Bank Lawyer's Blog

Drilling Down On De Novos

After reading one of my recent posts on the headwinds faced by those who are thinking of starting a new (de novo) bank, David Rice, the Senior Editor of the Federal Reserve Bank of Richmond's Econ Focus, kindly sent me links to a couple of recent articles from that publication that address the same issue. The first is "Who Wants to Start a Bank?," by Tim Sablik. Sablik explores the possible reasons for the dearth of de novos since 2008. Many of those reasons have been discussed here, but the article is an excellent compilation of the potential reasons and research (especially Federal Reserve Bank research) on the issues. Although I'd recommend that any interested reader review the actual article, here's a bullet point list of the reasons cited by Sablik:

• Regulatory burden on banks of all sizes that has grown like marigolds since Franken-Dodd was hatched by Barney, Chris, and Those Who Only Lizzie Loves.
• FDIC roadblocks to the formation of de novos during the period following the Great Recession's onset in 2008 until very recently (more on that in a future post).
• Low interest rates since 2008, and the resulting narrow interest rate spread, which makes it tough to make a buck in the banking business, especially when you're the new kid on the block.
• Competition form nonbanks.

Although regulatory burden is often given top billing by the biased, it's only part of the story. As the research cited by Sablik demonstrates, and as is the case with most things in life, problems are often more complex than those who like their story lines simple might like to acknowledge, including those who blog. Whatever the various causes, the article ends on a chipper note via Chip Mahan, who has started two de novos, the last one in 2007, when he had to have a face-to-face meeting with Shiela Bair, then FDIC Chairman, to sell her on why his proposed bank should receive insurance of its deposit accounts from the FDIC. Although Mahan does not disclose it in the article, our investigative reporters have informed us that he attended the meeting with The Care Bair armed with five cloves of garlic, a portable flame thrower, a mirror, and a Vampira® model hammer-and-stake combo he picked up at Walmart (gratis, given Walmart's love affair with Bair).

Mahan thinks the future is bright for new banks — if they're willing to adapt to changing consumer demands. "You've got to be focused on technology and deliver products and services with a beautiful user experience," he says. "Because at the end of the day, who wakes up and thinks about their bank?"

At the end of the day, I don't wake up. That's usually what I do at the beginning of the day. On the other hand, when I do wake up, I wake up thinking about my bank. Maybe that's because they pay me obscene amounts of moola to do so. May be it's because I've always been what my elderly neighbor, Mrs. Scooter, characterized as "such an odd boy." Maybe its because I confuse "my bank" with "Tyra Banks." Maybe it's all of the above.

At any rate, whatever Mahan's smoking, I want a toke, because the second article by Mr. Sablik to which Mr. Price linked discusses the practical challenges of steering your new bank barque through the storm-tossed shoals off the FDIC's shoreline. Among the eye-popping (to the uninitiated) obstacles are the length of time (6 months to a year) and cost ($1 million is not an outrageous estimate), as well as the necessity to prove to people who don't currently, and likely never have, run banks that the community in which you'll locate the bank is not already adequately served by the banks operating in the community, and the fact that you'll have to raise and keep in place enough capital to fund a year's worth of cross-border smuggling activities for the Sinaloa Cartel ($15 million to $30 million). I recall when $2 million might allow you to blow and go with a de novo, but then, that was when folks thought bell bottom pants, Nehru jackets, and Madras shirts were cool.

This article ends with a less rosy view of de novo prospects from Fred Green, CEO of the South Carolina Bankers Association.

It can be challenging to recruit executives and directors for a new bank. "Historically," Green says, "a lot of folks aspired to be on a bank board and be part of a founding group. Serving on a bank board was an honor." Today, the hurdles to starting a new bank seem higher and the rewards less enticing. From 2006 to 2010, the average return on assets for community banks less than five years old was negative, according to a 2012 FDIC report. Older and larger banks managed to earn positive returns on average during that period, though they too suffered a hit.

"It’s harder to find people that would have the energy and desire to be involved in a startup today," says Green.

Following November's election results, you might have a better chance of finding them in Belize than in the U.S., because whichever of the two front runners for the Oval Office wins, the dearth of de novos will not be the only cause of community bankers seeking a warmer clime, especially one where English is the first language, taxes are extremely low, Cuban cigars are duty-free, and you're upwind from air currents that might carry nuclear fallout from D.C.

No Light At The End Of The Tunnel

Investment banker (and former OTS official) C.K. Lee has been keeping his finger on the pulse of the financial institution capital markets for years, and when it comes to the future of de novo banks, the outlook, to him, looks grim. It's not just due to the hostile attitude of the FDIC, FRB and OCC (although Lee notes that hostility as a factor), it's because of the difficulty of raising capital.

