Mary Grace Arehart

The question for most financial institutions is not if a valuation is necessary, but when it will be required. Valuation issues that may arise include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Thus, an understanding of some of drivers impacting your bank’s value is an important component in preparing for these eventualities.Data Analysis & Quantitative Factors Affecting Your Bank’s ValueDetermining the value of your bank is more complicated than simply taking a financial metric from one of your many financial reports and multiplying it by the relevant market multiple. However, examination of current and long term public pricing trends can shed some light on how certain quantitative factors may affect the value of your bank.To analyze trends, we focus our discussion on P/TBV ratios since this is one of the most commonly cited metrics for bankers. While all banks can be affected by overall macroeconomic trends like inflation rates, employment rates, the regulatory environment, and the like, we explore relative value in light of three factors we consider in all appraisals – size, profitability, and asset quality.SizeSize differentials generally encompass a range of underlying considerations regarding financial and market diversity. A larger asset base generally implies a broader economic reach and oftentimes a more diverse revenue stream which can help to mitigate harmful effects of unforeseen events that may adversely affect a certain geographic market or industry. Furthermore, larger banks tend to have access to more metropolitan markets which have better growth prospects relative to more rural markets. Figures 1 and 2 on the next page illustrate that, to a point, larger size typically plays a role in value, as measured by price / tangible book value multiples. The sweet spot for asset size seems to be between $5 and $10 billion in total assets. Banks in this category traded at the highest P/TBV multiple as of September 30, 2017 and have generally outperformed all other asset size groups over the long term.ProfitabilityTo examine how profitability affects the value of your bank, we compare median P/TBV multiples for four groups of banks segmented by return on average tangible equity (Figures 3 and 4 on the prior page). A bank’s return on equity can be measured as the product of the asset base’s profitability (or return on assets) and balance sheet leverage. Balancing these two inputs in order to maximize returns to shareholders is one goal of bank management. A bank’s return on equity measures how productively the bank invests its capital, and as one would expect, the banks with the highest returns on equity trade at the highest P/TBV multiple.Asset QualityInferior asset quality increases risk relative to companies with more stable asset quality and may limit future growth potential, both of which may negatively impact returns to shareholders. In addition, it makes sense that a bank with high levels of non-performing assets might trade below book value. Book value of the loans (or other non-performing assets) may not reflect the true market value of the assets given the potential for greater losses than those accounted for in the loan loss reserve and the negative impact on earning potential. Figure 5 illustrates how pricing is affected by higher levels of non-performing assets. As shown in Figure 6, P/TBV multiples plummeted at the start of the economic recession and have yet to recover to pre-crisis levels.ConclusionSize, profitability, and asset quality are factors to consider in your bank’s valuation. From an investor’s perspective, your bank’s worth is based on its potential for future shareholder returns. This, in turn, requires evaluating qualitative and quantitative factors bearing on the bank’s current performance, growth potential, and risk attributes.Mercer Capital offers comprehensive valuation services. Contact us to discuss your valuation needs in confidence.This article originally appeared in Mercer Capital's Bank Watch, November 2017.

