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."

To be fair, the regulators are under a ton of pressure to implement hundreds of rules mandated by the 2010 Dodd-Frank Act. No one doubts how hard they are working. But this is about seeing a problem on the horizon and acting to address it. It's much easier to say no to private equity than it is to invite it in and then have to police it.

"Right now they are so scared, they have so much on their plate and people have just beaten the tar out of them," says Carla Brooks, a former regulator who now invests in banks as a managing director at Commerce Street Capital in Dallas. "Once this crisis is over, I think they'll revisit it."

Brooks agrees with Kaufman that for change to occur community banks must get behind it. But she says too many bankers remain skeptical of PE firms.

"They want the money, but they don't want the interference that goes along with it," she says. "It's, 'Give me the money but don't hold me accountable.' They have got to view private equity as a partner, as someone who adds value, before they let them in."

The tide may be turning. Cam Fine, CEO of the Independent Community Bankers of America, said many of his members have changed their minds about PE investments. "When I came here eight and a half years ago, the idea of PE people buying community banks was anathema. A very tiny percentage of bankers in my universe would have approved of that," he says. "But I have seen that steadily change. That pendulum is swinging."

Some will argue that inviting PE money into community banking will only speed the sector's consolidation. These are investors looking for a return and eventually to cash out.

But consolidation is coming with or without PE money.

"We are going to get there one way or another, and it would be nice if the successful community banks had an opportunity to participate so that they could succeed," Kaufman says. "In the meantime, we'd bring capital into the system as opposed to get there by starving it out of the system."

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