INDUSTRY INSIGHTS | FALL 2009 EFFECT

How Banks Can Prosper in a Challenging Economy

by Emily Scheevel

Community bank challenges have continued to increase in 2009 as the economy fails to generate much upward momentum and growth. The number of problem banks continues to rise along with the number of failed institutions, which will considerably outpace 2008’s total.

In 2009, it all depends on which side of the economic crisis you are on. The reward for thoughtful, proactive decision making prior to the financial crisis is not only the ability to weather this storm—banks that survive are uniquely positioned to grow and prosper.

To thrive in today’s economy, you must execute strategies that focus on five areas: capital, liquidity, credit quality, profitability, and customer service.

Capital

Capital is key. Banks should build their capital levels relative to their risk profiles. Those that take on more risk should ensure that they have more capital to support it. This means the standard regulatory, well-capitalized ratios may not adequately provide for the growth opportunities available.

Bank regulators today are encouraging banks to raise enough capital to survive a steeper-than-projected downturn and still have enough funds to continue lending. However, banks with excess capital should be able to take advantage of low stock valuations and consider mergers or acquisitions of other banks.

Liquidity

Liquidity is also critical. Liquidity risk management practices require a sound contingency funding plan. A contingency funding plan is needed to provide a framework for meeting temporary and long-term liquidity disruptions. A good plan should be reliable, flexible, and realistic. For example, as an added source of liquidity, banks could apply for the Federal Reserve Bank discount window.

The ever-changing financial markets have altered the dynamics of funding; therefore, you must monitor your liquidity position and funding strategies on an ongoing basis. Unexpected events, economic or market conditions, earnings problems, or situations beyond your control could cause either a short- or long-term liquidity crisis. A liquidity crisis could lead to a bank failure, as was the result with IndyMac in 2008. In that case, Senator Charles Schumer’s comments about IndyMac were blamed for spooking depositors, resulting in millions of dollars being withdrawn by the day. This sudden decline in depositor confidence led to the bank’s failure.

Credit quality

To manage risk, conduct a credit checkup when assessing the health of the loan portfolio. All significant credits in the portfolio should be independently examined for credit quality and stress tested. It is the responsibility of bank management to implement, monitor, and manage these controls. Strong problem-asset identification and work-out action plans are critical for surviving in this economy. The ability of a bank to manage problem assets in a timely and cost-effective manner will allow it to better utilize its funding on earning assets.

Additionally, your bank needs to rigorously evaluate credit risks. Understanding and estimating global cash flows and debt service capacity provides the baseline for evaluating the probabilities of repayment. By stress testing the loan portfolio on a micro and macro level, you can better identify your bank’s ability to weather the economy if it worsens.

Banks must maintain a reserve for loan losses adequate to cover losses inherent in its loan portfolio. This reserve is based on problem assets, historical losses, economic conditions, and trends within the various segments in the portfolio. If banks have not already done so, they should implement the allowance for loan loss methodology in accordance with the interagency statement issued in December 2006. For both impaired loans and the general reserve on non-impaired loans, be conservative in assessing the need for additional reserves.

Profitability

In the fourth quarter of 2008, the average net interest margin (NIM) at community banks fell to a 20-year low. With this pressure on NIM, banks keep looking at trimming expenses as a way to reduce losses or improve profitability. This expense reduction must be done thoughtfully to avoid affecting customer service or the bank’s internal control system. The pricing decisions a bank makes for its loans and deposits plays a huge role in its profitability.

Customer service

Banks need to recruit and retain strong employees who are committed to providing total client service. The success in providing better products and services will allow your bank to generate more stable core deposits and place smaller reliance on the less stable and more volatile funding sources. Your customer service policies and procedures should support and promote this attitude, and employees should take ownership of customer concerns and the value of customer satisfaction.

The banking landscape will continue to change in response to the credit crisis, and management and board members need to continue to evolve with these transformations. There will be those that decide to sell and others who will fight to survive. The best opportunities, however, will be for those who execute a strategy that takes advantage of the opportunities.