Ed Wehmer saw an opportunity to fill in a niche in Chicago as the change in branch banking laws quickly created a void for hometown banks to fill.
Wehmer quit his job as chief financial officer at River Forest Bancorp, rented a 1,200-square-foot storefront on Main Street in Lake Forest, Ill., picked up a case of beer and a box of cigars and invited some colleagues to start a bank.
"My wife had to bring us a card table. She had our five kids in the car and she said, 'I have faith in you, but I hope you know what you're doing," Wehmer said. "I was 37 years old and thought if it didn't work out I could always go back to being a CPA."
It was Labor Day weekend in 1991. Wehmer's team raised $6.6 million and, at the end of December, opened Lake Forest Bank. In subsequent years, that team formed nine banks, creating what is now the $19 billion-asset Wintrust Financial, one of Chicago's biggest banking companies.
Such stories used to be fairly common. Now, they are on their way to being urban legends.
Do novo banking has all but dried up. Only one new bank has been founded in the last few years, and industry observers say an increase in new entrants is unlikely given the existing operating and regulatory environment.
New charters were an integral piece of the bank M&A food chain. In the years leading up to the 2008 financial crisis, there was a cycle of starting banks, selling them for fat premiums and using the proceeds to start anew.
"It was normal for your bank to get bought and, two or three years later, sit around a kitchen table, decide to start a bank, plot to get local shareholders," said Timothy Chrisman, principal of executive the search firm Chrisman & Co. in Los Angeles.
"It was a feeder source," Chrisman added. "It was the process of community banking and that has changed dramatically."
Though advisers have largely written off the concept of a "massive wave" of M&A, the pace of consolidation is expected to stay steady, if not rise gradually each year. Michael Rose, an analyst at Raymond James, wrote in a July research note that 2014 is on track to be the busiest year of M&A since 1998, when viewed as a percentage of total banks.
A smaller banking industry facilitated by acquisitions and few new entrants has various ripple effects. In the short term, a lack of second-act opportunities could stymie activity as bankers hold on to what they have. In the long run, it will lead to a consolidated industry with less innovation and a deteriorating customer experience, some advisers say.
"There will be no sophomores and juniors," said Stephen Klein, a partner at Graham & Dunn in Seattle. "When you have competition, it makes everyone better. The march toward fewer banks is really an unhealthy development."
From 2000 to 2008, more than 2,400 banks were sold. During that period, the Federal Deposit Insurance Corp. granted deposit insurance to 1,313 new banks. When the real estate bubble popped, the economy went into a tail spin and de novo activity all but stopped, with the rare exception of private-equity-backed groups that aimed to buy failed banks. Some de novo hopefuls reconfigured their strategies and bought damaged, but salvageable, banks.
Reacting to the disproportionate number of failed de novos, the FDIC extended the special oversight of new banks from three years to seven years. The industry has long believed the FDIC also had an unwritten moratorium on new charters, though the agency has long said it did not.
The downturn accelerated industry consolidation, with 502 banks failing. Since 2009, nearly 1,200 bank acquisitions were announced with only 15 new banks chartered. Overall, the number of banks has contracted 18% since 2009, compared to 16.5% from 2000 to 2008.
De Novo? No Way
The supposed moratorium on new banks has given way to a lack of interest and a need for more capital. A bank once could gain approval with as little as $5 million; now it is $20 million to $25 million, lawyers and advisers say.
A higher barrier of entry is met with an uncertain future. If small bank executives think the only way to survive an uneven economy and more regulation is by pairing up with another institution, then a new bank would be knowingly opening up in a tough environment.
"The belief that exists now is that it would be hard to prosper as a de novo," said Wesley A. Brown, a managing director at KPMG Corporate Finance. "Bankers starting a new bank 10 years ago would have done it with enthusiasm. The idea that they can thrive has been shaken."
A lack of de novos is largely a function of the remaining stock of troubled banks and the economy, said Doreen Eberley, the FDIC's director of risk management supervision. "I think it is a function of the economic cycle," she said.
"There are still a large number of problem banks that are more attractive than starting from scratch," Eberley added. "It is also a tough operating environment. That is a far bigger factor than regulatory factors."
Some would-be entrepreneurs are looking to buy existing shops, Brown said. Given expectations that a de novo burns through about a fifth of its capital trying to make a profit, starting a new bank is like buying one for 120% of tangible book. As long as there are existing banks available for less than that, buying is better than chartering, he said.