“The barriers to entry are high, not just on the regulatory side but with raising capital.”

It's not the big banks that are having trouble, it's the little guys. The results of those troubles are stark.

The firm estimates it’s raised about $700 million in investment capital for banks in the last six or seven years. Two investment groups they’ve put together recently are in North Texas.

Lee is a former official at the Federal Deposit Insurance Corp. and was regional director of the Office of Thrift Supervision’s Western region. He said in the past three years, about one-third of banks located in the Dallas-Fort Worth area with less than $5 billion in assets have been consolidated. But the biggest shift has been seen at the smallest end of the market, where the smallest businesses go if they can’t get a line of credit at the giant firms.

There were 3,255 banks with less than $100 million in assets in 2003, making up more than 43 percent of all community banks. By 2014, however, there were 1,919 of these firms, making up less than one third of community banks, according a report from the Brookings Institution published in December.

Before 2011, about 3 percent of all banks would merge or be acquired each year. But Lee said recently they are above a 4 percent clip.

So, not only are their many, many fewer little banks today than 13 years ago, but they are merging at a faster rate than even five years ago. As the big get bigger and the small disappear altogether, the consequences for the economy are troublesome.

“A big part of the decline in small business creation in this country over the last six or seven years is because smaller, community banks are going out of business, not necessarily through failure but consolidation,” Lee said. “We are shocked at the level of consolidation that we’ve seen.”

Small businesses have been the nation's biggest job creators and small community banks have been their biggest source of financing. Therefore, the rapid decline in the number of small community banks has hampered job creation. Perhaps that has contributed to the fact that the recovery of the economy from the 2008 recession has been the slowest recovery from a recession since 1949.

Like many of us who serve the community banking business, Lee ends with a common theme: the federal financial regulatory regime has not been helpful.

But Lee insists regulators need to allow banks to keep up with other industries that are seeing a boom in start-ups.

“I just think the regulatory machine is going to be 20 years behind,” Lee said. “I just think we are making a mistake as a country if we’re going to let a lot of really good banks walk off into the sunset.”

So do I, but I won't hold my breath that such a mistake will ever be admitted, much less corrected. On the other hand, geniuses like Lizzie Warren think the U.S. Post Office will pick up the slack.

Come November, I don't expect that the attitude of those with their hands on the levers of power will improve, whichever of the two eminently qualified candidates for the possessor of the nuclear codes grabs the grass crown.

Barney Bites Bernie (And Neel)

Now that hell has frozen over, I find that all kinds of amazing things are occurring, one of which has created the danger of ripping a huge hole in the space-time continuum: I find myself in agreement with Barney Frank.

While watching the PBS News Hour this past Thursday night, who should pop up but the former House Banking Committee Chair and favorite Bank Lawyers Blog Bullseye, Barney, who was interviewed by Jeffrey Brown about Frank's reaction to statements by Neel Kashkari, currently president of the Federal Reserve Bank of Minneapolis and former Bush Bailout TARP Toolmaker, and the ever-cranky Bernie Sanders, Gen Y's favorite "Democratic Socialist," about "To Big To Fail Banks." Sanders also alleged that the way to break up big banks is to reimpose the Glass-Steagall on commercial banks. Frank, now that he's out of the political arena and no longer feels compelled to be what every politician feels he or she must be, i.e., a caster of shade upon of the truth, was remarkably critical of two gents who are spouting the Democrat Party line about the evils of Wall Street's "TBTF" banks.

Barney may have gained some objectivity, but he's lost none of the pungent-tongued arrows from his verbal quiver.

In the first place, both Senator Sanders and Mr. Kashkari continue to evade the biggest question. That is, how big is too big? The crisis which touched off when Lehman Brothers couldn’t make its payment, Lehman Brothers was about $650 billion in assets. We have banks four and five times that size

And the question is, does everybody have to be smaller than Lehman Brothers is today? But that would have consequences. Getting there would be a problem. By the way, it should be very clear, Glass-Steagall doesn’t do it. There is a disconnect between Senator Sanders insisting that the banks be broken down to the point where they won’t by their own size threaten, if they have too much debt, to undermine it.

And Glass-Steagall — Glass-Steagall would reduce — it wouldn’t do anything to Goldman Sachs and to Morgan Stanley, which are almost Glass-Steagall-ized themselves. But looked at Citicorp, or J.P. Morgan Chase, or Bank of America, Wells Fargo, even if they were subject to Glass-Steagall, they would still be well beyond the size that Lehman Brothers was.

