Getting a Return on Relationship Profitability

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profitability-7-8-19.pngHow profitable are your bank’s commercial relationships?

That may seem like a strange question, given that banks are in the relationship business. But relationship profitability is a complex issue that many banks struggle to master. A bank’s ability to accurately measure the profitability of its relationships may determine whether it’s a market leader or a stagnant institution just trying to survive. In my experience, the market leaders use the right profitability metrics, measure it at the right time and distribute that information to the right people.

Should Your Bank Use ROE or ROA? Yes.
Many banks use return on assets, or ROA, to measure their portfolio’s overall profitability. It’s a great way to compare a bank’s performance relative to others, but it can disguise credit issues hidden within the portfolio. To address that concern, the best-performing banks combine an ROA review with a more precise discussion on return on equity, or ROE. While ROA gives executives a view from above, ROE helps banks understand the value, and risk, associated with each deal.

ROA and ROE both begin with the same numerator: net income. But the denominator for ROA is the average balance; ROE considers the equity, or capital that is employed by the loan.

If your bank applies an average equity position to every booked loan, then this approach may not be for you. But banks that strive to apply a true risk-based approach that allocates more capital for riskier deals and less capital for stronger credits should consider how they could use this approach to help them calculate relationship profitability.

Take a $500,000 interest-only loan that will generate $5,000 of net income. The ROA on this deal will be 1 percent [$5,000 of net income divided by the $500,000 average balance]. The interest-only repayment helps simplify the outstanding balance discussion and replicates the same principles in amortizing deals.

You can assume there is a personal guarantee that can be added. It’s not enough to change the risk rating of the deal, but that additional coverage is always desirable. The addition of the guarantee does not reduce the outstanding balance, so the ROA calculation remains unchanged. The math says there is no value that comes from adding the additional protection.

That changes when a bank uses ROE.

Let’s say a bank initially allocated $50,000 of capital to support this deal, generating a 10 percent ROE [$5,000 of net income divided by the $50,000 capital].

The new guarantee changes the potential loss given default. A $1,000 reduction in the capital required to support this deal, because of the guarantee, increases ROE 20 basis points, to 10.20 percent [$5,000 of net income divided by the $49,000 of capital]. The additional guarantee reduced risk and improved returns on equity.

The ROA calculation is unchanged by a reduction in risk; ROE paints a more accurate picture of the deal’s profitability.

The Case for Strategic Value
Assume your bank won that deal and three years have now passed. When calculating that relationship’s profitability, knowing what you’ve earned to-date has a purpose; however, your competitors care only about what that deal looks like today and if they can win away that customer and all those future payments.

That’s why the best-performing banks consider what’s in front of them to lose, not what has been earned up to this point. This is called the relationship’s “strategic value.” It’s the value your competition understands.

When assessing a relationship’s strategic value, banks may identify vulnerable deals that they preemptively reprice on terms that are more favorable to the customer. That sounds heretical, but if your bank’s not making that offer, rest assured your competitors will.

The Right Information, to the Right People, at the Right Time
Once your bank has decided how it will measure profitability, you then need to consider who should get that information—and when. Banks often have good discussions about pricing tactics during exception request reviews, but by then the terms of the deal are usually set. It can be difficult to go back to ask for more.

The best-positioned banks use technology systems that can provide easily digestible profitability data to their relationship managers in a timely fashion. Relationship managers receive these insights as they negotiate the terms of the deal, not after they’ve asked for an exception.

Arming relationship managers with a clear understanding of both the loan and relationship profitability allows them to better price, and win, a deal that provides genuine value for the bank.

Then you can start answering other questions, like “What’s the secret to your bank’s success?”

How to Design a Winning Capital Management Plan

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capital-4-22-19.pngThe significant downturn in bank stock prices witnessed during the fourth quarter of 2018 prompted a number of boards and managements to authorize share repurchase plans, to increase the amounts authorized under existing plans and to revive activity under existing plans. And in several instances, repurchases have been accomplished through accelerated plans.

Beyond the generally bullish sentiment behind these actions, the activity shines a light on the value of a proactive capital management strategy to a board and management.

