BANKING Due Diligence in the NEW Financial World BY CYNTHIA J. EVANGELISTI AND KEVIN C. LOCKHART
he financial world is changing every day. A record number of banks have gone under, and interest rates have hit rock bottom. What this means is that finance officers need to understand what is happening in the banking system and be more careful than ever about due diligence. And to do that, it is necessary take a step back and see what has been going on in this new financial world. DISORDER IN THE BANKING SYSTEM The current situation brings to mind a 1936 episode of “The Three Stooges” called “Disorder in the Court.” The plot goes as you might expect: a debacle ensues as the Stooges provide testimony on a case. The word “disorder” especially resonates.This recession has created irregularity and a breach of stability in the U.S. banking system, causing confusion and public discord. While there is nothing laughable about the impact of the sub-prime market crisis and its continued rippling effect on the economy, the situation does at times seem like a farce.
banks. The FDIC also shares regulatory duties with other federal agencies, including the Office of Thrift Supervision, which oversees chartered savings and loans, and the Comptroller of the Currency, which monitors national banks and state banking regulators’ review of state-chartered banks.3 The Obama administration’s proposed financial oversight plan includes a recommendation to consolidate all the federal bank regulatory agencies into a single one, the Consumer Financial Protection Agency. The agencies and a number of industry associations oppose this proposal, arguing that it will create more confusion and public discord about the banking system.
Part of the FDIC’s mission is to monitor the safety and soundness of financial institutions, especially banks on its list of troubled institutions — which reached a 15-year high of 416 as of June 30, 2009 (in an effort to maintain stability and confidence in the banking system and to prevent a run on the banks. the list is not made publicly available). More than 100 banks are expected to fail in 2009, and more than 1,000 are expectIn November 2008, a former vice ed to fail from 2009 through 2012, costFinance officers need to revisit the chairman of the Federal Reserve was ing the FDIC approximately $70 bilquoted as saying:“The public is left in basics and determine how safe lion. The string of banks failures has the dark about the financial condition their government’s money is. The also brought the insurance fund to of all banks. How are people supposed $10.4 billion, its lowest level in more to know what’s going on in depths of good news is that we have more than 10 years. In spring 2009, the FDIC the bank’s balance sheets when the information at our fingertips than sought to shore up its insurance fund regulators, as we’ve learned in this by asking Congress to grant the agency crisis, don’t even know?”1 Since then, we have ever had in the history of $100 billion in borrowing authority. It there have been signs that the econoreceived that authority, along with an my is slowly stabilizing, yet hiccups in government finance. increase in its credit line to $500 bilthe recovery remain — including the lion. The agency is also considering continually escalating number of bank imposing an additional special assessfailures. To avoid future financial meltment fee on the banks before the end of the year, which may downs, new and proposed rules to overhaul the financial further add pressures on already struggling banks.The current system require additional capitalization by the banks, potensituation is a matter of concern for finance officers on two tial consolidation of the regulators, and the imposition of fronts: 1) the continual increase in the number of bank failfurther regulations on the system. ures, and 2) the impact of such failures on the ever-dwindling insurance fund.These issues might eventually affect taxpayers THE FDIC’S GROWING PAINS and even government agencies because they could cause It has been said that the Federal Deposit Insurance banks to charge higher fees for conducting day-to-day Corporation (FDIC) was born of a crisis and made for a crisis.2 business transactions. Congress created the FDIC in 1933 as an independent agency At the same time, the FDIC is seeking to broaden the in response to the Great Depression, a period when approxiagency’s powers by obtaining further authority over the mately 4,000 banks collapsed. The agency’s original purpose banks, arguing that the agency has a vested interest, since it was twofold: to insure bank deposits and to close failing
October 2009 | Government Finance Review