As expected after lackluster job gains in May, the Federal Open Market Committee declined to raise the Fed Funds target at the latest policy meeting on June 15th. While the majority of policymakers still expect the Fed to boost rates twice before the end of this year, the number of officials who forecast just one rate hike increased from one to six from the previous forecasting round in March. In addition, Fed officials lowered their expectations for future years, now expecting the fed funds rate to rise to 1.6% by year-end 2017, down from the 1.9% estimate in March, and 2.4% in 2018, down from the previous estimate of 3.0%. During a press briefing on June 3rd, members of the Economic Advisory Committee of the American Bankers Association said they still expect the Fed to boost rates twice before the end of this year, but after years of speculation regarding timing of rate increases, when that will happen remains anyone’s best guess. The bond market never believed the forecasts.Rate increases are long awaited by community bankers as banks are facing profitability challenges. Net interest margins continue to compress and loan growth remains stymied by intense competition for high quality loans. Margin relief remains out of the grasp of most community banks, absent further rate hikes beyond the December 2015 hike. After rebounding modestly in the third and fourth quarter of 2015, the median net interest margin of community banks (defined as those with assets between $100 million and $5 billion), ticked down modestly in the first quarter of 2016 as intense competition for quality loans drove down loan yields and the decline in long-term rates put downward pressure on securities’ yields (Charts 1 and 2). Overall, median net interest income continued to increase as growth in loans offset margin compression, but intense competition raises concerns over how much credit standards have been relaxed to drive loan growth. Although the majority of banks’ balance sheets are poised to take advantage of rising rates, the lift to net interest margins is dependent on asset yields rising faster than the cost of funds (Chart 3). While deposits costs essentially reached a floor several quarters ago, data suggests the threat of rising deposit rates may limit margin expansion in a rising rate environment. As shown in Chart 4, the percentage of banks reporting quarter-over-quarter increases in the cost of interest bearing deposits has been trending upward over the last eight quarters. In a higher rate environment, customers are more likely to shop around for higher rates. The increase observed in interest bearing accounts could reflect the fact that higher loan growth has compelled some banks to raise rates or perhaps an effort to build goodwill with customers in anticipation of rising rates and increased rate sensitivity. For banks with asset sensitive balance sheets, the benefit of rising interest rates will be greater the stickier low cost deposits are. While net interest margin is a key metric for banks, focusing on other drivers of profitability is one way to combat margin compression in the face of further delays in interest rate hikes or upward pressure on deposit costs. Consider the following: Look for opportunities to grow non-interest income. One strategic option may be to expand bank offerings into non-traditional bank business lines that are less capital intensive and offer prospects for non-interest income growth such as acquisitions or partnerships with insurance, wealth management, specialty finance, and/or financial technology companies. FinTech’s consumer-focused technology and ability to quickly adapt can pair well with community banks who can provide an established customer base and knowledge of the regulatory process and environment. For more information, we recently wrote an article on why current market conditions may be ripe for FinTech partnerships.Leverage technology to curb efficiency ratios. Compliance and regulatory costs continue to rise and represent a bigger burden to community banks who lack the scale to accommodate these expenses in comparison to their larger peers. A recent article from American Banker included data presented by Chris Nichols, chief strategy officer of CenterState Banks, at a recent fintech conference in Atlanta that shows why engaging customers digitally is more efficient. Furthermore, a recent article published on SNL highlights how, in some regards, community banks can be quicker to adopt new technology than larger peers. While size may limit what projects are feasible for community banks, agility has its benefits.Increase scale. Create economies of scale and improve profitability organically or by merging with a larger company. Organic loan growth is an obvious cure to the margin blues, but must be achieved while maintaining credit quality and holding adequate capital. M&A remains a classic solution to revenue headwinds in a mature industry, and bank acquirers can potentially have savings beyond expense synergies with some NIM relief resulting from potential accretion income on the acquired assets, which are marked to fair value at acquisition. Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank’s unique situation in confidence, feel free to contact us.

