BankNotes ...

In the beginning of 2009, the media was pushing the idea that this would be the year for the community bank. Many smaller banks had not weighted down their balance sheets with subprime loans, asset-backed securities and complex derivatives. In theory, they had the stability to pick up loan customers that had been turned away by larger institutions. Columbus Business First published an article entitled, "Larger competitors' retrenchment may give smaller banks opening." And Business Week said, "As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business customers."

Getting in to the banking industry during a power shift from big banks to small ones would appear to be an attractive opportunity for bank executives and community leaders who wish to be bank investors. But the predictions of a few publications don't sufficiently address the risk involved in buying a bank. Bank investors need to have some framework for separating the good targets from the bad ones.

In a speech made last July, San Francisco Fed President Janet Yellen summarized the characteristics of at-risk community banks. She cited:

• High concentrations of construction loans for speculative housing projects
• Concentrations of land acquisition and development loans
• Poor appraisal systems
• Weak risk-monitoring systems

Looking ahead, Yellen also identified "income-producing office, warehouse, and retail commercial property" as an area of potential risk. She cited rising vacancies and poor rent dynamics, which are putting negative pressures on property values. These value declines can be particularly problematic for maturing loans that need to be refinanced. Community banks that maintain large portfolios of commercial property loans should be proactively managing these risks. Bank acquisition groups should verify that target banks are updating property appraisals, recognizing impairments early, and negotiating work-outs with borrowers when appropriate.

Tim Coffey, Research Analyst for FIG Partners, LLC, agrees that commercial real estate is the next area of risk for banks. In an interview, Coffey said,

Coffey's comment was included in a report by The Wall Street Transcript that also quoted commentary from other banking analysts. The consensus among them was that some community banks are still facing potentially disastrous problems ahead.

Separating the good acquisition targets from the bad ones, then, requires careful analysis of the balance sheet, loan portfolio and the bank's current risk management practices. If the bank isn't managing risk proactively, there could be unknown problems brewing within the loan portfolio. Buying a bank with known problem assets is a manageable challenge-but buying a bank with unknown problem assets is something else entirely.

SNL recently published an article discussing the FDIC's new policy change on de novo banks. In "Extending Bank's Adolescence," author Christina M. Mitchell writes, the "change effectively extends adolescence for young banks, lengthening the period of increased regulatory supervision required for de novo institutions in a move that industry observers say will heighten the already considerable barriers to opening new banks." Over the past few years, the regulators have nearly shut down the flow of de novo bank openings with a drastic increase in regulatory scrutiny.  As the regulatory approval timeline continues to increase, the capital requirements and start-up expenses of opening a bank have climbed significantly. These challenges are keeping many potential investors on the sidelines, and too few of them are looking for other opportunities to enter the banking industry, such as Buying a Bank. 

The Congressional Oversight Panel (COP), tasked with monitoring the Treasury's progress combating the financial crisis, has released an update on the continued risk of troubled assets in the banking industry. While the report doesn't address bank organizing groups specifically, its content does emphasize the challenges of evaluating target banks during this financial crisis.

Those challenges include valuing the target bank's troubled assets and identifying the reasons why those assets became troubled in the first place. In the general sense of the term, troubled assets are loans or securities that no longer meet (or perhaps never did meet) acceptable underwriting standards. The credit risk on these assets exceeds acceptable levels, repayment is questionable, and the aggregate asset value is far lower than originally assumed. Troubled assets commonly include:

Community banks generally have more exposure to troubled whole mortgages.

The bank organizing group does have a certain level of negotiating power when the target bank's balance sheet is weighted down with too many troubled assets. That's where the advantages end, however. Even before the negotiating begins, organizers must identify the underlying causes of the bad assets:

The organizing group is then tasked with devising the underwriting, workout and procedural standards that will:

Obviously, these are relatively complex objectives in this economic environment. Unemployment is still rising and the outlook for property values, particularly commercial property values, remains uncertain. Excessively timid underwriting can minimize the creation of new problems, but it's counter-productive; banks have to make loans to survive. The new management team simply has to find a way to originate loans that make sense.

Setting appropriate capital requirements is also a key step in evaluating the target bank. Ample capital can be a buffer for future loan losses, but organizers have to balance the capital needs with the availability of investor funds. Under current conditions, it is possible for organizers to meet their capital raise targets-but it isn't easy. The process takes planning, knowledge and expertise.

Next week, we'll discuss the accounting for troubled assets, as discussed in the COP report. You can access the full COP report here: http://cop.senate.gov/documents/cop-081109-report.pdf

Given the large number of bank failures over the last 18 months, the FDIC is seeing increased interest from would-be investors interested in purchasing depository assets of the failed institutions. Concern has risen at the regulatory level about whether these new bank owners and investors have the qualifications necessary to keep the acquired assets from returning to the failed assets pool. That concern has led the FDIC to issue a proposed policy statement that would, if adopted, establish a new set of qualifications for investment groups intending to purchase failed bank assets. 

