Why Community Banks Are Investing in Startups

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Reliant Bancorp is a community bank by almost any definition of the word. It has $3 billion in assets and focuses on its Middle Tennessee community around its headquarters in Brentwood, Tennessee. It funds what community banks commonly fund: loans mostly tied to real estate, commercial and industrial loans and a small amount of consumer loans. And now, it’s funding something less common for a community bank: startups.

Reliant Bancorp is joining a group of 66 institutions, mostly community banks, who recently helped close a new $150 million fund for financial technology companies called JAM FINTOP Banktech. JAM Special Opportunity Ventures, an affiliate of New York based-bank investor Jacobs Asset Management, and Nashville-based technology investor FINTOP Capital announced the joint raise last month, which will plow Series A funding into startups that cater to community banks.

I got a chance recently to speak to Reliant’s chairman and CEO, DeVan Ard Jr., a longtime Middle Tennessee banker. He explains the logic of community banks putting their hard-earned dollars into one of the riskiest investment categories there is.

“I don’t view it as risky as much as I do giving us a window into new financial technology opportunities,” he says. Ard declines to disclose Reliant’s investment amount, but says it was small. Currently, no institution owns more than 4.4% of the fund, says John Philpott, general partner at FINTOP Capital.

The sizeable list of community banks joining the funding round shows that even fairly small institutions are investing as a way to get in on the ground floor of technological development. Ard thinks JAM FINTOP Banktech will help the bank get early access to opportunities in the tech space.

“All banks today know they can be nimble,” Ard says. “That’s the lesson we learned throughout the pandemic. You have to do business with your customers wherever and whenever they want to do business with you.”

But the fund wasn’t exclusive to community banks. A few mid-sized and large institutions joined in on the raise, including $57 billion East West Bancorp, based in Pasadena, California, and the St. Louis-based investment bank Stifel Financial Corp., according to JAM FINTOP’s website.

The investment managers billed the fund as a way for community banks to learn about the technology space, given the sheer number of financial technology companies competing for their business. “The banks [are] being shown thousands of demos,” says Adam Aspes, a general partner at Jam Special Opportunity Ventures. “It’s overwhelming. If you make the wrong decision, it can really set you back.”

Why Record Deposit Growth Should Spur Funding Rebalancing

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Is there such thing as a gold lining?

In a year with seemingly constant crises, finding silver linings has been crucial in maintaining optimism and planning for a post-pandemic future. Banks have faced myriad challenges, but core deposit growth may represent a fundamental strategic advantage for profitability enhancement.

Total FDIC-insured domestic bank deposit balances increased by nearly 18%, or just under $2.6 trillion, over the first nine months of 2020. While government stimulus efforts and the Federal Reserve’s return to a zero interest rate policy are driving factors, higher levels of deposits should remain on bank balance sheets into the foreseeable future. Forward-thinking banks should be proactive in repositioning this funding to aid profitability improvement for years to come. Core deposit growth gives banks a chance to reduce exposure to higher cost non-transaction deposits, brokered deposits, repurchase agreements and borrowings. But despite this year’s massive deposit inflows, the Federal Deposit Insurance Corp. reports that other borrowed funds have only declined by 12%, or $167 billion, over the first nine months of 2020.

Higher loan-loss provisioning in 2020 has strained net income across the banking sector, reducing net operating income to levels not seen since the Great Recession. This may make the costs of funding restructuring — such as prepayment fees or relationship discounts on loan pricing — seem like exorbitant earnings constraints, representing an impediment to action. We believe this is short-sighted.

Economic weakness and macro uncertainty has tempered loan growth, and forced banks to maintain larger balances of lower-yielding liquid assets on the asset side of the balance sheet. Most community banks remain heavily reliant on net interest income to drive higher operating revenues. But net interest margin pressure has accelerated in 2020; combined with negligible core loan growth (excluding participation in the Small Business Administration’s Paycheck Protection Program), operating revenues have been stuck in neutral. As a result, return on equity and return on assets metrics have suffered.

There are three reasons why banks should judiciously adjust their funding profiles while the yield curve maintains a positive slope and before competitive factors limit alternatives.

