Is The Time Right for De Novo Banks?

1-23-15-BryanCave.pngTen years ago, business was booming for community banks—profitability driven by a hot real estate market, a wave of de novo banks receiving charters, and significant premiums paid to sellers in merger transactions. Once the community bank crisis took root in 2008, however, the same construction loans that once drove earnings caused significant losses, merger activity slowed to a trickle, and only one new bank charter has been granted since 2008. But as market conditions improve and with Federal Deposit Insurance Corporation’s (FDIC) release of a new FAQ that clarifies its guidance on charter applications, there are some indications that an increase in de novo bank activity may not be far away.

To understand the absence of new bank charters in the last six years, one must look to the wave of bank failures that took place between 2009 and 2011, which involved many de novo banks. Many of these banks grew rapidly, riding the wave of construction and commercial real estate loans, absorbing risk to find a foothold in markets saturated with smaller banks. This rapid growth also stretched thin capital and tested management teams that often lacked significant credit or loan work-out experience. When the economy turned, these banks were not prepared for a historic decline in real estate values, leading to a wave of FDIC enforcement actions and bank failures.

In light of these factors, as well as heightened regulatory expectations for operating financial institutions, many observers have questioned whether regulatory or market demands would allow for any new bank charters. Senior FDIC officials have maintained in public comments that there is no moratorium in the approval of de novo applications and that they would consider all new applications that were consistent with FDIC policy. These officials have also indicated that interest in de novo banks typically increased when acquisition pricing  reached roughly 1.25 times book value. With acquisition premiums trending upward in response to greater deal activity, the new FAQ is well-timed to anticipate additional de novo applications in the coming years.

With much having changed since 2007, what would a viable de novo bank look like in 2015? The FDIC’s current guidance, as well as its enforcement actions with respect to some troubled banks, may provide a blueprint:

  • Increased capital will slow aggressive growth. In the public comments of its senior supervisory officials and its recent FAQ, the FDIC indicates that a viable de novo charter will not be required to exceed a Tier 1 Leverage Ratio of more than 8 percent, provided the proposal “displays a traditional risk profile.” In our reading, de novo institutions focused on construction lending or with a concentration in commercial real estate lending will likely be required to maintain a leverage ratio more in line with those imposed by FDIC consent orders, which is typically at least 10 percent. The net effect will be to moderate business plans that call for higher-risk lending or growth in excess of market rates.
  • Business plans and market footprint. As noted in the FDIC’s FAQ, de novo applications must contain only a three-year business plan, rather than a seven-year business plan. Although there is often little value to projections that fall outside of this three-year window, applicants should make sure that their business plans describe a distinct need for a new bank in the market that can generate a sustainable pattern of growth and earnings into the future. Identifying strong community support, a healthy market footprint, and a clear niche for the bank will be integral to any business plan.
  • Experienced management a must. While the FDIC’s guidance does not place any added emphasis on the senior management of a proposed de novo bank, we expect significant scrutiny to be devoted to the qualifications of the applicant’s management team prior to a de novo application being approved. In the wake of the crisis, de novo banks will need to demonstrate they have strong leadership to weather a potentially volatile market.

In light of the FDIC’s new guidance and its public comments, we believe that as market conditions improve and merger activity continues, de novo banks will begin to re-appear. However, with higher regulatory expectations and without double-digit annual growth, these new banks will need to grow more slowly, gaining a foothold in their market footprint organically. This focus on the generation of franchise value will distinguish these new banks from many of the de novo institutions of ten years ago.

Is the Grass Greener? Five Considerations before Converting your Charter

greener-grass.jpgBecause many banks continue to take a bruising from banking examiners, it should come as no surprise that some have considered a change of charter in hopes of finding a less overbearing overseer.

In particular, recent headlines have shown that a significant number of national banks have left a national charter for a state charter.  Since 2000, almost 300 national banks have made the switch. 

Provisions from a spate of recent Office of the Comptroller of the Currency consent orders may illustrate why, with some provisions requiring significantly higher capital ratios than other regulators have demanded from similarly situated state-chartered institutions as well as  other provisions essentially forcing national banks to either sell to new owners or face receivership.

If you are contemplating a charter conversion for your bank, there are a number of key issues to consider before you make the change.  These include:

Access to Government Officials:  Because state regulators are geographically closer and more familiar with the situation on the ground, channels of communication may be more open and less adversarial.  Likewise, small financial institutions may exert greater political influence either directly or through their state bankers’ association. 

However, in practice, most state regulators exercise great deference to the FDIC or Federal Reserve in both examinations and regulatory approvals, and for institutions seeking growth, dual application processes required by the state and federal regulator may raise more issues in connection with required regulatory approvals.

Reliance on Federal Preemption:  Many multi-state institutions rely on the federal preemption of state laws afforded national banks.  Although the Dodd-Frank Act has rolled back federal preemption in some respects, preemption remains effective in many areas crucial to national bank operations.  Consequently, conversion to a state charter could raise supervisory issues for certain product lines.   

While a 1997 Cooperative Agreement brokered by the Conference of State Bank Supervisors is intended to coordinate regulation and supervision among the states, certain state laws in jurisdictions outside of the bank’s home state continue to apply and may necessitate changes to various products to comply with consumer protection statutes and fair lending laws.  However, this concern is mitigated by parity or “wildcard” statutes enacted in many states, which allow state-chartered banks to engage in activities that would be permissible for a nationally chartered institution. 

The upshot, however, is that converting institutions in some cases may need to undertake burdensome surveys of state laws to ensure compliance with disparate local requirements.

Additional Powers and Restrictions:  State bank charters frequently feature notable differences in terms of the powers granted and restrictions imposed on bank activities.  These often include different legal lending limits, restrictions on sales of insurance, and ownership of banking premises.  For states that permit LLC banks, even the legal structure of an institution can be different.  A thorough understanding of these differences is important to ensure that the bank’s business plan following conversion will not be impeded.

New Requirements under Dodd-Frank: To eliminate perceived problems related to regulatory arbitrage, the Dodd-Frank Act generally precludes charter conversion whenever the converting institution is subject to a consent order or memorandum of understanding issued by its current regulator.  Although there is an exception to this rule if the converting bank seeks prior approval from its regulator and submits a written corrective-action plan, relief under this exception is rare and unlikely to be granted in most circumstances.

Conversion Expenses and Licenses:  State examination fees are generally less than those charged by the OCC, in part because state regulators share examination responsibility with either the FDIC or Federal Reserve, neither of which charge fees for their exams.  However, state regulators typically charge an application fee for a conversion plus additional fees based on things like the number of branches and the bank’s authorized capital stock.  In some states, bank directors and officers also may be required to obtain licenses, and in any jurisdiction, the bank likely will incur legal fees to prepare compliant board and shareholder resolutions, articles of incorporation, bylaws, publication notices, and other legal documents related to the conversion process.  As such, while banks should enjoy long-term savings, bankers should be cognizant of the up-front cost of conversion.

Charter choice remains a key consideration for bank operations.  Although historical benefits of the national bank charter continue, it appears that many are finding in the current regulatory environment that those benefits do not outweigh other considerations affecting bank performance.