions, you can reach Mike Lehr at mlehr@younginc.com.

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.

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.