The importance of a strong capital management plan can’t be overstated and shouldn’t be confused with a capital management policy. A capital management policy is required by regulators, while a capital management plan is strategic. Effective capital management is, in large part, an exercise in identifying and understanding future risks today. Capital and strategy are tightly linked — a bank’s strategic plan is highly dependent on its capital levels and its ability to generate and manage it.

There are a couple of guidelines that executives should bear in mind as they develop their capital management plans. First, the plan needs to be realistic and achievable. The windows for accessing capital are highly cyclical. There’s limited value in building a plan around an outcome that is unrealistic. Second, if there is credible information from trusted sources indicating that capital is available – go get it! Certain banks, by virtue of their outstanding and sustained performance, may be able to manage the just-in-time model of capital, but that’s a perilous strategy for most.

Managements have a number of levers available to manage capital. The key as to when and which lever to pull are a function of the strategic plan. A strong plan is predicated on staying disciplined but it also needs to retain enough nimbleness to address the unforeseen curveballs that are inevitable.

Share Repurchases
Share repurchases are an effective way to return excess capital to shareholders. They are a more tax-efficient way to return capital when compared to cash dividends. Moreover, a repurchase will generally lift the value of a stock through the reduction in shares outstanding, which should increase earnings per share and the stock price itself. Share repurchases are generally the favored mechanism of institutional owners and can make tremendous sense for broadly held and liquid stocks.

Cash Dividends
Returning capital to shareholders in the form of cash dividends is generally viewed very positively in the banking industry. Banks historically have been known as cash-dividend paying entities, and the ability and willingness to pay them is often perceived as a mark of a healthy and stable company. A company’s decision regarding whether to increase a cash dividend or to repurchase shares can be driven by the composition of the shareholder base. Cash dividends are generally valued more by individual shareholders than institutional shareholders.

Business Line Investment
Community banking at its core is a spread dependent business. The ability to diversify the revenue stream through the development or acquisition of a fee generating business can be an effective and worthwhile use of capital. Common areas of investment include mortgage banking, wealth management, investment products and services and insurance. Funding the lift out of lending teams can also be a legitimate use of capital. A recent development for some is investment in technology as an offensive play rather than a defensive measure.

Capital Markets Access
Effective capital management plans also consider the ability to access the capital markets. In the community banking space, accessing capital is not always a foregone conclusion. Over the past couple of years, the most common forms of capital available have been common equity and subordinated debt. For banks of a certain size and market cap, it’s a prudent capital management strategy to file a shelf registration, also known as form S-3, which provides companies with flexibility as to how and when they access the capital markets. The optionality provided by having a shelf registration far outweighs the concern that the shelf itself suggests a shareholder dilutive activity is on the horizon.

It’s important to note that these capital management activities can be utilized individually or in combination. An acquisition may necessitate the need to access the capital markets. Or given the relative inexpensiveness of sub debt, raising some for the purpose of a share repurchase could make sense. A strong capital management plan can allow a management team to be ready both offensively and defensively to drive their businesses forward in optimal fashion.

Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.

Should 1,900 Banks Restructure After Tax Reform?

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strategy-2-18-19.pngOne of the big story lines of 2018 was tax reform, which should put more money in the pockets of consumers and businesses to grow, hire, and borrow more from banks.

Shareholders of Subchapter-S banks may ask whether the benefits of Sub-S status are as meaningful in the new tax environment. Roughly 35 percent of the 5,400 banks in the U.S. are Subchapter-S corporations, and given the changes brought by the Tax Cuts and Jobs Act, some choices made under the prior tax regime should be revisited.

Prior to tax reform, the benefits of Sub-S status were apparent given the double taxation of C-Corp earnings with its corporate tax rate of 35 percent, plus the individual dividend tax rate of 20 percent. That’s compared to the S-Corp, which only carried the individual income tax rate up to 39.5 percent.

Tax reform lowered the C-Corp tax rate to 21 percent, lowered the maximum individual rate to 37 percent, and created a potential 20 percent deduction of S-Corp pass-through earnings, all of which make the choice much more complicated.

