Challenges and Opportunities: Mutual Banks


10-16-14-Naomi-DC.pngMutual savings banks have had a tough time the last several decades. Their ranks have been reduced by roughly one-third during the last 10 years, mostly due to stock conversions or failures. What got started as a philanthropic endeavor in the early part of the 19th century and grew to considerable prominence in the banking industry, mutual savings banks now are fewer in number, have multiple challenges and are little understood. But they also have advantages that continue to draw proponents to this day.

Mutuals do not have stock holders. Instead, the owners of the mutual are its depositors. Because of limitations of the mutual charter, mutuals can do little to raise capital, aside from generating earnings or converting from a mutual into a stock corporation. This can put them in a precarious situation, but it also means they tend to be better capitalized, more conservative and with better asset quality than other banks and thrifts because they are extra careful to protect capital. Just like stock-based thrifts, mutual thrifts have loan portfolios with heavy concentrations in residential one-to-four family mortgages. Federally charted mutual banks are regulated by the Office of the Comptroller of the Currency (OCC) and mutual holding companies are regulated by the Federal Reserve Board, after the Dodd-Frank Act disbanded their previous regulator, the Office of Thrift Supervision, in 2011. Mutuals that are state chartered have the OCC as their secondary regulator.

There are fewer than 500 mutual banks left today, many of them in New England, and in particular, Massachusetts, which has a total of 46, according to industry consultant RP Financial in Arlington, Virginia. Mutuals have deep historic roots in New England, which explains why the region has such a high concentration. During the early 1800s, philanthropists started mutuals by donating the capital and appointing themselves trustees of the organization to help the working class become savers at a time when commercial banks had little interest in them. Mutuals were extremely popular throughout much of their history. The average mutual had $3.7 million in assets in 1900, compared to $700,000 for the average commercial bank at that time, according to the Federal Deposit Insurance Corp. (FDIC). Today, about 90 percent of mutual banks have assets of less than $500 million.

Many mutuals failed in the 1980s as interest rates rose, and they struggled to compete for depositors while contending with a lot of fixed-rate assets on their balance sheets. A law meant to strengthen the banking industry, the Financial Institutions Reform, Recovery and Enforcement Act of 1989, eliminated certain forms of regulatory capital that had benefited mutuals. As a result, even more mutuals disappeared in the 1990s.

Regulators have struggled with what to do with a mutual bank that needs capital and doesn’t have the earnings growth to get stronger.

Capital and Regulatory Issues
Mutuals have the same regulatory capital requirements as banks and other thrifts. To raise capital, they can use unique forms such as pledge deposits, but these are not FDIC-insured and depositors can’t make a withdrawal without regulatory approval, so this form of capital is rarely used.

Mutuals can also raise capital through stock conversions, but that essentially converts a mutual into a stock company. Some mutuals have converted in stages, with a first step conversion selling less than half the subsidiary bank’s stock to the public and retaining the rest in the mutual holding company. The second step can fully convert the mutual holding company down the road. This lets the mutual raise capital in stages while maintaining majority control. Investors Bancorp., the holding company for New Jersey-based Investors Bank, did so this year, raising $2.2 billion in a second-step stock offering. Hudson City Bancorp, one of the largest mutuals, did so in 2005 and raised $3.93 billion.

Because of the lack of stock, mutuals tend to be highly capitalized and are not so interested in risky investments or risky growth. The average mutual in the $250-million to $750-million asset range had a Tier 1 leverage ratio of 11 percent as of December, 2013, compared to 9.8 percent for other institutions in that size range, according to an analysis by RP Financial.

As a result of capital constraints, the OCC considers capital planning “critical” for mutuals, as described in an OCC bulletin from July 2014. To do so, the board needs to stress profitability and moderate the company’s growth so it doesn’t outgrow its capital base, says Ron Riggins, president and managing director of RP Financial. From a risk management perspective, mutuals need to position the balance sheet with lower risk than competitors might typically take on. For instance, mutuals tend not to do much in the way of consumer or commercial lending, which can be higher risk, and they purchase more government-issued securities than their non-mutual competitors.

Because of the lower risk profile, mutuals tend to have slightly better asset quality than other types of banks and thrifts. The average non-performing asset ratio for mutuals in the $250 million to $750 million assets range was 1.4 percent, compared to 1.5 percent for all non-mutuals.

