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.
With 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.
It 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.
For 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. 
After 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.
There 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.
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On 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