Small Failure Unearths Big Issue for Private Banking

The failure of Lydian Private Bank last Friday was a mere blip on the financial landscape, but its collapse may have exposed far bigger problems with the private banking model.

Critics argue that private banking is a difficult business to master and that large scale is the only route to long-term success. The financial crisis and ensuing economic malaise have cast an even harsher light on such shortcomings, they say.

"Nationally, a lot of these private banks are in big trouble and they need to reinvent themselves," says Edward Siedle, who investigates money managers on behalf of institutional investors at Benchmark Financial Services in Ocean Ridge, Fla., and is an American Banker contributor.

Private banking is "easy to say and hard to do because it's a completely different skill set" than most bankers have, says Gideon Haymaker, the chief executive of Seaside National Bank and Trust in Orlando, Fla.

Often, private bankers have gotten into trouble by diversifying beyond managing assets for affluent clients into areas that require different talents and resources. "What got [Lydian] in trouble was its wholesale deposit funding and single-family mortgage loans from the Internet," Haymaker says. "That's not private banking."

Boston Private Financial Holdings Inc., with $6 billion of assets, lost $11 million last year. The red ink flowed from activities outside its original money management business.

"Our mistake was bad exposure and too much concentration on commercial real estate and development loans," says Clayton Deutsch, Boston Private's president and chief executive. Deutsch was hired last year to revive the company. "The No. 1 [goal] was to stop doing stupid things and remember who we are," he says

Boston Private reported its first profitable quarter in a year when it earned $14.3 million in the second quarter. A crucial objective for the company has been placing renewed emphasis on its roots and investors' preference for relatively modest-size institutions in the wake of the financial crisis. "The beauty of wealth management and private banking is that size does matter and small beats big," Deutsch says.

Scale is a complicating factor for smaller private banks. Siedle says many small shops have a limited ability to manage assets and instead farm out management to third parties. Such products and services "are generally far inferior" to those of general asset managers, he says.

Despite the risk of diversifying, some private banks see little choice. Private Bank of the Peninsula in Palo Alto, Calif., changed its name to Avidbank in March to reflect expansion into commercial banking and asset-based lending. (The parent, which turned its first profit last year, became Avidbank Holdings Inc. in July.)

Kenneth Brenner, Avidbank's president and CEO, says the change was needed because the company was never really a wealth management firm. Also, it was too small to generate the returns it needed only managing assets.

"You've got to be in the billions of dollars range to make money out of it," Brenner says. "We're too small and there's too much competition to be a pure private bank."

Avidbank isn't the only bank changing its identity. Just 15 U.S. banks had "private" in their names at June 30, compared with 24 in mid-2007, according to data from the Federal Deposit Insurance Corp.

The model also remains under pressure as consumers cut back. Boston Private's assets under management stalled in the second quarter compared with a quarter earlier, at $20.2 billion. Deutsch, who attributed a lack of growth to economic conditions and a downturn in U.S. equities, says he remains optimistic about private banking over the long term. "I'm a major, major believer in the private banking model as we practice it," he says.

"We see a lot of banks jumping into wealth management as a Band-Aid for banking problems" but the markets "go up and down and many banks don't like volatility," Deutsch says. "If their core banking business is not robust, wealth management isn't going to fix you."

Haymaker, whose bank has increased assets under management to $207 million since its formation five years ago, agreed that private banking is a difficult business to develop from scratch. Another option for smaller private banks is consolidation. Lydian, which was based in the affluent hub of Palm Beach, Fla., was sold to Sabadell United Bank of Miami. For Sabadell United, a U.S. unit of Banco de Sabadell of Spain, the deal built on last year's purchase of Mellon United Bank.

Sabadell has already built a "private banking business in Spain, they've developed this business focus in Europe and they thought it would be a good model to have here in the states," says Fernando Alonso, a partner at Hunton & Williams LLP's Miami office. Alonso was a legal advisor to Sabadell on the Lydian deal.

"One of the elements that Sabadell has is international scope and international dimension to their business," Alonso says.

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