The Credit Mark Predicament: A Bank Recapitalization Hurdle

Recently posted in the National Law Review an article by The Financial Institutions Group of Schiff Hardin LLP regarding community banks are searching for capital:




Many community banks are searching for capital either as a cushion to cover credit losses, to meet higher capital standards set by regulatory enforcement actions, or to support balance sheet growth driven by open or closed bank acquisitions, branch purchases or organic expansion.

Any community bank that intends to raise capital has to deal with investor skepticism over the bank’s credit quality. That skepticism gets addressed in most cases by a third-party credit review performed at the direction of the bank, with the results later confirmed by the investor’s own review firm. Because third-party credit reviews have become a gating issue to raising capital, management teams are making decisions about what firm to hire for the work, the scope of the review and how to strategically manage the risks inherent in these reviews.

Many of the risks and strategic approaches for managing third-party credit reviews may not be obvious to bank management, which is for the first time retaining a firm to perform this type of review with the very specific purpose of inducing investors to invest. Likewise, management may not be fully informed as to how the portfolio review will be used by potential investors to evaluate the merits of their investment.

It is hard to over-emphasize the importance of management being careful and strategically thoughtful in: the selection of its third-party credit review firm; the timing of the review in relation to an impending regulatory exam, year-end audit or capital-raising transaction; the scope and methodology of the review; and the use of the results of the review once completed. There are nuances galore in this process and the very survival of the bank can rest in the balance if the process is mishandled.

The attached article surveys the key issues management should consider before retaining a third-party credit review firm, and explains how these reports are used by potential investors in making determinations about investing in a particular bank. In addition, the article reviews common mistakes made in retaining third-party credit review firms.

In assessing a particular third-party credit review firm for hire, the following are ten key questions:

  1. Are the bank’s files and documentation in good shape before the third-party credit review begins? If questionable, will several days of advance “triage” of the portfolio be useful in assessing whether the bank will show well based on the order of its documents, all in an effort to avoid judgmental credit downgrades based on file quality?
  2. Does the firm have a senior project manager with strong verbal communication skills that will facilitate discussion of the review results with the board of directors and any potential investors?
  3. Will the firm commit to remaining engaged and active throughout the recapitalization process, to serve in a rebuttal capacity with third-party credit review firms retained by potential investors, and to update its work if necessary as the recapitalization process progresses?
  4. Will the firm provide value to the bank solely by providing a credit valuation, or would the bank benefit from a firm that has not only valuation experience but also skills and capabilities to provide post-valuation loan workout services, including assisting in developing recovery strategies on an individual NPA basis?
  5. Should the firm provide a verbal conclusion on its credit mark before committing its conclusions to writing?
  6. Should the firm be retained by the bank’s legal counsel as opposed to directly by the bank?
  7. Should the firm review and value only the NPA portfolio, or should the review extend to the performing portfolio as well, and, accordingly, assess migration risk of the performing book?
  8. Is the bank seeking capital from institutional investors that will insist on a brand name credit review firm in order to give the review results credibility?
  9. Will the firm review only “paper” in the files or will it spend time with both the bank’s chief credit officer and other credit professionals in reaching valuation determinations?
  10. Finally, will the bank’s personnel have the time and capacity to respond to the document calls by the third-party credit review firm given the other demands on management’s time, recognizing the burden these reviews place on management?

© 2011 Schiff Hardin LLP