Comments on: A private stock market for small banks A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: drewfield Wed, 22 Feb 2012 22:07:07 +0000 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 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.

By: Eericsonjr Mon, 20 Feb 2012 17:10:10 +0000 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.

By: AABender1 Fri, 17 Feb 2012 12:21:40 +0000 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.

By: y2kurtus Fri, 17 Feb 2012 02:50:54 +0000 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.