Banks Increasingly Use Sub Debt to Raise Capital

2015 is set to become the third year in a row that total capital raised among U.S. banks has increased—on track for more than $140 billion issued by year-end. The recent boon in capital raising activity generally is attributed to the simultaneous increase in public bank stock values. The effect of market values on the decision to raise capital should not be discounted; however, capital demand has continued despite the market’s recent volatility and perceived weakness. Why has this trend continued?

The confluence of three factors, in particular, within the banking industry have helped fuel capital demand and have shifted demand for different forms of capital, including an increased demand for subordinated debt. First, the interest rate on Troubled Asset Relief Program funding has increased to 9 percent for most banks that still hold TARP funds. Second, participants in the Small Business Lending Fund have experienced—or will soon experience—an interest rate hike on those funds to 9 percent or more. Third, banks that deferred interest payments on trust preferred securities in the wake of the financial crisis must determine how to repay the deferred interest after five years or risk default. Each of these factors is prompting banks to consider capital alternatives.

The Rise of Subordinated Debt
Subordinated debt has become the darling form of capital for community banks (i.e., those banks less than $10 billion in assets). Thus far in 2015, subordinated debt has comprised 30 percent of all capital raised by community banks—up from 24 percent in 2014 and 7 percent in 2013. Why has this form of capital become so popular?

In simple terms, banks facing rate hikes on TARP, SBLF, and/or repayment of trust preferred securities have taken advantage of the low interest rate environment to raise capital on more favorable terms. Furthermore, the interest expense paid on subordinated debt is tax-deductible and it generally qualifies as Tier 2 capital on a holding company consolidated basis. In other words, newly issued sub debt can enable banks to reduce debt service requirements, increase regulatory capital, and preserve current ownership interests that otherwise could be diluted by raising common equity.

And as banks have become more creditworthy and investors have raised funds dedicated to community bank sub debt investments, the interest rate on sub debt has steadily declined: the median coupon for sub debt issuances in 2015 is approximately 5.25 percent, down from 7 percent in 2011. 

You’ve Decided to Issue Sub Debt…Now What?
The process of issuing sub debt for most banks is straightforward. Investment bankers generally know investors with an appetite for sub debt and can provide banks with preliminary term sheets relatively quickly. For banks with more than $1 billion in assets, it could make sense to obtain a bond rating from a rating agency; the process generally takes four to six weeks and can be a great marketing tool when raising capital. A solid rating helps banks achieve better terms and opens the door to new potential investors, such as insurance companies, plus it gives investors added comfort in their own assessment of the deal.

Investor demand for sub debt will continue to increase as long as interest rates remain low and bank balance sheets remain strong. Banks considering a future capital raise should understand the benefits of sub debt and seriously consider it while the market is ripe.

What Wall Street Thinks About the Banking Industry

A panel of three leading banking analysts from top research and brokerage firms share their insights and views on macro-economic trends specific to financial institutions during Bank Director’s Acquire or Be Acquired conference in January. Moderated by Gary R. Bronstein, partner with law firm Kilpatrick Townsend & Stockton LLP, the panel discusses the impact that a slow economy and increased regulatory pressures are having on bank stocks.

Video Length: 45 Minutes

Highlights include:

  • Comparing banks to utilities
  • Regulatory impact on M&A activity
  • Future of branching 

About The Speakers

Gary Bronstein is a partner with Kilpatrick Townsend & Stockton LLP. Gary provides a broad spectrum of strategic advice to financial institution and public company clients. He concentrates on initial public offerings and other specialized public and private capital raising transactions, M&A, proxy contests and a host of other corporate and securities law matters that arise during the life of clients.

Anthony Polini is a managing director with Raymond James & Associates, Inc. Equity Research. Anthony follows banks and thrifts primarily located in the Northeast and Mid-Atlantic, as well as several large-cap banks. He began following the banking industry in 1985, when he joined Pru-Bache Securities.

Jim Sinegal is the director of financial services research at Morningstar, overseeing equity and credit coverage of more than 250 companies in the financial services industry. Jim has covered a wide range of U.S. banks, specialty finance companies and Asian financial institutions since joining Morningstar in 2007. Fred Cannon is the director of research and chief equity strategist for Keefe, Bruyette and Woods Inc. He joined KBW in 2003, providing equity research on banks and thrifts with a specialization in the mortgage sector. Over his years at KBW, Fred’s coverage has included a diverse universe of financial institutions, ranging from community and regional banks to mortgage finance companies, and has included some of the country’s largest financial institutions, including Fannie Mae, Countrywide Financial and Wells Fargo.

