Love in a Cold Climate

It was the wrong time and the wrong place to go looking for love. First Financial Bancorp. in Cincinnati, Ohio, went to the equity market in June 2009 and sold $103.5 million worth of stock at $7.50 per share, a 35 percent decline in price from the stock price early the month before.

Eight months later, investors were a bit warmer. First Financial, the $6.3 billion-asset holding company for First Financial Bank, had purchased the assets of several failed banks from the FDIC, had strong capital, was acquiring good core deposits and was in a position to grow even more. It raised $96.5 million in a public offering in February 2010 at a price of $15.14 per share, double the price of just eight months earlier. As of late September 2011, the bank was trading at about $14.72 per share.

For the bank’s Executive Vice President and Chief Financial Officer Franklin Hall, capital is what put the bank in a strong position.

“It’s because of that that we are able to confidently acquire,” he says.

The bank has a tangible common equity ratio of 11 percent, compared to the KBW regional bank index median of 8 percent, according to SNL Financial. First Financial has gone 83 quarters without a loss.

It will be tough to raise capital in the years ahead, although some banks, such as First Financial, will have an easier time than others. Regulators are demanding better quality capital in larger amounts, which could mean lower profitability for the industry going forward, and almost certainly so if the economy continues to slump along. But how will banks attract capital from investors with the promise of lower profitability? It will be nothing but a struggle for the poor performing banks, and much easier for banks that have strong capital management skills, a solid base of core deposits and a trustworthy executive team, investors and investment bankers say.

It won’t be the end of the world for banking, but it will spell the end for some banks.

“The forces at work, punitive regulations, protracted low interest rates, plus extra required capital will result in a sizeable proportion of banks facing great challenges,” says James McCormick, the president and founder of New York City-based First Manhattan Consulting Group. “Those without an effective value proposition and operating model will either languish for a while or undertake a merger.”

It begs the question: Who, in their right minds, would want to own bank stock today?

“There is a market for bank stocks but it’s selective,” says Ben Plotkin, executive vice president of St. Louis-based investment bank Stifel Financial Corp. “All banks shouldn’t assume capital is available.”

Banks, thrifts and bank holding companies are being forced either through regulatory exams or international bodies to carry more capital and higher quality capital on their books.

Fernando de la Mora, a partner with auditing and consulting firm PriceWaterhouseCoopers who leads the banking and capital markets group, says that new capital requirements under Basel III’s international rules will require banks to have more capital, better quality capital, more liquidity and more stable sources of funding.

“The reforms will fundamentally impact profitability and require transformation of the business models of many banks,” says a PwC report on the topic.

The global guidelines apply to most European banks and go into effect gradually starting in January 2013, although it’s unclear which U.S. banks will have to follow the rules, de la Mora says.

“The most significant impact will be on the larger institutions, but as the regulators try to harmonize Basel III in a way that provides a consistent approach for all U.S. institutions, I would have to think the Basel III concepts, whether it is the definition of capital or the ways you risk-weight, will be the same for smaller institutions,” says Alan Avery, an attorney at Arnold & Porter in New York.

The top 10 global financial institutions have already disclosed the potential impact of Basel III on their balance sheets, equating to an average 300 to 500 basis points less return on equity, says de la Mora.

In addition, many U.S. banks already have been raising capital during the past three years to comply with regulators’ demands and conducting annual stress tests to measure their ability to handle future economic pain. The Dodd-Frank Act requires any bank with more than $50 billion in assets to conduct annual stress tests, and a poor grade could result in restrictions on the bank’s ability to pay out dividends or buyback shares.

Another Dodd-Frank provision says bank holding companies must have the same capital and risk standards as banks insured by the Federal Deposit Insurance Corp., which forbids them from counting hybrid capital instruments such as trust preferred securities as Tier 1 capital, starting in January 2013.

The impact of this on the entire industry still is unclear, but it could force some bank holding companies to dilute shareholders with a common stock offering, says Avery. (There are exemptions for bank holding companies under $500 million in assets. There also is an exemption for holding companies under $15 billion in assets, which can grandfather in securities held before May 19, 2010.)

Plus, more than 460 financial institutions, most of them smaller banks, still are participating in the U.S. Treasury Department’s Capital Purchase Program, with more than $18 billion worth of stock owned by the Treasury as of early September. Banks will have to wean themselves from that program at some point, and whether that will cause more capital raises in the next few years is uncertain.

But one thing many investment bankers agree on is that the higher capital requirements means the banking industry will be less profitable, so investors and buyers will be willing to pay less for banks.

“(Higher capital and lower profitability) will fundamentally lower valuations, which will put pressure on financial stocks,” says Bill Hickey, co-head of investment banking at Sandler O’Neill + Partners in New York City. “Fundamentally, it’s how the calculation works that is a challenge facing the entire industry.”

