In a recent announcement, Crescent Financial Bancshares (CRFN), holder of Crescent State Bank, announced the merger of ECB Bancorp (ECBE), 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 about 115%.
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 banks (NASDAQ:QABA) with the most successful consolidators having the most potential for both revenue and profit growth, while many of the smaller institutions languish.
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 multiples.
Why is this typical of what the future will hold?
First, the constant pressure of maintaining high regulatory capital ratios requires banks to reach certain efficiency ratios sooner rather than later to be profitable.
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 market(s),
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 ratios?
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 still unknown.
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 measured.
So What Is In Store For Community 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 attract capital.
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 $1 billion. 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 business loans. 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 foreseeable future.
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 book.
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 further out.
- The pressure on those banks with TARP funds will continue to grow.
- 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.
Disclosure: 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.