Being Public: Is It Worth It?

Six months after the JOBS (Jumpstart our Business Startups) Act went into effect, making it easier for banks to remain private, we asked lawyers their opinion on the advantages and downsides of public ownership. Although all raise good points, many believe the expense is just not worth it for that size bank. But if the bank is looking at acquisitions and access to capital that the public markets provide, public ownership is a good idea.

Does it make sense for banks with less than $500 million in assets to be public companies? 

Mark-Nuccio.jpgWith increasing needs for capital and a desire to grow, some smaller banks may want to become or remain public companies, in spite of the significant burdens imposed on smaller public company issuers. Access to the public markets and shareholder liquidity, in the right situation, are worth the price of admission. Without a growth agenda, however, small, publicly held banks would be well-advised to privatize.

—Mark Nuccio, Ropes & Gray LLP 

Peter-Weinstock.jpgIt is hard to see many benefits for companies with less than $500 million in total assets to have their shares registered with the Securities and Exchange Commission (SEC) under the Exchange Act.  The accounting costs associated with public company status continue to increase, as do legal and regulatory check-the-box exercises. Perhaps it is worthwhile for boards to consider the issue again at $1 billion in assets, which is when the requirements for Federal Deposit Insurance Corp. Improvement Act certifications and the Federal Reserve’s enterprise risk assessments kick in. It is clear how smaller, publicly traded banking organizations view this issue. After the JOBS Act, the pace of such companies going dark has resembled Pamplona’s Running of the Bulls.

—Peter Weinstock, Hunton & Williams LLP 

Gregory-Lyons.jpgFor many banks with less than $500 million of assets, the burdens of operating as a public company likely outweigh the benefits. The reporting obligations themselves are substantial. Moreover, particularly as many community banks continue to feel the burdens of the financial crisis, the need to satisfy the short-term view of many investors can impede the pursuit of the long-term objective for a return to health. And the public markets often place a discount on the stock price of banks this size, thereby limiting the upside potential of an offering. Despite having said that, if a bank of this size is in comparatively good health, there are many opportunities for acquisitions in the marketplace now.  For these banks, the publicly traded stock can still be a useful currency in a growth strategy.  

—Greg Lyons, Debevoise & Plimpton LLP 

Schaefer_Kim.pngAfter the JOBS Act increased thresholds for registration from 500 shareholders to 2,000 and deregistration from 300 shareholders to 1,200, many banks have been closely examining the practicality of being a public company, especially considering the tremendous expense and additional regulation. However, the sensibility of that decision truly rests in the bank’s strategic plans for its future. How does the bank want to position itself? If a bank wants to expand its market or services, or if it wants (or needs) to raise capital, its prospects for doing so are much brighter as a public company. Some banks also enjoy the prestige and attention that they receive as a public company. Being a public reporting company may add significant expense, but the visibility and flexibility for raising capital is certainly enhanced for a public company, which may turn those expenses into a valuable investment for future growth.

—Kim Schaefer, Vorys, Sater, Seymour and Pease LLP               

John-Gorman.jpgThere is no one-size-fits all response to this question.  For the institution that sees itself generating enough capital to pay dividends and sustain growth and does not see itself expanding its footprint, then it should seriously consider deregistering with the SEC.  There is a unique ability for a bank or bank holding company (and a savings bank and savings and loan holding company) to continue to trade on the bulletin board without having to be registered with the SEC. This is not available for non-financial institutions.

For many small-cap banks, bulletin board trading may provide as much liquidity as NASDAQ OMX, and provides insiders with an outlet for their shares, which is one of the major downsides of deregistering (i.e., it is difficult for insiders to sell their shares).  For an institution that sees itself accessing the public markets for additional capital or expanding through mergers and acquisitions, continuing with an SEC registration could prove critical, despite the costs and burdens. And as the market cap of a bank/holding company increases, the need to maintain a trading alternative is also important for shareholders. 

—John Gorman, Luse Gorman Pomerenk & Schick PC

Analyst Report: Community Banks Saw Improving Metrics In The First Quarter

piggy-bank-health.jpgInvestment firm McAdams Wright Ragen has recently released its first quarter 2012 Community Bank Report which includes over 1,100 publicly traded banks and thrifts and provides data broken down by asset size as well as by region. The report is a unique look at many of the banks that aren’t traded on the NYSE Euronext or NASDAQ OMX, which so get little attention in the world of equity research. When looking at a bank’s asset size in comparison to the level of non-performing loans still held on the books, the statistics show a wide variation between the largest and smallest institutions. The average Texas ratio for the largest institutions (28 percent) is much lower than that for the smallest institutions, those with under $250 million in assets (43 percent). A similar story plays out in values. Banks above $25 billion in assets traded at an average of 129 percent of tangible book value. Banks below $250 million in assets traded at an average of 69 percent of tangible book.  Smaller banks have less access to capital markets, which could impact values, but many of them have more troubled loans on the books as well, which impacts the Texas ratio. A ratio above 100 percent is an indication of a potential bank failure.

