In a recent announcement, Crescent Financial Bancshares (
),holder of Crescent StateBank, announced the merger of ECB Bancorp
),holder of East Carolina Bank, both well-established banks in
North Carolina. The transaction is pending regulatory approval and
will be treated as stock for stock and the value to book will be
Transactions like this will become a common trend over the next
three to five years with a Wall Street projection that some 20% to
30% of banks will be merged before it is all done. This will
profoundly affect the fortunes of smaller regional and community
) with the most successful consolidators having the most potential
for both revenue and profit growth, while many of the smaller
The opportunity today is parallel to the 1970s when many banks
traded well below book value. The best saw spectacular gains in the
following decades as the banking industry was reinvented and the
industry consolidators prospered. A similar opportunity may exist
today and careful analysis and stock picking in the small bank
sector could reward investors that pick fast growth winners in the
consolidation game whose stocks can benefit from both improvement
in their internal metrics and expansion of their trading
Why is this typical of what the future will
First, the constant pressure of maintaining high regulatory
capital ratios requires banks to reach certain efficiency ratios
sooner rather than later to beprofitable.
Second, the access to capital for all banks is limited, at best.
Hence, there will be a "survival of the fittest" banking industry
environment with each bank striving to be the dominant bank in its
Third, to be competitive and sufficiently profitable to maintain
such a position in the market, community banks must achieve a
minimum asset size of around $1 billion.
What is behind the higher regulatory capital
The lingering effects of the economy and the Great Recession
have made a significant impression on all banks, especially those
serving their communities. The asset devaluation of real estate
(both residential and commercial) took a significant chunk out of
capital and there are no expectations for a quick recovery. Hence,
many banks are in a precarious position in which the future is
Further compounding this is a recent announcement by the Federal
Reserve that suggested it would likely implement Basel III and make
its capital requirements applicable for all banks, large and small.
Simplified, Basel III sets new rules for the capital ratios based
on a bank's complexity of risk-based assets. In the past, there
were only bucketed assets in the 0%, 20%, 50% and 100% risk
weighting. However, Basel III calls for more buckets, with mark to
market requirements for difficult-to-value illiquid loans
previously exempted from MTM.
This will make both the reporting requirements and the resulting
capital requirements for banks much more complex, particularly for
community banks with limited accounting and compliance resources.
Further, most community banks have significant commercial loan
portfolios in which each loan is unique and difficult to treat in a
homogeneous manner. Simply put, Basel III for community banks will
make the determination of capital needs much more difficult and
expensive. Compounding this is the Dodd-Frank Act, which will have
a significant impact on all banks and that has still not been fully
SoWhat Is In Store ForCommunity Banks?
In the past, banks were willing to pay a premium to buy another
bank due to the franchise value already invested and the cost and
time to implement an organic growth plan. A growing bank could
finance the premium for acquisition through an expected increase in
its trading multiple. That luxury of being able to trade at 2 to 3
times book is likely a thing of the past. Both the capital
requirements and the economy are dictating much lower premiums and
in many cases deals closer to book value rather than over.
First Virginia's purchase of 1st Commonwealth at 97% of book was
essentially a value neutral transaction. Aside from the legal and
investment banking fees, First Virginia paid no premium to acquire
a well positioned, growing bank. 1st Commonwealth was new and
growing and had not fully reached its potential. Capital aside, the
appeal for First Virginia is clear;it has grown its balance sheet
and improved its potential for additional growth by adding a strong
new team of bankers at no net cost.
So what was in the deal for the seller? Operationally, the deal
gave 1st Commonwealth's bankers access to a larger lending limit,
access to other resources and products of First Virginia, and a
growing platform with access to capital and stock that was valued
at almost 1.5 times book (could be used for future acquisitions).
Could 1st Commonwealth have continued to grow on its own? Perhaps,
but it appears likely that the management team had assessed the
need for additional capital, the time to attain it and the
complexity of regulatory requirements in maintaining the required
capitalization in making the decision to sell.
Bottom line - this was a great opportunity for 1st Community's
management to enhance its career growth opportunities. But what was
in it for the shareholders?
