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SecondMarket is moving into regional and community banks — something which can’t possibly be bad and might well be very good for the industry.

Right now, if you’re a community bank and you need to raise capital, it’s not easy. Equity stakes in such banks are highly illiquid, and almost impossible to monetize, which means that when an owner of such a bank needs some money, they all too often have to sell the bank outright.

When I wrote about the Bank of Cattaraugus in December, I worried about the fact that it was hard to do community banking without the risk of the owners selling out. My proposed alternative was credit unions — and I’m still a big fan of those. But I can tell you, as a six-year credit union board member myself, that it’s hard to get the owners of credit unions engaged, partly because board members are unpaid and have no real stake in the bank beyond the single vote they have by dint of being a member.

I can think of a few socially-responsible double-bottom-line-style investors who might be interested in taking a minority stake in institutions like the Bank of Cattaraugus. Ideally they would see returns roughly in line with inflation, nothing special: the idea would be to encourage utility banking, rather than high-risk, high-growth strategies.

The need for equity capital at all levels of the banking world has never been greater. We learned two big lessons during the financial crisis: firstly that banks had too much leverage, and secondly that subordinated debt is all but useless in doing its job. It doesn’t provide a cushion against bankruptcy: if you’re forced to default on your subordinated debt, you will be shut down and sold off, in one way or another. Which is why regulators and analysts started concentrating much more on tangible common equity (TCE) instead.

Public banks can increase their TCE just by issuing new stock; with privately-held banks it’s much harder. And, truth be told, it’s still going to be hard even if and when the new SecondMarket exchange in bank equity gets off the ground. It’s not designed for capital-raising operations; it’s just designed as a way for existing shareholders to be able to sell their stock. Which funnels money to the shareholders, but not to the bank.

Still, raising capital is always easier if the person providing the money has some kind of possible future exit. So it stands to reason that if a bank’s equity is trading on SecondMarket, potential participants in a capital raise will be more likely to take part, just because they know that they have a relatively easy way of selling that stock in the future.

And some of these banks are going to turn out to be spectacular investments. SecondMarket calls it “exposure to hyper-local economic growth,” with an embedded M&A option: if small banks continue to struggle and get eaten by their bigger competitors, shareholders at least generally get to charge a premium when they sell. More generally, banks can provide massive returns just by dint of their embedded leverage.

There are massive risks involved here, too, of course. There’s no guarantee that investors will be willing to buy when you want to sell. The bank could get into trouble with the FDIC and get taken over, wiping out all its equity. Boards of community banks tend not to be particularly independent. Small banks have been shrinking, as a sector, for years, and there’s no reason to believe they’re going to stop doing so, the occasional populist campaign notwithstanding. Etc. etc.

So the people investing in this market, quite rightly, are going to have to be accredited investors who can afford to lose their entire investment. And I’m a bit sad that the SecondMarket platform isn’t being tweaked a bit more, here: I’d love to see prices (but not the names of the buyers and sellers) being listed, in public, after every auction. After all, it’s not like the financial information about these banks is secret: go to the FDIC website, and you’ll find every last bit of information you could possibly want, on any bank in the country.

But still, anything which increases the universe of options available to the owners of small banks is going to help them at some level compete with the bigger banks. And that’s got to be a good thing.

Source: A Private Stock Market For Small Banks