Bank Board Letter September 2014 : Page 3

are often geographic in nature or are related to either bank’s success with various market segments or products. Merger part-ners are able to more quickly diversify than they could through organic growth, which can enhance profitability and limit risk. A strategic merger is an opportunity for succession plan-ning. By combining boards and management teams, each bank will have the opportunity to identify the most capable personnel to run the combined bank. Such a merger also re-moves much of the pressure associated with choosing succes-sors within a bank’s current roster of employees or members of a controlling family. Participating in a merger of equals may also allow privately owned banks to provide liquidity to shareholders. While strategic mergers are primarily stock deals, many contain an option for a limited number of shareholders to receive cash in exchange for their current shares. Even if there is no liquid-ity event built into the transaction, the increased number of shareholders and size of the combined organization can lead to future liquidity opportunities through private sales to other shareholders or redemptions. mergers of equals can be much more complicated to negotiate than a typical transaction in which the seller will not have a say in the post-closing business. A strategic merger involves many social issues that are key to the success of the combined institu-tion. These issues usually include the following: • Who will be on the board of directors? • Who will fill the key executive management positions? • Where will the combined bank’s headquarters be located? • Will any overlapping branches be closed? • What name will be used by the combined bank? • Will all employees be retained? • What employee benefits will be offered? • What will the charter documents and bylaws look like? • Will the combined organization be a C corporation or S corporation? • Who will be the combined organization’s regulators? • What data processing and other key vendors will be used? There are many potential areas for disagreement regarding these and other social issues, especially given that a merger of equals often involves direct competitors. It is therefore im-portant to agree on the social issues most important to your bank upfront in a letter of intent or term sheet before spending time and money negotiating a definitive agreement. The parties should then work with legal counsel to ensure that decisions on key social issues are covered in the covenants of the definitive agreement so that the parties are contractually obligated to carry out the combination as proposed. In addition, major organiza-tional issues like board composition should be included in the combined institution’s charter and bylaw documents so that any post-closing change requires input of representatives of both parties. A successful merger of equals is built on mutual trust that the survivor will carry out the parties’ combined vision. Paul J. Cambridge and Joseph R. Mantovani are banking mergers and acquisition attorneys in the St. Louis office of Polsinelli PC. They can be contacted at 314-889-8000 and at pcambridge@polsinelli. com or jmantovani@polsinelli.com. Image Ridofranz/istock. Merger of equals Deal Points Many of the legal, regulatory, shareholder approval and dis-closure issues in a merger of equals are the same as those in a standard stock-for-stock acquisition. Despite the similarities, Banks RepoRt HigHeR eaRnings, stRong Loan gRowtH a ggregate net income of $40.2 billion was reported by commercial banks and savings institutions insured by the FDIC in the second quarter of 2014, up $2 billion (5.3 percent) from earnings of $38.2 billion the industry reported a year earlier. The increase in earnings was mainly at-tributable to a $1.9 billion (22.4 percent) decline in loan-loss provisions and a $1.5 billion (1.4 percent) decline in noninterest expenses. Also, strong loan growth contributed to an increase in net interest income compared to a year ago. However, lower income from reduced mortgage activity and a drop in trading revenue contributed to a year-over-year decline in noninterest income. Of the 6,656 insured institutions reporting, 57.5 percent had year-over-year growth in quarterly earnings. The proportion of banks that were unprofitable during the second quarter fell to 6.8 per-cent from 8.4 percent a year earlier. “We saw further improvement in the banking industry during the second quarter,” FDIC Chairman Martin J. Gruenberg said. “Net income was up, asset quality improved, loan balances grew at their fastest pace since 2007, and loan growth was broad-based across institutions and loan types. We also saw a large decline in the number of problem banks. However, challenges remain. Industry revenue has been under pressure from nar-row net interest margins and lower mortgage-related income. Institutions have been extending asset maturities, which is raising concerns about interest-rate risk. And banks have been increasing higher-risk loans to leveraged commercial borrow-ers. These issues are matters of ongoing supervisory attention.

BANKS REPORT HIGHER EARNINGS, STRONG LOAN GROWTH

Aggregate net income of $40.2 billion was reported by commercial banks and savings institutions insured by the FDIC in the second quarter of 2014, up $2 billion (5.3 percent) from earnings of $38.2 billion the industry reported a year earlier. The increase in earnings was mainly attributable to a $1.9 billion (22.4 percent) decline in loan-loss provisions and a $1.5 billion (1.4 percent) decline in noninterest expenses. Also, strong loan growth contributed to an increase in net interest income compared to a year ago.

However, lower income from reduced mortgage activity and a drop in trading revenue contributed to a year-over-year decline in noninterest income. Of the 6,656 insured institutions reporting, 57.5 percent had year-over-year growth in quarterly earnings. The proportion of banks that were unprofitable during the second quarter fell to 6.8 percent from 8.4 percent a year earlier.