There is just a disconnect between saying we’re going to do Glass-Steagall and getting the banks down to a size where, if there was a complete failure, you would get damaged by it.

The entire response above by Frank is remarkable for the fact that he's right. It's obvious that he's not been spending his time since retirement sampling the wares of Mar Jane-related "legal" businesses in Colorado.

Frank also jumped all over Kashkari's comparison of the 2008 meltdown to the S&L crisis of the 1980s, and Kashkari's statement that the reason the S&L crisis didn't bring the economy down was because none of the S&Ls was "too big to fail." Again, Frank asks why Kashkari won't tell us how big is too big? He also correctly notes that the bailout of the S&Ls cost a lot more than the bail out of big banks in 2008, although he does not also observe that this was because the 2008 TARP allowed the big banks to survive, while the S&L "bailout" allowed them to fail (or most of them, at any rate (outside the Southwest Plan thrifts), and established the Resolution Trust Corporation, staffed by the FDIC, to liquidate their assets. If the politicians, including Frank, had stayed out of it in the 1980s and let the initial bailout template concocted by the former Federal Savings and Loan Corporation play out, there's a chance that the money from that bailout might also have been largely repaid.

Frank says the primary risk is not size but "indebtedness," and on this point he's got a point. However, I disagree with his assertion that his bloated namesake, Dodd-Frank, has dealt successfully with the risk of bank's engaging in excessive borrowing and hinky derivatives that made "The Big Fail" such a hit (his misapprehension of the effect of the Volcker Rule has been lambasted previously), and his assertion that now, no bank is too big to fail. 

If a large institution can’t pay its debts, it fails. It is not too big to fail. It is put out of business, by law. No federal official can advance any money to pay its debts under the law until it is dissolved.

TARP also required legislation to create, and the wide-open authority it provided the federal government to bail out banks was induced by panic among folks at the highest levels of the federal government (including Frank) of immanent widespread economic collapse. We'll see how effective Franken-Dodd is when the next crisis hits, as it inevitably will. There's no prohibition on a future panicked Congress changing the rules on the spur of the moment to do what Frank claims can never again be done.

To prove that I haven't completely turned to the dark side, I think his statements about overturning Citizens United are bunk. Nevertheless, all-in-all, startlingly, he makes a lot of sense.

Stressing Stress Testing

A recent White Paper from the consulting firm Invictus discusses what those of us who represent community banks have been aware of for some time now: the requirements for "stress tests" that were supposed to apply only to those "Too Big To Fail" banks are "trickling down" to community banks. The buzzwords that apply to banks both large and small are "forward-looking risk analytics." While Invictus notes that bank regulators initially publicly stated that stress testing was only for the Big Guys, their actions belied their words (or, they simply changed their minds).

Regulatory actions in the waning months of 2015 should serve as notice that ignoring forward-looking analytics will lead to lower CAMELS scores, more examiner scrutiny and higher regulatory capital requirements. The new current expected credit loss model (CECL), which is expected early in 2016, is also a forward-looking tool.

Behind the scenes, however, regulators began changing their own methods for examining community banks, relying more and more on forward-looking analytics. In recent months, with signs that community banks are again accumulating higher concentrations of risky commercial real estate loans, regulators are reminding community banks that stress testing is indeed required to manage concentration risk in their portfolios and to develop realistic scenarios for interest rate risk management.
Regulatory actions in the waning months of 2015 should serve as notice that ignoring forward-looking analytics will lead to lower CAMELS scores, more examiner scrutiny and higher regulatory capital requirements. The new current expected credit loss model (CECL), which is expected early in 2016, is also a forward-looking tool.
The large banks have already adopted forward-looking risk analytics and are using the results with regulators. Although community banks are not subjected to the same stress testing requirements as the large banks, the regulatory trend is in the same direction. Those community banks that fail to incorporate new analytics into their risk management systems will find it difficult to communicate effectively with regulators.

The White Paper traces recent public issuances by the FDIC, FRB, and OCC in this direction. A specific red flag is the December 2015 joint agency guidance on CRE concentrations. Those of us who represented community banks and their directors in the aftermath of the last meltdown, when commercial real estate brought a number of community banks to grief, took special note of that guidance. It's "guidance" in the same way vendor management guidance is merely "guidance." Try violating it and see how "sticky" the wicket gets. You'll be up to your eyeballs in MRAs on the your next report of examination...or worse.

Even if you thinkl your CRE isn't all that "concentrated," Invictus thinks that you ought to seriously consider hoping on this forward-looking train.