Driving higher core deposit balances in challenging economic times through above-peer rates not only promotes growth, but engenders customer goodwill and loyalty. Banks have the luxury of growing customer deposit balances by increasing their offered interest rates, which  can be offset by reducing the reliance on higher-cost borrowings. Furthermore, assuming the Federal Reserve’s interest rate policy stays in place for several years, future opportunities will emerge to gradually adjust core deposit products’ rates. 

Funding adjustments provide the chance to rethink deposit products, loans or investments that may no longer be core to the business strategy. Liability restructuring can be the impetus for corresponding changes to the asset side of the balance sheet. Perhaps certain loan categories are no longer strategic, or investment securities have moved beyond risk parameters. Asset and liability rebalancing can refresh and refocus these efforts. 

Banks with higher core deposits as a percentage of total deposits higher tangible book value (TBV) multiples than peers. Our research at Janney shows that for all publicly traded banks, price-to-TBV multiples are 15% higher for banks with core deposit ratios above 80% compared to banks with less than 80% core deposit ratios. Better funding should also result in a higher core deposit premium, when a more-normalized M&A environment returns.

Nobody expects banks to perfectly forecast the future, but it would be a low-probability wager to assume that Fed intervention and the current interest rate policy will remain in place indefinitely. Banks that allow market forces to dictate deposit pricing and borrowings exposure without taking action are missing a huge opportunity. Making mindful funding decisions today to reduce reliance on non-core liabilities lays the groundwork for changes in future profitability and shareholder value.

The Uncertain Impact of COVID-19 on the Bank M&A Playbook

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As banks across the country grapple with market and economic dynamics heavily influenced by COVID-19, or the new coronavirus, separating data from speculation will become difficult.

The duration and ultimate impact of this market is unknowable at this point. The uncertain fallout of the pandemic is impacting previously announced deals and represents one of the biggest threats to future bank M&A activity. It will force dealmakers to rethink risk management in acquisitions and alter the way deals are structured and negotiated.

As we have seen in other times of financial crisis, buyers will become more disciplined and focused on shifting risk to sellers. Both buyers and sellers should preemptively address the impact of the coronavirus outbreak on their business and customers early in the socialization phase of a deal.

We’ve compiled a non-exhaustive list of potential issues that banks should consider when doing deals in this unprecedented time:

  • Due Diligence. Due diligence will be more challenging as buyers seek to understand, evaluate and quantify the ways in which the coronavirus will impact the business, earnings and financial condition of the target. Expect the due diligence process to become more robust and protracted than we have seen in recent years.
  • Acquisition Funding. Market disruption caused by the virus could compromise the availability and pricing of acquisition financing, including both equity and debt financing alternatives, complicating a buyers’ ability to obtain funding.
  • Price Protections. For deals involving publicly traded buyer stock, the seller will likely be more focused on price floors and could place more negotiating emphasis around caps, floors and collars for equity-based consideration. However, we expect those to be difficult to negotiate amid current volatility. Similarly, termination provisions based upon changes in value should also be carefully negotiated.

In a typical transaction, a “double trigger” termination provision may be used, which provides that both a material decline in buyer stock price on an absolute basis (typically between 15% and 20%) and a material decline relative to an appropriate index will give the seller a termination right. Sellers should consider if that protection is adequate, and buyers should push for the ability to increase the purchase price (or number of shares issued in a stock deal) in order to keep the deal together and avoid triggering termination provisions.