Add complexities about how to calculate the 20 percent pass-through deduction on S-Corp earnings, the 3.8 percent net investment income tax on C-Corp dividends and some S-Corp pass-through earnings, and it becomes more challenging to decide which is best.

Here are some broad concepts to consider:

  • S-Corp shareholders are taxed on the corporation’s earnings at the individual’s tax rate. If the corporation does not pay dividends to shareholders, the individual tax is being paid before the individual receives the actual distribution. 
  • The individual tax on S-Corp earnings may be mitigated by the 20 percent pass-through deduction allowed by the IRS, but not all the rules have been written yet. 
  • A C-Corp will pay the 21 percent corporate tax, but individual tax liability is deferred until shareholders are paid dividends. The longer the deferral, the more likely a C-Corp structure could be more tax efficient.

The impact of growth, acquisitions, distributions, and capitalization requirements are interrelated and critical in determining which entity makes the most sense.

If a bank is growing quickly and distributing a large percentage of its earnings, its retained earnings may not be sufficient to maintain required capital levels and may require outside capital, especially if the bank is considering growth through acquisition. Because an S-Corp is limited in the type and number of shareholders, its access to outside capital may also be limited, often to investments by management, board, friends, family and community members.

A bank with little or no growth may be able to fully distribute its earnings and still maintain required capital levels. Depending on the impact of Internal Revenue Code Section 199A, state taxes, the 3.8 percent net investment income tax and other factors, Subchapter S status may be more tax efficient.

Section 199A permits the deduction of up to 20 percent of qualifying trade or business income and can be critical to determining whether Subchapter-S makes sense. For shareholders with income below certain thresholds, the deduction is not controversial and can have a big impact.

For shareholders with income above the thresholds, the deduction could be limited or eliminated if the business income includes specified service trade or business income, which includes investment management fees and may include trust and fiduciary fees and other non-interest income items.

S-Corp structures can be terminated at any time. If your bank is a C-Corp and considering a Subchapter S election for the 2019 calendar tax year, the election is due on or before March 15, 2019.

Given the level of complexity and amount of change brought about by the new tax legislation, it is clear that that decisions made under the old rules should be revisited.

Should Banks Repurchase Stock Right Now?

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stocks-2-5-19.pngWith expectations of regulatory reform and growth in organic capital generation, it is generally expected that over the next 12 months banks will continue to return capital to shareholders through continued M&A activity, dividend increases or share buybacks.

Given the current market environment, it is an opportune time for banks to consider initiating a share repurchase program.

As market volatility continues, a growing number of banks have been implementing share repurchase – or stock buyback – strategies to manage capital and shore up stability. During volatile periods, financial companies are frequently the first to feel the pain, and buyback programs are a means of getting in front of potential price dips and preserving value.

The buyback market set records in 2018 across many industries. As of late December, more than $1 trillion in share repurchase programs had been authorized – eclipsing the $655 billion total for 2017. The third quarter of 2018 was especially active, with financial institutions making up the third-largest sector. In the bank buyback space alone, 22 repurchase programs were announced in October, 18 in November and 27 in December.

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Generally, companies that participate in share repurchase programs are carrying cash on the balance sheet in excess of what is necessary to fund daily operations and growth opportunities. The question then becomes how to use it. Given the relative slowdown lately in the M&A market, buybacks have presented banks with the opportunity to accomplish a variety of goals.

Reasons why banks undertake share repurchase programs:

  • Reducing the number of outstanding shares can be accretive to earnings per share, making the company more attractive to investors 
  • A buyback signals to the market that a bank views its share price as undervalued
  • It can absorb overhang from capital markets transactions
  • These programs can help manage or optimize capital structure 
  • They return excess capital to shareholders 
  • Buybacks can offset or mitigate the dilution from employee equity compensation awards

What banks should keep in mind when pursuing buybacks:

  • It will reduce capital available for future growth and acquisitions
  • A buyback utilizes cash and regulatory capital and may impact book value
  • They will likely reduce the number of shareholders and future share liquidity.
  • The impacts are temporary.
  • Blackout periods may apply.
  • Banks with pending acquisitions where the target shareholder vote has not taken place cannot execute a buyback unless the transaction is paid with solely cash, or unless the bank was repurchasing shares pursuant to SEC Rule 10b-18 in the three months preceding the announcement.