Even if your bank doesn’t have CRE concentrations, use forward-looking risk analytics to stress test your capital, your strategic plans and any potential acquisition you might be considering. Present the results to regulators. Invictus’ clients that have used stress testing results with examiners have seen their capital requirements decrease, their management piece of their CAMELS composite increase, and their strategic plans win fast regulatory approval.

At the very least, it's worth pausing for a moment and, while you stoop to smell the roses, thinking about whether you might benefit from this approach (if you haven't already adopted it).

Rent-a-Charter vs. Strategic Alliance

In June 2004, I wrote a post about schemes by non-bank lenders, especially payday lenders, to "partner" with banks and thrifts in ways that would allow the non-banks to use the bank's or thrift's status to "preemept" "inconvenient state laws, such as those pesky usury limits. As I said at the time:

Apparently, the state-chartered banks involved in this practice are counting on the continued lack of objection by the FDIC, and the continued sympathy of state banking regulators who are eager to increase the number of state-chartered institutions that they regulate. In my opinion, this is a risky course.

I also pointed out at the time that national banks and federal savings banks could rest assured that their primary federal regulator would be scrutinizing their business arrangements with non-banks like Elizabeth Warren looking under her bed every night for a bad banker looking to steal all the cash she has hidden in the sock that she keeps under her pillow.

According to a recent client alert from Chapman and Cutler LLP, this bad old idea not only refuses to die, but has engendered state officials to take action to stop it in its tracks. While the alert discusses the State of Pennsylvania going after payday lenders who've aligned themselves with Native American tribes (which has been a problematic marriage for quite some time), it has wider implications for similar arrangements. In this instance, the Commonwealth of Pennsylvania alleged that the "true lender" for regulatory purposes was not a bank in Delaware that would have been exempt from Pennsylvania usury limits and licensing requirements but the non-bank website "originator" that did most of the origination work and derived most of the economic benefits from the loans. The authors note that in other jurisdictions, the court decisions have not been in lockstep on the issue of preemption, arrangements like the one challenged here are likely always to put the lenders in the regulatory crosshairs.

No clear rule has emerged although regulatory challenges almost certainly are more likely to be made when excessive interest rates and/or abusive sales or collection practices are involved. In this case, the loans imposed interest rates of 200% to 300%.

The alert notes that even though the court's decision involved only a motion to dismiss Pennsylvania's action, and that is a long way from a judgment on the merits, the red flags for financial institutions involved in such relationships are clear "because it demonstrates that plaintiffs will continue to raise the “true lender” theory and courts will not necessarily dismiss at an early stage (for failure to state a claim upon relief can be granted) “true lender” claims solely because a bank is the named lender on the loans, at least where there are allegations that the originating bank does not have substantive duties or an economic interest in the program."

In order to mitigate the risk of claims based on the “true lender” doctrine, companies that engage in internet-based lending programs through an arrangement with one or more banks should consider how the programs are structured. For example, consideration should be given to operations where the bank has substantive duties and/or an economic interest in the program or loans. We are aware that some internet-based lending programs are considering structural changes of this nature.

The firm also advises institutions to make certain that they comply with regulatory guidance governing relationships with service providers. They cite FIL-9-2016 and related FDIC guidance. I'd also suggest taking a look at the OCC's Bulletin 2013-29.

Or, for a change of pace, a bank considering one of these schemes might decide to take its entire capital to The Bellagio in Vegas, walk up to nearest roulette wheel, and lay it all on "00." I mean, if you like dancing along the razor's edge with insured deposits, you might as well go all-in. Plus, you get free booze as long as your money lasts. To hedge your bet, you might want to hold back enough to buy a one-way ticket to Havana (regular flights from the States start soon) just in case that method of income-generation doesn't work out as well as a strategic alliance with a non-bank payday lender.

Activist Investors Betting On Bank Mergers

It appears that "activist" investors are turning to banks because they, like many of the rest of us close to the banking sector, think that there will be continued consolidation of the banking industry in the U.S., and what better way to make yourself some hard-earned profits than buying shares in a business and then pushing its board to sell the family farm so you can cash out. Some of you may remember that this model business plan was why the FDIC apparently soured on relying on "private equity" investors to help it clean up the mess after the last banking meltdown.

According to reporters in the St. Louis Post-Dispatch, "[a]ctivist investors are putting the U.S. banking sector in their crosshairs, betting that headwinds whipping through the industry will accelerate consolidation among lenders." The authors cite the rapid uptick in such "activist campaigns" in the financial sector last year, and observe that the "activists" are turning their attention from insurance companies and other non-bank financial businesses to commercial banks.

