Five Reasons Why You Should Reconsider Short-Term Loans

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lending-7-16-18.pngFor the better part of a decade, regulatory agencies have placed obstacles in front of banks that all but prohibited them from offering short-term, small-dollar lending options for their customers. Now, at least one major regulator has signaled a shift in its opinion about those products, which should inspire banks to reconsider those options.

Here are five reasons banks often cite when discussing why they don’t offer short-term, small-dollar options, and a case why they should rethink those ideas.

You don’t think your customers need it
Perhaps many of your branches are in affluent areas, or you believe that your customers have access to other types of short-term liquidity. But the statistics regarding American personal finances may surprise you:

Nearly 50 percent of American consumers lack the necessary savings to cover a $400 emergency, according to the Federal Reserve.
The personal savings rate dipped to 2.8 percent in April 2018, the lowest rate in over a decade, according to the St. Louis Fed.
Each year 12 million Americans take out payday loans, spending $9 billion on loan fees, according to the Pew Charitable Trusts.

Based on these statistics, it’s likely that a portion of your customer base is affected by the lack of savings, or has a need for better access to liquidity, and chances are good that they’d be receptive to a small-dollar, short-term loan solution.

It’s Cost and Resource Prohibitive
For most financial institutions, introducing a traditional small-dollar loan program is cost-prohibitive–operationally, and from a staffing standpoint. From the cost of loan officers and underwriters to the overhead, the reality is it would take time and resources many banks do not have.

Enter fintech firms, bringing proprietary technology and the application of big data. The right fintech partner can manage the time, human and financial resources you may not have, such as application, underwriting and loan signing processes. In some cases, the whole thing can be automated, resulting in a “self-service” program for your customers, eliminating the human resource need.

Underwriting Challenges and Charge-Off Concerns
Another challenge is the loan approval process and how to underwrite these unique loans. A determination of creditworthiness by a traditional credit check does not adequately predict the consumer’s current ability to repay using recent behavior instead of a period of many years. Today’s fintech firms use proprietary technology to underwrite the loans, incorporating a variety of factors to mitigate charge-offs.

The OCC recently released a bulletin outlining “reasonable policies and practices specific to short-term, small-dollar installment lending.” It stated such policies would generally include “analysis that uses internal and external data sources, including deposit activity, to assess a consumer’s creditworthiness and to effectively manage credit risk.” The right fintech partner will apply big data solutions to assess creditworthiness using the OCC’s criteria and other factors.

Compliance Burdens
There’s no question short-term loan options have been heavily regulated over the past eight years. The CFPB placed predatory lending and payday loans under scrutiny. In 2013, the OCC and FDIC effectively ended banks’ payday loan alternative, the deposit advance. The CFPB cracked down even harder in October 2017 with their final payday lending rule, which had the potential to devastate the storefront payday loan industry, forcing consumers to seek alternative sources of quick liquidity.

The pressure is easing. The OCC was the first agency to encourage banks to make responsible and efficient small-dollar loans. If history has taught us anything, it’s that the other regulatory agencies likely will soon follow suit.

Concern About Cannibalizing Overdraft Revenue
Exclusive data collected by fintech firms experienced with overdraft management has shown there are two distinct groups of consumers managing their liquidity needs in different ways:

The Overdrafters
These are consumers that struggle with transaction timing and incur overdraft or NSF fees. A significant portion of this group might have irregular income streams, such as small business owners or commissioned salespeople. In many cases, these consumers are aware of their heavy overdraft activity, and will continue to overdraft, because for them, it makes financial sense.

The Loan-Seekers
A second group includes those consumers who simply lack the cash to promptly pay their bills, and either can’t obtain adequate overdraft limits or failed to opt-in to overdraft services. These consumers are actively seeking small-dollar loans to avoid the double whammy of hefty late fees and negative hits to their credit score for late payments.

Savvy financial institutions will ensure they have the programs in place to serve both groups of consumers, and fill the gap for the second category by using an automated small-dollar lending program with sound underwriting from a trusted fintech vendor.

Are the Ducks Quacking?

