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Regulators Need to Give PE a Chance to Help Community Banks Thrive

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Community banks are fighting the wrong battle in Washington.

Barbara A. Rehm

The sector is starving for capital, and yet debate is dominated by complaints about regulatory burden. While that's an important issue, it pales in comparison to the problem of financing future growth.

Quite simply, the community banking sector will not survive without better access to capital.

"If you take an industry and you cut it off from capital structurally, it will just die," says Mark Kaufman, Maryland's banking commissioner.

That structural cutoff came about because institutional investors now dominate our markets, and federal rules keep investments in community banks so small that institutional players just aren't that interested.

"If you had your choice and you could get passive, retail capital that doesn't necessarily focus on return and is investing partially on a social desire to serve the community, that would be fabulous," Kaufman says. "But I don't think you can build a banking industry on that."

Kaufman is part of a group of state banking commissioners who are trying to figure out how to improve community banks' access to capital. The group released a white paper on the question Dec. 7 and I interviewed Kaufman on Dec. 12.

"I don't know why people aren't talking about this. I don't know why bankers aren't more concerned," Kaufman says.

The policy "solution" to date has been government programs, but none of them have worked. The most recent, the Small Business Lending Fund, distributed just $4 billion of the $30 billion available. Why? Because the government has no interest in taking a risk on a bank. It wants rock-solid investments and the community banking sector is anything but these days.

Clearly we need to move past government capital to private equity. And yet some regulators remain skeptical of PE firms. They worry the firms will press community banks to take on too much risk and question how long they are willing to commit their capital before seeking a payoff either through a sale or a public offering.

But remember, making money is not a bad thing and banks are in business to take risks. It's just possible an infusion of PE money could energize the community banking business, supply it with the leaders and ideas it needs to flourish.

"We bring professional management, professional governance to help a small bank," says Joe Thomas, managing director at Hovde Private Equity Advisors, which has been investing in community banks since 1994. "We focus on the blocking and tackling of community banking, which is garnering low-cost core deposits and a diversified loan portfolio in a particular market."

Hovde's investment horizon is seven to 10 years, which Thomas says "gives you a lot of time to be in alignment with legacy shareholders to seek liquidity in the stock of the company either through a public offering or a sale of the bank."

What Hovde and other investors like it are offering is a chance to help small banks survive. If they make money doing it, what's wrong with that?

I am not suggesting regulators throw open the doors to anyone willing to invest in a community bank. They need to vet the motivations and abilities of investors. But federal regulators should take a fresh look at the hurdles they have placed before private-equity firms, and they should simplify and streamline the rules governing investments in banks with assets of $2 billion or less.

The Federal Reserve did ease its rules in September 2008 in an attempt to coax more PE money into the business. But it didn't go far enough and it didn't carve out any exceptions for small banks.

Such an approach would jibe with the whole notion of scaling oversight to fit the risk posed by a class of banks. At a $2 billion-asset threshold, nearly 7,100 banks would be covered, or more than 95% of the industry. But all those banks combined hold just over 13% of the industry's assets, or $1.85 trillion, according to the FDIC.

We ought to be able to construct rules that work for this huge segment of the industry, one that poses little risk to the system as a whole. "Let's do like you're catching flies and put some honey out there," says Ray Grace, deputy banking commissioner in North Carolina. "Once they come in with their money, we control what they do. It's a regulated industry."

Three former comptrollers of the currency agreed: Bob Clarke, Jerry Hawke and John Dugan.

"Properly done it makes perfect sense," Clarke says. "And that's why we have regulators, to make sure things are done properly."

Dugan added that "there is a knee-jerk worry that nonstrategic buyers are 'speculators' and won't have the bank's interest at heart. I don't think there is any evidence to show that has really been the case."

Dugan calls PE money "an important source of new capital for the industry that ought to be allowed to be done under appropriate supervision and controls."

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Comments (4)
Barb:
You hit the nail on the head. We have community bank clients in need of capital and PE firm clients willing to provide it. In trying to get them together, although the previous community banker aversion to that form of capital has changed, the regulatory hurdles you discuss still prevent reasonable transactions from being completed. Without new capital, many community banks won't survive, so worrying about an increasing regulatory burden is a waste of time.
Thanks for highlighting the issue.
Len Rubin
Nelson Mullins
Posted by lenrubin | Thursday, December 15 2011 at 10:11AM ET
Well written as usual, Barbara, but commissioner Kauffman's comments regarding "social capital" and sense of urgency among bankers are a bit curious. What bank investor--retail, corporate or private equity, ever committed capital without expecting a financial return? And what banker (with a pulse and a clue) isn't concerned or "talking about" capital adequacy these days? Smart money knows how to size up an investment--not-so-smart money is what fueled the boom-turned-bust. Community banking needs investors that know how to size up a business model and compel management to hit performance goals---inclusive of risk management, customer satisfaction AND profitability.

No reasonable investor will ever capitalize a bank in order to save it from failure. A capital investment anticipates a return on capital---not just a return of capital. While it is true that control and disclosure requirements are a deterrent to institutional investors, the fundamental drawback for potential bank investors of any stripe is the lack of forecasted returns.

For example: let's say a $500MM bank has depleted its tier 1 capital to $10MM where ideally (in a regulator's mind) it should be $40MM. Further, let's say that our bank is holding 5% non-performing assets and that our cost of funds is 1%. As such, the bank's NPA funding cost amounts to $250K/annually--on top of everything else it costs to keep the bank running. The desired $40MM investment will cure our capital ills for the time being, but unless that capital can be deployed into earning assets (aka loan growth), how will a capital injection assist the profitability of the bank? Until loan demand picks up, all you've accomplished is a marginal reduction in funding costs through the utilization of commissioner Kauffman's "social" capital.

And by the way...how much of a write-down will ultimately be required on those NPA's? We need private equity. We need even more the investment discipline that private equity would require.

Bob Koncerak
Posted by RDKoncerak | Thursday, December 15 2011 at 10:34AM ET
Barb, as always a great piece. Capital remains KING, and we all know this but the issue remains whether PE or Institutional, that the players
are all looking for little risk, and further, a lack of understanding of unique models. They speak of diversification and low cost deposits being their key to garnering interest in an institution, but do not appreciate what diversification really means and can not appreciate the fact that there is a lack of talent who have actually underwritten diverse loan types in todays market. It is tantamount to comparing a Tebow quarterback, unique and different, who wins all his games, yet still gets a bad rap in the press because he is different! Why? Simple! he is different but he is successful, and the arrogance within the sport, as is the arrogance within the Banking industry will not accept out of the box thinking. So albeit Kaufman, states "passive investors do not exist", some are working hard to prove him wrong, and the one that does, will be the rock star in Banking in the coming years.
Nice article, look forward to the next one.
Posted by tfer | Thursday, December 15 2011 at 11:44AM ET
The key here is that PE firms can bring in the capital that is needed as well as the discipline to help strengthen the sector. PE investors -- especially strategic PE investors -- should be encouraged. We are active in the socially responsible/CDFI banking space that sorely needs more capital - but it is just not available. Thanks for keeping the debate alive. Saurabh Narain
Posted by snarain | Thursday, December 29 2011 at 1:33PM ET
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