Hedge funds such as Ancora Advisors, Clover Partners and Seidman & Associates are buying up stakes in lenders across the U.S., from community banks to large regional lenders.

Driving these investments is the view that ultra-low interest rates, lagging returns on equity and tough regulations will push more banks to merge, with buyers willing to pay a hefty multiple to a bank’s tangible book value. Activist investors interviewed by Reuters say another factor is exposure to energy-related loans, which is driving down the valuations of certain banks and making them all the more vulnerable to a takeover.

“Bigger banks are back in the market doing deals,” said Ralph MacDonald, a partner at law firm Jones Day, who specializes in mergers and acquisitions.

U.S. bank mergers and acquisitions volume rose 58 percent last year to $34.5 billion, according to Thomson Reuters data.

The authors think that Zions and Comerica are likely targets. Both "Systemically Important Financial Institutions" had under performing returns on equity last year. That alone makes them prime targets for "activists."

The firm believes that any bank earning a 12 percent or less return on tangible common equity needs to consider whether it can prosper as an independent institution, PL Capital co-founder Richard Lashley said in an interview.

A bank’s exposure to falling energy prices makes it even more vulnerable, he noted. But another key factor is a bank’s ability to maneuver through a climate where low rates are compressing net interest margins, and stricter regulations are increasing costs.

“Management teams and boards are just exhausted,” said Lashley, who is based in New Jersey. “It’s not fun to run a bank anymore.”

However, the article also contains a quote from a community bank chief that indicates that the trend to consolidate is not just for SIFIs.

“My phones are ringing off the hook with calls coming in from banks wanting to sell,” said Pat Hickman, the CEO of Happy State Bank, a lender in the Texas panhandle. “And one of the primary reasons is regulation.”

Yes, it's not fun to run ANY bank anymore, not just the large ones. Whether your a big bank or a small one, publicly traded or privately held, pressured by "activist" investors or simply by the facts of life: as we said a few weeks ago, 2016 will very likely be the year of the bank merger.

De Novo Deep Freeze Thawing? Not So Fast!

Although SNL's Nathan Stovall tantalizes readers with the headline "De novo market could be warming up," I think that--reading between the lines--the De Novo Deep Freeze of the past 8 years is not going to be thawing this year.

Stovall cites the recent de novo charter approval of California's Core Commercial Bank. However, that bank's investment adviser's CEO, Edward Carpenter, while stating his belief that "you can expect to see more applications in the relatively near future," warns that the path to approval of a de novo charter is a rocky one.

[T]he application process for de novos is "considerably more difficult" and requires much greater preparation now than before the credit crisis...

[...]

"We believe that a new bank requires more capital than it did in the past. It requires a stronger and deeper management team than it did in the past. And it needs to make a more persuasive case than was often made in the past about community need."

Core Commercial, like the two other most recent de novos, Pennsylvania's Bank of Bird-in-Hand and New Hampshire's Primary Bank, "plans to target a fairly narrow customer base as well, catering to small and medium-sized businesses that might feel disenfranchised by the nation's largest institutions." I assume that the geographic market area is also relatively focused, and that the applicants had to prove with more than lip service that the community was not being adequately served by existing financial institutions.

While Carpenter seems optimistic (and, I'm sure, stands ready to assist other potential clients with their de novo needs), others, including some regulators, are less pie-eyed.

Candace Franks, commissioner of the state banking department in Arkansas, acknowledged that de novo banking activity certainly slows during a recession, but said prior downturns have been followed by a "generous" era of de novo applications. She said that certainly hasn't been the case this time around. Franks, the immediate past chairman of the Conference of State Bank Supervisors, said the lack of de novo activity is "very concerning to us," particularly in rural areas like Arkansas, where community banks serve as the engine of small business activity.

Some observers have argued that regulators were hesitant to grant new charters since many banks that failed during the crisis were de novos formed in early 2000s. The Federal Reserve discussed the issue on a handful of occasions. Robert Mahalik, director of applications at the Federal Reserve Bank of Dallas, said at a conference in April 2014 that he saw no hint that new charter activity or approval would be on the near horizon.

Stoval also discusses other disincentives that may restrain a de novo deluge.

While regulators might be easy to blame for the dearth of de novos, Stevens noted that bankers have not painted a very attractive picture for parties considering entering the industry, often complaining about heightened regulatory burdens. Such rhetoric could serve as a deterrent to potential investors.

