What's Next for Banks?

As the industry surprises continue to unfold, the questions of "what's next" and "when will the turnaround occur" are on everyone's mind. I anticipate that things will go from bad to worse as a shift from asset write-downs based on optimism, to ones based on a sober reality takes place.

This process will not be pretty. The widespread adoption of realistic marks will expose the industry as woefully undercapitalized, and will likely engender a wave of bank failures that could quickly drain the FDICs insurance fund. But this will also facilitate the necessary bifurcation of the industry into those banks that are fixable with new capital (and, in many cases, new management), and those that dont justify recapitalization.

What is a bank to do?

Like all crises, the current situation also will present opportunities to banks that possess the wherewithal to capitalize on them. There will be winners as well as losers. I believe there are three things a bank needs to do in order to be among the winners.

Accurate assessment of capital levels, based not on what assets were assessed at in the first half of 2008, or what they could be worth now, but on what they are likely to be worth in 2009 and 2010 if home prices continue to decline. As part of that analysis, banks should consider whether they have assets, or lines of business, in which they have no special advantage and from which capital is more fruitfully redeployed. Webster Bank has undertaken such an analysis effectively.

Based on that assessment, banks need to consider whether they need additional capital, not just to shore up the balance sheet, but to be positioned to scoop up assets of strategic value when the opportunity arises.

Finally, banks need to think about what their core strengths are, and how to augment them amid the current dislocations. The banks that have been weathering these troubled times the best are those institutions who long ago achieved strategic clarity. These companies conducted an accurate SWOT analysis and then actually executed it. They continued to thrive as they built on their strengths and avoiding the fed du jur our industry is well known for.

Banks cant begin to fix their problems until they know how extensive they are, so the top priority for any bank management and board should be a no-nonsense assessment of the value of their assets, including assumptions of further deterioration in the operating environment. A recent Birds Eve View article offered one possible methodology for conducting such sensitivity analysis. You should ask questions such as:

• What happens to the severity of residential losses if home prices continue to decline for the next two years?
• What if our auditors decide we need to recognize other-than-temporary impairment in our Held-to-Maturity account?
• What if regulators take issue with our tax-deferred asset valuation?
• How many more of your loans will be down-graded by the regulators due to insufficient collateral valuation regardless to other sources of payment?

Remember, nothing will damage managements credibility as severely and as irrevocably as having to come back to market for new capital a second time.

After a realistic assessment of how much capital they actually have, step two for bank management is to think about how much capital they need, not just to keep the doors open, but to be positioned to capitalize on dislocations. Potential dilution needs to be weighed against the value of having the balance sheet strength to absorb failing banks (or parts thereof), snatch talent away from weakened rivals, grow loans as customers are being turned away from capital-starved banks, or simply garner deposits by being able to show nervous depositors a rock-solid capital base. In weighing the costs and benefits of incremental capital, bank boards should bear in mind that investors may be willing to invest more capital, on more favorable terms, with a proven management team or a new team at the helm if the institution is troubled. When the environment deteriorates so much so quickly it can be difficult to tell the dancer from the dance, but the market will make its own judgment about incumbent managements' culpability and credibility, and boards should do the same.

Finally, after addressing the issue of capital, the winners in this cycle need to think about what they are really good at, what opportunities are worth pursuing with excess capital they may have raised, and what capital can be freed up by exiting non-core lines of business or geographies. Of course, in this regard, the winners in the current cycle will be the same as the winners in every cycle - managements that stick to their knitting, and focus on recruiting, training, empowering and incentivizing the right people to execute. Banks that do this feel relatively little pressure to chase hot markets. In July, 2007 then-CEO of Citigroup, Charles Prince, famously said "As long as the music is playing, you've got to get up and dance." No, you don't. Surveying the overheated subprime mortgage market, Wells Fargo made the decision to sit that dance out, and is much the better for having done so. In the end, the recipe for success in banking today remains quite simple - avoid getting distracted by fashionable new products, overheated markets, or large acquisitions, and focus on what you do well.