taking on these additional roles, and insures approximately $4.3 trillion in A number of factors need to these groups have been lobbying bank deposits. The FDIC spearheaded and implemented the Temporary be considered in a banking Congress and advocating to refrain Liquidity Guarantee Program (TLGP), relationship. One of them is struc- from allocating certain additional powers of authority to the FDIC. The which allows banks to issue debt with ture — any constraints or political impact the FDIC’s role will have on the AAA credit rating. As of July 31, 2009, $320 billion in debt had been issued considerations that might affect outcome of financial crisis obviously has yet to be determined. under the program. The FDIC is essenservices. tially the guarantor. While there has been discussion about extending TLGP, THE STATE OF THE BANKS the FDIC has introduced a proposal to Since the financial crisis began in discontinue the program.The proposal 2007, 120 banks have failed: three that year, 25 in 2008, and would have banks stop issuing protected debt by October 31, 92 as of mid-September 2009 (see Exhibit 1). In spring 2009, 2009,and it would create an emergency guarantee for approxthe Federal Reserve revealed the outcome of the stress tests it imately six months for banks experiencing undue hardships. performed on 19 banks. The reviews were intended to calm The agency is also managing the sales of toxic assets via the the financial markets, ensure that banks have sufficient funds Public-Private Investment Program, a partnership in which in their capital reserves to distribute loans and offset any the FDIC and a private investor or investors split the equity to further losses, provide financial transparency, and avert a 4 financial crisis in the future.The tests found that some of the purchase a pool of toxic assets. Various groups have voiced banks were financially stable and that several needed to raise concerns that the FDIC is straying from its core mission in
Exhibit 1: Bank Failures across the United States
1|1 NV CA
14 | 9
17 | 16
24 | 18
■ Banks Failed 2007 to Present ■ Banks Failed in 2009 ■ Most Failed Banks, 2007 to Present
28 Government Finance Review | October 2009
capital or required a capital infusion. The tests also highlighted issues other than the losses from residential mortgages: mainly, the potential for defaults of commercial real estate mortgages and credit card loans.Industry analysts have expressed uneasiness about the initial design of the stress tests, which used a 21 to 28 percent loss ratio as its worst-case assumption. They were concerned that the tests didn’t take higher loss ratio assumptions for subprime mortgages into account because by the time the tests were initiated, a high percentage of loans were already in arrears by 30 to approximately 60 days. But there have been some pieces of good news, albeit with qualifications. In June 2009, 10 of the largest banks repaid the funds that they received from the federal government under the Troubled Asset Relief Program (TARP), but they were also required to prove to the regulators that they could indeed stand alone, without additional financial assistance from Washington. In addition, some of the larger banks reported better-than-expected earnings for the quarter ended June 30, 2009. However, the issues identified in the stress test remain a concern. Analysts have noted that the new accounting rule pronouncements the Financial Accounting Standards Board (FASB) issued in April 2009 appear to have given banks leeway to mask their losses. The rule benefitted the banks in the mark-to-market accounting of their assets by basically allowing them to ignore current long-term losses in relation to debt securities on their books.5 However, in July 2009, the FASB announced an initiative that will change the way corporations reflect their financial assets on their balance sheets. All financial assets will have to be recorded at fair value on a quarterly basis. This initiative will create more transparency for the market and public in addition to alleviating concerns about how banks are recording losses of long-term assets. BANK SAFETY So, in light of all that is happening in this new economic atmosphere, what is a finance officer to do? The answer is, in fact, apparent: Finance officers need to revisit the basics and determine how safe their government’s money is. It is a question that needs to be asked every day. The good news is that we have more information at our fingertips than we have ever had in the history of government finance. The bad news is that most finance officers are probably not making use of all the tools available to help them to ensure the safety of the funds. (See Exhibit 2 for a listing of Web sites that provide free information.)