The conservative nature of mutuals and the higher cost of regulation given their small size tends to make them less profitable than other institutions. The average return on average assets was .5 percent for mutuals above $250 million in assets and .9 percent for similar sized non-mutuals and commercial banks as of December 2013.

The OCC has spent the last couple of years trying to better understand the traits of mutuals and how to regulate them effectively. Mutuals have been lobbying to be compared only with other mutuals, which has been proposed by Comptroller Tom Curry. Exceptions occur when there are no similar mutuals for comparison, as when the mutual is very large. In such instances, examiners will make adjustments. For example, when comparing net income between a stock bank and a mutual, the OCC will subtract dividends of stock banks to make a better comparison with the net income of mutuals.

“I think the OCC has worked really hard to understand our cultures better,’’ says Paul Mackin, the president and chief executive officer of $1.5-billion asset Think Mutual Bank in Rochester, Minn. Mackin is on the OCC’s advisory committee for mutuals. “Most [mutuals] would say the examination process today has advanced because of that work and the work they continue to do.”

Early on during the transition from the OTS, mutuals had to learn that exams would be tougher and the OCC had a different way of looking at risk, which was much more forward focused, he says.

Riggins says there was little change for mutuals that were state chartered, but for those with federal charters, the OCC had a different view of the adequacy of loan loss provisions and the sufficiency of capital to manage risk than the OTS did.

Mergers and Acquisitions
The unique structure of a mutual also leads to challenges in mergers and acquisitions. There is no stock to exchange, unless the mutual institution has at least gone through a first stage conversion. This is an expensive and time consuming proposition. Mackin doesn’t see M&A as much of an obstacle for a well capitalized mutual, which in most cases can afford to pay cash. For mutuals wary of paying cash, an alternative strategy could be a merger of equals. Since no premiums are paid, management of the target can be rewarded with enough compensation to attract a merger partner, Riggins says.

Growth through acquisitions might benefit a mutual in terms of dealing with increased regulatory costs, the increased costs of technology and cybersecurity, as well as the need to compete with growing credit unions and other banks.

Compensation and Working for a Mutual
Like other non-stock companies, mutuals can’t pay employees or executives in stock, but Mackin hasn’t found that to be much of an issue for his employees. He finds he can attract employees from the bigger banks because his bank focuses on customer needs instead of investors’ needs. The web site for the mutual declares: “We believe fair prices are more important than increased profits.”

“As an industry, we lost a lot of trust with customers because of what happen in late 2000s,’’ Mackin says. “I think [Think Mutual has] really strong brand appeal because we are owned by our customers. In this day and age, when banks are not as widely trusted as they once were, we have a strong appeal to the marketplace.”

That brand promise is a powerful recruitment and retention tool. Mutuals tend to have less of a focus on short-term profitability than publicly traded banks, and might win over employees who are interested in institutions that can make long-term investments and provide job stability because of reduced earnings pressure. Think Mutual does not offer cash bonuses or a stock incentive plan but does pay higher salaries than banks that do, Mackin says. He believes this is consistent with the mutual’s customer-ownership culture.

“Paying higher salaries means we expect top performance from every employee and our managers have to be very active coaches,’’ he says. “Still, earnings remain important to build longer term capabilities and we do offer profit sharing to all employees when we exceed our net profit goals.” The plan pays out a percentage of their salaries based on the company’s level of excess earnings and is distributed shortly after fiscal year end.

Governance Issues
Being owned by depositor-members who don’t own stock also brings up its own governance issues. Members have many rights, for example, the right to vote on board members, inspect corporate records, amend the charter and request special meetings, but in practice many give voting rights by proxy to the board or a special committee of the board. Getting a quorum is always an issue at an annual meeting to re-elect directors, so in some cases as little as one member is needed to make quorum, and there is no requirement to mail out proxies to member homes in advance of the meeting. The bylaws of the mutual will dictate rules and procedures, and will be governed by state law or by the OCC’s rules. Regulators understand that in effect, mutuals have a tough time getting participation from depositors when those depositors may feel like they have no financial stake in the vote.

The special governance structure could lead to weaker governance practices, such as a lack of accountability to depositor-members on the part of the board. Mackin suggests that every mutual should develop its own corporate governance policies for directors, expectations for the board and a rigorous evaluation process. At Think Mutual, directors are individually evaluated every other year. The board then assesses its overall performance during the off-years. The individual assessment calls for each director to complete a self-evaluation and do the same for the other directors. The executive management team also participates in the process. The process is complete once the chairman and vice-chairman of the board have met with each director about their performance and that includes recommending continuing education as needed.

