Growth Capital

The capital environment shifts to a proactive posture as community banks position themselves for expansion and acquisition.

By Brian Nixon

Coming out of the financial crisis of 2008, capital was a defensive weapon, enabling banks to shore up their footings and build fortress-like balance sheets, a trend that continued through 2011 or so.

Then things began to reverse a bit. Capital began to be viewed as an offensive tool, to be used carefully and strategically to gain ground against competitors through acquisitions or to support organic growth.

“There’s been a pretty dramatic change over the past four or five years,” says Nathan Stovall, senior editor with S&P Global Market Intelligence in New York. Indeed, today, he adds, some banks may think they have a different capital problem—one of excess.

The industry’s overall position of strength, combined with a number of other factors, including regulatory burden and accounting changes, have slowed banks’ need to access the capital markets. “You haven’t seen that much common equity issuance,” says Stovall. The trend isn’t surprising, since capital tends to be both expensive and issuers better have a good need for it, he adds.

That doesn’t mean banks aren’t carefully picking their spots. “What we have seen over the last few years, particularly among smaller institutions, is a pickup in debt issuance and subordinated debt,” Stovall says. “The reason is because it’s really cost-effective capital.”

In 2015, for example, there was a flurry of sub debt raises to support banks’ growth or for capital planning purposes at a cost of 6.5-7 percent, “which might sound high, but when you think about it, those are pretax payments on that debt,” Stovall says.

The after-tax cost of such sub debt would be around 4.3-4.6 percent, which is much less than the cost of common equity of 8-11 percent. “A lot of institutions definitely took advantage of that,” Stovall says. “Debt issuance did slow down earlier in the year when oil prices fell. The markets rebounded and some issuance activity came back.”

On the opposite side of the ledger, banks’ sub debt is attractive to investors as well. “While it’s advantageous for the bank, if you’re an investor, where are you going to find that kind of yield?” Stovall points out. “You’d have to almost go to the high-yield market to find that kind of yield and buy distressed paper.”

And currently, the banking industry shows few signs of stress. “Right now, this industry does not look distressed at all,” says Stovall. “Capital levels are way higher than where they were and credit is as good as it’s been in the last 10 years. It doesn’t mean it’s going to stay here forever, but if you’re a debt investor, you’re concerned about default risk. No one seems concerned about default risk. So there still is a strong investor base because the risk/reward looks pretty attractive.”

Josh Siegel, managing partner and CEO of StoneCastle Partners LLC, has a positive view of the industry’s prospects, particularly for community banks. (Through its Corporation for American Banking subsidiary, ABA endorses StoneCastle Financial’s direct capital investment program.) “I tend to be a half-full guy,” Siegel says. “I see a banking landscape that I can’t remember in any recent history as being so favorable for a community bank.”

There are two major factors shaping his outlook. One, regulatory pressures are only growing on larger banks. And, two, technology is the great equalizer.

“For the first time we’re now seeing little, tiny banks put in mobile remote deposit capture or personal financial management tools or new technology faster than either super-community or some regional banks,” Siegel says. “The cost of technology and the flexibility has come down so much that the small bank disadvantage is nearly gone. That now allows for a level playing field because there really is no convenience factor other than maybe ATM access without a fee that a large bank can say it has over a small bank anymore.”

The industry’s credit quality also continues to be strong. “That’s kind of the good side—stable market, easier to compete,” says Siegel.

The downside, he notes, is the interest rate cycle, as well money fund reform and the Liquidity Coverage Ratio rules, which are increasing the cost of bank-to-bank lending and creating funding issues.

“I think the fact that since the local government investment pools are exempt from the money fund reform rules, their yields have gone up dramatically and that’s taking municipal dollars away from what would normally have gone to community banks and creating some holes in the funding side,” Siegel says. “Also, [with] the prime money funds that saw nearly a $1 trillion of outflow, it’s really gone almost entirely back into government funds so it didn’t land at the banks. That’s creating some issues.”

On the capital front, “it’s still reasonably open for people to raise capital,” Siegel says. “It’s not easy, ever, for a small bank. But there are more options today than there were a few years ago.”

With that said, bank valuations have come down. “We’ve moved more into a buyer’s market now for acquirers rather than acquirees,” Siegel says.

One driver of that trend is the challenge of succession. “That’s one of the highest pressure issues for selling is you just don’t have succession planning,” Siegel says. “Most of the deals that I’ve seen hit the table recently that weren’t driven by a private equity situation were driven by age. It’s the shareholders and board effectively huddling around a table and looking at each other and saying, ‘Well, who’s going to run it going forward and are we confident putting the value that we’ve built up over all of these decades in the hands of someone new?’ More often than not, the answer is no.”

Smaller banks that may be more concentrated in interest-earning assets are particularly challenged, says Dennis Trunfio, deals partner and U.S. banking & capital markets deals leader with PwC. Community banks, he says, will seek to find scales to offset high compliance costs. They also must court younger and more tech-savvy borrowers. “Those that don’t have the same relationships with their banks that their parents have,” he says.

On the customer-facing front, community banks are uniquely positioned to leverage social and cultural trends, such as the localism movement emphasizing such things as craft breweries, artisanal food and farm-to-table restaurants. “I can’t think of an institution better suited for that than local banks,” Siegel explains, “where ‘know your customer’ really means know your customer.” That factor is quantifiable, he adds. “If you look at the yield on earning assets at community banks, it’s about 40 basis points higher than regional or money center banks. Your nonbank person would say, ‘That’s because they take more risk.’ Well, the numbers don’t lie there either.”

The chargeoff rate for small banks for the last 20 years, including through the crisis, has been about half that of large banks. So, they’re not taking more risk.

“My explanation for those two numbers is that local customers don’t mind paying a little more for that relationship,” Siegel says. “They’re not going to shop for the last quarter or half a point of interest rate. Real, local underwriting tends to always be better than running FICO scores or national criteria.”

The bottom line, according to Siegel: “If you are a banker and if you are excited about the future, I think it’s a very viable time, both from regulatory, capital markets, technology and, probably, social interests for you to actually seize the opportunity.”