As you know, the banking industry is one of the most regulated in the country. While many of the largest financial institutions have the resources to adapt quickly to these new developments, community banks have to be more prepared. An in-depth and comprehensive focus on industry trends, legislation and merger activity can help your organization adjust to the changing climate.
In fact, community banks are currently experiencing an influx of activity. Mergers, acquisitions and conversations between organizations have become more common, and many financial institutions are looking for ways to expand into new market areas, develop new products or implement additional lending options. In order to achieve these goals, community banks must understand what their compliance costs are going to be given new rules and regulations. Government action on a national scale can determine whether or not merging is a smart decision, and a trickle-down effect will impact this type of financial institution.
Trends, developments affect community banking
If a merger is a possibility for your community bank – or has already taken place – effective valuations can provide insight into your compliance costs and your professional goals. Since regulations and the government, both national and local, play important roles in the health and sustainability of your organization, watching for current events and new trends is incredibly helpful.
Here at Clark Schaefer Hackett, we have over 25 years of experience working with financial institutions to navigate this challenging environment. Our experts keep an eye on all legislation and rules in the sector, and we are also well-versed in audit, tax and consulting services. Not only can we provide accounting assistance, but we will also work with you to ensure your community bank is as profitable as possible.
Bank earnings on the way up
Understanding the true value of your community bank is increasingly important. According to the Federal Deposit Insurance Corporation, FDIC-insured financial institutions’ income increased 5.3 percent on a yearly basis in the second quarter of 2014. Between April and June, these organizations earned more than $40 billion.
Even with the surging trend in earnings, financial institutions still have to deal with regulations, compliance requirements and other details in order to remain profitable, as pointed out by James Chessen, chief economist for the American Bankers Association in a statement on the FDIC news release.
“We continue to see a strong, steady improvement for America’s banking industry, headlined by a sharp increase in business loans and a dramatic improvement in the quality of bank portfolios,” said Chessen. “While net income is at a near-record high, profitability is down compared to pre-crisis levels as institutions grapple with a surge in compliance and regulatory costs that have had a sharp impact on the bottom line.”
Valuations vital during merger or acquisition
Earnings aren’t the only thing on the rise for financial institutions. Mergers and acquisitions are increasing in frequency as well, and now that there are a number of deals taking place in this segment, you’ll need to focus on how they are structured and what the future holds for the acquiring organization. This emphasis will give you an advantage during an acquisition of your own, so you are aware of all the costs and can navigate your community bank into a position to succeed.
To begin, look at fair market value. This is based off of research of previous, similar transactions. For instance, a key trend at the start of 2014 was the trading of prices at a 20 percent premium – a trend carried over from 2013. These overarching themes in the marketplace will impact your own transaction, so consider these factors when looking into your own deal’s details.
While fair market value is only the starting point, you can also gain an understanding of the value of your bank through purchase price accounting (PPA). We’ve explained the importance of this process before, if you’re interested in learning more.
Take ‘goodwill’ into account
With a foundation of fair market value and PPA in place, you can move on to more detailed aspects of community bank valuation. A key part of this stage is called goodwill – or the excess purchase price paid over assets acquired minus liabilities assumed – and loans receivable.
Getting to goodwill takes time. There are many factors to consider, including assets, before making this leap. Once you have determined goodwill, you still have a few options in front of you. For example, you can choose to amortize. Going this route can become a clear option only after you’ve gauged the impact to your bank and to the capital – while there is no clear answer, an in-depth analysis can help determine if this is the right choice for you.
Furthermore, goodwill is subject to impairment testing on an annual basis. Your auditors will scrutinize your deal and ask tough questions, so be prepared to know every detail beforehand.
Look into every loan on the books
A merger or acquisition will bring a number of new loans into question, and the first step before goodwill is fair value of your loans receivable. Here, there are two methods:
- ASC 310-20: In play when a loan or group of loans is purchased
- ASC 310-30: When your acquired loans have deteriorated credit quality
ASC 310-20, 310-30 provide valuable insights into your bank
ASC 310-20 is relevant when you have performing loans in your bank, or those without cash flow issues or impairment. ASC 310-30 can address other types of loans, including those that are impaired. There will be some discount in acquiring loans during the M&A process – and that discount must then be accreted or amortized into income over the contractual terms of the loans.
There are a few things to keep in mind here. If the borrower in question prepays, that discount will then have to be removed proportionally. No matter what, set up a system to track each loan, its balance and its prepayments, either via an automated system or manually.
Most importantly, take note of the nonaccretable difference and the accretable yield. The former is defined as excess of contractual cash flows over expected cash flows; the latter is defined as the amount of expected cash flow that exceeded initial investment in the loan.
Take note of CDI
Finally, you’ll want to look into the Core Deposit Intangibles (CDI) when valuing your community bank.
CDI is the extra amount paid to give access to lower cost source of funds. In relation, the net income stream includes income from net investment assets and service charge income. CDI is amortized over the estimated useful life of deposit relationships. You’ll want to consider mortgage servicing rights here as well, and include all this as part of the due diligence process.
Valuators important during this process
Professional valuators should be involved with your community bank as soon as possible, so they can aid your institution in the process of combing over and thinking about your deal. A trusted advisor can also help you create value and identify other transactions in the market that could lead to opportunities.
It is incredibly important that your advisors have experience. Clark Schaefer Hackett’s team has many relationships with financial institutions, so we are well aware of the issues involved with acquisitions. Our highly skilled experts can avoid problems and prevent conflicts of interest during M&A deals. With CSH, you will get a dedicated, focused team who works with industry clients year-round, with services ranging from audit and tax to bank rescue, risk management and consulting.