During 1980 the Federal Reserve issued the Small Bank Holding Company Policy Statement (“Policy Statement”), which recognized from a regulatory perspective that small bank holding companies have less access to the capital markets and equity financing than large bank holding companies. Although the Fed has sought to limit holding company debt so that the parent can serve as a “source of strength” to its subsidiaries, especially the deposit-taking bank subsidiaries, the Policy Statement allowed small bank holding companies to utilize more debt to finance acquisitions and other ownership transfer-related transactions than would be permitted by large bank holding companies. The Policy Statement initially applied to bank holding companies with assets less than $150 million; it was amended in 2006 to include bank holding companies with assets up to $500 million. Effective May 15, 2015, the threshold increased to consolidated assets of less than $1 billion for both bank holding companies and savings and loan holding companies, provided that the company complies with the Qualitative Requirements and does not:engage in significant nonbanking activities either directly or through a nonbank subsidiaryconduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or indirectly through a nonbank subsidiaryhave a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the SEC Holding companies that meet the above requirements may use debt to finance up to 75% of the purchase price of an acquisition, but are subject to the following ongoing requirements:parent company debt must be retired within 25 years of being incurredparent company debt-to-equity must be reduced to 0.30:1 or less within 12 years of the debt being incurredthe holding company must ensure that each of its subsidiary insured depository institutions is well capitalizedthe company is expected to refrain from paying dividends until it reduces its debt-to-equity ratio to 1:1 or less The primary benefit of small bank holding company status is that it creates a larger universe of bank and now savings and loan holding companies that are not subject to the Federal Reserve’s risk-based capital and leverage rules, including the Basel III rules. As of year-end 2014, 454 bank holding companies with assets between $500 million and $1 billion filed a Y-9C according to SNL Financial LC. From a functional standpoint, small bank (and S&L) holding companies do not file a quarterly Y-9C or Y-9LP; instead these companies only file a Y-9SP semi-annually. Regulatory capital rules for these companies continue to apply to their bank subsidiaries, which represents no change from past practice.ImplicationsExpansion of Policy Statement eligibility is likely to affect strategic and capital planning for small BHCs.Companies that now fall under the Policy Statement oversight can use traditional debt at the holding company level and potentially generate higher returns on equity with a lower cost of capital. Senior debt may be used to replace existing capital such as SBLF preferred stock or fund stock repurchases or dividend distributions.Higher capital requirements for larger bank holding companies, coupled with relaxed capital regulations for small bank holding companies, may provide smaller companies an advantage when bidding on acquisition targets inasmuch as the ability to fund acquisitions with a greater proportion of debt results in a lower cost of capital.S corporation bank holding companies should remain particularly cognizant of the 1:1 debt/equity ratio constraint that should be maintained in order to declare dividends. For S corporations, the inability to declare dividends may result in shareholders being responsible for their pro rata share of the BHC’s taxable earnings with no offsetting distributions from the BHC. Since the debt/ equity ratio is calculated using equity determined under Generally Accepted Accounting Principles, significant volatility in securities carried as available-for- sale may impair the BHC’s ability to declare dividends.If the subsidiary bank holds assets with more onerous risk weightings under the Basel III regime (such as mortgage servicing rights), the holding company may wish to evaluate whether holding such assets at the holding company, rather than the bank, may be more capital efficient. For more information or to discuss a valuation or transaction advisory issue in confidence, please do not hesitate to contact us.

The Global Investment Performance Standards (GIPS®) were adopted by the CFA Institute in 1999 and are widely accepted among the international investment management industry. GIPS are a set of ethical principles based on a standardized, industry-wide approach that apply to investment management firms and are intended to serve prospective and existing clients of investment firms. While compliance by investment firms is voluntary, many investors consider GIPS compliance to be a requirement for doing business with an investment manager. Alternative managers have lagged behind the industry in claiming compliance with GIPS, but changes in the industry suggest GIPS compliance is becomingly increasingly important.On the CFA Institute Market Integrity Insights blog, Beth Kaiser identifies two reasons GIPS compliance is becoming increasingly important, specifically for alternative investment managers. One driver is that alternative strategies are becoming increasingly mainstream and investors and consultants are engaging in more comprehensive due diligence. Compliance with GIPS can help managers to stand out amongst their peers. Furthermore, the issuance of the GIPS Guidance Statement on Alternative Investment Strategies in 2012 makes it easier for alternative investment managers to comply.The GIPS Guidance Statement on Alternative Strategies and Structures specifically addresses compliance for hedge funds and other alternative investment strategies. GIPS standards state that portfolios must be valued in accordance with