If there’s a private equity fund that would be inclined to invest in banks, one would think it would be Falfurrias Capital Partners. Two of its founders were long-time executives at Bank of America Corp. One of them, former Chairman and Chief Executive Officer Hugh McColl, is a legend in the industry. It was under his watch that Bank of America’s in-house attorney drafted the Southeastern Regional Banking Compact, an agreement between 10 southern states to allow banks from participating states to acquire each other. It proved to be one of the earliest and most significant salvos in the march to nationwide branch banking-giving McColl a head start at building what is now the country’s second largest bank.
Yet if you ask McColl about Falfurrias Capital’s investments, he’s more inclined to talk about Bojangles’, a restaurant chain it owned from 2007 until 2011 that’s famous for chicken ‘n biscuits. In fact, aside from a now-realized position in Capital Bank Financial, a $10 billion asset bank headquartered in Charlotte, North Carolina, which has since merged with First Horizon National Corp., a $30 billion bank based in Memphis, Tennessee, Falfurrias Capital hasn’t invested in a single bank since the fund was founded over a decade ago. And it only invested in Capital Bank because McColl and his colleagues knew and believed in its founder, Gene Taylor, a fellow Bank of America alumnus.
“We’re in a private equity fund that’s trying to make an 18 percent to 25 percent annual return on investment, and you can’t do that in banking,” says McColl. “We’re buying companies in industries that are growing faster, where we see opportunities for more improvement in their earnings. Banks are too stable for us. There’s not enough volatility in them to make for an attractive investment.”
Falfurrias Capital isn’t alone in this regard. “Given the current operating environment in the industry, [investing in banks] doesn’t make a lot of sense right now for big growth investors,” says James Dunavant, senior associate at Ford Financial Fund, a Dallas, Texas-based bank buyout fund. “There are still opportunities out there, but certainly fewer of them than there used to be.”
This is emblematic of a broader shift in the type of investor that has gravitated toward the industry since the financial crisis. “One of the major themes we’ve seen over the past decade in the banking space is a shift from growth to value investors,” says Frederick Cannon, director of research at Keefe, Bruyette & Woods. McColl agrees: “I ran a growth company. An explosive growth company. It’s hard to see that happening now.”
There are many explanations for this shift, but it springs fundamentally from the stricter regulatory environment brought on by the Dodd-Frank Act of 2010. Under the new rules, known as Basel III, banks must hold more capital relative to their assets than they did before the crisis, which reduces leverage and thereby profitability. Banks also face higher compliance costs in the post-crisis world, thanks to the litany of new rules passed in Dodd-Frank’s wake. And low interest rates, as well as regulations such as the Durbin Amendment, which limits how much retailers can be charged for debit card processing, are a drag on revenue.
As a result, the typical bank on the KBW Regional Banking Index earned a 15 percent return on equity in the years before the crisis. But this has since plateaued at less than 9 percent.
“From the beginning of the crisis until just recently, returns in the industry have been below the cost of capital, with a number of large banks trading below book value,” says John Allison, who served from 1989 until 2008 as CEO of BB&T Corp., a now $221 billion bank based in Winston-Salem, North Carolina. “An industry can’t be healthy over the long term if they’re earning less than their cost of capital. It has happened in the past in certain industries, and when it does something dramatic happens to those industries.”
This isn’t the first time banks have experienced a prolonged decline in profitability. “When I came into the industry in 1959, banks were run by people who had lived through the Great Depression and World War II. They were old and conservative. The best bank in the country in terms of return on equity made 12 percent,” says McColl. As memories of the depression subsided over the next decade and a half, thanks in part to an influx of new talent into the industry, risk appetite began once again to grow. “So, we doubled our leverage, and our return on equity went from 8 percent to 10 percent, to between 16 percent and 20 percent. At one point, we earned a 25 percent return on equity.”
A similar aversion to risk that weighed on returns following the Great Depression is at work today. “There was the huge shock after the financial crisis about some of the things that we thought were impossible but actually happened. There was never supposed to be anything like this in most peoples’ imagination,” says Alan Blinder, vice chairman of Washington-based Promontory Interfinancial Network and a former vice chairman of the Federal Reserve’s Board of Governors. “That changed attitudes about risk. The crisis made an indelible imprint that won’t be quickly forgotten.”
Blinder’s point is hard to deny, yet some of the leaders of banks that performed best through the crisis argue that it paints with too broad of a brush. “Some banks would be much more conservative today, but the healthy banks-ones like U.S. Bancorp, BB&T, and M&T Bank-wouldn’t have adjusted lending standards that much after the crisis because we weren’t doing crazy stuff in the first place,” says Allison, who made it through the crisis at the helm of BB&T without having to record a single quarterly loss. “And we wouldn’t have been burned to the same extent as we were, even though we did well through the crisis, if the regulators hadn’t made us change our approach to serving customers. So you had a regulatory magnifying glass on risk taking that’s been quite significant, even for healthy banks.”
