Kentucky banks are expected to re-enter a consolidation phase this year that is likely to see one in 10 – and perhaps up to a fourth — of the state’s “community” financial institutions take their nameplates down in the next several years.
Community banks of less than $1 billion in assets dominate the commonwealth’s commercial landscape. Their conservative business practices largely shielded the state from the worst of the fiscal trauma that resulted when last decade’s real estate-based investment bubble finally burst. Despite that, state banks were buffeted by the 2008 financial crisis, a deep U.S. recession with continuing impacts and especially the ongoing regulatory backlash – much of it a result of unintended consequences.
“The examiners, Dodd-Frank, the regulatory environment is creating a bigger problem than the economy is,” said Ballard Cassady Jr., long-time president/CEO of the Kentucky Bankers Association.
Kentucky banks have fared well in comparison to counterparts in most of the nation. Earnings, capital levels and return on assets are above the national average and the average of contiguous states, said Commissioner Charles Vice of Kentucky Department of Financial Institutions. But those metrics all look worse than they use to.
The lackluster recovery has commonwealth bankers scratching harder for returns on capital, qualified borrowers and deals they can feel good about. And their efforts to get back to pre-crisis profitability are being double-teamed by the weak economy and stronger regulation.
The past few years have been a difficult time to be a banker, which is one reason industry merger and acquisition activity that occurs in normal times has been nearly nonexistent in Kentucky and across the nation. Banking insiders and observers, however, believe that is changing.
For a combination of dollar-driven reasons, industry pundits think at least 15 percent and perhaps 25 percent of U.S. community banks will disappear, said Walter Byrne, a banking attorney in Kentucky with Stites and Harbison for more than 30 years.
Their fallen return on assets looks unlikely to rebound in the next several years. Income prospects are diminished because loans are harder to make. Administrative costs are increasing for community banks that lack compliance department staffs to fulfill increasing regulatory reporting requirements – a burden expected to grow because federal authorities have written only a half to two-thirds of the new rules implement the Dodd-Frank Act’s 400 provisions.
Other Kentucky banking experts predict the rate of consolidation will be less dramatic, though still significant.
Bank M&A also requires buyers
“I would expect it to be between 10 and 20 percent,” said Don Mullineaux, professor of banking and financial services at the University of Kentucky for 29 years. “That’s strictly a guess; it’s extremely hard to predict.”
“I do think we will see M&A (merger and acquisition),” said Vice. “I think we will see 10 percent to 20 percent (consolidation) in the next five years.”
Cassady’s guess is that “they’re going to end up in the 10 to 15 percent range.” His estimate would be higher, he said, if only there were enough prospective buyers.
It’s as hard or harder to borrow money for bank-capital purposes as it is for other business uses.
Bank prices are down. The “premium” paid for banks formerly was two to two and a half times book value – assets minus liabilities in very basic terms. Today’s “premium” is only about one and a quarter to, at best, one and a half times book value.
“Where we are seeing deals, buyers are not willing to pay any premium to acquire a bank,” Mullineaux said. “Prices have gone way down for selling your bank. That’s part of the reason you’re not seeing much (M&A) activity.”
Fewer new-charter bank start-ups are taking place as well.
“There is not a lot of interest among investors to enter banking currently,” he said. “They do not see a lot of growth potential … and the cost (of entering) is high.”
Before the Great Recession, banking often generated a 2 percent return on assets and a 20 percent return on equity, Byrne said. Today both those rates of return are halved. Federal Reserve policy of near zero interest rates to encourage business activity squeezes bank loan margins and earning potentials.
“It’s very hard to attract capital to banking today,” according to Byrne, because capital costs are higher than returns. This is true especially for community banks, he said.
Yet, community banks do have staying power and “are much more nimble than the larger banks,” Byrne said. But they also have fewer products and income generating options, less geographic diversity to tap into, less access to capital and lack large banks’ competitively advantageous economies of scale, especially in fulfilling regulatory compliance demands.
Wall Street sins weigh Main Street down
Ramped-up regulation’s burden is proportionately much heavier for community banks than for the enormous Wall Street institutions that were the original target after their collective near-death experience in late 2008 and early 2009 literally threatened the global financial system’s collapse, in turn creating fear, anger and demands for more bank oversight.
In the United States, banking regulation change came via the Dodd-Frank Wall Street Reform and Consumer Protection Act, whose implementing language is still being written nearly three years after its passage. According to the U.S. House Committee on Financial Services website, in late February regulators had written 224 of the estimated 400 rules the act requires. Those rules are 7,365 pages long already and will require at least 20 million private-sector man hours yearly to meet, according to the congressional panel.
Another 175 rules are yet to come.
Already, Dodd-Frank and other regulatory changes have required banks to come up with cash several times to increase capital reserves to ensure there are adequate reserves on hand if loans or investments go bad. That’s come at the same time it has become harder to qualify customers for the loans that generate bank income.
The Federal Deposit Insurance Corp. increased member banks’ premiums several times in recent years to maintain its required reserves-to-insured-deposits ratio after having to back the deposits of hundreds of U.S. banks closed since late 2008 – banks that are all outside Kentucky, which has not seen a state-chartered bank close since 1987.