the definition of fair value and that all investments, regardless of liquidity, must have valuations that adhere to the definition of fair value. In addition, firms are to disclose if pricing has been performed internally and not by an external third party.At the 2015 GIPS Annual Conference, it was revealed that the California Public Employees’ Retirement System (CalPERS) inquires of all investment managers, including alternative investment managers, seeking to do business with them whether they are GIPS-compliant. The position of CalPERS in the industry suggests that managers will take the steps necessary to win its business and that GIPS-compliance is quickly becoming the norm for investment managers.Related LinksPortfolio Valuation - Private Equity Marks & TrendsUpdated: Valuation Best Practices for Venture Capital and Private Equity FundsRules for the Modern Investment ManagerMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

This guest post first appeared on Mercer Capital's Financial Reporting Blog on July 17, 2015. On May 20, 2015, the Securities and Exchange Commission proposed new rules and amendments to modernize and enhance information reported by investment companies and investment advisers. The proposed rules would be applicable to most investment companies registered under the Investment Company Act of 1940 and all investment advisers registered under the Investment Advisers Act of 1940. The SEC is the primary regulator of the asset management industry, and over the years, assets under management have grown, new product structures have been developed, and technology has evolved. The SEC staff estimated that there were approximately 16,619 funds registered with the SEC as of December 2014 as well as 11,500 investment advisers and 2,845 exempt reporting advisers as of January 2015. Assets of registered investment companies exceeded $18 trillion at year-end 2014, having grown from $4.7 trillion at year-end 1997. Per SEC 33-9776, the proposed rules aim to:Increase the transparency of fund portfolios and investment practices both to the Commission and to investors,Take advantage of technological advances both in terms of the manner in which information is reported to the Commission and how it is provided to investors and other potential users, andWhere appropriate, reduce duplicative and otherwise unnecessary reporting burdens in the industry. The proposed rules include two new forms (N-PORT and N-CEN), new rule 30e-3, and amendments to Regulation S-X that would rescind current Forms N-Q and N-SAR. Management investment companies currently are required to report their complete portfolio holdings to the SEC on a quarterly basis (on Form N-Q for 1Q and 3Q and Form N-CSR for 2Q and 4Q). The proposed Form N-PORT would replace Form N-Q, would require registered funds other than money market funds to provide portfolio-wide and position-level holdings data to be filed monthly with the SEC, and would be available to the public every third month, sixty days after the end of the month. Form N-PORT requires a structured format that will make it easier to analyze and requires additional data not currently provided on Forms N-Q or N-CSR such as information relating to derivative investments and certain risk metric calculations that measure a fund's exposure and sensitivity to market conditions. Rule 30e-3 provides funds the option to meet shareholder report transmission requirements by posting reports online, if certain conditions are met. The proposed amendments to the existing Regulation S-X require standardized enhanced derivatives disclosures in fund financial statements. Currently, Regulation S-X does not include standardized requirements as to the terms of derivatives that must be reported for most types of derivatives including swaps, futures, and forwards. The proposed amendments should allow for greater comparability between funds and help all investors better assess a fund's use of derivatives. Form N-CEN would replace the existing Form N-SAR, which was adopted thirty years ago, and continue to report census-type information similar to Form N-SAR. The new form will replace some of the outdated elements of Form N-SAR with ones that are more relevant today. In addition, Form N-CEN will be filed in XML format, which will reduce filing burdens and make it more user friendly for the SEC and other users. Finally, Form N-CEN would be filed annually, rather than semi-annually as is currently required by Form N-SAR The investment adviser proposals include amendments to the investment adviser registration and reporting form (Form ADV) and amendments to Investment Advisers Act Rule 204-2. The proposed amendments to Form ADV would require aggregate information about separately managed accounts, incorporate certain "umbrella registration" filing arrangements that are currently outlined in staff guidance, and provide additional business information about the adviser's offices, the number of employees, and the use of social media. The amendments to the Investment Advisers Act Rule 204-2 would require advisers to maintain records of the calculation of performance information distributed to any person, which is more stringent than the existing rule that applies to information distributed to ten or more persons. Furthermore, the amendments would require advisers to maintain communications related to performance or rate of return of accounts as well as securities recommendations. Mercer Capital provides investment managers, RIAs, trust companies, private equity firms, and other financial sponsors with corporate valuation, financial reporting valuation, transaction advisory, portfolio valuation, and related services. Contact a Mercer Capital professional to discuss your needs in confidence.Related LinksPortfolio Valuation: Private Equity Marks & Trends | Second Quarter 2015Portfolio Marks: 2Q15 OutlookAsset Management Industry NewsletterMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.