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IPO-5-17-18.pngAn initial public offering isn’t the only path to listing your bank’s shares on the Nasdaq or New York Stock Exchange, and gaining greater liquidity and more efficient access to capital via the public markets.

Business First Bancshares, based in Baton Rouge, Louisiana, opted for a direct listing on the Nasdaq exchange on April 9, over the more traditional IPO. Coincidentally, this was the same route taken a few days prior—with greater fanfare and media attention—by Swedish entertainment company Spotify. A direct listing forgoes the selling of shares, and provides an instant and public price for potential buyers and sellers of a company’s stock.

Business First’s direct listing could be seen as an IPO in slow motion. The $1.2 billion asset company registered with the Securities and Exchange Commission in late 2014, ahead of its April 2015 acquisition of American Gateway Bank. Business First then completed a $66 million private capital raise in October—$60 million of which was raised from institutional investors—before acquiring MBL Bank in January. The institutional investors that invested in Business First last fall did so with the understanding that the bank would be listing soon. “We actually raised money from the same people as we would have in an IPO process,” says Chief Executive Officer Jude Melville.

Melville says his bank took this slow route so it could be flexible and take advantage of opportunities to acquire other banks, which is a part of the its long-term strategy. Also, bank stocks in 2015 and 2016 had not yet hit the peak levels the industry began to see in 2017. The number of banks that completed an IPO in 2017 more than doubled from the prior year, from eight to 19, according to data obtained from S&P Global Market Intelligence.

“The stars aligned in 2017” for bank stocks, says Jeff Davis, a managing director at Mercer Capital. The Federal Reserve continued increasing interest rates, which had a positive impact on margins for most banks. Bank M&A activity was expected to pick up, and the Trump administration has appointed regulators who are viewed as being friendlier to the industry. “There’s a saying on Wall Street: When the ducks are quacking, feed them, and institutional investors wanted bank stocks. One way to feed the ducks is to undergo an IPO,” Davis says. Bank stock valuations are still high, and so far, 2018 looks to be on track for another good year for new bank offerings, with four completed as of mid-April.

The more recent wave of bank IPOs, which had trailed off in 2015 and 2016, was largely a result of post-crisis private equity investors looking for an exit. As those investors sought liquidity, several banks opted for life as a public company rather than sell the bank. That backlog has cleared, says Davis. “It’s still a great environment for a bank to undergo an IPO,” he says. “Particularly for a bank with a good story as it relates to growth.”

The goals for Business First’s public listing are tied to the bank’s goals for growth via acquisition. Private banks can be at a disadvantage in M&A, having to rely on all-cash deals. A more liquid currency, in the form of an actively-traded stock, is attractive to potential sellers, and the markets offer better access to capital to fuel growth. Melville also believes that most potential employees would prefer to work for a public versus a private company. “Being publicly traded gives you a certain stability and credibility that I think the best employees find attractive,” he says.

Business First’s delayed listing was a result of leadership’s understanding of the seriousness of being a public bank, and the management team focused on integrating its acquisitions first to be better prepared for the listing.

“You really have to want to be a public company and make the sacrifices necessary to make that possible,” says Scott Studwell, managing director at the investment bank Stephens, who worked with Business First on its pre-public capital raise but not its direct listing. “There has to be a lot of support for doing so in the boardroom.” The direct preparation for an IPO takes four to six months, according to Studwell, but the typical bank will spend years getting its infrastructure, personnel, policies and procedures up to speed, says Lowell Harrison, a partner at Fenimore, Kay, Harrison & Ford. The law firm serves as legal counsel for Business First. Roadshows to talk up the IPO and tell the company’s story can have executives traveling across the country and even internationally.

And the bank will be subject to Wall Street’s more frequent assessment of its performance. If a bank hits a road bump, “it can be a rough go for management in terms of looking at the stock being graded by the Street every day, not to mention all the compliance costs that go with being an SEC registrant,” says Davis. All of this adds more to the management team’s plate.