Charles Calomiris, the Henry Kaufman professor of financial institutions at the Columbia Business School, takes this argument even further. “We’re really living in a kind of Kafkaesque world now in terms of the way regulation is done in the banking system,” says Calomiris, who co-authored a seminal book (“Fragile by Design”) on the evolution of financial regulation in the United States. “And it’s not just the regulations. It’s also the new mode of approach by regulators, especially toward financial institutions.”
Calomiris points to how regulations passed since the crisis impede growth in the industry and, together with low interest rates, have all but halted the filing of new bank charters, both of which would logically hasten the exit of rational growth investors.
“Each of the size categories of banks are facing different hurdles,” says Calomiris. “For small banks, they have huge overhead costs because of the heavy compliance burden. For medium-sized banks, given that we have these regulatory hurdles at $10 billion and $50 billion in assets, you see banks not wanting to grow and cross those thresholds. Then of course the big banks are subject to a whole different set of rules. And you see almost no new banks for one of the few times in history.”
Only eight banks applied for insurance coverage through the Federal Deposit Insurance Corp. in 2016 compared to an average of over 200 applications in a typical year before the crisis, as Bank Director magazine detailed in its second quarter 2017 issue (“The New Crop of De Novo Banks”). And even at just eight applications, last year marked a fourfold increase over 2015 and an eightfold increase over 2014.
“Investors can’t earn an adequate rate of return on the capital that they’d be required to put into a de novo bank,” Tom Brown, founder and CEO of Second Curve Capital, a New York-based hedge fund that invests in banks, said in an interview for the de novo story. “I think anybody who applies should be denied just on the basis of poor judgment.”
The impact on growth in the industry has been similarly profound, as banks navigate the added compliance burdens that kick in after banks pass $10 billion and $50 billion in assets.
Researchers at Texas A&M University found that banks just below $10 billion in assets are more acquisitive than banks far below the threshold, in terms of both the likelihood of doing an acquisition and the number of acquisitions. “When banks cross the $10 billion threshold, they tend to jump well over it and continue to grow faster, presumably because they need the additional scale to absorb the increased regulatory costs and burden,” says Shane Johnson, a professor at Texas A&M’s Mays Business School and one of the study’s co-authors.
The data bears this out. The 10 fastest-growing regional banks over the past decade had an average of $4.5 billion in assets going into the crisis. Today, those banks have an average of $23 billion in assets on their balance sheets.
Pinnacle Financial Partners offers a case in point. The Nashville-based bank passed the $10 billion mark in the third quarter of 2016 following its acquisition of another Nashville bank, Avenue Financial Holdings, which expanded Pinnacle’s presence in the city. Six months later, Pinnacle agreed to buy BNC Bancorp, a $7.4 billion asset bank in High Point, North Carolina. The combined companies add up to approximately $20 billion in assets. This gave Pinnacle the scale to more manageably absorb the $8 million in additional compliance costs that it believed it would incur upon passing the $10 billion mark.
Conversely, as banks approach $50 billion in assets, they tend to stop growing altogether in order to avoid crossing the threshold, Johnson and his co-authors found. It’s at that point that a bank qualifies as a Systemically Important Financial Institution, or SIFI, and is therefore subject to, among other things, the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) regulatory framework, which mandates annual stress tests. CCAR is especially onerous because it dictates how much capital a bank can return to shareholders through dividends and stock buybacks, which can have a significant impact on a bank’s stock price.
The only bank to cross this threshold since 2010 is New York-based CIT Group, which grew from $47 billion in assets to $68 billion as a result of its 2015 acquisition of OneWest Bank, which rose from the ashes of IndyMac Bancorp, a California-based mortgage lender that failed during the financial crisis.
New York Community Bancorp is the only other bank to attempt to cross $50 billion in assets. The $48 billion bank based in Westbury, New York, spent the past few years restraining its lending growth to avoid incidentally passing the threshold while at the same time adding millions of dollars in compliance costs to prepare for eventually doing so. “We’d prefer to jump through the $50 billion mark with a large deal,” said Chairman and CEO Joseph Ficalora in a 2014 interview with The Wall Street Journal.
That’s exactly what New York Community set out to do one year later, agreeing to acquire Lake Success, New York-based Astoria Financial Corp., which would have brought the combined institutions’ assets to $64 billion. But the deal came with a catch. New York Community cut its dividend by a third to bring its payout ratio down from around 90 percent, as regulators have signaled a 40 percent cap on payout ratios for SIFIs. This broke the bank’s streak of distributing $0.25 per share for 47 consecutive quarters, something it continued to do even through the financial crisis. It also transformed the investment thesis in New York Community’s stock, which has long been one of the highest yielding in the banking industry, as well as one of the industry’s best performers in terms of total shareholder return since the mid-1990s.
Consequently, when the banks called the deal off at the end of 2016, ostensibly due to an elongated regulatory approval process incidental to creating a new SIFI, New York Community was left with all of the disadvantages of breaching $50 billion (higher compliance costs and a lower payout ratio) but none of the advantages (bolstered economies of scale). And in the meantime, its shares have lost 30 percent of their value, dropping from a high of more than $19 per share in the third quarter of 2015 down to less than $13 per share in mid-August 2017.