While there is no cookie-cutter profile for companies that elect to participate in share repurchase programs–they vary in terms of market capitalization, balance sheet composition and industry sector – there is a well-defined and strictly regulated process these types of transactions must follow.

While SEC Rule 10b-18 governs the parameters of a buyback, including the manner of purchase, the timing of the repurchases, the prices paid and the volume of shares repurchased, companies executing a buyback program should consider the benefits of Rule 10b5-1.

The rule provides companies the ability to establish a buyback plan in an open window that can be executed during closed trading periods. Many companies establish 10b5-1 plans to ensure continuous execution of their buyback strategy and to take advantage of periods of market volatility where opportunistic purchases may be realized.

The buyback market is busy and breaking records. The Corporate & Executive Services team at Raymond James has discussed repurchase programs with more than 50 regional banks in recent months.

Now is a good time for banks with excess capital to weigh their options and reach out to partner firms that can help develop and execute successful repurchase strategies.

Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value. © 2019 Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. © 2019 Raymond James Financial Services, Inc., member FINRA/SIPC. Raymond James® is a registered trademark of Raymond James Financial, Inc.

Your M&A Success Could Depend On This One Thing

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merger-12-19-18.pngBenchmarking key performance indicators (KPIs) can help you more fully understand your bank’s financial condition and operating results, as well as the true value in a potential M&A market.

The success of your M&A strategy – whether buy, sell or stay – measurably increases with a sound grasp of the metrics that drive shareholder value.

KPIs as M&A drivers
KPIs can help you to identify important strengths in your target organization and your own institution. This can help determine the areas you could strengthen in an acquisition, or understand where your bank’s value lies within a merger. You can also learn about your organization’s, or your target institution’s, primary challenges and how this might impact the transaction.

These metrics can also help the organization evaluate the success of the transaction after completion. Have the key performance indicators drastically changed? Was that change different from the anticipated adjustment from the combination of the two entities? Understanding the metrics, and some of the forces impacting them, can be a strong foundation for successful M&A transactions.

Q3 2018 KPI observations
Community banks throughout the U.S. used the strong economy and relatively stable interest rate environment to maintain steady operations throughout the third quarter of 2018.

Baker Tilly’s banking industry key performance indicator (KPI) report reflected almost no change in comparison to the same benchmarks for the second quarter of 2018. Earnings, credit quality and capital adequacy benchmarks all remained essentially the same. This consistency appears to reflect a more stable economic environment, disciplined management of credit pricing and quality, notwithstanding a continued highly competitive environment, and the early stages of a move to higher interest rates.

M-A-chart.png

If there is anything to take away from the relatively unchanged KPIs over the first nine months of 2018, it is that community bankers have diligently pursued the opportunities emerging from the strong economy.

Loan growth, reflected in the comparison of the loan-to-deposits ratios each quarter, has been somewhat subdued. Potential drivers of this include increasing liquidity pressures arising from changes in interest rates, early stages of the potential for a downward credit cycle and the uncertainty of the November midterm elections. These factors kept many community bankers focused on internal matters such as compliance and technology during the second and third quarters of 2018.

Many banks continued to assess consolidation opportunities on both the buy and sell side. Until the recent series of market declines, bank equity currency remained quite strong, supporting a continued active consolidation of the industry, at price points that, on average, exceed 1.5 – 1.7 times book value.

We expect more of the same consistency in the KPIs as we have seen throughout 2018. It does not appear there will be any significant shifts in either direction arising from changes in economic policy. However, the pace of deregulation may subside due to the change in leadership in the U.S. House of Representatives.

If equity markets rebound following the midterms and the Federal Reserve pauses its increase of interest rates, we may see a re-acceleration of the consolidation of community banks, especially those with assets of $500 million or less. Other than an increased emphasis on securing and maintaining low cost deposits, we anticipate community banks to maintain a steady course into early 2019.