Considering a public path is an important discussion for boards and management teams, and is ultimately a strategic decision that should be driven by the bank’s goals, says Harrison. “What is the problem you’re trying to solve? Do you need the capital? Are you trying to become a player in the acquisition market? Are you just simply trying to create some liquidity for your shares?” Filing an IPO, or opting for a direct listing, should check at least two of these boxes. If the bank just wants to provide liquidity to its shareholders, a listing on an over-the-counter market such as the OTCQX may achieve that goal without the additional burden on the institution.

In considering the bank’s capital needs, a private equity investor—which would allow the bank to remain private, at least in the near term—may suit the bank. Institutional investors favor short-term liquidity through the public markets, which is why Business First was able to obtain capital in that manner, given its near-term direct listing. Private equity investors are willing to invest for a longer period of time, though they will eventually seek liquidity. These investors are also more actively engaged, and may seek a board seat or rights to observe board meetings, says Studwell. But they can be a good option for a private bank that’s not ready for a public listing, or doesn’t see strategic value in it.

Though Business First’s less-common path to its public listing is one that could be replicated under the right circumstances, the majority of institutions that choose to go public are more likely to opt for a traditional IPO. “The reality is that direct listings are very rare, and it takes a unique set of circumstances for it to make sense for a company,” says Harrison. While a direct listing provides more liquidity than private ownership, be advised that the liquidity may not be as robust as seen in an IPO, which tends to capture the attention of institutional shareholders. “Usually, it’s the actual function of the IPO that helps kickstart your public market activity,” he adds. And if the bank needs an injection of capital—and determines that a public listing is the way to do it—then an IPO is the best strategic choice.

Creating Liquidity: Alternatives To Selling The Bank

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Executives and boards of private banks have to think outside the box if they want to create a path to liquidity for shareholders that doesn’t require selling the bank. In this video, Eric Corrigan of Commerce Street Capital outlines three liquidity alternatives to consider, and shares why a proactive approach can help a bank control its own destiny.

  • Challenges in Creating Liquidity
  • Three Liquidity Alternatives
  • Benefits and Drawbacks to Each Solution
  • Questions Boards Should Be Asking

Understanding the Attributes of Core Deposits

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deposits-9-27-17.pngAs loan growth materializes, it is important to renew the focus on liquidity management, have an overall liquidity plan and a contingency funding plan. In order to create and implement such plans, it is important to understand the attributes of deposits. Even if a bank is not experiencing stronger loan growth, it is necessary to understand the elasticity of core deposits in order to make accurate modeling assumptions.

Anyone who experienced a higher interest rate environment remembers depository institutions having to compete with money market funds and other non-bank investment instruments that paid comparatively high rates. As the economy emerges from the bottom of a 10-year interest rate trough, depositors are starving for interest income. Institutions are finding that customers are willing to buy longer term CDs in exchange for yield. We simply do not know how long deposits will remain on books in a higher rate environment or how much we will have to pay to keep them.

The primary core deposit assumptions used for interest rate simulation models are beta and decay. Deposit beta is an indication of how rates correlate to the market. For example, if you use a beta of 0.25 on your savings rate, for every projected market rate move of 100 basis points, the savings account rate will move 25 basis points.

Decay is the measure of deposit attrition, or how long deposit accounts will likely remain open. If you decay a savings account over a 60-month period, you make the assumption that the savings account will have a 60-month maximum life. The normal range for decay is 24 months for sensitive deposits and 84 months for more static accounts.

Historically these numbers have been typically supplied by market averages, vendors, the Office of Thrift Supervision (which was merged with the Office of the Comptroller of the Currency in 2011) and management estimates. Various forms of deposit studies are gaining popularity but remain the least common means of obtaining core deposit assumptions. Meanwhile other modeling assumptions utilize prepayment rates, discount rates and spreads and are much more precise. The higher degree of precision for these non-deposit modeling assumptions helps reduce simulation risk. The irony here is that even though non–deposit assumptions are much more precise, they have a lesser impact on simulation results. This means that the greatest amount of simulation risk comes from assumptions with the least amount of basis!