Think Mutual also addresses board tenure with age limits and mandatory resignations. The age limit is 72 years old. Also, directors must submit their resignation letter should a material career change occur, including retirement. This provides the board with a decision point so it can evaluate if the director will have the same capacity to perform their duties, says Mackin.

Conclusion
With the loss of mutual banks in this country, it could easily seem as if they were becoming a poorly understood minority in the financial marketplace. “They don’t have the lobbying power they once had,’’ Riggins says.

In an age where credit unions are growing in size and mutual banks are declining in number, who will advocate for their health, and role in society? Who will make sure their voice is heard at the regulatory table, and that they don’t go the way of the passenger pigeon?

Mutuals tend to attract impassioned advocates, and their survival may hinge on the strength of those passionate managers and board members who cleave to the form.

Analyst Notes


From recent analyst reports:

Analysts at Keefe, Bruyette & Woods report strong commercial and industrial lending:

Excluding consolidation, loan growth has been more measured at 7.1 [percent] annualized, but still solidly ahead of last quarter’s pace. 

For the quarter, C&I remains the largest source of growth for banks, now up 13.4 [percent] in total, modestly above last quarter’s 11.7 [percent] pace. Consumer lending continued to expand at a solid pace, which we believe may have been aided by increased spending through the holiday season. For the quarter, consumer balances grew 9.9 [percent] across all banks, led by credit cards.

Real estate lending edged higher, benefiting from increased residential mortgage and CRE volumes.  For the quarter, CRE [commercial real estate] grew 3.8 [percent] over 3Q12 levels. While modest, the growth does reflect the first quarter of positive CRE growth at large banks since the end of 2008, suggesting that these banks may have turned the corner on CRE lending after running off these portfolios for nearly four years.

Analysts at Raymond James & Associates predict consolidation over the next five to 10 years, rather than a large wave of acquisitions:

With many of the mega and large regional banks more focused on capital repatriation to more normalized levels (stress test results due in March), meeting Basel III capital standards (countercyclical + SIFI buffers), and improving their valuations, we believe M&A activity in 2013 to again remain largely relegated to smaller deals for banks with assets of $1 billion or less. Indeed, we note that of the 788 announced acquisitions from 2009 through 2012, 705 (89 percent) were for banks with less than $1 billion in assets. With the view that greater scale is needed in the new banking paradigm to combat the costs and time associated with implementing new rules associated with Dodd-Frank, we see more management teams/boards of smaller banks “throwing in the towel” in coming months and years. To this end, we note of the 7,181 FDIC-insured institutions as of 9/30/12, 6,522 (91 percent) had assets under $1 billion, which in our view will continue to be where the majority of deals come from in the nearer-term. Still, we wouldn’t rule out a handful of larger deals similar to what we saw in 2012 (like M&T’s acquisition of Hudson City or FirstMerit’s acquisition of Citizens Republic).

In our view, we see meaningful industry consolidation over the next 5-10 years rather than a large wave that occurs over just a few given our belief that banks are sold and not bought. Using this logic, coupled with an improving (albeit slowly) economy, modestly better asset quality, and shades of loan growth, we believe an M&A target’s view of franchise value will remain above that of potential acquirers. Put another way, we expect the disconnect between buyers’ and sellers’ expectations to remain wide but slowly move closer to equilibrium over time.

SNL Financial reports few conversions of mutuals:

Only 13 conversion deals were completed during 2012, significantly down compared to 20 deals in 2011 and 24 deals in 2010. Seven of the 13 deals were standard conversions and six were second-stage conversions.  As for standard deals, one theory maintains that mutuals specializing in single-family mortgages without too much of a capital cushion will need to look for equity infusions, possibly in the form of a conversion, so as to diversify revenue and minimize interest rate risk. That theory has not panned out so far, but if credit quality worsens, some companies may opt to go public. Excluding the publicly traded [mutual holding companies], pending conversions and pending mergers, 149 mutual thrifts have more than $100 million in total assets, hold at least two-thirds of their loans in single-family mortgages and carry less than 15 [percent] tangible equity to tangible assets.