Provident Bancorp Says Company Failed to Set Appropriate Tone at the Top

Plus, Parke Bancorp discusses a "notable contingency"

Earlier developments in the story of Provident Bancorp (PVBC) have been discussed on this blog before, but just to quickly recap the background:

• PVBC is a small bank holding company based in Massachusetts with around $1.7 billion in total assets. It conducts business through its subsidiary BankProv, a Massachusetts state savings bank.

• In mid-November, PVBC filed an 8-K announcing that it would be late in filing its Q3 10-Q. The 8-K also sheepishly disclosed that the company expected to report a net loss of around $27.5 million for Q3 2022, compared to net income of $5.1 million for Q3 2021.

• This was because, “[d]uring the third quarter of 2022, the volatility in Bitcoin and rising energy costs called into question the financial stability of the Company’s borrowers who hold digital asset mining loans, the collectability of all principal and interest related to these loans, as well as the value of the cryptocurrency mining rigs that serve as the underlying collateral.”

• The next month, PVBC on the afternoon of December 23 filed another 8-K with an attached press release announcing that its President/CEO had “separated from both Provident Bancorp, Inc. and BankProv effective December 20, 2022,” to be replaced by joint interim Co-Presidents/Co-CEOs.

PVBC was finally able to file its Q3 10-Q this week. They reported a $35.3 million loss for Q3, although the stock is actually up around 10% over the past five days as of the close of trading on Thursday (albeit still down 55% over the past year). [Note: This post has been edited to fix an error - originally this post conflated the quarterly loss with the loss for the nine months ended 9/30/22.]

More relevant to our purposes, though, is a disclosure included elsewhere in the 10-Q. The Interim Co-Presidents/Co-CEOs have been in their current roles for just about a month now, and they have reached a few conclusions:

[T]he Company’s management, including (i) the Interim Co-President and Co-Chief Executive Officer and (ii) the Interim Co-President and Co-Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were not effective because of the material weakness in internal control over financial reporting described below.

As explained in the filing, a material weakness in this context means that “there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis,” although PVBC notes that it has no reason to think any material misstatement in fact occurred here.

PVBC then goes on to describe what it and its outside advisors have concluded was the root cause of this material weakness:

The Company’s Audit Committee, and subsequently the Board of Directors, has reviewed, with the assistance of outside legal counsel who were independent of the underlying matters, the facts and circumstances relating to the Company’s digital asset lending practices.  In connection with this review, certain deficiencies in the Company’s internal controls were identified, which, in management’s opinion, when evaluated collectively, amounted to a material weakness in the Company’s internal control over financial reporting as of September 30, 2022.  This material weakness in the control environment stemmed from “tone at the top” issues that contributed to a control environment that was insufficiently tailored to monitoring of risks as it relates to the digital asset lending program.

PVBC does not assign blame for this inappropriate tone to any named individual or group of individuals.

PVBC does hint, however, again without going into specific details, that some choices the company made about its activities could have been driven by “internal conflicts of interest related to the digital asset lending program.” Or, at the least, its lending decisions were vulnerable to risks arising from conflicts because the “precision of the design and maintenance of effective controls” did not “sufficiently address” such risks.

Moreover, PVBC acknowledges that there were not “effective avenues” of communicating relevant information to the company’s board of directors related to the digital asset lending program.

To fix all this PVBC has developed a remediation plan. Here again, internal conflicts of interest are called out multiple times:

• Revision of the Company’s three-year strategic plan, including ceasing to originate new loans secured by cryptocurrency mining rigs;

• development of an appropriate onboarding process for internal conflicts of interest that establishes proper internal controls to sufficiently address the related risks;

• implementation of enhanced procedures, which will include but not be limited to, the annual review and disclosure to the Board of identified internal conflicts of interest as they relate to officers of the Company, and the timely disclosure to the Board of identified potential internal conflicts related to officers of the Company, which should include detail regarding Management’s assessment of related risks.

Other than thinking this was worth discussing just by virtue of it being an interesting story, the main reason I mention it here is that many of the above failings - inappropriate tone at the top, poor board information flow, conflicts of interest, etc. - are the same sort of issues with which banking regulators are frequently concerned. Nothing yet has happened to PVBC on the bank regulatory enforcement action front (publicly at least), but I wonder whether there might be more to come.

A Notable Contingency

In other unfortunate developments regarding small banks — although this one may not be the bank’s fault — Jeff Marsico this week highlighted an earnings release from Parke Bancorp, a New Jersey bank holding company with just under $2 billion in total assets.

The earnings release reported net income for 2022 of $10.4 million, but disclosed an ongoing situation that could affect future results.