Why Investors Are Still Hungry for New Bank Equity

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capital-10-12-18.pngThe U.S. economy is riding high. Bank stocks, while their valuations are down somewhat from their highs at the beginning of the year, are still enjoying a nice run. For most banks that want to raise new equity capital, the window is still open.

The banking industry is already well capitalized and bank profitability remains strong. According to the Federal Deposit Insurance Corp., the industry earned $60.2 billion in the second quarter of this year, a 25 percent gain over the same period last year, thanks in no small part to the Trump tax cut, which has also helped prop up bank stock valuations. The truth is, in the current environment, banks don’t need to raise new equity just to increase their capital base—they can do that through retained earnings. The industry is awash with capital and most banks don’t necessarily need even more of it.

“The industry overall is enjoying capital accretion,” says Bill Hickey, a principal and co-head of investment banking at Sandler O’Neill + Partners. “Capital ratios industry-wide have continued to increase as banks have earned money and obviously enjoyed the benefits of tax reform. … I think the need for equity capital has lessened slightly as a result of capital ratios continuing to increase.”

Over the last few years, banks have clearly taken advantage of the opportunity to repair their balance sheets, which were ravaged during the financial crisis. According to S&P Global Market Intelligence, there were 123 bank equity offerings in 2016, which raised nearly $6 billion in capital at a median offering price that was 125 percent of tangible book value (TBV) and 52.8 percent of the most recent quarter’s earnings per share (MRQ EPS). There were 146 equity offerings in 2017 that raised nearly $7.5 billion, with offering price medians of 66.3 percent of TBV and 16.6 percent of MRQ EPS. (The industry was much less profitable in 2016 than in 2017, which explains the wide disparity between the median values for the two years.) And through Sept. 26, 2018, there were just in 66 offerings—but they have raised $7.6 billion in equity capital, with a median offering price that was 175 percent of TBV and 13.3 percent of MRQ EPS.

As the median offering prices as a percentage of TBV have gone up over the last two and a half years, while also declining as a percentage of the most recent quarter’s earnings per share—which means that institutional investors are in effect paying more and getting less from a valuation perspective—you might think investor appetite for bank equity would begin to wane. But according to Hickey, you would be wrong.

“There is a lot of money out there looking to be deployed in financial services and banks,” he says. “So there are folks who need to deploy capital—pension funds, funds specifically focused on investing in financial institutions. They have cash positions they need to deploy into investments. So there is a great demand for equity, particularly bank equity at the current time.”

Hickey says most of this new equity was raised to fuel growth, either organic growth or acquisitions. But any bank considering doing so needs to provide investors with a detailed plan for how they intend to use it. “You have to be able to articulate a strategy for the use of the capital you intend to raise,” says Hickey. “That seems obvious, but it needs to be explained quite well to the investment community so they understand how the capital is going to be deployed and have a sense of what their return possibilities are.”

And if you’re going to tap the equity market to support your strategic growth plan, make sure you raise enough the first time around. “Arguably, a company [should] raise enough money that will allow it to fund their growth for at least 18 to 24 months,” Hickey explains. “Investors don’t like it when they’re investing today and then 12 months later the same company comes back looking for more capital. Investors would [prefer] to minimize the number of offerings so they’re not diluted in the out years.”

What It Takes to Go De Novo Today

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de-novo-7-27-18.pngAaron Dorn spent two years putting together a checklist of things that needed to be in place and questions that needed to be answered before starting a new bank.

He considered buying an existing bank, but acquiring a company built on legacy core technology was a big inhibitor to building a digital-only bank, which was Dorn’s business plan. However, the idea of going de novo became too costly and intensive to justify the effort after the FDIC increased its capitalization requirements for startups following the financial crisis. Now, there are signs that the environment for de novos is improving. Economic conditions around the country are better and bank stock values are higher, but there are other factors that could also be significant drivers behind a recent uptick in de novo activity, all of which Dorn discovered in Nashville as he considered the de novo route.