Exhibit 2: Online Resources American Bankers Association (ABA), www.aba.com The Web site for the ABA, the professional association for the U.S. banking industry, provides potentially useful economic bulletins and advocacy action alerts. Bank Rate, www.bankrate.com This site provides updated information on the financial condition of banks, pricing comparisons, and links to bank Web sites. Office of the Comptroller of the Currency, www.occ.treas.gov The Web site for the administrator of national banks provides resources including information, alerts, education and publications, databases, research, and analysis. Board of Governors of the Federal Reserve System www.federalreserve.gov The Web site for the Federal Reserve, Central Bank of the United States, provides banking information and regulation, economic research and data, monetary policies, and publications. U.S. Securities and Exchange Commission, www.sec.gov The federal financial watchdog’s Web site provides lists of banks that are participating in the TARP program. U.S. Department of Treasury, www.ustreas.gov The Treasury Web site provides access to regulatory reforms, daily economic information, and databases, including interest rate statistics. Federal Deposit Insurance Corporation, www.fdic.gov The FDIC site has a number of “quick links” to resources for banking professionals and consumers; information, alerts, and advice; databases, research, and analysis; assets for sale by the FDIC; FDIC news and announcements; and doing business with the FDIC. The most critical piece of information to obtain when investing is a list of the underlying securities that comprise the bank’s collateral — or, perhaps, if it has collateral. Collateral refers to the securities that the bank pledges to secure deposits of public funds, usually from an approved list of investments that are backed by the full faith and credit of the U.S. government. If the bank has pledged secure collateral assets to your investments, then your money is safe even if the bank fails, since you will have first access to those specific
October 2009 | Government Finance Review
assets. The FDIC is also a critical part of the safety net. The agency recently increased the amount of FDIC coverage on investments in one account to $250,000 until December 31, 2013, after which the amount reverts back to $100,000. Therefore, finance officers need to be sure that any deposits beyond the FDIC limit are collateralized by that bank. For example, one government recently purchased certificates of deposits (CDs) in an amount that did not exceed the FDIC coverage on any of the investments. Research on the banks from which the CDs were to be purchased indicated that there were problems with these institutions,and in fact,one of the banks went under two weeks later. Fortunately, since the investment was less than the FDIC limit, the money was returned in about three weeks. MANAGING BANKING RELATIONSHIPS
instituting a direct fee for bank services
making use of the automated information the bank can supply
monitoring services, balances, charges, and volumes in account analysis
The RFP process can and should be a detailed analysis of the organization’s current banking usage and probable future banking needs, providing the banker with enough information to tailor a plan that will help the organization not only reach its banking and investment goals but also enable it to reach some of its operational goals.
The next critical aspect of ensuring that the government’s money is safe and that you are getting the best deal is the relationship you have with your bank and your banker. Evaluate your jurisdiction’s current banking services to determine how many banks and accounts are really needed, if deposit management is efficient, if your funds are available as quickly as possible, and if the relationships are managed centrally. The most successful finance officers tend to have outstanding relationships with their bankers, having one main banking contact and a strong relationship with that individual that is based on trust, mutual respect,and an understanding of the jurisdiction’s specific needs.There are two ways to ensure that your banker has that detailed understanding. The first is a long-standing relationship with a banker who understands the municipality intimately — although these types of relationships are going the way of the dinosaurs. Bank employees have a high turnover rate, and the turnover rate among finance officers is increasing as well.The other way to ensure that your bankers understand your organization’s needs is to provide them with a detailed RFP.
A number of factors need to be considered in a banking relationship. One of them is structure — any constraints or
30 Government Finance Review | October 2009
political considerations that might affect services. These include state and local laws, when obligations must be paid, where deposits can be placed, what securities can be purchased, and prohibitions against investing money or using institutions that are based outside the government’s jurisdictional area.Another factor is the overall effectiveness of bank relationships. Finance officers need to assess potential areas of improvement, including:
evaluating the need for overdraft loan services
establishing procedures to periodically review accounts, services, and agreements
requiring formal written agreements for all services
Whether the jurisdiction issues an RFP or simply has agreements with one or more banks, finance officers should be asking their banks some pointed questions.The banks’ responses should help in making the most informed decision about your bank relationships. They should also give you an indication of the bank’s financial status — whether toxic assets and other potential issues are likely to affect the bank’s profit margin.The questions include: ■
Is the bank currently participating in the Troubled Asset Relief Program? If so, what is the status of its participation? Has the bank asked to leave the program and repaid its government loan?
Is the bank currently participating in the Temporary Liquidity Guarantee Program? If so, what is the status of its participation? (While this program will be discontinued at the end of October 2009, an option was proposed to provide emergency help for banks that are experiencing problems, so it may still be useful to include this question in an RFP.)
the bank included in the bank stress-test review conducted by U.S.Treasury and the Federal Reserve? If so, please provide the findings, in detail, and the bank’s response to the government (its business plans for the present and future — the bank’s plan for how it will handle existing loans and future loans, losses, etc.).
