The stress in most banks these days is intense. The fire drills and economic uncertainty make it difficult for management to step back and plan. Boards of directors and senior management of banks at risk may be in denial, refusing to face the severity of the problems on their books.
It's reality time.
Management must immediately accept the need for a turnaround plan — a disciplined approach to managing the organization out of a tailspin. Serious business decisions need to be made and risks taken to avert bank failure.
Boards need to challenge management to produce a turnaround plan and then hold management accountable. This approach also helps to restore management's and the board's credibility with the regulators.
In fairness, many senior management teams have not been in this environment before and simply don't know what to do. The interrelationship among issues is complex for a distressed bank.
For instance, many banks try managing the risk around their deferred tax assets, because taking an impairment charge drains capital. The DTA is a complex tax and accounting issue, but it is a contingency that threatens capital and a bank's standing with regulators. Banks under regulatory orders are typically told to cut nonperforming assets, which inevitably puts severe pressure on capital ratios.
A well-executed turnaround plan brings a strategic approach to moving NPAs off the books and weighs how disposition will affect capital ratios under the prompt corrective action thresholds. Management teams under regulatory pressure can take an ad hoc approach to asset disposition, which can have unintended consequences on capital, the DTA and the bank's long-term viability.
For distressed banks, the chief restructuring officer becomes the key player, often with help from outside counsel. For the CRO, the overriding rule is the same as a physician's: first, do no harm. Banks in distress present complicated financial engineering questions, and often there is little room to maneuver on the balance sheet.
The capital-PCA dashboard — a single sheet that pulls key performance metrics together — becomes the centerpiece of the CRO's activities and gives the board what it needs to understand the difference between success and business failure. The bank's capital position relative to the PCA capital standards (well, adequately, undercapitalized, significantly undercapitalized and critically undercapitalized) needs to be memorialized on paper along with the same ratios on a quarter-forward pro forma basis. All material decisions in the turnaround must be evaluated in the context of their effect on capital within the context of the PCA thresholds.
A second dashboard covers credit-quality indicators, with special attention given to criticized and classified assets, respectively, to Tier 1 capital plus the allowance for loan and lease losses. The bank's coverage ratio is another material ratio to monitor.
Early in the turnaround process, goals for improvement in key credit-quality metrics must be set. Management must review performance on weekly status calls, mindful of unintended consequences of given actions.
Credit quality is the dominant issue on most bank balance sheets, and a third-party review of the portfolio is essential to get a realistic assessment on the best strategy for reducing NPAs. A turnaround strategy should quickly dispose of the largest NPAs with the smallest effect on the bank's capital ratios. But with the market saturated with problem assets, it's virtually impossible to execute fast, clean, book value sales. Leadership must develop a disposition strategy that achieves a meaningful reduction in NPAs without decimating the bank's capital position and pushing it toward critically undercapitalized status.
And while many banks see raising capital as salvation, selective investors must first see transparency in credit quality and a conveyor belt moving NPAs off the books. The bank must find the bottom to its asset-quality problems, develop an NPA disposition plan and then start selling NPAs. This is the only path to success for most distressed banks.
Have you heard the wake-up call, and are you ready to turn around your bank?
Christopher Zinski is a partner in Schiff Hardin LLP. He advises financial institutions on strategic matters including turnarounds, capital raising and acquisitions and divestitures.