June, 2010
Thoughts
on the banking industry
As you are aware, The Capital Corporation works with a large number of banks in the Midwest on mergers, acquisitions, divestitures and other consulting projects. During the past few months we have been spending more of our time talking to bankers, boards of directors and ownership groups about what is happening in the industry and what the future may bring. We decided to outline our talking points and share them with you. We hope you find our thoughts and opinions on the banking industry helpful to your organization.
We have also included part of a handout that was passed out at a FHLB meeting in Kansas City that we felt was very insightful. Ed Krei of The Baker Group prepared the handout and we want to give him full credit for the handout, but again thought it was very relevant and wanted to pass it on.
Below, in no particular order, are the highlights of some of our talking points we have used recently.
A. Primary issues with banking today – Midwest market.
City Community
Banks. Many were are
too concentrated, especially in Commercial Real Estate, Land Development and
Construction. Question is what is the
business plan for these banks moving forward?
It is unlikely that the regulators will allow these concentrations in
the foreseeable future.
Rural Community Banks. Those that stayed home are okay; those that
did not are a whole different story. The
following is a list of specific issues in Kansas and Missouri, primarily for
rural banks:
Brooke Insurance Sterling
Leases
Allstate loans (similar
to Brooke) Stonebridge Leases
Participations
Airplane Leases
Cattle Fraud Marshall/Bank
First
Significant shift in the regulatory environment. The regulators have made a sudden and drastic
change in how they look at bank credits, concentrations and capital
ratios. Banks are now criticized for
loans they made a couple of years ago that at the time they were made were pass
credits – even if there is no change in the quality of the credit. Although the regulators allowed these
concentrations to rise, they did little to stop the banks from continuing this
line of business. Now they expect banks
to stop making new loans and want the banks to substantially reduce their
concentrations – it can’t happen overnight.
Regulatory uncertainty. Both
the House and the Senate versions of Financial Reform will have significant
negative impacts on community banks – interchange fees, treatment of Trust
Preferred Securities, consolidated capital, etc. Recently added to the mix is FASB’s new
proposal for full fair value accounting that will require banks to value all
assets and liabilities on their balance sheet. In addition to the tremendous amount of work
required by banks to comply, this could have a dramatic impact on a bank’s
desire to lend. The ABA calls the
proposed FASB rule the biggest accounting event that banking has ever seen.
B. How did we get into this situation:
1.
Greed – banks needed the loans and fees, they did
not question the quality of the borrowers or the value of the collateral. No one anticipated that values could
decrease.
2. Appraisals – no one questioned the appraisals, or
the fact that values continued to climb.
3.
Short Memories – bankers forgot that bubbles burst,
prices drop, the economy and cash flows can stop.
4.
Over leverage – the banks helped their customers
over leverage themselves.
5.
Lack of understanding – Many banks made loans or
bought participations on credits that they did not understand, collateral they
did not see, and loaned to borrowers that they did not know. They relied on the bigger bank selling
participations assuming that the bigger bank understood the credit and the
risk.
C. Future Earnings Capability
We believe over the next several years that Bank earnings will be materially affected by the following:
1.
FDIC costs –
the FDIC fund will need additional money to cover the continuing bank failures.
2. Compliance / Regulatory Costs –Consumer Protection, etc.
3.
Lower Loan to Deposit Ratio – Regulators will want
to see balance sheet liquidity
4.
More Loan Loss Reserves and continued losses in the
portfolio
5.
Higher Capital Requirements
6.
Fair Value Accounting
D. Cycle of Value/Price
We believe that
these issues could affect valuation for an extended period of time. Historically, bank values moved fairly
consistently in a cyclical pattern that lasts about 5 to 8 years. The impact of these changes, along with the
age of current owners and the significant number of banks in the Midwest could
stretch out the current pricing cycle for much longer than historic models
show. Valuations could remain low for an
extended period of time. However, well
positioned banks should still bring a premium over the market.
E. Capitalize on Shareholder Value
We believe that
Banks should focus on improving and solidifying their value during this period
of turmoil in the industry. Banks need
to develop and follow a strategic plan for the future. Each Bank’s plan will be different depending
upon the ownership’s ultimate goal – sell, grow, improve earnings, etc.
F. Priorities going forward
1.
Community Banks must focus on what they know, not
chase yields and “new” opportunities.
Fundamentally, banking has not changed.
2.
Capital will be more difficult to get, and more important
to have.
3.
Core deposits and customers will set a community
bank apart from the investment banks and Wall Street.
4.
Banks need to focus on real growth and real
earnings. Too many banks loaned interest
carry and fees which resulted in short-term, but not true, earnings.
5.
Management and key employee succession is very
important – there are fewer good bankers available, and your location may make
it more difficult to attract key personnel.
6.
Board of Directors will be held to higher standards
by the regulators and be required to have a better understanding of banking,
and the laws and regulations that affect banks.
Conclusion
The next few years in banking will continue to be very difficult for the
industry as a whole, but create great opportunities for strong
organizations. No matter where you are
in the spectrum you must have a plan to move forward and devote the time,
energy and thought to execution of that plan.
Thank you for letting us share our opinion on
the banking industry with you. If you
have any questions or comments, please feel free to give us a call. We would be happy to discuss any of these
issues with you.
Sincerely,
The Capital Corporation, LLC