There is little doubt in viewing recent banking composite data that, in general, community banks located in Kentucky have weathered the Great Recession in far better financial condition than community banks located in many other states. However, before community bankers commence any victory celebration for surviving the recent economic chaos, they must consider several troubling conditions that remain in community banking today that must be adequately addressed for community banks to prosper in the future.
As a whole, most community banks will remain independent and viable in the foreseeable future, while others will not be as fortunate. Many banking pundits in the United States anticipate that there will be substantial consolidation among community banks in the future. The pundits mostly differ on the timing under which this consolidation will likely occur. There are approximately 7,300 or so financial institutions remaining in the United States (approximately 194 in Kentucky), and some of the more aggressive commentators on consolidation in community banking estimate that 30 percent to 40 percent of these institutions will be absorbed in the next decade or so. The outcome will likely be the survival of the fittest financial institutions, with the weakest being acquired.
There have been very few financial institutions that have been chartered by the bank regulators in the past few years, and there is not a strong likelihood that many new charters will be approved by the regulators until the economy improves and stabilizes. This obviously means that, as community banks consolidate, there will be fewer community banks in existence.
The consolidations that are being proposed by the experts are to occur among the community banks and not the largest banks. Several of the largest banks are already bumping against national concentration ratios that retard future domestic acquisitions. There have even been some comments on whether or not some banks are “too small to survive,” based upon economies of scale going forward and their present business model. While no one knows with certainty what the future holds for community banks, there are several issues that community bankers must consider in making decisions about the future of their institutions that are short term in nature and subject to constant change and other issues that are longer term in nature and considered more systemic.
This article explores some of the reasons a community bank may choose to consolidate with other institutions and why others may choose to remain independent.
The case for remaining independent
There are many well managed, well capitalized and relatively strong-performing community banks that exist today that are under no compulsion to consolidate, but in due course, may want to take advantage of opportunities that may exist to acquire other financial institutions. Some of the issues that currently preclude healthy community banks from consolidating with other financial institutions are as follows:
There is a disconnect between buyers and sellers in many potential transactions with respect to deal pricing, with many sellers holding out for higher pricing that is just not available in the current market for bank stock and buyers unwilling to pay sellers’ unrealistic demands.
Many community banks are unwilling to undertake transactions, either capital raises or bank purchases, which are dilutive to their current shareholders. The volatility of the pricing in the current stock market today is daunting to many bankers. Loans to bank holding companies are difficult to locate.
Many potential buyers are concerned with the likely required regulatory conditions that may be imposed to approve a transaction today.
There still exists tremendous toxicity in many sellers’ loan portfolios of distressed institutions that are quite difficult to quantify and that make acquisitions problematic.
The case for merger of equals in banking is very difficult to undertake because seldom are buyer and seller equal in deals. Many fail because of social issues.
The case for consolidation
There are many reasons a community bank may choose to consolidate or sell, and a few of these considerations, which are in no particular order, follow:
Banking as an industry has been demonized in the press and in Washington, D.C., and the prestige of being a banker is not as high as it once was.
Many community bankers and their boards of directors are tired of banking after the economic downturn and are desirous of selling their institutions as soon as practical. A recent study by the American Association of Bank Holding Companies indicates “over 800 provisions in statute, regulations or banking guidance that impose obligations on bank directors” and notes this as a major concern prospectively. No wonder directors are tired and concerned.
For the last several years, the economies of scale for operating a community bank have worsened for many banks as they view the cost of increased regulation, lack of loan growth, difficulty of growing non-interest income, narrowing of margins and returns, increased capital and liquidity requirements and, in general, reduced profitability.
Seasoned managers and directors for community banks have become increasingly more difficult to locate at a time when many bankers are retiring. Smaller banks are having a difficult time recruiting and paying the new managers and compliance officers they require to remain independent.
Regulatory burdens have increased exponentially with no end in sight. The recent Dodd-Frank Act has significantly added to the burden on community banks, and uncertainty is continuing as much of the Dodd-Frank Act has yet to be enacted. Much of the increase in regulatory burdens in the past decade are new regulations directly applicable to community banks, but there has also been an indirect effect of unintended consequences where regulations applicable only to large banks become best practices for community banks going forward.
There is difficulty for many community banks in raising new capital at a time when community banks are uncertain about what levels of liquidity and capital will be required by bank regulators going forward. The elimination of trust preferred capital (by the Dodd-Frank Act) going forward as an acceptable form of regulatory capital will eliminate a previously used capital tool. Many community banks have exhausted the possibility of raising capital from their family and friends and fear facing a very volatile stock market. The recently enacted federal Jobs Act may provide some relief to community bank holding companies undertaking capital raises in the future.
Many banks that have a strong lending focus on real-estate lending, both residential and commercial, are concerned over the slowness of recovery in those real-estate portfolios and slowness of loan growth projected for the next few years. They are also concerned with the lack of loan diversification in their loan portfolios.
Many bankers are presently concerned about the general economy, frustratingly low interest rates, plunging stock prices in banking, the level of taxation at both the entity and shareholder level, the increasing level of regulations (both direct and unintended consequences), relations with bank examiners, and the general level of uncertainty with their business model going forward.
While the number of bank failures has lessened from the last few years, many of the remaining problem banks are community banks and must be dealt with going forward. Many of these institutions that cannot remedy their problems will either voluntarily sell, be encouraged to sell by bank regulators because of their poor financial condition, or fail. More than 800 banks remain on the FDIC’s problem bank list.
Community banks that previously used TARP funds from the U.S. Treasury to increase their capital are faced with coming up with ways to repay these government funds. Issuing new capital for this purpose is difficult today, as has already been discussed.
Community banks have had to deal with many accounting changes recently, to include fair value accounting and computation of the loan loss reserve account, which has only added to the complexity of operating a bank.
In conclusion, for community banks the outlook for the future is favorable for the well-managed, well-capitalized and relatively strong performing banks and not so favorable for the remainder.
Walter F. Byrne, an attorney in the Lexington office of Stites & Harbison PLLC, has an established practice in financial institutions law and regulation, business planning, corporate law, securities law and mergers and acquisitions.