THE RFP PROCESS The request for proposal (RFP) process can and should be a detailed analysis of the organization’s current banking usage and probable future banking needs. The RFP should include a description of all financial products being used, a detailed presentation of daily usage, and estimates of future changes and new products.This type of information provides the banker with enough information to tailor a plan that will help the organization not only reach its banking and investment goals, but also enable it to reach some of its operational goals. Banking RFPs can cover not only basic banking services but also investment services, custodial relations, information reporting, reconciliation services, positive pay, lockbox services, credit card processing, purchasing cards, and many other items related to banking. In developing the RFP, the jurisdiction should provide a standardized format for the banks to submit their cost proposals.The form should be as simple as possible,with detailed usage information provided on the form, along with space for the bank to provide its responses in either a direct cost format or a compensating balance format. It will streamline the cost analysis process for the finance officer if the banks are required to provide the information in the specified format. Also, review statutory and local regulations; it may be necessary to publish the request in a local newspaper, for instance. The introductory section of the RFP should include several key elements. Banking institutions will need to know the size of the government and its current banking services and requirements, as well as information about its financial condition (e.g., the current annual budget and comprehensive annual financial report, or CAFR).The RFP might also include the government’s investment policy, and it is a good idea to list all constraints or political considerations that might affect services. The RFP should also provide a timeframe of request such as an issue date or due date, and any qualifying criteria (e.g., minimum financial requirements, Community Reinvestment Act rating, or bank location requirements
within city limits). Include standard procurement language (e.g.,“The government reserves right to reject any or all bids”) and indemnification language. The scope of banking services the jurisdiction requires needs to be clearly communicated.This section should incorporate the government’s objectives — that is, the services that are deemed mandatory. Required core services might include wire transfers, automated clearing house (ACH) transactions, online banking, and automated fraud detection and stop payment services. The RFP might also ask about ancillary services such as trust services and credit cards, and about electronic storage of documents (type of media; archive and document retention). Developing an RFP does not have to require a lot of time and effort. In addition to the above tips, there are numerous resources available that provide can provide samples, including local and state chapters of the Government Finance Officers Association (GFOA), and in the GFOA’s publication, Banking Services: A Guide for Governments. Information can also be obtained from other governments. CONCLUSIONS One of the most important components in managing bank relationships is communication. Due to the nature of the cur-
October 2009 | Government Finance Review
rent financial landscape, maintaining an open line of communication with bank relationship managers is imperative. Meet with banks once a quarter to discuss new technologies, your level of satisfaction with the service provided, and any other points that might emerge. Communicate with other local governmental entities to share information about bank performance. The RFP process provides crucial information about potential banking partners, but given the current financial landscape, finance officers will want to conduct their own due diligence while reviewing proposals. This can be done using free resource tools and information available on the Internet. The FDIC Web site (www.fdic.gov) is particularly useful, providing quick links to locate the latest list of failed banks and guidelines for what to do if a bank you work with fails. Keeping up on the most current information will mean that you will have critical information when you need it, before it hits the newswire. ❙ Notes 1. David Evans,“Banks on the Edge — The Crisis that Has Toppled the Titans of Finance is Now Rocking Main Street Lenders,” Bloomberg Markets Magazine, November 2008. 2.Alison Vekshin,“The FDIC’s Power Play — Shelia Blair Has a Plan to Tame Wall Street,” Bloomberg Markets Magazine, July 2009. 3. Evans. 4.Vekshin. 5.Yalman Onaran,“Stress Management — U.S. Banks May Be Less Healthy than They and the Government Say,” Bloomberg Markets Magazine, July 2009.
CYNTHIA J. EVANGELISTI is the deputy treasurer for the Chicago Park District, managing its debt portfolio. She is also a member of the GFOA’s Treasury and Investment Management Committee. Evangelisti has a bachelor’s degree in political science with emphasis in public administration from Northeastern Illinois University, a post-baccalaureate certificate in paralegal studies from Roosevelt University, and a master’s degree in public services management from DePaul University’s School of Public Service. KEVIN C. LOCKHART is the business manager of the Niles Library District in Niles, Illinois. He is one of the authors of the GFOA book, Banking Services: A Guide for Governments. Lockhart has a bachelor’s degree in finance from Illinois State University with a minor in economics and a master’s degree in business administration from Lewis University.
32 Government Finance Review | October 2009