“We saw further improvement in the banking industry during the second quarter,”FDIC Chairman Martin J.Gruenberg said. “Net income was up, asset quality improved, loan balances grew at their fastest pace since 2007, and loan growth was broad-based across institutions and loan types. We also saw a large decline in the number of problem banks. However, challenges remain. Industry revenue has been under pressure from narrow net interest margins and lower mortgage-related income. Institutions have been extending asset maturities, which is raising concerns about interest-rate risk. And banks have been increasing higher-risk loans to leveraged commercial borrowers. These issues are matters of ongoing supervisory attention. Nonetheless, on balance, results from the second quarter reflect a stronger banking industry and stronger community banks.”

Total loan and lease balances rose by $178.5 billion (2.3 percent) in the second quarter to $8.1 trillion. This is the largest quarterly increase since the fourth quarter of 2007. Commercial and industrial loans increased by $49.9 billion (3.1 percent), residential mortgage loans rose by $22.7 billion (1.2 percent), credit card balances were up by $20.0 billion (3.0 percent), and auto loans grew by $10.9 billion (3.0 percent). Over the last 12 months, loan and lease balances increased by 4.9 percent, the highest 12-month growth rate since before the recent financial crisis.

Asset quality indicators continued to improve as insured banks and thrifts charged off $9.9 billion in uncollectible loans during the quarter, down $4.1 billion (29.5 percent) from a year earlier. The amount of noncurrent loans and leases (those 90 days or more past due or in nonaccrual status) fell by $13.4 billion (6.9 percent) during the quarter. The percentage of loans and leases that were noncurrent declined to 2.24 percent, the lowest level since the 2.09 percent posted at the end of the second quarter of 2008.

Despite the quarterly increase in mortgage balances, income from mortgage-related activity remained well below the level of a year earlier. Noninterest income from the sale, securitization and servicing of mortgages was $3.7 billion (42.5 percent) lower than a year ago. One- to four-family residential real estate loans originated and intended for sale during the quarter were $290.6 billion (63.9 percent) lower than in the second quarter of 2013, as higher interest rates reduced the demand for mortgage refinancing. Realized gains on securities sales also were lower than a year ago, as higher medium- and long-term interest rates reduced the market values of fixed-rate securities. Banks reported $770 million in pretax income from realized gains in the second quarter, a decline of $601 million (43.8 percent) from the second quarter of 2013.

Second-quarter net operating revenue of $169 billion was $1.5 billion (0.9 percent) lower than a year earlier, as a $2 billion (1.9 percent) increase in net interest income was outweighed by a $3.6 billion (5.3 percent) drop in noninterest income. The average net interest margin was 3.15 percent, the lowest since 3.11 percent in the third quarter of 1989, as declining asset yields at larger institutions outpaced the decline in the cost of funds.

Noninterest expenses for goodwill impairment declined by $4.4 billion, and expenses for salaries and employee benefits were $399 million (0.8 percent) lower than in the second quarter of 2013. Banks set aside $6.6 billion in provisions for loan losses, down 22.4 percent from $8.5 billion a year earlier. This is the 19th consecutive quarter that the industry has reported a year-over-year decline in loss provisions.

The average return on assets rose slightly to 1.07 percent in the second quarter from 1.06 percent a year earlier. The average return on equity rose from 9.46 percent to 9.54 percent.

Community banks earned $4.9 billion during the quarter. In the previous Quarterly Banking Profile, the FDIC added a new section that reports on the performance of community banks, which the agency defines as those institutions that provide traditional, relationship-based banking services in their local communities. Based on criteria developed for the FDIC Community Banking Study published in December 2012, there were 6,163 community banks (93 percent of all FDIC-insured institutions) in the second quarter of 2014 with assets of $2.0 trillion (13 percent of industry assets). Second quarter net income at community banks of $4.9 billion was up $166 million (3.5 percent) from a year earlier, driven by higher net interest income and lower loan loss provisions. The report also found that loan balances at community banks in the second quarter grew at a faster pace than in the industry as a whole, asset quality indicators continued to show improvement, and community banks again accounted for 45 percent of small loans to businesses.

The number of banks on the FDIC’s problem list declined from 411 to 354 during the quarter. The number of problem banks now is 60 percent below the post-crisis high of 888 at the end of the first quarter of 2011. Seven FDIC-insured institutions failed in the second quarter, compared to 12 in the second quarter of 2013.

The Deposit Insurance Fund balance continued to increase, rising to $51.1 billion as of June 30 from $48.9 billion at the end of March. Assessment income was the primary contributor to the growth in the Fund balance. Estimated insured deposits declined by 0.2 percent, and the DIF reserve ratio (the fund balance as a percentage of estimated insured deposits) rose to 0.84 percent as of June 30 from 0.80 percent as of March 31. A year ago, the DIF reserve ratio was 0.64 percent. By law, the DIF must achieve a minimum reserve ratio of 1.35 percent by 2020.

Financial results for the second quarter of 2014 are contained in the FDIC’s latest Quarterly Banking Profile, available at www2.fdic.gov/qbp.

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