Thin margins and fat compliance costs
lessening numbers of Kentucky’s community banks
Kentucky bank valuations are still well below those of a decade ago but have risen a quarter to a third from post-recession lows, which is helping facilitate ongoing consolidation in the commonwealth. With a slowly improving economy in 2014, U.S. bank merger and acquisition deal numbers increased 50 percent.
Industry consolidation is a decades-old trend, but state banking experts credit some of the recent acceleration to a combination of slim margins – a product of still historically low interest rates – and increasing compliance costs created by tougher federal and even international regulations.
Deals offer owners an instant return on their capital while ending operational headaches. In the United States, there were 340 whole bank mergers in 2014, said Debra Stamper, general counsel and executive vice president of the Kentucky Bankers Association. That’s up from 227 mergers and acquisitions nationally in 2013, according to numbers from American Banker magazine. And it marks the fourth consecutive year of growth in M&A activity.
Across the country, October 2014 yielded the most bank M&A transactions in 15 years with 36 bank deals announced, according to Scott Harrison of the Nashville Business Journal. The Kentucky Bankers Association reports eight completed state institution mergers and acquisitions between March 2014 and January 2015. Those include Your Community Bank’s acquisition of First Federal Savings Bank in Elizabethtown; Commonwealth Bank & Trust Co.’s acquisition of Florence-based First Security Trust Bank; and Citizens National Bank of Paintsville’s acquisition of Peoples Security Bank in Louisa.
Another five announced between September 2014 and February 2015 await final regulatory approval, according to Ballard Cassady, president/CEO of KBA. The biggest is North Carolina-based BB&T’s agreement in September to purchase Crestview Hills-based Bank of Kentucky for $363 million in cash and stock, an acquisition that garnered national headlines. Others include Kentucky Bank of Paris’s acquisition of Madison Bank in Richmond; and the merger of First Federal Savings and Loan Association of Hazard with First Federal Savings Bank of Frankfort.
In the current climate, BB&T’s purchase of Bank of Kentucky was notable, for both its size and purchase price. Bank of
Kentucky had been one of the state’s largest community banks, with $1.6 billion in deposits, 32 branches and $1.825 billion in total assets. (Only eight other Kentucky-based banks have more than $1 billion in assets.)
“Of the recent (state deals), BB&T and Bank of Kentucky was the big one,” said Walter Byrne, a banking attorney with Stites & Harbison in Lexington. “I doubt you’ll see one that size again. It’s possible, but not soon.”
Charles Vice, commissioner of the Kentucky Department of Financial Institutions, took note of the BB&T-Bank of Kentucky deal as an indication that community bank valuations are recovering. In the industry, he explained, purchase prices are typically described as a multiple or a percentage of the bank’s total capital, which is its “book” value. “If you look at the BB&T deal, (the price) was right at 2.1 times book (for Bank of Kentucky). So potentially we are entering this phase again of higher prices for banks,” Vice said.
Other recent commonwealth bank purchases are occurring at lower book values. “In the heyday of pre-2007/2008 recession,” he recalled, “when things were going well in the economy, bank (acquisition) prices were typically going 2 to 2.5 times book. Meaning that, if you had $10 million in capital, some other bank would be willing to pay you $20 to $25 million.”
The climate changed when the recession and financial crisis struck, however.
“Post-2007, if you were a strong bank with no problems, the typical selling price would be 1.1 to 1.2 times book, just a 10-20 percent markup,” Vice said. With increased M&A activity in the last two years, Vice feels the selling prices for banks are inching back up – though they are not to pre-recession levels.
“What we are typically seeing now are selling prices in the 1.4 to 1.5 times book range,” he said. “I think it’s going to stay steady for a while or maybe increase a bit, because some of the uncertainties have gone away in the market, and competition is starting to come back in.” Don Mullineaux, emeritus professor of banking at the University of Kentucky and chairman of the board of the Federal Home Loan Bank of Cincinnati, agrees.
“For a long time, almost all the deals you were seeing were what are called ‘distress’ deals, where one bank was buying another bank that for all practical purposes was going to be closed down by the FDIC. And when you buy a bank in distress, you are not going to pay a big premium,” Mullineaux said. “Those deals are largely over. And now we are starting to see an increase in premiums.”