  • Representations and Warranties. As we have seen in other economic downturns, expect buyers to “tighten up” representations and warranties to ensure all material issues have been disclosed. Likewise, buyers will want to consider including additional representations related to the target business’ continuity processes and other areas that may be impacted by the current pandemic situation. Pre-closing due diligence by buyers will also be more extensive.
  • Escrows, Holdbacks and Indemnities. Buyers may require escrows or holdbacks of the merger consideration to indemnify them for unquantifiable/inchoate risk and for breaches of representations and warranties discovered after closing.  
  • Interim operating covenants. Interim operating covenants that require the seller to operate in the ordinary course of business to protect the value of their franchises are standard provisions in bank M&A agreements. In this environment we see many banks deferring interest and principal payments to borrowers and significantly cutting rates on deposits. Sellers will need some flexibility to make needed changes in order to adapt to rapidly changing market conditions; buyers will want to ensure such changes do not fundamentally change the balance sheet and earnings outlook for the seller. Parties to the agreement will need focus on the current realities and develop reasonable compromises on interim operating covenants.
  • Investment Portfolios and AOCI. The impact of the rate cuts has created significant unrealized gains in most bank’s investment portfolio. The impact of large gains and fluctuations in value in investment securities portfolios will also come into focus in deal structure consideration. Many deals have minimum equity delivery requirements; market volatility in the investment portfolio could result in significant swings in shareholders’ equity calculations and impact pricing.
  • MAC Clauses. Material Adverse Change (MAC) definitions should be carefully negotiated to capture or exclude impacts of the coronavirus as appropriate. Buyers may insist that MAC clauses capture COVID-19 and other pandemic risks in order to provide them an opportunity to terminate and walk away if the target’s business is disproportionally affected by this pandemic.
  • Fiduciary Duty Outs. Fiduciary duty out provisions should also be carefully negotiated. While there are many variations of fiduciary duty outs, expect to see more focus on these provisions, particularly around the ability of the target’s board to change its recommendation and terminate because of an “intervening event” rather than exclusively because of a superior proposal. Likewise, buyers will likely become more focused on break-up fees and expense reimbursements when these provisions are triggered.
  • Regulatory approvals. The regulatory approval process could also become more challenging and take longer than normal as banking regulators become more concerned about credit quality deterioration and pro forma capitalization of the merged banks in an unprecedented and deteriorating economic environment. Buyer should also consider including a robust termination right for regulatory approvals with “burdensome conditions” that would adversely affect the combined organization.

While bank M&A may be challenging in the current environment, we believe that ample strategic opportunities will ultimately arise, particularly for cash buyers that can demonstrate patience. Credit marks will be complex if the current uncertainty continues, but valuable franchises may be available at attractive prices in the near future.

Seven Small Business Lending Trends In 2020

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There are roughly 5.1 million companies that comprise the small to medium-sized business (SMB) category in the U.S. today — and that segment is growing at 4% annually. Many of these businesses, defined as having less than 1,000 employees, may need to seek external funding in the course of their operations. This carves out a lucrative opportunity for community and regional banks.

To uncover leading trends and statistics, the Federal Reserve’s 2019 Small Business Credit Survey gathered more than 6,600 responses from small and medium U.S.-based businesses with between 1 and 499 employees. These are the top seven small business lending statistics of 2019 — along with some key insights to inform your bank’s small business lending decisions in 2020.

1. Revenue, employee growth in 2018
The U.S. small business landscape remains strong: 57% of small businesses reported topline growth and more than a third added employees to their payrolls. Lending to these companies isn’t nearly as risky as it once was, and the right borrowers can offer an attractive opportunity to diversify your bank’s overall lending portfolio.

2. Steady rise in capital demand
Small businesses’ demand for capital has steadily risen: in 2017, 40% of surveyed businesses applied for some form of capital. In 2018, the number grew to 43%, with no drop-off in sight. Banks should not wait to tap into this lucrative trend.

3. Capital need
With limited and/or inconsistent cash flow, small businesses are almost bound to face financial hurdles. Indeed, 64% of small businesses said they needed capital in the last year. But when seeking capital, they typically find many banks turning their backs for reasons related less to credit-worthiness, and more to slimmer bank margins due to time-consuming due diligence.

As a result, over two-thirds of SMBs reported using personal funds — an outcome common to many small businesses owners. This is a systemic challenge, with a finding that points to an appealing “white space” opportunity for banks.

4. Capital received
Too many small businesses are settling for smaller loans: 53% of small businesses that sought capital received less funding than they wanted. Banks can close this funding gap for credit-worthy small businesses and consistently fill funding requests by decreasing the cost of small business lending.

5. Funding shortfalls
Funding shortfalls were particularly pronounced among specific small businesses, with particular credit needs. Businesses that reported financing shortfalls typically fell into the following categories:

• Were unprofitable
• Were newer
• Were located in urban areas
• Sought $100,000 to $250,000 in funding

Of course, not all small businesses deserve capital. But some shortfall trends — like newer businesses or those in urban areas — may suggest less of a qualification issue and more to systemic barriers.