Banking is in a period of consolidation seen in many other
industries in the past. The consensus amongst bankers is to be
competitive in the emerging financial industry environment - the
minimum viable bank size will have to be around $1 billion in total
assets. This number, while not magic, creates the economies of
scale in which a bank can afford compliance, achieve growth and
While there will be some innovative outliers with highly focused
and specialized business models and some of the smallest banks will
achieve sufficiently rapid growth, those that don't will languish
and eventually fail or sell for a low multiple of book value. It is
far better for the shareholders of such institutions if the boards
have the insight to trade their moribund small company shares for
those of a larger, better capitalized and rapidly growing community
or regional bank. By doing so they can ride with a winner, enjoying
the benefits of both an increased rate of growth and potentially
expanding the P/E multiple.
Why Are Small Banks Important?
There are approximately 5,700 commercial banks in the U. S. with
assets under $1billion . The regulators appear to believe that they
will find their lives easier if they have fewer mini-banks to
supervise. However, this does not account for the real purpose of
community banks in the American economy, where they have
historically played a critical role in funding our vital small
business economy. Everyone seems to agree that small businesses
must be healthy for innovation and economic growth. But without
community banks where is the funding going to come from to feed
small company growth? Community banks may hold only 8% of total
U.S. assets, but they are responsible for 40% of small
businessloans . This is not insignificant.
The reason: community banks and small businesses maintain an
equal stake in the long-term success of the small business
community. This symbiotic relationship goes well beyond filling out
a loan application and decisions are made on more than credit
scores. The relationship between a community bank and its small
business customer involves a significant part of the company's
financial dealings, which entail both business and personal
deposits, retirement planning, tax advice, community participation
and the list goes on.
What Is the Prognosis for Smaller Banks?
From 2000 to 2008, state and federal authorities chartered 1,400
new banks with approximately $23 billion in capital. With the onset
of the financial crisis and through its aftermath, the capital
window slammed shut and bank trading multiples collapsed, limiting
the appetite for bank investment and bank acquisitions. Small bank
trading multiples are likely to remain depressed and we are not
returning to the halcyon days of 2 to 3 times book in the
Most small bank deals for decent quality banks have seen
valuations in the 1.0 to 1.5 book value range. A few of the better
regarded fast growth banks have seen valuations as high as 1.75
times book, but this is rare. For those fortunate few, this
provides a huge advantage both in terms of raising capital and
currency valuation in stock-for-stock transactions. In the
secondary markets, most smaller bank stocks are trading at or below
Many small bank boards are operating under the illusion that, in
time, prior elevated valuations will return. This has the potential
to be a fatal illusion for many.
- Regulatory pressure will not abate. With the recent Basel III
announcement by the Federal Reserve the pressure for maintaining
higher levels of capital will be sustained and the calculation of
the buffer required by Basel III will make capital calculation
much more complex for all banks. The smart money bet is that
risk-based capital ratios will be no less than 12%.
- Keeping the above in mind, the ability of smaller banks to
achieve a 1% return on assets, which translated to a 12% return
on capital under the old rules, will be further hampered with low
loan demand, tighter spreads and the higher capital ratios. At
present, the average return on assets is 0.5% yielding a 6%
return on capital.
- The economy is not helping. While the U.S. economy is
recovering, it is doing so at the slowest rate since the Great
Depression. Most economists do not project pre-2008 unemployment
and growth rates to return before 2015 and some say 2017 or even
- The pressure on those banks with TARP funds will continue to
- The uncertainty of the Tax Cliff presents an additional issue
for low basis investors. It may make sense to trade out of their
appreciated bank securities now (if possible) and pay a 15%
capital gains tax. If their bank is languishing, their best
alternative will be a tax-free merger into a stronger bank with a
higher stock multiple.
The outlook for community banks less than $1 billion? Succeeding
on their own does not look promising. However, when united with
regional winners through merger, the economics greatly improve as
the asset base nears $1 billion.
Unless a community bank has shareholders with VERY deep pockets,
the path to success is greatly inhibited by the pressures outlined
above. This leaves most community banks with only two choices: 1)
raise capital if they can do so on an affordable basis; or, 2) it's
time to start looking for a merger partner.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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