Dorn, 37, formally began the process of raising capital in the fall of 2017 to form Studio Bank, which will officially open in a few weeks. He will serve as the CEO and also brought along a few former colleagues from Avenue Bank, where Dorn was the chief strategy and marketing officer. Avenue Bank was a 10-year-old “de facto de novo” (a recapitalized and rebranded Planters Bank of Tennessee) that sold in 2016 to Pinnacle Financial Partners, another Nashville-based bank. In fact, Studio’s music company-turned bank home sits in the shadow of Pinnacle’s headquarters building.

Just two banks have earned FDIC approval this year, but nearly more than a dozen de novo applications were awaiting approval in mid-June. That comes after just 13 banks opened in the seven preceding years, according to the agency. Capital raises for the new banks have been anywhere from a fairly standard $20 million to $100 million by Grasshopper Bank, based in New York.

This flurry of activity has naturally drawn attention and speculation about whether there will be a return to the level of new charter activity we saw previous to the financial crisis when in any given year there could be between 100 to 200 new bank formations. What exactly has inspired this growth in applications? Along with a stronger economy and higher valuations, the industry’s ongoing consolidation has created opportunities for former bankers like Dorn who are itching to get back into a business currently ripe with promise.

“These mergers are producing opportunities for groups to put together locally owned, more community focused financial institutions to service their market and also play an important role as community leaders,” said Phil Moore, managing partner at Porter Keadle Moore, an advisory and accounting firm.

But the question circulating among bankers and insiders is what has inspired the sharp increase in de novo activity. Or perhaps more importantly, what’s the recipe for starting a new bank today?

There’s a few things some agree need to be in place to get a new bank off the ground.

“The first is that these de novos are organizing in what could be considered underserved markets, secondly they are focusing on vibrant growth areas and third, they are generally organizing to serve an affinity group,” says Moore.

This is Dorn’s perspective also, who says he created Studio in part because the booming Nashville market has few local banks. Studio will focus on “creators,” as Dorn calls them, including musicians, nonprofits and startups, a very similar model to Avenue, except that Studio will operate from a digital platform.

The Nashville deposit market has doubled since the last de novo opened there in 2008, Dorn says. There is also a preference for local ownership. “Empirically, (Nashville is) a market that strongly prefers locally headquartered banks,” he says.

Studio is one of just two de novos that have been approved this year. The other, CommerceOne Bank, is in Birmingham, Alabama, another blossoming metro area that also has very few locally owned banks. Birmingham rates in the top 160 metro areas in the country, according to the Milken Institute’s 2017 Best-Performing Cities report.

Other pending applications that are also in high-performing areas like Oklahoma City, ranked 131, and Sarasota, Florida, ranked No. 6.

That’s still a far cry from the de novo activity seen in the decades prior to the financial crisis, but the interest in starting new companies can certainly be seen as encouraging.

Four Ways to Effectively Deploy Excess Capital

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capital-7-23-18 (1).pngFavorable economic conditions for banks, which include a healthy business sector, a rising interest rate environment, and the impact of tax and regulatory reforms, have resulted in strong earnings for many community banks. While this confluence of positive market developments has led many growing banks to tap public and private markets for additional capital to fund growth opportunities, many other institutions are facing an opposing challenge.

These institutions, many of which are located in non-metropolitan markets, are experiencing record earnings yet do not have existing loan demand to effectively deploy the capital into higher yielding assets. As a result, these institutions must evaluate how best to deploy excess capital in the absence of organic growth opportunities in existing markets to avoid the impact on shareholder returns of reinvestment into the securities portfolio during a period that continues to be characterized by historically low interest rates.

Dividends. Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank’s strategic planning.

Tender Offers and Other Stock Repurchases. Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility.

De Novo Expansion into Vibrant Markets. Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers. For example, a rural bank with a high concentration of stable, inexpensive deposits but weak loan demand could expand into a larger market where loan demand is strong but deposit pricing is elevated. By doing so, the bank can leverage excess capital and inexpensive deposits through quality loan growth and, optimize its net interest margin and earnings potential. With advances in technology, overhead costs associated with de novo entry into a new market have substantially decreased, although competition for deposit and loan officers is intense. Startup costs may be further diminished through a loan production office, rather than a branch in a new market.