6. Unmet needs
Optimistic revenue growth paired with a lack of adequate funding puts many viable small businesses at unnecessary risk. The survey found that 23% of businesses experienced funding shortfalls and another 29% are likely to have unmet funding needs. Capitalizing on these funding trends and increasing small business sustainability may well benefit both banks, businesses and communities in the long run.

7. Online lenders
Online lending activity is on the rise: 32% of applicants turned to online lenders in 2018, up from 24% in 2017 and 19% in 2016. The digital era has made convenience king — something especially true for small business owners who wear multiple hats and are naturally short on time. Online lending options can offer small business owners greater accessibility, efficiency and savings throughout the lending process, especially as digital lending solutions become increasingly sophisticated.

Three Things You Missed at Experience FinXTech

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technology-9-11-19.pngThe rapid and ongoing digital evolution of banking has made partnerships between banks and fintech companies more important than ever. But cultivating fruitful, not frustrating, relationships is a central challenge faced by companies on both sides of the relationship.

The 2019 Experience FinXTech event, hosted by Bank Director and its FinXTech division this week at the JW Marriott in Chicago, was designed to help address this challenge and award solutions that work for today’s banks. Over the course of two days, I observed three key emerging trends.

Deposit displacement
The competition for deposits has been a central, ongoing theme for the banking industry, and it was a hot topic of conversation at this year’s Experience FinXTech event.

In a presentation on Monday, Ron Shevlin, director of research at Cornerstone Advisors, talked about a phenomenon he calls “deposit displacement.” Consumers keep billions of dollars in health savings accounts. They also keep billions of dollars in balances on Starbucks gift cards and within Venmo accounts. These aren’t technically considered deposits, but they do act as an alternative to them.

Shevlin’s point is that the competition for funding in the banking industry doesn’t come exclusively from traditional financial institutions — and particularly, the biggest institutions with multibillion-dollar technology budgets. It also comes from the cumulative impact of these products offered by nondepository institutions.

Interestingly, not all banks struggle with funding. One banker from a smaller, rural community bank talked about how his institution has more funding than it knows what to do with. Another institution in a similar situation is offloading them using Promontory Interfinancial Network’s reciprocal deposit platform.

Capital allocation versus expenses
A lot of things that seem academic and inconsequential can have major implications for the short- and long-term prospects of financial institutions. One example is whether banks perceive investments in new technologies to be simply expenses with no residual long-term benefit, or whether they view these investments as capital allocation.

Fairly or unfairly, there’s a sense among technology providers that many banks see investments in digital banking enhancements merely as expenses. This mindset matters in a highly commoditized industry like banking, in which one of the primary sources of competitive advantage is to be a low-cost producer.

The industry’s justifiable focus on the efficiency ratio — the percent of a bank’s net revenue that’s spent on noninterest expenses — reflects this. A bank that views investments in new technologies as an expense, which may have a detrimental impact on efficiency, will be less inclined to stay atop of the digital wave washing over the industry.

But banks that adopt a more-philosophical approach to technology investments, and see them as an exercise in capital allocation, seem less inclined to fall into this trap. Their focus is on the long-term return on investment, not the short-term impact on efficiency.

Of course, in the real world, things are never this simple. Banks that approach this decision in a way that keeps the short-term implications on efficiency in mind, with an eye on the long-term implications of remaining competitive in an increasingly digitized world, are likely to be the ones that perform best over the long run.

Cultural impacts
One of the most challenging aspects of banking’s ongoing digital transformation also happens to be its least tangible: tailoring bank cultures to incorporate new ways of doing old things. At the event, conversations about cultural evolution proceeded along multiple lines.

In the first case, banks are almost uniformly focused on recruiting members of younger generations who are, by habit, more digitally inclined.

On the flipside, banks have to make hard decisions about the friction that stems from existing employees who have worked for them for years, sometimes decades, and are proving to be resistant to change. For instance, several bankers talked about implementing new technologies, like Salesforce.com’s customer relationship management solutions, yet their employees continue to use spreadsheets and word-processing documents to track customer engagements.

But there’s a legitimate question about how far this should go, and some banks take it to the logical extreme. They talk about transitioning their cultures from traditional banking cultures to something more akin to the culture of a technology company. Other banks are adopting a more-tempered approach, thinking about technology as less of an end in itself, and rather as a means to an end — the end being the enhanced delivery of traditional banking products.