Small banks are increasingly seizing on opportunities to lend to their peers.

Opus Bank in Irvine, Calif., and PrivateBancorp (PVTB) in Chicago have formed correspondent banking units. CenterState Banks (CSFL) in Davenport, Fla., and AloStar Bank of Commerce in Birmingham, Ala., have expanded their product offerings. These banks see opportunities as bigger institutions exit and the banking industry stabilizes, industry experts say.

Correspondent services can help commercial banks diversify and generate fee income, experts say. Still, it is a highly relationship-driven business, so banks often need to hire talent from rivals. Also, many banks remain cautious about the riskiest aspects of the business.

"Correspondent banking was a dinosaur," says Randy Dennis, president of DD&F Consulting. "A lot of the larger players … got out of it. But we've seen a resurgence in the last several years."

Correspondent banking covers a range of services, including balance sheet management, providing letters of credit and lending to holding companies.

Banks that offer such services often are looking to generate fee income in the face of regulatory pressure elsewhere, Dennis says. Demand is picking up as small banks seek help with everything from strategies for investment portfolios to securing funds for growth.

A small bank that offers correspondent services could be better equipped than larger institutions when it comes to understanding clients' needs, says Stephen Gordon, Opus' chairman and chief executive. The $3.7 billion-asset bank launched a correspondent banking division last week after hiring Sally Hazen, Union Bank's former head of correspondent banking.

"There are five banks that dominate the market, yet there are about 7,000 banks," Gordon says. "There is room for a sixth. We want to help banks that have a vision to expand and grow."

Opus' size and staff experience will help it succeed in a business that heavily relies on relationships, Gordon says. Opus will provide cash vault services, time CDs and money market accounts to banks. The company will also make senior loans to bank holding companies secured by bank stock.

Banks were more willing to lend to other depository institutions before the financial crisis. Loan from banks with $20 billion or less to other depository institutions topped $4 billion at the end of 2006, according to the Federal Deposit Insurance Corp. As of Sept. 30, 2013, such loans total about $1.7 billion.

Loans to a bank holding company are usually secured by the stock in a borrower's bank, says Chip MacDonald, a partner at Jones Day. That practice became risky during the financial crisis as scores of banks failed, essentially making the "collateral worthless," he says.

Integra Bank in Evansville, Ind., recorded a large charge off in 2009 tied to a loan to Peoples Community Bancorp in West Chester, Ohio, which failed that same year. (Integra also failed, in 2011.)

If a bank borrower failed, the lender "almost had a second-lien position" as the regulator seized the bank, says Steve Brown, president and CEO of the $567 million-asset Pacific Coast Bankers' Bancshares in Walnut Creek, Calif.

Interest is starting to recover for potential borrowers and lenders, industry experts say. At banks with $20 billion of assets or less, loans to U.S. depository institutions in the U.S. rose about 70% at Sept. 30 from the end of 2012, according to FDIC data.

Demand will likely fall way short of pre-crisis levels, but "as banks continue to consolidate and buy other [nonbanks], some of that will need to be funded through holding company loans," says Terry Keating, a managing director of Amherst Partners.

Lending to holding companies hasn't been a large part of the $2.3 billion-asset CenterState's correspondent business so far, but the company is reconsidering that, says Brad Jones, who manages the correspondent division.

Memories of the financial crisis remain fresh, so correspondent banks will likely remain cautious when lending to other institutions, experts say. Due diligence is likely to be more thorough. Opus is managing its risk by making sure a bank has a "stellar management team" and will avoid the pre-crisis mind set where "if you can check five items off a list and they breath" they got the loan, Gordon says.

"I think banks have learned their lesson," says Ruth Razook, CEO of RLR Management Consulting. "Banks learned they needed to do better due diligence. I also think we weeded out some of the banks that were nonperforming and the industry has stabilized a bit, so it is less risky now."

Smaller banks that provide correspondent services are also looking to expand their offerings. CenterState added an assumable rate conversion program where a community bank can originate a fixed-rate loan then CenterState hedges it on its balance sheet.

The $771 million-asset AloStar launched Source, a program that lets small banks offer businesses capital through asset-based loans, in October. Banks can refer a client to AloStar to complete the transaction or make the loan as a participation. AloStar started the program after hearing about a need from community banks, says Lisa Beck, an executive vice president at the company.

"All of our [correspondent] team comes from a community bank background," Beck says. "They've worked in community banks so they understand the nuances."

Community banks offering correspondent services to other small banks can raise some questions regarding trust and competition, some observers say. There have been suggestions in the past that some banks made loans to other financial institutions to scout out those borrowers as potential acquisition targets.

"It is a good way to essentially see what another bank is doing," Brown says. "It is a way to get an inside view of their loan activity."

In fact, John Corbett, president and CEO of CenterState Bank of Florida, told American Banker in 2012 that correspondent banking was a way for his company to build relationships with potential targets.

None of CenterState's recent acquisitions have come from its correspondent banking division, Jones says. A customer might occasionally express concern about CenterState's Florida expansion, but it is rare, he says.

Smaller banks that offer correspondent banking are sensitive to such concerns, and insist they work to keep separate their correspondent operations from broader objectives. Still, bankers admit that they need a great deal of trust from their bank customers. "Relationships and trust are two integral factors that exist between our correspondent division bankers and its bank clients," Jones says.

"While it's possible that our commercial business development activities could occasionally overlap with business development activities of our bank clients, the correspondent division takes great care to ensure that its bank customer interests are protected," Jones adds. "To do otherwise would jeopardize our correspondent business model."

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