While Winston-Salem, N.C.-based BB&T’s relatively high purchase price for Bank of Kentucky makes it an outlier in terms of current market trends, the move gives BB&T a coveted entry into the Cincinnati metropolitan area market and its first Ohio branch. “The Bank of Kentucky is a good match for BB&T due to its similar community bank operating model and culture, its focus on customer relationships and its commitment to employee engagement and local communities,” said David White, vice president of corporate communications for BB&T. “Also, this will improve BB&T’s ranking in Kentucky from a No. 4 to a No. 2, add 32 new branches in a strategically attractive market, establish BB&T at No. 7 in the Cincinnati MSA and add $1.6 billion of largely core, low-cost deposits.”
Regulatory demand driving force behind M&A
But what does the continuing M&A trend mean for Kentucky’s remaining community banks? The answer is complicated.
In some instances, mergers can lead to stronger, streamlined, more economically sound banks able to offer a wider range of services, such as wealth management advising, to their customers, Mullineaux said. On the other hand, many in the industry are concerned by the continuing decrease in the number of community banks nationally from a peak of 14,400 in 1984 to 5,571 in fourth quarter 2014, according to Federal Reserve Bank of St. Louis figures. During the same 30-year period, community banks’ share of total U.S. banking assets fell from 41 percent to just 18 percent, while the nation’s largest banks’ asset share grew from 18 percent to 46 percent, according to Forbes.com.
In Kentucky, the number of commercial banks (not including savings and loans) has dropped from a high of 336 in 1984 to 168 at the end of 2014, the St. Louis Fed reports. By the FDIC’s count, as of late February there are 176 banks headquartered in Kentucky, including savings and loans and both state- and federal-chartered institutions. Of those, 151 are state-chartered banks, Vice said. In the past three years, 14 state bank charters have been surrendered due to mergers and acquisitions, he said, but no state-chartered bank in Kentucky has failed since 1987.
The decreasing ranks of community banks is not a new trend. But many, including the KBA’s Cassady, feel the decline of
community banks accelerated post-recession in large part due to increased compliance and regulatory costs created by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. While purportedly drafted to rein in America’s largest banks – especially lending to underqualified borrowers that was at the center of the financial crisis – Dodd-Frank’s regulatory restrictions and compliance demands apply to all U.S. banks, regardless of size.
“Dodd-Frank is killing community banks” is now a common battle cry. It is heard in hometown bank boardrooms; in Congress, as the U.S. Senate Banking Committee began hearings in February on possible concessions for America’s smallest banks; in the media, including Carrie Sheffield’s Feb. 5 opinion piece on Forbes.com; and even in academia, with the Harvard Kennedy School of Government’s recently published comprehensive research report, “The State and Fate of Community Banking.”
In that report, researchers note that since the second quarter of 2010, around the time of Dodd-Frank’s passage, community banks have lost market share at double the rate they had during the previous four years. “The burden of over-regulation since the passing of Dodd-Frank is the No. 1 reason (for the increase in M&A activity),” Cassady said. “The burden of overregulation and compliance is outrageously high. You’ve got a $50 million bank in Anytown America that has to abide by the same rules that a $200 billion bank has to abide by, and that’s just ridiculous.”
Cassady points to additional regulations following adoption in 2013 of the international banking Basel III rules by the FDIC, the OCC and the Federal Reserve as particularly burdensome for community banks. (Broadly speaking, Basel III requires banks to maintain higher capital ratios than under previous regulations, with stricter definitions as to what constitutes capital.)
“Basel III capital rules were designed for banks that do international capital, only. And yet here in the U.S., regulators decided to make all banks abide by Basel III capital, across the board,” Cassady said. “The original intent of Dodd-Frank was not to hurt community banks; it was meant to keep big banks from doing proprietary trading,” said Dianna Preece, a professor of finance at the University of Louisville who teaches classes on bank management. “And yet all these new requirements that are a function of Dodd-Frank – regulations about mortgage lending and additional reporting requirements, for example – have now hit small banks. There’s been a real sea change because of the regulation, when you look at how banking has changed between 2006 and 2015.”