Some advisers say there simply are not many investors looking to form new banks. DD&F Consulting Group President Randy Dennis, who has helped launch a number of de novos in his career, said there is a whole new breed of investors that want to put money to work in the banking sector, but some are concerned they will not be able to receive regulatory approval. He further said the higher capital requirements facing de novo banks have limited investor interest.

[...]

...Tom Brown, longtime bank investor and CEO of Second Curve Capital LLC, said at a conference in mid-November that he understood why there is so little investor interest in forming a new bank charter. He believes the capital constraints on de novos make it difficult for investors to earn adequate returns on their capital.

"Who in their right mind would start a bank today? The FDIC requires $35 million in capital to start a bank. And no one can pencil out an annual rate of return on $35 million in the next five years, so you're not seeing new chartered banks," Brown said at the event.

Well, obviously the investors in Core Commercial, who we presume are not insane.

Noted bank attorney Walt Moeling of Bryan Cave also is cautiously optimistic. He thinks the prospects of additional de novo applications is "real," but that there numbers will be far less than in the past.

All the observers seem to agree that the application process will not be easy. The organizers will need to present a convincing case, based on hard data, of the need for the new institution. Capital will be king, and as Tom Brown asserts, the more capital required, the more difficult it is to earn a decent return on equity, especially when private investors have places to place their capital where the returns are larger, quicker. Management will also be critical, with both expertise and probity playing critical roles. Finally, the application process is likely top much more time-consuming and expensive than it ever has been.

And, of course, once the doors are opened, what you have is a community bank, trying to make money in a Post-Franken-Dodd world chock-full of Maxine Waters, Elizabeth Warrens, and other "progressive" ideologues who will look over your shoulder 24/7/365 to "guide" you on the path to righteousness, if not necessarily to profitability.

The Lesser Of Two Evils

In a fascinating bit of humbuggery, the US House of Representatives decided last week not to follow the lead of the US Senate and, instead, chose to screw the Federal Reserve rather than the banks who are members of the Federal Reserve System. Of course, both houses of Congress are robbing Peter to pay Paul, his cousin Guido, and their extended family back in Sicily, but that's beside the point. The point is that bank-bashing took a back seat to the realization that next year is an election year, and pissing off bankers might have to take a back seat to fundraising needs until after the first week of November 2016.

Nobody likes the Fed (except when it bails out the world), so messing with that august entity is usually fine and dandy, politically speaking.

The New York Times lays it all out for us.

The banking industry scored a surprise victory on Thursday when the House voted to pay for part of a new highway bill by draining a rainy-day fund at the Federal Reserve rather than cutting federal payments to some of the nation’s largest banks.

The Senate, scrounging for road-building money, voted earlier this year to reduce the Federal Reserve’s annual dividend payments to large commercial banks, saving about $17.1 billion over the next decade. The House was to follow suit, but after loud protests from the big banks, its final version of the highway bill preserves those dividends and instead requires the Fed to provide $59.5 billion over 10 years instead of putting the money into an account intended to cover potential losses.

Now congressional negotiators must decide which to hit, the Fed or the banks.

The Times notes the ultimate injustice of either alternative funding source: funds for highways are supposed to come from the gasoline tax. Naturally, politicians don't want to pass a tax raise that would enrage supporters of both Bernie Sanders and Ben Carson (which covers the political spectrum from coast-to-coast). Moreover, banks are (almost) lower than lawyers in the mind of the average mouth-breathing, knuckle-dragging voter, and bending banks over the back of the sofa isn't generally a risky play. So, whether it's the Fed or its member banks that pay the unjust price of this latest boondoggle, the banking system will pay a price.

If the banks pay the price by being shortchanged, considerably, on dividend income from the Fed, that will hurt their bottom lines. Moreover, Fed Chair Janet Yellen is probably correct in her warning that the Fed will lose members. On the other hand, if the Fed is the direct loser, its surplus will take a hit, which is not something that is in the interest of the financial system. The article points out that the surplus is in addition to capital the Fed raises by selling shares and it may not be needed to bail out the Fed if it goes negative over the next few years as it unwinds the stimulus. It also observes that Congress has tapped the surplus in the past. Setting aside the fact that just because you beat up an old lady and steal her Social Security check one month does not justify making it a habit, this would be the first time since the Fed was created that Congress would completely drain the surplus and prevent it from being refilled.

Other commenters, including some members of Congress, also think either choice is a loser.

"They’re both bad," said Aaron Klein, director of financial regulatory reform at the Bipartisan Policy Center, although he noted Congress has a history of tapping the Fed’s reserves.