Mergers and Acquisitions. Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective. For example, a bank’s acquisition strategy could involve joining forces with, or eliminating, a competitor with a complementary business and corporate culture. Alternatively, it could be driven by corporate objectives to enhance earnings by expanding into a larger market with stronger demand for high-quality loans. On the other hand, an institution based in a metropolitan market may be inclined to target a lower growth market with a high concentration of lower cost, core deposits. In either case, the acquisitions are complementary to the institutions.

All banks with excess capital have strategic decisions to make to maximize shareholder value. In many cases, these decisions result in returning capital to shareholders, while others seek to leverage excess capital in support of future growth. The strategy for deploying excess capital should be a material component of a bank’s strategic planning process. There is no universal, or right, answer for all banks. Each bank must consider its options against its risk tolerance, long-term strategic goals and objectives, shorter term capital needs, management and board capacity.

Are De Novos Making A Comeback?

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de-novo-7-3-18.pngThere was a time, not long ago, when FDIC approved 237 applications in a single year. That was 2005. It’s unlikely there will be a return to similar activity levels, the de novo activity has grown from the post-recession single-digit levels to more than 20 open applications. That number that is anticipated to increase through 2018.

Among the de novos are geographically diverse groups involving non-traditional business models, online services, foreign nationals, ethnic/professional niches and minority ownership. Regulators have been open to applications that may have been deemed “non-starters” years ago.

Changes have been made to the FDIC application process that will benefit new community banks such as lessening the de novo period from seven to three years. The rescinding of the FDIC de novo period, the designation of de novo subject matter experts in the regional offices, and the issuance of supplemental guidance along with the FDIC’s “A Handbook for Organizer of De Novo Institutions” indicate a growing commitment by regulators to facilitate the process of establishing new community banks.

To ensure a smooth regulatory process and avoid significant cost outlays, groups should schedule and attend meetings with various regulatory agencies before pre-filing meetings to discuss the timeline and the likelihood of acceptance of an application. Federal and state regulators act in a timely manner, provide constructive feedback and can be easy to work with throughout the de novo process. Strong working relationship with the federal and state regulators, along with the collaboration between all parties highlight the importance of building the right team at the start.

The minimum opening capital requirement has been established at around $22 million. The caveat is that the capital must be in line with the risk profile of proposed bank, though more often than not $20 million or more of seed capital is almost always needed. Why is $22 million or more the magic number?

  • Start-up costs and initial operating losses of $1.5 to $3 million;
  • Profitability being achieved at between $175 to $225 million in assets;
  • Required Tier One Leverage ratio above 8 percent or more throughout the de novo period;
  • Creates an adequate loan-to-borrower limit.

Once the formation bank reaches the minimum capital requirement and gains approval it can open the doors. Once open, the bank can continue raising capital until a higher or maximum level is reached. Additionally, the ability to use 401k accounts for investors is a necessity.

De novo formations bring value to their communities, their markets, shareholders, and the banking industry by filling a void created by the consolidation. With the loss of many key banks, organizers and local businesses feel that larger banks are not providing the level of service and credit desired by small- to medium-sized business owners.

Since the Great Recession, select areas of the country have rebounded more strongly than others. Texas, the Dakotas, Florida, the Carolinas, Washington, D.C., Utah and Washington state are among leaders in job creation and population growth. Given the growth, along with the opportunities to serve growing ethnic and minority populations, many geographies across the country offer attractive opportunities for de novo banking.

Returns for de novo investors can be attractive. There is a risk associated with the initial start-up expenses and a resulting decline in tangible book value. A de novo raises initial capital at tangible book value. While building a franchise, reaching profitability and creating a successful bank allows for multiple expansions and strategic options which can provide attractive returns for initial investors.

Creating a well-connected and qualified board, management team and investor group is proven to be the best recipe for success. Having these individuals and businesses as deposit and lending customers increase, the community’s confidence in the bank facilitates the business generation, along with the marketing and word of mouth publicity.