While the largest banks originally targeted for regulation can afford to hire teams of lawyers and staffers dedicated to compliance, small community banks in Kentucky often “are lucky to have one compliance officer” to tackle the same amount of work, Cassady said. Faced with growing compliance costs that are cut into profit margins already made thin in an era of very-low-interest-rate loans, some small bank boards increasingly view merger as a means of streamlining their overhead, experts said.
“Some of these smaller banks are now looking at merger that may not have even been willing to look at it three or four years ago, before the regulation,” Preece said. “When we see these in-market mergers, of one small to mid-size bank buying another bank that it’s competing with, the primary reason is to cut costs,” Mullineux said. “It’s a means of blending technologies, reducing staffs and finding economies of scale.” Given the climate, experts predict M&A activity to be robust again in 2015.
“I would not be surprised to see another five or six Kentucky banks merge this year,” said Vice. “I do think the M&A trend will continue.” “I would estimate somewhere between seven to nine transactions in Kentucky in 2015,” Byrne said. “That puts us right on par for last year. People are saying the M&A trend could stretch for five to 10 years.” Still, in the wake of Basel III, Preece said, “Everyone is skittish now about how regulators are going to look at their assets, and the quality of their assets, and all of that plays into whether or not M&A deals are going to be approved.”
The role of community banks
In the tumult and public outcry for reform following the Wall Street banking crisis, regulators felt compelled to apply the new compliance standards to all banking institutions without regard to size, Cassady said, largely because there is no commonly agreed upon standard within the industry as to what delineates a national “Wall Street bank” from a local “community bank.”
Recently, Cassady was part of a four-state team of Bankers Association leaders that drafted a proposed definition of a “community bank” based in part on limited size, cross jurisdictional activity and complexity. They submitted it to the chairman of the U.S. House of Representatives Financial Services Committee for consideration.
Team members came to the conclusion that delineating between bank types solely using asset size is misguided. Instead, “you have to look at the bank’s complexity of operations,” Cassady said. “The more complex a bank is, the more regulation it needs. What we found is that there are some $20 billion banks that only take deposits and make loans, which is a very basic, non-risk operation. Then there are those really big banks that get into (securities) ‘market making,’ international activities, derivatives and the like.” The latter type of banks, Cassady feels, do require the type of heightened regulation Dodd-Frank and Basel III outline.
By almost anyone’s definition, all banks based in Kentucky are “community” banks. The Harvard report, for example, defined “community” banks as institutions with less than $10 billion in assets. In Kentucky, more than two-thirds of the state’s 176 banks have less than $250 million in assets, according to the FDIC. Only 48 Kentucky-based banks have assets between $250 million and $1 billon. And just nine have assets greater than $1 billion – eight after Bank of Kentucky’s sale to BB&T is finalized.
A large role in local economies
While Congress may yet offer community banks wholesale relief from various aspects of Dodd Frank’s 90 provisions – a hot-button issue in Washington this year – Cassady feels the more likely outcome may be piecemeal “rifle-shot reform,” such as an exemption from Basel III requirements for community banks. Many in the industry hope regulatory relief – as well as the entry of new banks into the market when regulators become open again to approving new charters – can help community banks retain their market share so that they can continue providing a vital role within their communities.
“If you see a community that is growing, you will find an active community bank in that community,” Cassady said.
Vice agrees. Despite their smaller market share, community banks provided 48.1 percent of small business loans in the United States in 2013, he said. According to the Harvard report, they make 77 percent of all agricultural loans nationally, helping drive business in small-town and rural economies.
“Community banks are a huge boost to their local economies,” Vice said. If public opinion is a sound determiner, it seems safe to say that while M&A deals are likely to continue, community banks won’t disappear entirely.
A recent KBA telephone poll of 600 Kentucky registered voters found that 70 percent of the respondents said they prefer to bank with a locally owned bank, Cassady said. And 85 percent believe that local banks have a positive effect on the quality of life in their communities. ■
Robin Roenker is a correspondent for The Lane Report. She can be reached at [email protected].