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.

Raising Capital in a Difficult Environment

1-31-14-Hunton.pngIn this environment, bankers can be excused for a fixation on capital. The demise of trust preferred (“TRUPs”) pools means there is no longer “just in time capital.” Regulators have demanded higher capital levels for troubled institutions, and new rules under the global agreement known as Basel III are set to go into place for community banks in January of 2015. Accordingly, bankers need to plan for their capital needs.

The following are some options for raising capital.

Bank Stock Loan
Bank holding companies (BHCs) of more than $500 million in total assets will generally be required to maintain a leverage ratio of 5 percent, a Tier 1 capital to risk-weighted assets ratio of 6 percent and a total capital to risk-weighted assets ratio of 10 percent, all on a consolidated basis. Basel III increases the total risk based capital ratio, including a new conservation buffer, and will add a common equity risk-based ratio, starting Jan 1, 2015. Bank holding companies below $500 million in assets are subject to a leverage limitation (essentially, the company must have a ratio of 100 percent debt to holding company equity) and a requirement that a subsidiary bank remains well capitalized. Dodd-Frank phases in quantitative capital requirements for savings and loan holding companies regardless of whether they have $500 million in assets or not.

All BHCs can borrow funds and contribute such funds into their banks as capital. BHCs of less than $500 million in total assets need mainly to stay within the debt-to-equity limits. Obviously, interest on bank stock debt is tax deductible.

For larger BHCs (those subject to consolidated capital guidelines), the Federal Reserve generally provides that subordinated debentures with an average weighted maturity of at least five years count as Tier 2 capital. These debentures are also an option for any size BHC looking for an interest-only alternative. Subordinated debentures must be unsecured. There are also other technical requirements to count as Tier 2 capital.

Preferred Stock
Dividends paid by a BHC on preferred stock are not tax deductible. Preferred stock must be noncumulative to qualify as Tier 1 capital, in other words, it doesn’t pay the holder any unpaid dividends retroactively. Consequently, a BHC may be able to justify the higher cost as compared to debt if necessary to improve the BHC’s leverage or Tier 1 risk-based capital ratios. Cumulative preferred stock is Tier 2 capital.

Common Stock
Common stock is obviously the cheapest form of capital, but also the most dilutive, to shareholders.

Private Offering
There are a number of options for an offering of securities. The JOBS Act regulations allow broad marketability of offerings solely to accredited investors. A BHC can engage in a nonpublic offering for up to 35 accredited investors or an offering which is otherwise exempt from registration. For instance, the BHC can engage in an exempt offering under Rule 144A to qualified institutional buyers (QIBs), which allows subsequent resales of the securities when resold to QIBs. This can mitigate the embedded marketability discount on securities sold in private placements.

Public Offering
To the extent that the BHC is public and it anticipates making frequent offerings of its securities, it may decide to file a shelf registration under Rule 415. A shelf registration covers securities that are not necessarily sold in a single discrete offering immediately upon effectiveness, but rather a number of tranches sold over time or on a continuous basis. With a shelf registration in place, the BHC has increased flexibility to raise money without the need of further Securities and Exchange Commission (SEC) clearance. There is also a considerable saving in paperwork, as only a prospectus supplement need be filed with the SEC.

Rights Offering
A BHC may consider a rights offering to existing shareholders as a means to raise additional capital. The rights offering could either be registered with the SEC or, if an exemption from registration were available, as a private offering. In a rights offering, the BHC allows existing shareholders to purchase their pro rata share of the securities offered.

In a PIPE offering, which stands for private investment in public equity, a public company issues securities in a private placement to selected accredited investors, normally QIBs or other institutional accredited investors. As a part of the securities purchase, the issuer agrees to file a resale registration statement covering the resale of the securities within a period of time following the closing. This allows the holders of the securities to gain liquidity while allowing the issuer to receive the capital without the delay of an SEC registration process.

Our expectation is that the most likely source of funding for most is a retail offering either with or without an investment banker. Nonetheless, in light of the rebounding capital market, offerings in a 144A or in a public offering are increasingly available.