Even the author of the House plan sounded apologetic. "This is not perfect policy, but it is much better than the alternative," Representative Randy Neugebauer, a Texas Republican, said on the House floor early Thursday. Mr. Neugebauer said he hoped that future transportation funding "comes from transportation users and not completely unrelated sectors of our economy."

When Porky sprouts wings, Randy.

One silver lining to this dark cloud is that it has upset Maxine ("The Socializer") Waters.

"How many of my colleagues or their constituents have a safe investment that pays this well?" Representative Maxine Waters, a California Democrat, asked on the House floor Thursday morning. "Most of my constituents are lucky to earn a penny a month on their bank accounts."

The fact that the dividend rate paid by the Fed to its members has absolutely nothing to do with the appropriate source of funding for highway construction is beside the point to The Socializer. The money's there, banks are getting it, they're making a better return than me and my friends, the federal government wants the money, so what's the problem? Take it!

I can't wait for either Hillary Clinton or The Greatest Show On Earth (EVER!) to get into the White House in 2017 and set all this right.

Wallison Whales On Dodd-Frank

While he'll convince no one in love with Big Government of his thesis, the American Enterprise Institute's Peter Wallison is making the case that recent academic research supports the proposition that Dodd-Frank and other regulatory burdens imposed by the federal government in the wake of the economic recession of 2008 are hampering the economic recovery of the U.S. (hat tip to a community bank CEO and blog reader for sending me the link).

First, a study by Michael Bordo and Joseph Haubrich showed that recoveries after financial crises are actually sharper than other recoveries. After studying 27 recession-recovery cycles since 1882, they concluded that “the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis.” So we should have expected a steep recovery after the sharp 2008–09 recession rather than the stuttering and stalling economy we have experienced.

Also, studies of Dodd-Frank’s effect have shown that the regulatory burdens imposed by that law have been particularly harsh for community banks. The Fed defines community banks as banks with $10 billion in assets or less; 98.5 percent of all US banks fall into this category. A 2012 Government Accountability Office study showed that 7 of the 16 titles in Dodd-Frank had potential adverse effects for these banks, and studies by scholars at George Mason University and Harvard’s Kennedy School have found significant compliance cost increases attributable to Dodd-Frank. “Since the second quarter of 2010,” said the Harvard study, “around the time of [Dodd-Frank’s] passage, we found community banks’ share of [US banking] assets has shrunk drastically—over 12 percent.”

Of course, the regulatory costs to community banks are not a new story; Congress has been attempting to mitigate these costs for years. What is new is the data that shows the effect of these regulatory costs on small business and hence on economic growth.

Wallison asserts that the vast majority of small businesses (traditionally, the primary drivers of job growth) require bank financing because they do not have the access to capital markets that larger business have. Increased regulatory costs mean less credit. Less credit means slower growth. Slower growth means less job creation.

This is where the costs loaded on small banks begin to affect US economic growth. Regulatory costs affect small banks more than large banks because the costs are largely fixed and large banks by definition have a bigger asset base over which to spread these costs.

When a small bank is required to hire a compliance officer, that is an employee who is not making loans or producing revenue. When the Consumer Financial Protection Bureau—set up by Dodd-Frank and the bane of small banks—sends out a 1,099-page regulation on mortgage lending, that means a community bank must engage a lawyer to interpret the new regulation, a compliance officer to apply the regulation in individual cases, and a tech firm to retool its mortgage underwriting system. All costs, no revenue, and fewer funds to lend. When a bank examiner criticizes a loan because the bank does not have audited financial statements for a customer who has never missed a payment in 20 years, that forces a bank to revise its business model and change its customer relationships. Again, costs for the bank and less financing for the small business.

If the costs Dodd-Frank has imposed on small banks are hurting small business, we should see a significant difference between the growth rates of small and large businesses since 2010. That is exactly what the data shows. In a Goldman Sachs report published in April 2015 and titled “The Two-Speed Economy,” the authors found that firms with more than 500 employees grew faster after 2010—the year of Dodd-Frank’s enactment—than the best historical performance over the last four recoveries. These firms largely had access to the capital markets for credit. However, jobs at firms with fewer than 500 employees declined over this period, although this group had grown faster than the large-firm group in the last four recoveries.

Here, then, is the source of the slow recovery from the 2008–09 recession. Although 64 percent of net new jobs in the US economy between 2002 and 2010 came from employment by small business, this source of growth has disappeared since the enactment of the Dodd-Frank Act. While larger firms have access to credit in the capital markets, millions of small firms, limited to borrowing from beleaguered community banks, are not getting the credit they need to grow and create jobs.

As I said above, Wallison won't convince the Bernie Sanders/Elizabeth Warren crowd with facts. One of the commenters to Wallison's article makes this point ably.

