An increase in dividend rates tied to the Small Business Lending Fund is the latest issue that could prompt bank consolidation.

The SBLF was launched in 2010 to provide capital to banks in an effort to boost small-business lending. The nearly 90 banks that held SBLF capital at the end of February are facing a big dividend increase that, combined with ballooning compliance costs and revenue challenges, will put more pressure on profit.

Selling could be the best option for participating banks, industry observers said.

The SBLF "is spurring banks to put themselves up for sale," said Michael Rave, a lawyer at Day Pitney who is working on deals where the seller is still in the fund. "They aren't in a position to repay the money or refinance it. They don't have a lot of choices."

Dividend rates on preferred shares jump to 9% after four and a half years. The initial rate was 5%, but banks could lower it to 1% by lending to more businesses with less than $50 million in annual revenue. Rates for banks that issued senior securities are set to reach almost 14% after four and a half years.

"The last thing I would want is money that is costing me 9%," said James Cassel, chairman of the investment bank Cassel Salpeter. "These are generally community banks, and smaller banks tend to have less access to the capital markets."

To be sure, selling isn't the only viable strategy. Some banks could use retained earnings to exit, industry observers said.

Banks with holding companies could issue debt to exit the SBLF, while others could consider a rights offering to existing investors, Cassel said. Participants could also borrow the funds from a correspondent bank, said Michael Iannaccone, managing director at FinPro Capital Advisors.

Still, banks could struggle to bring in fresh money, and small debt raises can often be cost prohibitive. New shareholders may also make outsize demands, including board representation.

New capital, meanwhile, may be just as costly as SBLF funding, said James Kaplan, a partner at Quarles & Brady.

Banks that choose to sell rather than repay the government likely have other issues that are pushing them to find buyers, such as revenue constraints and a lack of scale, industry experts said. At the same time, bank consolidation has picked up and premiums for deals have started to rise.

The SBLF "is just another headache, but it is significant," Kaplan said. "It's another thing that makes directors think they need to find an investor with reasonable demands or decide to sell."

Two recent sellers — Harmony Bank in Jackson, N.J., and New England Bancorp in Hyannis, Mass. — were holding SBLF capital when they agreed to be sold. The $295 million-asset Harmony announced in February that it had agreed to be sold to Lakeland Bancorp in Oak Ridge, N.J., while Independent Bank in Rockland, Mass., is buying the $260 million-asset New England Bancorp.

Harmony accepted $3.5 million in SBLF funds to boost its legal lending capacity, said Michael Schutzer, the bank's president and chief executive. The bank was planning on repaying the funds — the dividend increased to 9% last week — with existing capital or by raising $6 million, he added.

A variety of reasons, including regulatory costs and the need for operating efficiencies, prompted Harmony to agree to be sold to Lakeland, Schutzer said. (Rave at Day Pitney represented Harmony in this deal.)

Still, SBLF capital "was clearly part of the discussion" as the banks worked out a deal, said Thomas Shara, Lakeland's president and chief executive.

Harmony agreed to apply for regulatory approval to pay off the funds prior to the closing of the deal. Based on the companies' merger agreement, Lakeland must do its best to cooperate, while both parties must agree on how to fund the exit.

With that in mind, Shara said he could see more deals being influenced by the presence of SBLF funds.

"It is a significant issue," Shara said. "A lot of the small banks don't have access to the capital markets, so redemption can be difficult. It's a significant new cost."

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