A total of 10 U.S. banks closed in the five-year period from 2003 through 2007, the FDIC reports. In 2008 closures jumped to 25, and then the floodgates opened: 140 banks closed in 2009; 157 banks closed in 2010; and 92 more in 2011. Closures slowed to 50 in 2012. There were three the first two months of 2013.
Crisis has flat-lined banking M&A
“Typically the way it works is you have some type of crisis, you have additional regulations, and then you have some type of consolidations,” Vice said. “Then it stabilizes.” That was the case in the early 1990s after the national savings and loan crisis that brought closure of almost 750 of the nation’s 3,200 S&Ls.
Because the 2008-09 economic crisis directly involved banks, the industry “suffered a lot of reputation damage,” Vice said, and that also decreased bank prices.
There was plenty of banking M&A activity up until the recession.
“Since then it’s kind of flat-lined,” Vice said.
He agrees, though, that activity is about to return to Kentucky – and probably many other regions. At a banking conference he attended in New York recently, Byrne said, the consensus was that “community” size banks are at a disadvantage and will seek to consolidate into larger entities with efficiencies of scale for earning power, better return on equity and economies of scale in complying with regulatory work.
“All these different pressures are coming down on banks,” Cassady said. “It all circles back to the Dodd-Frank legislation. It was an attempt to rein in Wall Street; instead, they got everybody, and Wall Street got away.”
Dianna Preece, a professor of finance at the University of Louisville College of Business, points as an example to credit default swaps. Initially a type of investment insurance, they turned into an investment vehicle themselves when a market for swaps contracts developed. It became a pure bet. Hundreds of billions of dollars were lost when the bundled mortgages that swaps were linked to lost their value.
“People were upset about credit default swaps,” Preece said. “But reform did not really address that you don’t have to own underlying assets to buy credit default swaps on it.
It’s amazing you can buy a default swap on anything you want and not have to own it.”
‘It’s eating up all the revenue’
The large financial center banks find ways around obstructions created by regulations, Cassady said.
“They’ve got enough money they’ll go out and hire another 10 lawyers,” Cassady said. “A community bank can’t got out and hire two people just to be hiring them.
“There’s this constant downward pressure of compliance cost. It’s eating up all the revenue.”
For example, smaller banks that don’t have social media programs or offer mobile device banking still must comply with new rules for those services.
“Banks are having to write policies for products they don’t even offer,” Cassady said. “I have to hire somebody to write a policy for what I would do if I did have that. … There’s hundreds of examples like that.”
And Kentucky is primarily a smaller bank state. Chase, US Bank, PNC and BB&T, all banks of more than $125 billion in assets, do operate in the state, but their combined Kentucky market share is around 27 percent. Only 15 banks that operate in the state have deposits of at least $1 billion, an amount informally considered the minimal size to achieve economies of scale.
The size necessary for efficient compliance operations is debated, though.
“Some say at least $500 million, some say a billion,” said Cassady, who doesn’t subscribe to any specific figure. “Obviously the larger you are, the easier it is.”
Addressing the compliance burden
The compliance burden is known to policymakers in Washington, and they are trying to address the problem, according to Mullineaux.
“The FDIC (the primary regulator for most Kentucky banks) is very much aware of this problem,” he said. “They had a big conference last winter and they have a huge initiative going on so the community bank sector doesn’t disappear. It is vital to the economy, especially in smaller communities.”
Officials at the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency, the three banking regulatory agencies, are trying to come up with different approaches to treat smaller and larger banks differently, said Mullineaux.
“Lots of bankers support it, but they haven’t gotten a lot done.”
Banking has changed as a result of the economic crisis, recession and its lingering effects, said Preece.
“Community banks might feel it more because they are smaller, but they might be more insulated,” she said.
Preece also teaches at banking training programs in the states of Kentucky and Iowa. Neither state’s banks got involved in some of the practices that got the bigger banks in such trouble.
Commonwealth bankers’ conservative natures prevailed, according to Cassady, who said he specifically asked what had dissuaded most from making bad bets.
“One banker said he did not participate in what turned out to be problem investments,” Cassady said, “because they did not pass his Three-Question Rule: If I have to ask more than three questions to understand an investment, it’s too complicated for me.”
It turned out they were too complicated for the entire financial system.
Deep public resentment at the hundreds of billions of taxpayer dollars the federal government kicked in to prop up teetering financial giants and the several trillion dollars in individual and institutional assets that evaporated in the crisis continues to be manifested today via regulators who “have been very, very harsh with banks,” Byrne said. Enforcement actions, penalties and threats of further penalties, deposit insurance premium increases, requirements to raise capital reserves and raise them again take their toll on bank owners and board members.
Selling can look increasingly appealing, but finding a buyer might be yet another challenge.
“Large banks don’t want to be in 90 percent of the land mass of Kentucky,” according to Byrne. “They just want to be in Louisville, Northern Kentucky and Lexington.”
What will be the outcome in Kentucky? Boards and even individual board member have to assess their specific prospects.
“It’s a challenging environment to stay abreast of because it is changing so quickly,” said Byrne, who thinks Kentucky bankers’ past history suggests they will wait and watch what is happening elsewhere before deciding.
“What’s interesting is,” Preece said, “what is the new normal?”
Mark Green is editorial director of The Lane Report. He can be reached at [email protected]