After five years of adverse economic conditions, the economy is gradually improving, real estate values are stabilizing and most community banks are on the threshold of profitability. This gives the Federal Deposit Insurance Corp. the opportunity to help community banks by modifying its policies, in particular the liquidation process it has used in closing more than 400 failing banks since 2006.
This process has been necessary in the past, but with an improving economy there is a better alternative – I call it the Investment Method. Its use would be less costly for the Deposit Insurance Fund, less traumatic to bank customers, staff, etc., and it would preserve banks that deserve it.
The FDIC has indicated that the average cost incurred by the fund in liquidating a bank has been 20% or more of the assets covered by loss-sharing guarantees. For example, if the FDIC takes over a bank with $250 million in assets and covers 80% of them with a loss-sharing agreement, the projected cost to the fund will be $40 million (20% of 80% of $250 million). It would be much less expensive to the insurance fund if the funds in this example were invested in the equity of the failing bank rather than expensed by the fund in absorbing the losses created by selling assets at distressed prices.
The Investment Method could be used provided certain conditions are met:
- The failing bank must be able to attract sufficient capital to meet all FDIC capital ratios plus an additional amount to fully reserve for the bank's nonperforming assets. We suggest that half of the required capital would be raised via the sale of new common shares to investors after a rights offering and the balance would be provided by the insurance fund in nonconvertible, nonvoting, preferred shares. The preferred issue would have an initial annual dividend rate of 3% to 4%, increasing at a rate of 1% a year after the third year, but not to exceed a rate of 10. The issue would be prepayable at any time and dividends on the common shares would not be allowed until the preferred issue had been redeemed.
- The existing common shares would remain outstanding and they would be valued by an appraiser in determining the offering price of the new common shares. The investors in the new shares would likely own 90% or more of the pro forma shares to be outstanding.
- The existing board would appoint a special committee to negotiate the raising of the new capital. The bank must get a new CEO and the majority of the new board must be fresh faces.
- If a bank is unable to raise the required funds from investors it would likely be liquidated by the FDIC under the usual process.
The Investment Method would have several merits for the FDIC:
- It would reduce the number of future assisted transactions by the insurance fund.
- The fund's cost in resolving failing banks would be significantly reduced. In the example of the $250 million bank with a projected $40 million cost using the liquidation process, the Fund's cash contribution would be 50% or less of the $40 million and it would be an investment, not an expense.
- Can a failing bank raise the needed capital from investors? Those banks with an excellent franchises and competent, new management teams should be able to, but the market will make that judgment. Not all banks will qualify for the Investment Method. Banks with high nonperformers, mediocre core earnings and deposits and an inability to attract competent managers are unlikely to be able to raise the required common equity.
In evaluating the merits of the common shares to be offered, an investor would have the opportunity to invest in the shares of:
- An established banking franchise built over a period of years.
- A very well-capitalized bank (up to 20% equity to assets) with new management.
- The financial leverage provided by the nonconvertible, nonvoting preferred stock.
- An offering price approximating tangible book value.
The charter of the FDIC makes it responsible for the supervision of the banking industry and the fiduciary for the insurance fund, which includes minimizing the costs incurred in taking over failing banks.
By taking a different view of the role of community banks, not based on the past five years but on the future, the FDIC can justify this proposed change which would preserve solid, salvageable banks rather than liquidating them, lower the number of failed banks, reduce the insurance fund's insolvency costs and avoid higher insurance premiums in the future.
Benjamin C. Bishop Jr. is the chairman of Allen C. Ewing & Co., an investment banking firm in Jacksonville, Fla., that caters to financial institutions in the Southeast.