Notable Contingency

An armored car company used by the Bank to transport and store cash for the Bank’s cannabis-related customers has informed the Company that some of the cash stored for the Bank is missing from its vault and is presumed to have been stolen. The total amount of cash held at this third-party location prior to these circumstances was approximately $9.5 million. While management believes that some amount of loss is probable, the situation is currently under investigation and the amount of the loss cannot be reasonably estimated.

And so:

The Bank is working with relevant state and federal law enforcement authorities to investigate this matter as well as pursuing judicial avenues of recovery. The Bank is pursuing various avenues of recovery that it may have, including, among others, possible insurance claims. If it is ultimately determined that a loss is probable and estimable, we will record the loss in the appropriate fiscal period. If we are successful in making recoveries, we will record the recoveries in the period received, or when the receipt of such recoveries becomes certain.

In Significantly Less Exciting News, TLAC

Shifting gears clumsily to a much larger (and yet considerably more boring?) bank, this week PNC on its earnings call was asked about the possibility that the Fed/FDIC ANPR could, a while from now, result in PNC being required to issue additional long-term debt or other loss-absorbing capital.

The company’s current take is that this sort of requirement is not necessary for banks like PNC, but even if a long-term debt requirement is imposed, PNC executives believe it would be readily manageable.

Ken Usdin: I was wondering if you guys could talk about the still potential for the TLAC rules that come down to the category threes and how you would be thinking about either getting ahead of that or starting to issue? Or do you just have to wait for the final notice and then consider a phase-in period?

Bill Demchak: I mean a lot of people talking about this, not a lot happening around it. Where it to happen, by the way, we disagree with it, but let's walk down the path and say somehow down the road people suggest that this should happen and there'd be a phase-in period. Practically, as we look at the growth opportunity in our company new clients loan growth against what it is likely to be a constrained ability to grow total deposits, right? You're going to see our wholesale borrowings increase. And in the course of our wholesale borrowings increase in the ordinary course of business, we're going to fulfill all our parts of that TLAC requirement. […]

Rob Reilly: Yes. I'd just add to that, that's -- we see it on our path. It's not particularly problematic, but there's a lot to be played out. We still don't think it's necessary and there's also a reasonable chance there'd be some tailoring to it, which would be reduced in our case.

The comment period for the ANPR closes next Monday.

M&T Previews Upcoming Stress Test

Last year M&T Bank Corporation was assigned a stress capital buffer of 4.7%. Compared to its prior-year SCB of 2.5%, this represented the largest year-over-year increase in SCB for any U.S. banking organization.

On its earnings call this week, M&T management was asked how they thought this year’s stress test was going to go.¹

Manan Gosalia: … On the stress test, you've spoken about the adverse effects of the excess cash balances and of course, the Fed has been stressing CRE more than the other asset classes. Just given that December 31 will be used as a starting point for the next stress test, do you think you've done it now for how well do you think you're positioned going into that?

M&T’s CFO replied that the company has made a “meaningful shift” in its balance sheet, such that they believe they are well positioned going into this year’s test. At the same time, they - like everyone else - are waiting to see the actual scenario.

Darren King: We've certainly made a meaningful shift in the balance sheet this year. Cash balances, we mentioned, are down the better part of $17 billion from where they were at the end of last year. The mix of C&I and CRE when we focus just on commercial balances is almost 50-50, where it was 60-40 before CRE. And when we look at the -- or the construction balances, they're down a couple of billion dollars. And so -- and not to mention the margin is up and so the PPNR start point is higher. Things that we've got our eye on, and we're not -- we're uncertain a little bit is how the merger expenses will be treated in the stress test this year. But once we get through 2023, it should be clean. And so that will be helpful.

And then the other question is, what's the Fed scenario, right? We haven't seen it yet. It's very likely that it will continue to focus in the real estate sector. Previously it focused on hotel and retail. Those seem to be doing a little bit better. So it wouldn't surprise us if the new focus is office and healthcare. And so it just depends on where the emphasis is from that perspective as well. But we start from a really strong capital position. We've got the current SCB covered, which is pretty high. And we continue to move the balance sheet in a positive direction, which if it doesn't get us all the way where we want to be in 2023, it should carry us a long ways towards where we want to be in 2024.

This year’s stress scenario is expected to be released in late January or early February.

Thanks for reading! As usual if you think I missed or misstated something, or just have other thoughts to share, feel free to email bankregblog@gmail.com

1. Ordinarily as a Category IV firm M&T would not have to participate in an odd-year stress test, but because it made a large acquisition in 2022 and that large acquisition is not currently reflected in its stress capital buffer, the Federal Reserve Board is requiring a recalculation of M&T’s SCB again this year.