In order to demonstrate the impact of these core deposit assumptions, we can take a typical Bank asset/liability management simulation and compare the results of the Economic Value of Equity (EVE shock/stress both with and without these beta and decay assumptions.) This serves as a stress test of the deposit assumptions. To stress the assumptions, we will simply set all betas to one and all maturities to one month. Then we can compare the results. To keep it simple, we will look at it graphically:

EVE-chart.png

Note how the EVE variance is between +7 percent and -14 percent when the betas and decays are utilized in the simulation. Once they are removed, this variance is between +10 percent and -30 percent, showing that it almost doubles in a rising rate scenario. In this case, removing the assumptions or making material changes to them can cause a financial institution to approach or exceed prudent risk limits. Additionally, this will also impact the net interest income shock as well, but a complete simulation will need to be performed to assess the impact.

The graph shows that core deposit assumptions are an important variable in the modelling results, especially if used as a management tool. As mentioned, this can be also used as a regulatory stress test. Stress tests are good but they do not serve the purpose of creating valid assumptions for management purposes. This can be accomplished by a core deposit study. A detailed core deposit study is a fairly involved and costly project but it will produce the most accurate assumptions. An abbreviated core deposit study can be used to understand the correlation of deposit line items to market rates and back into decay rates. There are a number of companies offering such services for institutions without in house expertise. It is worth exploring such options as the regulators are most likely to focus on core deposits as interest rates rise.

Four Reasons Why Waiting to Sell May Be a Bad Idea

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bank-strategy-2-5-16.pngMost community banks have a timeframe for liquidity in mind. Strategic plans for these institutions are often developed with this timeframe as a key consideration, driven by the timing of when the leader of the bank is ready to retire.

We meet with a lot of bank CEOs, and we regularly hear some version of the following: “I’m in my early 60s and will retire by 70, so I’m looking to buy not sell.” When we ask these CEOs to describe their ideal acquisition target, the answer often involves size, market served, operating characteristics and, most importantly, talent. After all, banking is a relationship business and great bankers are needed to build those relationships with customers. Buyers will undoubtedly pay a higher premium for a bank with great talent that still has “fire in the belly.” It is hard to recall a time when a buyer was looking for a tired management team ready to retire. So, it seems ironic that a buyer cites talent as the key component to a desirable acquisition candidate, but that same buyer is planning to wait until retirement to sell. Put differently, they’re planning to sell at the point their bank will become less desirable.

We have highlighted four key items for boards and management teams to consider when evaluating the timing of a liquidity event as part of the strategic planning process: the timing of management succession, likely buyers or merger partners, shareholders and the overall economy and market for community banks.

Management Succession
Timing of management succession is critical to maximize price for shareholders. As referenced above, if the leadership of an organization would like to retire within the next five years, and there isn’t a logical successor as part of senior management, the board should begin evaluating its options. Waiting until the CEO wants to retire may not be the best way to maximize shareholder value.

Likely Buyers/Merger Partners
The banking industry is consolidating, which means fewer sellers and buyers will exist in the future. While there may be a dozen or more banks that would be interested in a good community bank, once price is considered, there may only be one or two banks that are both willing and able to pay the seller’s desired price. These buyers are often looking at multiple targets. Will a buyer be ready to act at the exact time your management is ready to sell? In fact, there are a number of logical reasons that your best buyer may disappear in the future. For example, they could be tied up with other deals or they may have outgrown the target so it no longer “moves the needle” in terms of economic benefit.

Shareholder Pressure
Shareholders of most banks require liquidity at some point. While the timing of liquidity can range from years to decades, it is worthwhile for a bank to understand its shareholders’ liquidity expectations. And liquidity can be provided in many ways, including from other investors, buybacks, listing on a public exchange, or a sale of the whole organization. As time stretches on, pressure for a liquidity event begins to mount on management and, in some cases, a passive investor will become an activist.

Overall Economy and Markets
With the Great Recession fresh in mind, virtually every bank investor is aware the market for bank stocks can go up or down. Before the Great Recession, managers who were typically in their mid-50s to early 60s  raised capital with a strategic plan to provide liquidity through a sale in approximately 10 years, which would correspond with management’s planned retirement age. We visited with a number of bankers in their early 60s from 2005 to 2007 and indicated that the markets and bank valuations were robust and it was an opportune time to pursue a sale. Many of these bankers decided to wait, as they were not quite ready to retire. We all know what happened in the years to follow, and many found themselves working several years beyond their desired retirement age once the market fell out from under them.