To blame the slow recovery on Dodd Frank is frankly hilarious. It defies logic. Big banks were the major contributors to the 2008 recession and their failure to re-inflate the lending system after the government had made them whole will go down as one the major acts of treachery against small business. Small banks are doing poorly for a far different reason. See the growth of a strong aggressive regional banking structure.

You'll notice that, unlike Wallison, no studies or statistics are cited by the commenter to back up his arguments or even his factual assertions, nor to counter those that support Wallison's arguments. Instead the basic ad hominem attack is made that Wallison's position is "hilarious."

No, it's anything but "hilarious." As people who have actually made a career in the community banking business understand, it is many things, but "hilarious" is not among them.

De Novo Logjam "Open"?

No sooner do we post an article about how the dearth of new bank charters appears to be a critical (if not the critical) factor in the phenomenon known as "the incredibly shrinking community banking universe" than out of the chute pops a new community bank (paid subscription required).

Primary Bank is just the second new bank to be approved in more than four years, and charts a potential path for other applicants to follow. The approval, which was reported last week, came more than a year after regulators signed off on Bank of Bird-in-Hand in Pennsylvania in late 2013.

"This does now open the logjam. Now the [Federal Deposit Insurance Corp.] has a process, and as long as future applicants follow that process, they should be in good shape," said Donald Musso, president and chief executive of the consulting firm FinPro, which worked with the new bank's organizers to move the application.

Musso said he is in conversations with four other clients possibly interested in filing de novo applications, although nothing is official yet.

The regulators are "working really hard in trying to open the doors for new de novos to form, but the standards are pretty high," he added. "You need $20 million-plus of new capital, which is a lot of capital. You've got to have enough capital to make it to profitability."

"A lot of capital." Ya' think? When I started working on de novo bank charters, back when Andrew Jackson was trying to bring down the Bank of the United States, you needed a tenth of that amount. Of course, a dollar went a lot farther then, as my buddy Tom Sawyer5 used to say.

American Banker reporter Joe Adler correctly observes that two banks in four years "hardly makes a trend." He also notes that the community in which the new bank is located suffered the sale of local banks, leaving it "local bank free." Also, the new CEO is a heavyweight in the banking industry and a former governor of New Hampshire is a board member. The bank's business plan appears to be conservative, focusing on small business loans, with no home mortgages and, I assume (although the article does not state this), little or no commercial real estate lending and certainly not much acquisition and development lending.

Consultant Byron Richardson also notes that private equity investors do not appear to be chomping at the bit to dive into de novo banks.

Richardson said a critical obstacle to new-bank formations lately has been finding investors willing to earn a slow rate of return in the face of heavy capital requirements and other regulatory burdens.

"A founder or organizer is not just going to put their money in a mattress," he said. "Part of the equation is: How much capital will the regulators require? But then with the cost of complying with the regulatory burden… how much money can the bank itself earn?"

On the other hand, the lead investor in Primary Bank said that he wasn't phased by the "regulatory burden".

"There has obviously been some concern with Dodd-Frank and regulations, and some people say, ‘That's why there's not banking activity,'" [William] Greiner said. "Our going forward is testament to the fact that we can see opportunity. We're not focused on some of the noise per se."

Unless, of course, the "noise" raises to the level of a diving-bombing Stuka. We'll see how the bank continues to ignore the regulatory burden "noise" as time marches on. Focusing on business rather than consumer loans is one way to lower the noise level.

Another factor involved in this de novo that may limit the pool of potential investors is the large number in the group.

"Most banks start with five, eight, maybe 10 individuals…. I felt it was important, given the environment, to have a bigger, broader group. We talked about having potentially 50 investors in that initial round," he said. (They ultimately raised an initial $3 million from 133 individuals.) "I thought if we could get 50 community leaders, business owners, professionals, to come and take a stake in this bank, it would make a statement that it's not a club… but really a community-based initiative," he added.

I agree with Greiner that the FDIC loves that aspect. Broad-based community investment groups tend to be more conservative, more focused on the long-term needs of the local business community that the bank will serve than on using the bank to make profits, ratchet up stock values through growth of assets and ROE, and cashing out in five years or so. If that's going to be a requirement going forward, however, it will dampen the enthusiasm of a number potential capital sources.

While this latest approval may, indeed (as Musso asserts), "open the logjam," we'll see how wide that opening is, and whether it remains open. At present, color me "skeptical." We may see a few more of these in the next couple of years, but I simply don't yet see a wave on the horizon that yet appears to be worth riding.