Banks Increasingly Move to Public Markets

10-9-13-OTC-Markets.jpgThree years after the financial crisis, we are finally seeing a resurgence of small banks around the nation raising capital, evident by the uptick in conversions, preferred stock and initial public offerings, as well as the number of private banks becoming publicly traded. Year-to-date, banks have raised $17 billion through preferred equity issuance, a pace that would surpass the $18.5 billion raised in all of 2012. Since January, 10 banks have joined the NASDAQ Stock Market: six as traditional IPOs, and four as transfers from the OTCQB marketplace.

To better determine how banks are trading today, I turned to our OTCQB marketplace, where over 700 regional and community bank and thrift trade their securities, making OTCQB the best gauge for liquidity and trading activity in small community bank stocks. Twenty-four banks have started trading on OTCQB this year, 20 of them since June, an increase from 15 banks last year. Comparatively, NASDAQ has seen six IPOs this year, up from five in all of 2012.

One differentiating factor between the national stock exchanges and OTCQB is that to trade on OTCQB, companies do not have to file periodic reports with the Securities and Exchange Commission (SEC). Banks, already highly-regulated within their industry, often favor a path that minimizes additional regulatory requirements, which has led more than three-quarters of publicly-traded banks under $1 billion in assets to trade on OTCQB. A small company may spend $150,000 to $300,000 annually on maintaining a NASDAQ listing, with much of that expense allocated towards filings and attorney and accounting costs associated with SEC registration. As reported by the Independent Community Bankers of America, 90 percent of all U.S. banks have less than $1 billion in assets. This year, three banks have voluntarily left the NASDAQ Stock Market, taking advantage of a provision in the recently enacted Jumpstart Our Business Startups Act (the JOBS Act) that allows banks with fewer than 1,200 shareholders of record to deregister their stock.

The more than 700 banks and thrifts trading on OTCQB represent banking communities in almost every state, including 138 banks and thrifts in the state of California alone. The map below shows the geographic breakdown and the number of OTCQB-traded banks in each state.

Number of Banks or Thrifts Trading on the OTCQB by State


There are different reasons why banks choose to trade on OTCQB. Here are three of their stories.

Nicolet Bankshares (OTCQB: NCBS) – Nicolet Bankshares commenced trading on OTCQB in April 2013, following a merger with Mid-Wisconsin Financial Shares. Prior to 2005, Nicolet was an SEC-reporting company, but it made the decision to deregister when regulatory changes and compliance with the Sarbanes-Oxley Act proved too costly and complex for the small bank. Following its merger with Mid-Wisconsin, Nicolet is now the sixth largest bank holding company based in Wisconsin, with $1.1 billion in combined assets, achieving economies of scale to stay competitive and expand its market presence.

CU Bancorp (NASDAQ: CUNB) – CU Bancorp, a $1.2-billion asset bank, moved from OTCQB to NASDAQ in October of 2012. The bank, originally named California Republic Bank, opened in 2005 with a little more than $100 million in assets, following a $35-million private placement. Subsequently, the bank became publicly traded and remained a non-SEC filer up until its merger in 2012 with Premier Commercial Bancorp, another OTCQB bank. While trading on the OTCQB, CU Bancorp was successful growing organically and raising $67 million in capital. It also acquired two banks since 2011, eventually becoming large enough to qualify for a NASDAQ listing.

Standard Financial Corp (OTCQB: STND) – Standard Financial Corp., a $437-million asset bank operating in central Pennsylvania, went public on NASDAQ in 2010 following a mutual-to-stock conversion and offering. The bank traded approximately 7,000 shares a day on NASDAQ, which the bank determined was not sufficient trading volume to support the significant costs associated with a NASDAQ listing and SEC reporting requirements. As a result, Standard Financial recently deregistered with the SEC and began trading on OTCQB. According to Standard Financial’s board of directors, deregistration has allowed the company to “focus more on profitable operation of the company as opposed to the considerable time and effort necessary to manage compliance with SEC reporting requirements.” Standard Financial Corp. is the 12th bank to voluntarily delist from NASDAQ since the enactment of the JOBS Act.