Over the past two years, we had very similar conversations with a lot of bankers and once again we see some who are holding out. While bankers and their boards generally can control the timing of when they would like to pursue a deal, the timing of their best buyer(s), the overall market and shareholder concerns are beyond their control. Thorough strategic planning takes all of these issues into account and will produce the best results for all stakeholders.

The Reinvented Stock Market for Banks: One Year Later

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4-3-13_Secondmarket.pngEarly last year, we examined many of the factors that caused the public markets to no longer support community banks.  Since that time, President Obama signed into law the JOBS Act, which enables community banks to remain private longer or more easily delist from the public stock markets.  While this legislation is an important step in the right direction, community banks still confront significant liquidity needs. 

Liquidity Runs Dry 

In 2012, we spoke with dozens of community bankers around the country, and also conducted a survey alongside the Independent Community Bankers of America (ICBA) to better understand the capital and liquidity needs of private community banks.  After all, more than 75 percent of the nearly 7,000 community banks and thrifts in the United States are privately held.  The ICBA’s findings indicated that many community banks do not have a platform to provide liquidity for their shareholders.  This means that thousands of community bank shareholders do not have access to liquidity on a regular basis.  Our conversations with management teams across the country made it clear that a new, stronger market needed to emerge for community banks across the country.

So why do banks want a secondary market for their shares in the first place?  We posed the question to a number of private banks, who shared their top reasons.  A secondary market:

  • Makes it easier to raise capital by providing new investors with a viable future exit option
  • Makes it easier to find new investors
  • Provides shareholders with liquidity while remaining private

The SecondMarket Approach

In February 2012, we launched a pilot program in select U.S. states to create customized, private liquidity programs for community banks.  The SecondMarket pilot program allowed banks to control all aspects of their secondary market, including who can buy and sell stock, and the frequency with which shares were sold.  This model emulates the successful approach we pioneered for private technology companies during the past several years. 

One year later, we reflect on the pilot by sharing some of the characteristics of the bank-approved buyers and sellers who worked with us, as well as the features of the banks themselves.

Characteristics of SecondMarket Banks

We often are asked about the makeup of SecondMarket community banks.  We initially decided to focus on banks in three different states, but did not restrict the types of banks that could participate in the pilot programs. 

  • We conducted seven trading windows in three different states: Texas, Pennsylvania and New Jersey.  The pilot program included Team Capital Bank of Lehigh Valley, Pennsylvania.
  • The asset size of the banks ranged significantly, from $300 million to $1 billion.
  • The size and diversity of the shareholder bases also fluctuated, as participating banks ranged from 125 to more than 500 shareholders. 
  • Banks were founded as far back as 1917 to as recent as 2005.
  • The banks’ shareholdings were both physical certificates as well as street name shares.

Characteristics of Buyers and Sellers of SecondMarket Bank Shares

Another frequent inquiry from bank executives across the country is the types of buyers that participated in the pilot program. Interestingly, the majority of bank-approved buyers consisted of individuals (70 percent) and trusts (21 percent).  Institutional investors comprised the remaining 9 percent of buyers.  Likewise, the sellers approved by the banks primarily comprised of individuals (79 percent) and trusts.  The composition of buyers and sellers did not vary between region and/or state, as most banks preferred individual investors. 

Conclusion

Limited access to capital is making it more difficult for private community banks to grow and remain independent.  The success of SecondMarket’s pilot program supported our initial theory that institutions facing difficulty providing secondary liquidity to their shareholders can benefit from liquidity programs facilitated by SecondMarket.  Thus, we will be expanding the program this year beyond the initial pilot states to help community banks more effectively respond to shareholder liquidity needs.

While we have only just begun to understand the nature of community bank liquidity needs, the early feedback from our clients has been positive.  An executive from a community bank in Texas stated, “A service like the one from SecondMarket could ease pressure while still providing a vehicle for raising capital.  For small banks, this could be revolutionary.”  We couldn’t have said it better ourselves.