The proposed standards address the following topics:

• Ownership structure
• Capital levels
• Cross guarantees
• Affiliate transactions
• Continuity of ownership
• Secrecy law jurisdictions
• Limitations on the existing owners of the failed institution
• Disclosure requirements

Key measures of the proposal

1. Silo structures will not be deemed eligible for bidding.
2. A Tier 1 leverage ratio of 15 percent is required and must be maintained for three years. After that, the institution must remain "well capitalized."
3. The holding company must agree to sell stock or engage in capital qualifying borrowing to support the depository institution.
4. Investors with interests in more than one FDIC-insured institution have to pledge to the FDIC their proportionate interests in each institution.
5. Loans to investors or investors' affiliates would be prohibited.
6. Investors would have to retain ownership in the institution for at least three years. The FDIC can approve exceptions.
7. Ownership structures involving entities domiciled in bank secrecy jurisdictions will not be eligible bidders.
8. Investors owning 10 percent or more of the failed institution will not be eligible bidders.
9. Investors will have to disclose to the FDIC information pertaining to the size and composition of capital funds, the business plan, the management team, etc.

Bidders subject to proposed rules

Under the current proposal, these rules would only be applicable to certain types of bank acquirers, namely:

• Private capital investors attempting to take ownership of deposit liabilities that are currently in receivership
• De novo institutions applying for FDIC insurance in association with "the resolution of failed insurance depository institutions" 

Balancing capital needs with prudence

While the FDIC is conscious of the need to qualify bidders, regulators are also concerned about placing too many limitations on the inflow of new capital into the banking system. The banking system needs private investor capital. Are these proposed rules going to inhibit the flow of that new capital? Or will the new standards deliver the right amount of prudence? Feel free to sound off!

Read the full FDIC statement here: http://www.thefederalregister.com/d.p/2009-07-09-E9-16077 The proposal policy statement is open for public comments until early-August.

Acquiring a bank with an eye on making an impact in underserved customer groups  

Bank investors and organizing groups know that to be successful in today’s environment, a different type of strategy is required. Acquiring a financial institution with an unhealthy balance sheet and anemic profit potential taps more than investors’ wallets; it can tap their creativity too. One challenge lies in developing a business strategy that can win, and keep, new customers.

Untapped potential

Lena Robinson, of the Federal Reserve Bank of San Francisco, identifies four areas of untapped customer potential for the banking industry: the unbanked, underserved, emerging and immigrant markets. Unbanked consumers are those who have no existing banking relationship. Underserved consumers maintain only a checking account. Emerging consumers who use minimal banking products, but could be ready for more sophisticated debt or investment services. And immigrant consumers are generally migrant workers who have historically been unresponsive to traditional bank marketing initiatives. All of these segments represent opportunity for a newly acquired bank to create value. (http://www.frbsf.org/publications/community/investments/0311/article1.html)

Rewriting the rules

The FDIC’s survey on banks’ efforts to serve unbanked and underbanked consumers, published in February, indicates that addressing these segments efficiently has long been a problem for the banking industry. (http://www.fdic.gov/news/news/press/2009/pr09015.html) Unbanked consumers are hard to locate and not generally interested in traditional banking products and services. Underserved, emerging and immigrant consumers may be more open to the idea of banking, but they have often have little money and minimal interest in borrowing. Those two characteristics are problematic for the traditional banking business model, which emphasizes deposits and lending.

Because these untapped segments aren’t well addressed by traditional banking operations, efforts to court them must take a different approach. This approach should:  

•    Clearly identify the wants, needs and aspirations of customer being targeted
•    Involve the creation of specialized products and services that match those customer needs, and distribution channels to match those customers’ lifestyles
•    Incorporate innovative outreach programs to establish lines of communication with those target customers
•    Find a way to develop trust among consumers who may be leery of financial institutions in general
•    Consider the development of new ways to measure creditworthiness; consumers in untapped segments may not “pass” traditional credit tests
•    Address the profit challenge associated with serving customers who aren’t likely to produce large deposits or request large borrowing facilities

In the introduction to Untapped: Creating value in underserved markets, (http://ca.csrwire.com/pdf/Untapped-excerpt.pdf) authors John Weiser, Michele Kahane, Steve Rochlin and Jessica Landis recommend businesses focus on creating win/win situations—where value is generated for the community and for the business. They also argue that it’s important for businesses to create strong partnerships with other organizations that can bring new insights and knowledge to the outreach effort.

As the banking industry continues to evolve through this period of change, new management teams and investors have the opportunity to create a new kind of value. To date, the banking industry has struggle to realize the potential in these segments—but if there ever was a time for change, it is now.  

Next week, we’ll discuss specific geographies where these underserved groups are likely to exist, as well as how you can use that information to target your bank acquisition search.