My friend and occasional guest blogger Pat Dalrymple, a former community banker, felt the need to blow off steam again, so I'm indulging him. Actually, he's a lot more optimistic than I am, but that doesn't take much.
The smart money today is emphatic in advising not to get into banking as a buyer of, or controlling investor in, a financial institution, especially in a smaller, so-called “community bank”..
The reasons cited are many and cogent:
· Regulatory restrictions are choking off profitability.
· There’s a dearth of acceptable assets for investment to soak up the deluge of cash deposits flowing into banks.
· The Dodd-Frank Act has triggered regulations that make compliance difficult, complex, expensive, and virtually impossible to accomplish.
· Appreciation in a bank’s market value is minuscule, compared to the windfalls that investors experienced over the past 40 years.
· Big bank competition makes it impossible for a small bank to thrive
· The quality of small bank loan portfolios is suspect.
· Banking isn’t fun anymore.
There are others, but you get the picture.
In fact, every one of the above is true.
Yet, if we’ve learned anything in the last 5,000 years or so of recorded history about war and commerce, when the experts say “do”, don’t. When the word is “don’t”, seriously consider doing the opposite.
Airplanes could never sink a battleship, submarines were nothing more than toys. Why would anyone invest in a flying machine, a horseless carriage, or a device that lets people talk on wires?’’
In this instance, we’re not talking about buying stock in a mega-bank. That’s probably a pretty good bet over the long haul, because the big banks almost can’t help but make money, positioned as they are at the crossroads of global industry and commerce. The opportunity, if there is one, lies with little banks in relatively small markets: the institutions under, say, $200 million.
Big banking and little banking are two almost completely different businesses that, paradoxically, are governed by the same set of regulations. Inevitably, these regs are applied differently to the two industries. Our focus here is on the smaller of the two, but, in terms of the number of individual institutions, and thus in opportunity, much the larger.
So, let’s take a quick look at all of the good reasons not to buy a bank:
Regulatory stifling of profitability:
This maybe should be first on the list of considerations, and it has to be recognized as a challenge at the outset. It’s absolutely a fact of modern commercial life that the regs make it difficult to make money the old fashioned way. Most community bank business models are using pre-crisis blueprints, which may not work in a post meltdown environment.
We’re all products of our training, and bank management teams certainly weren’t conditioned to adust when the basic rules of the game changed.
So, the plan for a purchaser may have to run contrary to a lot of conventional wisdom to thrive in the current economic ecosystem. Fore example, if the bank isn’t already doing so, become the go to residential mortgage lender for your customers. When the bank can’t make a loan which could ultimately result in a profitable long term relationship, (which will be often these days) find ways to assist that customer to find alternative financing. And above all, don’t forget to make money doing it.
Also, carefully look at the cost/benefit equation of paring expenses. All banks, big and little, have been cutting costs for the past several years. Most community bankers are convinced they’ve cut to the bone, but they’re wrong; they’re running the business that they built and were trained to run, and that model just doesn’t exist in the old format.
For example, small banks that have branches probably shouldn’t. The deposits accumulated simply don’t justify the cost. Paradoxically, management has kept the branches open to “preserve the institution’s franchise value” for potential purchaser. Ignored is the strong likelihood that, should that buyer come along, the branches will be shuttered soon after the sale closes.
Finally, in viewing a troubled bank, the income statement can tell an interesting story: when all of the expenses attendant to regulatory restrictions and undercapitalization are erased, one often finds that, even with last century’s business model, the bank can be adequately profitable.
Scarcity of good assets:
This phrase merits some redefinition: There are a lot of quality loan assets around; they just don’t fit the regulators’ discriminatory definition of what’s good. Of course the result doesn’t change. If the regulators classify the loans as second class citizens in the general population of paper, then that’s what they are.
Conventional wisdom says that a lot of bank dollars are chasing few assets, so the big fish will force the little ones out in the feeding frenzy. But CW, as usual, may have it wrong. Money center institutions have managed to cinch up the regulatory bonds past even what the examiners have done to them. This is because, in response to the post Dodd-Frank regs, they’ve instituted multiple layered internal policies that have destroyed their flexibility. Good loans often go to big banks to die, especially if they have to move up the approval ladder. Savvy community banks with good CAMEL ratings are using their huge edge in flexibility and processing time to take high quality business away from the bullies in the high rise offices.
Cost and complexity of compliance:
Nothing causes more angst and molar grinding among bankers than complying with the plethora of consumer laws and regs enacted and promulgated in the wake of the Great Meltdown. But most of the wailing is done by old duffers like me that have been around banking since way back in the last century. Fortunately for everybody, we’ll die off, to be replaced by bright young people who will grow up in an over-regulated environment and will opine, “Gee, what’s so hard about that”. And no matter what us old cowboys tell you, it doesn’t really cost an arm and a leg to accomplish the task.
Minimal appreciation in the bank as a salable asset:
True; you can’t buy a bank and sell it three years later at 3.5 times book. Putting equity money into a financial institution today is a longer term investment. But the cash on cash return can be very impressive, which will very nicely enhance book and market value.
Forget about owning a little bank. Big banks have all of the business:
No businesses are better positioned in their marketplace than community banks. Few businesses do a worse job of exploiting that advantage. (See the flexibility factor noted above) Imitation is the sincerest form of flattery: the big banks know the advantage of looking little to the home town folks, and often they’re more successful at it than their smaller brethren.
A prospective purchaser of a bank must understand the marketing plum to be acquired that very likely has been woefully underutilized.
Small bank loans are second class paper:
True for some; at least from the new regulatory perspective. And almost certainly so for institutions that are the prime targets for investors. These are the troubled banks that sometimes had to be satisfied with the skim after the cream was scraped off by competitors.
However, any of these loans that are currently performing in a post-nuclear financial landscape are survivors, and have a very good chance of continuing to be. One of the dichotomies of negotiation for a bank involves the owners touting the net interest margin of the portfolio, while the shopper counters with, “Yeah, but look at the loan quality”. Actually, the quality may be pretty good. The deals have been through the fire and they’re still anteing up that high interest rate, which can be pretty neat for an investor.
And then there are the non-accrual loans, those gems that you can’t book income from until they go away, one way or another.
What’s weird, is that a lot of these really rotten deals are performing.
My pilot friends tell me that any landing you walk away from is a good one. My wisest banking friends say that, in the final analysis, a good loan is one that gets paid back. This bottom line criterion doesn’t necessarily meet 21st century regulatory discrimination, but, in some instances, it can set up a nice little windfall for an investor, because all of that deferred interest on the loans that continue to perform will ultimately find its way to the bottom line.
That’s about it, so……….
What? Oh yeah….having fun. Well, if you’ve been a bank exec for more than ten years, it probably isn’t much fun. In, say, 2004, the 3-3-3 banking rule didn’t actually prevail (you know, pay 3% for your deposits, mark your loans up 3%, and be on the golf course by 3) but it was a day on the beach compared to 2014.
On the other hand, if you can buy a clean bank, or make sure that the existing owners clean it up before handing over the keys, then you might have a pretty good time, given the potential profit margin.