Here’s how the calculation works: If a bank must carry 2 percent more common equity over total assets, that can reduce returns on equity by 20 percent. If a $1 billion bank has $60 million in equity and earns $10 million, and that same bank must now carry $80 million in equity while earning the same $10 million, its return on equity shrinks from 16 percent to 12.5 percent.

After four consecutive years of negative returns, the average return on equity was just 1 percent in the second quarter of this year for all publicly traded U.S. banks and thrifts, down from 11 percent in the full year 1997, according to SNL Financial.

When profitability is under pressure, so are stock prices and the values that investors see in banks. Prices for bank stocks have been lower, in general, than their actual book values. The average price to tangible book value for publicly traded banks and thrifts in the second quarter of this year was 95.78, down from 214 in the full year 1997, according to SNL Financial.

Shareholders and bank officers will “have to get comfortable with valuations that are lower than historical valuations,” Hickey says.

Plotkin explains that pricing is partly related to acquisition values.

“When it comes to banks, especially community banks, the ‘take out’ value is a factor,” he says. “Some investors are always looking at the consolidation play. Takeout values have moved lower, so that’s hurting pricing. It will all solve itself. There are investors today who are saying ‘banks are cheap because I can buy them at a discount to book value.’”

“I can’t obviously tell banks they will particularly like the valuations necessarily that they get,” he says. “The good news is that the capital markets will be open.”

Still, Plotkin thinks it’s likely that the average price-to-tangible-book-value percentage will be 125 to 175 in the years ahead, nowhere near its peak, as growth remains low and profitability isn’t as good as it once was.

On the other hand, Michael Mayes, a managing director with Raymond James in New York, says higher capital could actually attract investors to the banking industry because it suggests a safer industry better able to weather bad times. Plus, he’s not so sure the industry as a whole won’t be just as profitable.

Factors such as competition, the degree of consolidation in the industry, the cost and price of products and services and economic forces all will impact the industry’s profitability, he says.

“There are significant cost savings coming out of the industry as it consolidates,” he says. “I do think some people assume higher capital will reduce profitability and that’s possible, but I’m not yet convinced. The industry has shown itself to be quite adaptable.”

Still, small banks will be at a disadvantage in attracting investors-just as they always have been-say investors and bank stock analysts. Banks with less than $100 million in assets will have a particularly tough time raising capital, because institutional investors are reticent to buy stock they can’t easily sell to other investors when they want out, says Plotkin.

Hickey thinks even those under $2 billion in assets will have a tougher time than bigger banks.

“What we are hearing from the investors, there is also an issue of relative valuation,” Hickey says. “(They say), ‘If I can buy a large cap financial at tangible book value, I know I can get out of if I need to.’”

Gary Townsend, president and CEO of Hill-Townsend Capital in Chevy Chase, Maryland, a hedge fund that invests in financial institutions, says bigger banks have more diverse revenue streams to handle the tougher economic environment.

“Community banks got screwed in the financial reform last year,” he says. “It has obviously turned into an enormous burden suggesting that a lot of banks won’t be able to afford the capital and compliance costs and will go away and have to merge with someone else.”

“The real problem is the competitive advantage many large banks have,” Townsend says. “Banks that grow quickly and have other competitive advantages will do well.”

Townsend likes banks that have good growth prospects, even though they can be hard to find.

“There have never been that many growth stories in banking,” he says. “Most bankers have not viewed their businesses as growth businesses. They try to cost save their way to prosperity. They do that by reducing branches, reducing personnel and cutting customer service. It is very unusual to find a banker who knows to do anything else.”

One exception to that, in his mind, is Signature Bank in New York City, a $13 billion-asset bank that is one of the smaller ones in Townsend’s portfolio. Signature is an example of a bank that should be able to attract capital in the years ahead because it has a strong story to tell, he says. The bank’s deposits increased 15 percent to $10.87 billion and loans increased 16.5 percent to $6.1 billion during the first half of the year. Return on equity was 14 percent during the most recent quarter, compared to an industry average of 1 percent for all publicly traded banks and thrifts, according to SNL Financial. Signature focuses exclusively on private client banking, meaning it caters to the owners of privately owned businesses and their senior managers, offering everything from commercial loans to mortgages and brokerage.

“When you hear that 20 percent of your clients bring in all your profits, we go after the 20 percent exclusively,” says the bank’s president and CEO, Joseph DePaolo.

Each customer is assigned a “team” of three to six bankers who cater to their needs. DePaolo says the bank nabs customers from the bigger banks, who pass around their business customers from one department to another without paying much attention to them. The mortgage department of your typical big bank, for example, doesn’t know the value of a particular business customer on the commercial side, and won’t treat that person in a way that reflects that value, he says.

Signature Bank only hires bankers who have been around the block, DePaolo adds.