Since passage of the Dodd-Frank Act, the $50 billion asset threshold has become an almost impenetrable barrier to growth through acquisition for bigger banks. And any bank that is able to cross that barrier must then look forward to two more-one at $250 billion in assets, at which point a bank is subject to an added qualitative test of its capital planning process in the annual stress test, and another once a bank amasses 10 percent of domestic deposits, as is the case with the nation’s three biggest banks: New York-based JPMorgan Chase & Co., Bank of America and Wells Fargo & Co. in San Francisco.
And it’s not just obvious hurdles like these that stand in a bank’s way as it seeks to grow. Banks have also found regulatory compliance issues to be a formidable barrier to acquisitions, which could otherwise be used as an effective growth strategy in a low interest rate environment.
U.S. Bancorp entered into a consent order with the Office of the Comptroller of the Currency in 2015, banning the Minneapolis, Minnesota-based bank from making whole-bank deals until deficiencies in its anti-money laundering compliance program were resolved. And not long after M&T Bank Corp. announced its intent to buy Hudson City Bancorp in 2012, the Federal Reserve put that deal on ice for the same reason. The Hudson City deal was finally approved by regulators in 2015 after M&T made significant changes to its program, although the Fed didn’t terminate a related enforcement action against M&T until July of this year.
This combination of explicit and implicit growth impediments at even the country’s best-run banks speaks to McColl’s observation that “you have a large number of small banks that have no place to go because there aren’t any buyers, no real buyers. And that’s where I think the industry is at today.”
It’s more than just the flow of capital into the industry from growth investors that’s being impeded by bottlenecks and regulatory quicksand; the influx of talent into banks has been stymied as well, say industry observers. This threatens to short circuit the natural recovery in risk appetite that would accompany an influx of new hires into banks that aren’t psychologically scarred by the financial crisis.
This creates a “double-barrel problem,” says McColl. “Because my company was growing, I was able to hire people who wanted to grow and do things. It’s very hard for banks to hire those kinds of people today. First, maybe the banks don’t want to. And second, people would rather work some place more exciting.”
Allison saw the same thing when he served on the BB&T board for five years following his retirement as CEO in 2008 after 20 years at the helm. “We didn’t have a single quarterly loss and yet the regulators were punishing us even though we had done an excellent job,” he says. “That was discouraging, and it took a lot of the fun out of being involved in the bank industry and the enjoyment of what I’d call entrepreneurship, finding better ways to help customers. That’s been a big negative for the industry and for the people working in it.”
“Since I’ve been out of the industry, I’ve taught at Wake Forest University’s graduate business school, and I get asked a lot by students about the future of the industry and whether they can make any money in it with all these regulations,” says Allison. “So I know the industry has lost a lot of potential talent, and it’s sad because they’re going to the nonregulated businesses that can do a lot more damage than banks could ever do.”
Calomiris sees the same thing with his MBA students at Columbia Business School. “Prior to the financial crisis, we were training a large number of people to work in the largest financial institutions,” he says. “We’re still doing that, but our finance enrollments went way down, and the number of people that we sent to those institutions also shrank. That’s another fairly long-term legacy. The notion that bright-eyed, top MBA students are going to have these sinecures earning top salaries at the top institutions isn’t happening any longer, at least not for now. From any perspective, this is really a watershed.”
Fortunately, things are getting better for banks on the regulatory front and involving the $50 billion bottleneck in particular. The Fed eliminated the most onerous portion of Dodd-Frank stress tests, concerning a qualitative assessment of a bank’s capital planning process, for financial institutions with assets between $50 billion and $250 billion. The regulatory approval process for mergers has been eased for deals that would result in the creation of a bank holding company with assets below $100 billion; it was previously $25 billion. And based on conversations with a wide range of industry observers, there’s a growing consensus among policymakers in Washington that the current $50 billion SIFI threshold should be raised.
These changes speak to the undulating nature of the regulatory cycle. “It’s almost inevitable that after you pass a regulatory bill like Dodd-Frank, that lobbyists will start descending, and the regulators are going to start loosening it,” says Blinder. “If you start it exactly where you think it should be in terms of regulatory tightness, you will shortly end up in a world where things are too loose. So you start in a place that’s a bit too tight, knowing that it’s going to loosen. I think of Dodd-Frank that way.”
It’s too early to say if these changes will reignite a broader interest in the sector from growth investors, as interest rates will continue to weigh heavily on bank profitability, and the $50 billion and $250 billion growth barriers remain in place despite optimism that they could be removed, but there’s no question that steps are being taken in that direction.
“I’m relatively optimistic about the industry given what’s been going on recently,” says Allison. “I think we will get some regulatory relief. I think interest rates might return closer to normal levels. But it’s going to take a while for the industry to get back to exciting growth, radical improvement in products and technology. And it’s going to be difficult to achieve that until we get true action by Congress to undo Dodd-Frank. You can’t just get better regulators, you actually need to undo some of the structure, which is hard to do in this type of political environment.”