The proper de novo team is comprised of the founder team, a strategic consultant with regulatory expertise and legal counsel. Business plans now routinely surpass 250 pages and legal requirements continue to expand. When choosing these partners, it is important they have experience in submitting de novo applications in recent years as nuances continue to evolve. Further, ensure all the fees paid are “success based,” so applicable expenses are aligned to the accomplishment of specific milestones.

Regulatory changes, market opportunities and industry consolidations have created an environment in which a de novo bank can form and flourish. With the right founding group and partners, now is the time to explore being part of the next wave of de novo banking.

CECL Will Result in a Sizable Capital Hit for U.S. Banks

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CECL-6-8-18.pngWhile a new reserve methodology is far from popular among U.S. banks, it could prepare them for the next economic downturn.

The banking industry has bemoaned the new provision largely due to its complexity. The current expected credit loss model, or CECL, will require banks to set aside reserves for lifetime expected losses on the day of loan origination, resulting in a sizable hit to capital at adoption.

S&P Global Market Intelligence has developed a scenario estimating CECL’s capital impact to the banking industry in aggregate as well as community banks — institutions with less than $10 billion in assets. The upfront reserve build that will come with CECL adoption could allow banks to better withstand a downturn, which could begin when banks adopt the methodology in 2020.

But, we don’t expect banks to take the change in stride and believe institutions will respond with higher loan prices and slower balance sheet expansion.

CECL becomes effective for many institutions in 2020 and will mark a considerable shift in practice. Banks currently set aside reserves over time, whereas the new provision requires them to substantially increase their allowance for loan losses on the date of adoption.

Given the capital hit, S&P Global Market Intelligence believes the industry’s tangible equity-to-tangible assets ratio could fall to 8.25 percent in 2020, assuming uniform adoption of CECL by all banking subsidiaries at that time. That level is 127 basis points below the projected capital if banks continue operating under the existing incurred loss model.

We expect a much more manageable capital hit for community banks, which could see their tangible-equity-to-tangible assets ratio fall to 11.13 percent in 2020, 50 basis points below the projected capital level for those institutions if they maintained the existing incurred loss model.

We assume that CECL reserves would match charge-offs over the life of loans. For the banking industry, we assumed the loan portfolio had an average life of three and half years, while assuming an average life of four and half years for community banks, based on the current loan composition of both groups of institutions.

The expected level of charge-offs stems from our longer-term outlook for credit quality. While improving sentiment among consumers and businesses should support relatively strong asset quality in 2018, credit standards should begin to slip in 2019 as banks compete more aggressively to win new business. Competition should increase because economic growth is not expected to be quite strong enough to create sufficient opportunities for banks to lever the additional capital created by tax reform.

Changes in the competitive environment could coincide with regulatory relief efforts. The Trump administration and Republican-controlled Congress have pushed to soften many rules passed in the aftermath of the credit crisis and the rolling back of regulations could invite further easing of underwriting standards. This would occur as interest rates increase, leading to a more expensive debt service and pushing some borrowers to the brink.

Even with those headwinds, community banks should once again maintain stronger credit quality than their larger counterparts. Community banks have greater exposure to real estate and while valuations have risen considerably since the depths of the credit crisis, there are reasons to believe smaller institutions’ credit quality will hold up far better through the next downturn.

The lack of a housing bubble and massive overbuilding in the residential real estate sector as well as heightened regulatory scrutiny over elevated commercial real estate lending concentrations should help prevent history from repeating itself.

The impact of CECL should also encourage banks to raise rates on newly-originated loans, particularly longer-dated real estate credits that will require a larger reserve build under the provision. We think that loan growth will be slower than it would have otherwise been as banks with thinner capital ratios hoard cash and work to rebuild their capital bases.

If the credit cycle bottoms several years after CECL’s adoption, the new accounting provision might work as intended. Banks will have set aside considerable reserves well ahead of a downturn and pull forward losses, meaning their earnings will be stronger when credit quality reaches a low point.

However, if losses peak as the industry implements the new reserving methodology, the hit to capital could prove even more severe and leave banks on weaker ground to weather a downturn.