“This is not a place for interns, for trainees,” he says. “Our clients expect an experienced person. Our bankers come on board with a book of business.”

But the bank doesn’t ignore the expense line, either. Signature Bank spends no money on TV, print or radio ads, and skips the high cost of a ground-floor retail location, which would attract unwanted street traffic anyway. Instead, its main branch in Manhattan sits on the 12th floor, one of 25 offices in the New York City metro area. Its expense ratio, which is operating expenses as a percentage of operating revenue, is about 37 percent. By way of comparison, Bank of America Corp. is trying to get down from an expense ratio of 62 percent to 55 percent.

Signature Bank raised net proceeds of $253 million in July for future growth in a public offering of stock at $56.25 per share. As of late September, it was trading at about $50.90 per share after a general market free fall that has hurt bank stocks in particular.

“Companies that can grow and can do it with panache are going to be sought out by investors,” Townsend says.

However, not all investors want the same things.

Terry Maltese, the president and CEO of Sandler O’Neill Asset Management in New York, which invests entirely in financial stocks, says there are three things banks must have to attract investors going forward: strong capital, strong credit and most of all, trust.

Since the financial crisis began, “there are banks that people don’t trust anymore,” Maltese says. “I won’t name names. This has been a huge issue.”

“We have had bankers, who in our opinion have been very honest and truthful and accurate in depicting what’s been going on and we have had management teams who outright lied,” about the depths of their credit problems or losses, he says. “We had management teams that didn’t lie, but weren’t completely upfront.”

Trust may have come to the forefront among investor concerns, but so has the value of a strong deposit base.

“It’s the ability to borrow money for a sustained period of a time at a low rate that is really where the value is,” Maltese says. “The ability to grow has become less important at this point, and the ability to manage through the cycle and not lose money has become more important.”

First Financial Bancorp. is one of his favorite stocks.

“The company has done very, very good assisted acquisitions,” he says. “The stock trades cheaply. When you ask people why, they say they’re worried the management team will do something stupid with that excess capital. They have only done smart things.”

The bank had the prescience to reorganize in 2004, prior to the financial crisis, selling off branches and poor performing loans.

“We really wanted to get the company to a place that had a strong level footing where we could grow in a consistent, deliberate way,” says First Financial’s CFO, Hall. “This was really just the tough medicine we took to position the company to grow. In retrospect, our timing could not have been better.”

First Financial just announced this summer that it would pay out 100 percent of its earnings in dividends. It has gotten some bargain purchase gains that have added to its capital through agreements with the FDIC when it purchased failed banks, but it also has been acquiring banks with an eye toward building solid core deposits.

“A community bank with a good deposit base has value that someone will want to purchase,” Plotkin says.

Collyn Gilbert, a small- and mid-cap bank stock analyst at Stifel Financial, says that investors are valuing capital and operational strengths more than topline growth.

She took a look at bank stocks going back to 1990 and found the biggest predictor of stock gains was a bank’s ability to generate higher return on assets.

“It should never be about the growth of assets, it’s about the profitability of those assets,” she says. “The industry is not growing. We all know that. There is going to be no margin, no interest expansion. Banks need to manage the profitability they have on the balance sheets.”

Banks will have to figure out how to eke out a profit in a low growth environment. But after all, they’ve done that before.

“We are returning to an industry that looks like banking in the early ’70s and ’80s,” said Jim McAlpin, a banking attorney for Bryan Cave in Atlanta. “We are basically turning the clock back. Older bankers will remember this environment. It will be more familiar to people in their 50s and 60s, who remember when banks were not growth stocks.”

Lee Kidder, practice group manager and senior consultant at CCG Catalyst, a bank consulting group in Phoenix, Arizona, says banking is going back to an earlier period of slow growth and low returns, which was “rather boring in some respects.” This was how it was for decades, before a period of deregulation that began in the 1980s, when banks were allowed to cross state lines through acquisitions and grow into much larger entities.

Later came more deregulation, in the form of the Gramm-Leach-Bliley Act of 1999, and banks began growing into all kinds of new businesses: insurance, brokerage, you name it. The days of deregulation and its growth opportunities have been halted in favor of a period of reregulation.

CCG Catalyst President Paul Schaus says the bank of the next few years will no longer be a “high-growth company where the stock might make you a billionaire. That never happened in banking.”

Instead, banks will have to attract investors with old-fashioned promises, such as stability and steady dividends.

It might not be easy territory. But the banking world has been there before. |BD|


Naomi Snyder


Editor-in-Chief Naomi Snyder is in charge of the editorial coverage at Bank Director. She oversees the magazine and the editorial team’s efforts on the Bank Director website, newsletter and special projects. She has more than two decades of experience in business journalism and spent 15 years as a newspaper reporter. She has a master’s degree in journalism from the University of Illinois and a bachelor’s degree from the University of Michigan.

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