Current deal pricing also makes it harder to rationalize the amount of work involved in a de novo.
"There's not a significant inducement," Brown said. "Before, the bank would be worth two times book after a few years, so it made great economic sense to charter."
No Second Acts
Many bankers are selling because they are tired of the business and are ready to move on. But there are still plenty of executives who have yet to reach retirement age, have families to support and are scared of what the sale of their bank would mean to their careers.
Though boards make the decision to sell, some chief executives might be pushing to remain independent, advisers say.
"The single best predictor of a sale is the age of the CEO," said John Roddy, a senior managing director and global head of the financial institutions group for Macquarie Capital. "In the past, if he was 54, a CEO could sell and set up a de novo. I do think it is one of the reasons we haven't had as robust M&A as we may have assumed."
Other advisers called it the "W-2 Effect" referring to the tax form that shows a worker's annual earnings.
Mid-tier managers once viewed chartering a bank as a way to move up to senior management or forge their own path in the wake of their bank's sale, said Jim Adkins, a managing partner at Artisan Advisors in Chicago.
"Some senior VP gets caught in the switches or maybe he doesn't like the new owners, so he starts a new bank and poaches the top lenders and they move $125 million in loans over and build a nice little bank to sell at a good premium," Adkins said.
In that regard, Roddy said the unattractiveness of de novos is a boost to M&A valuations. A buyer doesn't have to worry about senior people regrouping, so it can have more confidence that an integration will work out well.
"The lack of new entrants also makes the deals today more economically attractive because it has diminished the prospect of the seller's team walking out the door and setting up a new bank across the street," Roddy said. "The retention risk has declined, making sellers worth a little bit more."
Bad for Business?
If the trend of consolidation without new entrants continues, there is an expectation that there will be fewer, but bigger, banks, which will likely become more pronounced in metropolitan markets.
That's bad news for customers, said Byron Richardson, senior consultant for Bank Resources in Atlanta, noting that the target market for community banks is the entrepreneur.
"Larger banks claim to be committed to that segment too, but have never been able to reach it the same way as community banks," Richardson said. "What happens to small business when the feeder source of banking dries up and all the minnows become whales?"
Having fewer banks could also stymie innovation as competition narrows, said Bob Malone, chief executive of Steele Street Bank in Denver, which opened in 2003. The bank recently agreed to sell itself to MidFirst Bank in Oklahoma City.
"Having new entrants in any type of a business is good because it brings in fresh ideas, new perspectives, different approaches, which would lead to a better overall product that any industry," Malone said. "Not having new entrepreneurial go-getters involve themselves in the industry is a negative."
A lack of new entrants would also lead to a "brain drain" of talent, Klein said.
Chrisman disagreed, stating that consolidation could be a positive because there are fewer capable leaders today. Contraction could mean a reduction in banks with inadequate management.
"Banks aren't training people like they did anymore. It is becoming increasingly difficult to find competent management," Chrisman said. "If someone is competent and can't find a job, give me their number. We can find a home for them we can't supply the banks we had in 2000 with the type of talent we have today."
Conversely, Richardson said de novos breed new, well-rounded talent.
"They are training grounds for bankers to become presidents and other executives," he said. "You learn a lot, as opposed to being a narrowly focused banker."
There is still some interest in de novo activity. Richardson said he has had a couple of inquiries about chartering a bank this year. Interest, however, did not translate into action.
"The fear of the regulatory process made them reluctant to move forward," Richardson said.
Eberley said she remains optimistic that the tide will change and investors will once again want to charter new banks.
"There is some narrative out there that it is too hard to start a bank because regulatory expectations, but the bigger factor is the economy," Eberley said. Eventually, interest will accelerate and the FDIC is "ready to accommodate applicants once it happens."
Technology could drive down the cost of doing business, making it more attractive to start a bank, Malone said.
"We have the ability to transact business through our iPhones; that is a tremendous advantage," Malone said. "Technology is a great friend of the small bank."
Wehmer is also among the industry's optimists. While aspiring founders will need to raise more capital, and will be unable to rely on capital instruments such as trust-preferred securities, the desire to fill a void will eventually outweigh the hurdles.
"It is going to be harder, but I think two and half to three years from now, you'll start to see de novos again," Wehmer said.
Rapid consolidation in growing cities could hit a tipping point, where bankers see a void in the market the way Wehmer did in 1991.
"Attractive city markets are where the buyers want to buy and over time that could stimulate a demand for de novos," Brown added. "I think we could see finally some freshmen in the hottest schools."