When examining regional trends, every region has seen improvement in recent quarters in almost every important metric (price/tangible book, price to earnings ratio, Texas ratio, tangible equity/tangible assets). The three areas of the country where the banks have seen the greatest improvement in price and credit (the Southeast, Southwest and the Midwest) were hardest hit by the depression in the housing market and credit crunch. While these regions’ cumulative statistics have seen the greatest improvement since the third quarter of 2012, they still lag behind those of the Northeast and West.

The full report can be accessed here.

The Impact of the JOBS Act on Banks

construction.jpgOn March 27th, the House of Representatives passed the Jumpstart Our Business Startups Act (the JOBS Act). The Senate approved the same legislation the prior week and and the bill was signed by President Obama yesterday.

In part, the JOBS Act changes the Securities and Exchange Commission (SEC) registration requirements under the Securities Exchange Act of 1934 (the Exchange Act) in two respects for banks and bank holding companies.  

First, the JOBS Act increases the threshold for Exchange Act registration with the SEC from 500 shareholders of record to 2,000 shareholders of record. This amends the current rule which requires registration for companies with more than $10 million in assets and 500 shareholders of record. Up to this time, many small banks with assets over $10 million have avoided SEC registration by keeping the number of shareholders below 500. The new threshold will now allow smaller banks to raise capital by selling stock to new shareholders without having to register with the SEC.

Second, the JOBS Act increases the threshold for deregistering securities with the SEC for banks and bank holding companies from 300 shareholders of record to 1,200 shareholders of record. Consequently, more publicly-held banks may explore deregistration in order to avoid the costs and aggravation of continued SEC registration. 

Exchange Act regulations subject a company to the SEC’s public disclosure and reporting requirements, including periodic financial reporting (Forms 10-Q and 10-K), detailed governance and compensation disclosures (proxy statements) and share ownership reporting (Forms 3, 4 and 5). (It is not clear that Congress intended for the legislation to exclude thrifts and thrift holding companies and it is possible that the SEC may include thrifts and thrift holding companies when it issues regulations on the new registration thresholds.)

In deciding whether to explore deregistration, companies should consider some of its advantages and disadvantages:


Deregistration can provide a publicly held company with certain advantages, including:

Expense Reduction—Companies that deregister will save expenses in several areas, including costs associated with SEC filings, shareholder communications, professional fees, and, potentially, lower premiums for directors and officers liability insurance.

Increased Dividends—Companies that eliminate expenses associated with SEC registration may be able pass the savings to shareholders in the form of increased dividends.

Eliminate Personal Financial Disclosures—Deregistered companies would no longer be required to report transactions in the company’s stock and would also not be required to disclose detailed compensation information in the annual proxy statement of the company.

Reduce Pressure from Dissident Shareholders—Deregistered companies may be able to reduce certain pressures from dissident shareholders because those companies would no longer be required to comply with certain periodic reporting and disclosure obligations.  However, dissident shareholders would also not be required to publicly disclose their stock holdings.

Focus on Long-Term Goals—By eliminating certain reporting and disclosure obligations (quarterly reports, for example), deregistered companies may find it easier to focus on long-term business strategies rather than satisfying short-term shareholder expectations.


When weighing the advantages of deregistering, companies should also keep in mind certain disadvantages, including:

Reduced Access to Public Equity Markets—Publicly traded companies generally have greater access to equity markets and, therefore, can often raise capital more quickly than private companies.

Reduced Market for Stock—Deregistered companies are ineligible to list their stock on the NASDAQ OMX or other stock exchange. Consequently, shareholders of deregistered companies, including officers and directors, may not be able to sell stock as quickly as they could with an actively traded security. However, many registered companies have small markets for their stock which already limits the ability of individuals to timely buy and sell. Further, some institutional shareholders may have policies that prevent them from holding securities of deregistered companies.

Reduced Ability to Use Stock in Acquisitions—Deregistered companies may find it more difficult to use stock in structuring acquisitions because issuing stock as acquisition consideration may not qualify for a private placement exemption and, thus, require SEC registration. However, deregistering should not affect the ability of the company to be acquired.

Loss of Public Company Status—Many companies believe that being a public company enhances the business reputation of the company.