A private stock market for small banks

By Felix Salmon
February 16, 2012
moving into regional and community banks -- something which can't possibly be bad and might well be very good for the industry.

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SecondMarket is moving into regional and community banks — something which can’t possibly be bad and might well be very good for the industry.

Right now, if you’re a community bank and you need to raise capital, it’s not easy. Equity stakes in such banks are highly illiquid, and almost impossible to monetize, which means that when an owner of such a bank needs some money, they all too often have to sell the bank outright.

When I wrote about the Bank of Cattaraugus in December, I worried about the fact that it was hard to do community banking without the risk of the owners selling out. My proposed alternative was credit unions — and I’m still a big fan of those. But I can tell you, as a six-year credit union board member myself, that it’s hard to get the owners of credit unions engaged, partly because board members are unpaid and have no real stake in the bank beyond the single vote they have by dint of being a member.

I can think of a few socially-responsible double-bottom-line-style investors who might be interested in taking a minority stake in institutions like the Bank of Cattaraugus. Ideally they would see returns roughly in line with inflation, nothing special: the idea would be to encourage utility banking, rather than high-risk, high-growth strategies.

The need for equity capital at all levels of the banking world has never been greater. We learned two big lessons during the financial crisis: firstly that banks had too much leverage, and secondly that subordinated debt is all but useless in doing its job. It doesn’t provide a cushion against bankruptcy: if you’re forced to default on your subordinated debt, you will be shut down and sold off, in one way or another. Which is why regulators and analysts started concentrating much more on tangible common equity (TCE) instead.

Public banks can increase their TCE just by issuing new stock; with privately-held banks it’s much harder. And, truth be told, it’s still going to be hard even if and when the new SecondMarket exchange in bank equity gets off the ground. It’s not designed for capital-raising operations; it’s just designed as a way for existing shareholders to be able to sell their stock. Which funnels money to the shareholders, but not to the bank.

Still, raising capital is always easier if the person providing the money has some kind of possible future exit. So it stands to reason that if a bank’s equity is trading on SecondMarket, potential participants in a capital raise will be more likely to take part, just because they know that they have a relatively easy way of selling that stock in the future.

And some of these banks are going to turn out to be spectacular investments. SecondMarket calls it “exposure to hyper-local economic growth”, with an embedded M&A option: if small banks continue to struggle and get eaten by their bigger competitors, shareholders at least generally get to charge a premium when they sell. More generally, banks can provide massive returns just by dint of their embedded leverage.

There are massive risks involved here, too, of course. There’s no guarantee that investors will be willing to buy when you want to sell. The bank could get into trouble with the FDIC and get taken over, wiping out all its equity. Boards of community banks tend not to be particularly independent. Small banks have been shrinking, as a sector, for years, and there’s no reason to believe they’re going to stop doing so, the occasional populist campaign notwithstanding. Etc etc.

So the people investing in this market, quite rightly, are going to have to be accredited investors who can afford to lose their entire investment. And I’m a bit sad that the SecondMarket platform isn’t being tweaked a bit more, here: I’d love to see prices (but not the names of the buyers and sellers) being listed, in public, after every auction. After all, it’s not like the financial information about these banks is secret: go to the FDIC website, and you’ll find every last bit of information you could possibly want, on any bank in the country.

But still, anything which increases the universe of options available to the owners of small banks is going to help them at some level compete with the bigger banks. And that’s got to be a good thing.

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Comments
4 comments so far

Great post Felix… most interesting of 2012! (of course I’m a small banker though!)

It will be great for small banks to be able to raise equity when they need to. I think though that the small banks you admire most are mutual not private. My bank has earned a hundred million dollars in the 140 years we’ve been at it. We’re so over capatalized that we’re trying to steal the safest loans from other well run banks using pricing and terms… that’s a dangerous game to play but banks can’t let their balance sheets shrink unless they are willing to slash overhead expences at least as fast.

Maine is an old state with slow growth. Maybe it’s different out west or in the south… but for the most part I think small banks are thriving up here.

Posted by y2kurtus | Report as abusive

This all sounds a bit like Samuel Pickwick—-scientific, well-intentioned, and a bit too generous.

The underlying problem is the industry itself–community banking. No doubt, community banks are important capital and social vehicles but they are financially unattractive as a pure investment today. This severely restricts their capital markets, and this will continue at least until nominal interest rates head north allowing net interest margins to expand a bit. Whenever that might happen…

It should be noted that much of these woes are the result of complicated US public policy, but the math of community banks is fairly simple. The “embedded leverage” of a community bank maxes out at 10X-11X. Given margin compression and the increasing overhead and regulatory requirements, the pre-tax return on assets of a community bank generally tops out around 1.5%. The best of class therefore will not make much more than 10% return on equity, and most such banks will return about 5% on equity—if everything goes right. Adjust that already low ROE for credit risk, adverse credit selection, fraud risk, insider dealing risk, liquidity risk, IT risk, interest rate gap risk, consumer compliance risk, and all sorts of other regulatory risks, and an investment in a community bank doesn’t look terribly attractive from a risk-adjusted point of view.

And there are strategic constraints. Any community bank that ventures into more profitable fee businesses will typically and many times irrationally find nasty push back by their primary regulator, e.g. Republic Bank, Kentucky and their tax anticipation loan business.

So given the current anemic core returns from ongoing operations and given the difficulty of adding new higher return activities, it shouldn’t be a surprise that there is barely a capital market for community banks today and that the M&A option you suggest isn’t worth much.

Community bank stock buyers, maximizing financial return and not other goals, are currently looking for a discount to book in order to get the internal rate of return of their investment above a hurdle rate of 10%-15%. Owners eschew selling at significant discounts to book unless the institution is in significant distress. Hence the capital market disconnect. A clearinghouse or listing service won’t help this much.

Unfortunately for all of us, current US public policy seems to encourage rather than discourage further concentration in the banking industry. If job creation comes primarily from small businesses and if community banks (because of their deep knowledge of the local community) are the best institutions to allocate capital to these local job-creating small businesses, then US public policy is unknowingly shutting down a principal source of US entrepreneurial job creation.

Posted by AABender1 | Report as abusive

AABender is in the money on this one. Felix, if you see community banking as a form of enlightened altruism it means only that you’ve not looked very carefully at the sector. Most of these institutions are set up and operated by and for the local gentry, who most often have a separate ambition in mind. These banks are designed to serve as an arm for those insiders’ ambitions, whether they be in residential or commercial real estate, construction, transportation, political aggrandizement or plain old money laundering.

These ambitions translate, in the prospectus, into terms like “credit risk, adverse credit selection, fraud risk, insider dealing risk, liquidity risk, IT risk,” etc. but the reality is they’re usually part of the business model or, indeed, its raison d’etre.

Posted by Eericsonjr | Report as abusive

Thank you for linking the capital needs of small banks to an aftermarket for their shares. I’ve referenced your article in my online work, Bypass Wall Street. You can search for your name at bypasswallstreet.com. Most community banks were initially created by offering shareownership to individuals in their local communities, to comply with banking law requirements for a charter. But when they need more capital, they turn to Wall Street. It rarely occurs to them to offer shares directly within their service area, even when a local securities broker is providing a trading market.

Posted by drewfield | Report as abusive
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